Dennis L. and Sharon E. Hayden v. Commissioner ( 1999 )

112 T.C. No. 11
UNITED STATES TAX COURT
DENNIS L. HAYDEN AND SHARON E. HAYDEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 590-98. Filed March 19, 1999.
Ps are the sole partners in L. During 1994, L expended
$26,650 on sec. 179 property and elected to expense $17,500
of that amount. Without regard to this deduction, L had no
taxable income for the 1994 taxable year. The deduction
under sec. 179 flowed through to Ps' 1994 return. Sec.
1.179-2(c)(2), Income Tax Regs., provides that a
"partnership may not allocate to its partners as a sec. 179
expense deduction for any taxable year more than the
partnership's taxable income limitation for that taxable
year". Ps contend that the regulation is invalid. Held:
Sec. 1.179-2(c)(2), Income Tax Regs., is valid and
respondent's disallowance of the deduction is sustained.
Dennis L. Hayden and Sharon E. Hayden, pro se.
Brian M. Harrington, for respondent.
OPINION
DAWSON, Judge: This case was assigned to Special Trial
Judge Carleton D. Powell pursuant to section 7443A(b)(3) and
- 2 -
Rules 180, 181, and 182.1 The Court agrees with and adopts the
opinion of the Special Trial Judge that is set forth below.
OPINION OF THE SPECIAL TRIAL JUDGE
POWELL, Special Trial Judge: Respondent determined a
deficiency in petitioners' 1994 Federal income tax and an
accuracy-related penalty under section 6662(a) in the respective
amounts of $3,784 and $292.60.
The issues are whether petitioners are entitled to a
deduction in the amount of $17,500 under section 179 and whether
petitioners are liable for the accuracy-related penalty under
section 6662(a). At the time the petition was filed in this
case, petitioners resided in Frankfort, Indiana.
The facts may be summarized as follows. Petitioners are the
sole partners in a partnership known as Leddos Frozen Yogurt, LLC
(Leddos) that commenced operations on September 1, 1994. During
1994, Leddos purchased equipment for $26,650. On the partnership
return (Form 1065), Leddos reported the following:
Gross Receipts $20,105
Cost of Goods Sold 22,529
Total Income (loss) (2,424)
The partnership reported total deductions in the amount of
$13,294, and showed a loss in the amount of $15,718. These
figures did not include any deduction for the expense of section
179 property. On Form 4652 (Depreciation and Amortization),
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
- 3 -
attached to the partnership return, Leddos elected under section
179 to expense $17,500 of the $26,650 invested in equipment.
This deduction flowed through to petitioners' 1994 Federal income
tax return on Schedule E.2
Petitioner Dennis L. Hayden (petitioner) is a certified
public accountant whose practice includes a substantial amount of
tax work. Petitioner operated and practiced an accounting
business as a sole proprietorship. The proprietorship has
employees and maintains an account for "payroll" taxes that
includes employment taxes paid to the Federal Government. During
the 1994 taxable year, petitioner paid petitioners' 1993 Federal
income tax liability in the amount of $9,284 from the bank
account of the proprietorship, and that amount was charged to the
sole proprietorship's account for "payroll" taxes. On the
proprietorship's Schedule C attached to petitioners' joint 1994
Federal income tax return, petitioner deducted $17,630 as
"payroll" taxes, which amount included petitioners' 1993 Federal
income tax liability of $9,284. The correct amount of the
"payroll" taxes paid by the accounting practice for 1994 was
$8,346.
Upon examination, respondent disallowed the $17,500 section
179 deduction and the portion of the deduction claimed on
Schedule C that was expended for Federal income taxes.
Respondent further determined an accuracy-related penalty was due
2
Leddos qualifies as a so-called small partnership under
sec. 6231(a)(1)(B), and the partnership provisions of secs. 6221
through 6233 do not apply.
- 4 -
on the underpayment resulting from disallowance of the portion of
the Schedule C deduction expended for Federal income taxes.
1. Section 179
Section 179(a) provides:
A taxpayer may elect to treat the cost of any section 179
property as an expense which is not chargeable to capital
account. Any cost so treated shall be allowed as a
deduction for the taxable year in which the section 179
property is placed in service.
Under section 179(b)(1), the deduction is limited, inter alia, to
$17,500 and "shall not exceed the aggregate amount of taxable
income of the taxpayer for such taxable year which is derived
from the active conduct by the taxpayer of any trade or business
during such taxable year." Sec. 179(b)(3)(A). For purposes of
section 179(b)(3)(A), taxable income is computed without regard
to the section 179 deduction. See sec. 179(b)(3)(C). Section
179(d)(8) further provides: "In the case of a partnership, the
limitations of subsection (b) shall apply with respect to the
partnership and with respect to each partner." The regulations
amplify:
The taxable income limitation * * * applies to the
partnership as well as to each partner. Thus, the
partnership may not allocate to its partners as a section
179 expense deduction for any taxable year more than the
partnership's taxable income limitation for that taxable
year, and a partner may not deduct as a section 179 expense
deduction for any taxable year more than the partner's
taxable income limitation for that taxable year. [Sec.
1.179-2(c)(2), Income Tax Regs.]
Petitioners acknowledge that under section 1.179-2(c)(2), Income
Tax Regs., the section 179 deduction claimed here is not
allowable. They argue, however, that the regulation is invalid.
- 5 -
A Treasury regulation must be sustained if it "[implements]
the congressional mandate in some reasonable manner." United
States v. Vogel Fertilizer Co., 455 U.S. 16, 24 (1982) (quoting
United States v. Correll, 389 U.S. 299, 307 (1967)). The "issue
is not how the Court itself might construe the statute [to which
the regulation relates] in the first instance, 'but whether there
is any reasonable basis for the resolution embodied in the
Commissioner's Regulation.'" Schaefer v. Commissioner, 105 T.C.
227, 230 (1995) (quoting Fulman v. United States, 434 U.S. 528,
536 (1978)). Normally, "Treasury regulations must be sustained
unless unreasonable and plainly inconsistent with the revenue
statutes". Commissioner v. South Texas Lumber Co., 333 U.S. 496,
501 (1948).
The Code section primarily involved here is section
179(b)(3)(A) and (d)(8), which is directed to the limitations in
the case of partnerships. For purposes here, these limitations
have two sources.
The genesis of section 179 is section 204(a), The Small
Business Tax Revision Act of 1958, Pub. L. 85-866, 72 Stat. 1606,
1676, that provided a deduction for an additional first-year
depreciation. There was a $10,000 ($20,000 for joint returns)
limitation on the cost of the property subject to the additional
depreciation. That statute did not provide any limitation on
partners. Section 179(d)(8), relating to partnership
limitations, first appeared in the Tax Reform Act of 1976, Pub.
L. 94-455, sec. 213(a), 90 Stat. 1525, 1547. The legislative
- 6 -
history provides that "with respect to a partnership, the cost of
the property on which additional first-year depreciation is
calculated for the partnership as a whole is not to exceed
$10,000." S. Rept. 94-938, at 92 (1976), 1976-3 C.B. (Vol. 3)
49, 130. Section 179 was amended again by the Economic Recovery
Tax Act of 1981, Pub. L. 97-34, sec. 202(a), 95 Stat. 172, to
provide for an election to expense the cost of property rather
than taking additional depreciation), and that provision did not
amend section 179(d)(8). The committee report states:
Similarly, the same type of dollar limitations will
apply in the case of partnerships as currently apply under
section 179(d)(8). Under the committee bill, as under
section 179, both the partnership and each partner are
subject to the annual dollar limitation. [S. Rept. 97-144,
at 61 (1981), 1981-2 C.B. 412, 431.]
The taxable income limitation contained in current section
179(b)(3)(A) was added by the Tax Reform Act of 1986, Pub. L. 99-
514, sec. 202(a), 100 Stat. 2085, 2143. While the Senate version
of the taxable income limitation of section 202(a) was limited to
taxable income of the business in which property was used, see S.
Rept. 99-313, at 106 (1986), 1986-3 C.B. (Vol. 3) v, 106),
section 179(b)(3), as enacted, applied to taxable income from any
trade or business of the taxpayer. See H. Conf. Rept. 99-841, at
II-49 (1986), 1986-3 C.B. (Vol. 4) 1, 49; see also Staff of Joint
Comm. on Taxation, General Explanation of the Tax Reform Act of
1986 (Jt. Comm. Print 1987), at 109. Concurrently, section
179(d)(8), pertaining to partnerships, was amended to read as it
does now by the Tax Reform Act of 1986, Pub. L. 99-514, sec.
201(d)(3), 100 Stat. 2085, 2139.
- 7 -
Petitioners contend that, since for purposes of the section
179(b)(3)(A) limitation they may aggregate taxable incomes from
their different trades or businesses, they should be able to
aggregate their taxable income with the income of the partnership
under section 179(d)(8) to determine the partnership's taxable
income. In this regard, petitioners argue that section
179(b)(3)(A) applies only to the taxable income "of the taxpayer"
derived from the trade or business "by the taxpayer".
Petitioners contend that under section 701 a partnership is not a
taxpayer; therefore, that section cannot apply to a partnership.
The taxable income limitation in section 179(b)(3)(A) is,
therefore, meaningless when applied to a partnership, and section
1.179-2(c)(2), Income Tax Regs., is accordingly invalid.
The gravamen of petitioners' argument is that a partnership
is not a taxpayer under the definition contained in section
7701(a)(14). It should be noted initially that this is literally
incorrect. A taxpayer is defined as "any person subject to any
internal revenue tax." Sec. 7701(a)(14). In turn, a person
"shall be construed to mean and include * * * [inter alia] a
* * * partnership". Sec. 7701(a)(1). Under section 701 a
partnership generally is not "subject to the income tax", rather
the partners are "liable for income tax only in their separate or
individual capacities." But, a partnership may be subject to a
variety of internal revenue taxes, including, e.g., employment
taxes under section 3111(a) (United States v. Hays, 877 F.2d 843- 8 -
(10th Cir. 1989)) or other excise taxes (Young v. Riddell, 283
F.2d 909 (9th Cir. 1960)).
Equally important, the terms such as "taxpayer" and
"partnership" have certain elastic applications within the
Internal Revenue Code. While a partnership generally is not
subject to income taxes, concepts such as taxable income are
fully applicable. Section 703(a) provides that with exceptions
"The taxable income of a partnership shall be computed in the
same manner as in the case of an individual". In United States
v. Basye, 410 U.S. 441, 448 (1973), the Supreme Court noted for
the purpose of computing taxable income that "the partnership is
regarded as an independently recognizable entity apart from the
aggregate of its partners."
There are many examples of the term "partnership" being used
in place of the word "taxpayer" or other similar designations.
Section 446(a) provides: "Taxable income shall be computed under
the method of accounting on the basis of which the taxpayer
regularly computes his income in keeping his books." (Emphasis
added.) For purposes of section 446, however, the "taxpayer" is
the partnership. See Resnik v. Commissioner, 66 T.C. 74, 80
(1976), affd. per curiam 555 F.2d 634 (7th Cir. 1977). Section
1033(a)(2)(A) provides that "at the election of the taxpayer" a
gain may not be recognized. (Emphasis added.) For section 1033
purposes, when a partnership is involved, the taxpayer is the
partnership. See Demirjian v. Commissioner, 457 F.2d 1, 5 (3d
Cir. 1972), affg. 54 T.C. 1691 (1970). Section 183(a) (regarding
- 9 -
not for profit activities) speaks in terms of "an individual or
an S corporation", but, when a partnership is involved, the so-
called for profit analysis focuses on the partnership and not the
individual. See Fox v. Commissioner, 80 T.C. 972, 1006 (1983),
affd. without published opinion 742 F.2d 1441 (2d Cir. 1984),
affd. sub nom. Barnard v. Commissioner, 731 F.2d 230 (4th Cir.
1984). In this regard, it should be noted that the election in
section 179(a) is phrased in terms of a "taxpayer may elect".
Surely petitioners would not contend that an election may not be
made for property in a business conducted by a partnership. For
purposes of section 179(b)(3)(A), a partnership is a taxpayer.
It becomes apparent then that petitioners' dissatisfaction
is not with the regulation per se, but rather with the
incorporation of the section 179(b)(3)(A) limitation in section
179(d)(8). Thus, if we were to hold for petitioners, we would
have to read the section 179(b)(3)(A) limitation out of section
179(d)(8). This we cannot do. Section 179(d)(8) specifically
states: "In the case of a partnership, the limitations of
subsection (b)" apply to the partnership and the partners. It
does not say that only subsection (b)(1) and (2) shall apply. See
Green v. Commissioner, T.C. Memo. 1998-356 (applying section
179(b)(3)(A) to an "S" corporation).
At trial petitioners also seemed to argue that the term
"taxable income" as used in section 179(b)(3)(A) should be
interpreted to mean gross receipts of the trade or business
carried on as a partnership. This argument has no basis in law.
- 10 -
"'[T]axable income' means gross income minus the deductions
allowed". Sec. 63(a). Gross income is derived from gross
receipts less cost of goods sold. See Beatty v. Commissioner,
106 T.C. 268, 273 (1996); sec. 1.61-3(a), Income Tax Regs.
Furthermore, as pointed out above, the determination of the
taxable income of a partnership is essentially the same as with
an individual. Sec. 703(a). There is no indication that in
enacting the taxable income limitation in section 179(b)(3)(A)
Congress did not understand and intend these terms to have their
settled meaning.
In short, section 1.179-2(c)(2), Income Tax Regs., flows
directly from the requirements of section 179(b)(3)(A) and
(d)(8), is consistent with the statutes and their legislative
histories, and is valid. Therefore, respondent's determination
on this issue is sustained.
2. Section 6662-Penalty
Section 6662(a) imposes a penalty with respect "to any
portion of an underpayment of tax required to be shown on a
return" which is attributable to negligence or disregard of rules
or regulations. Sec. 6662(b)(1). The penalty is in an amount
"equal to 20 percent of the portion of the underpayment to which
this section applies." Sec. 6662(a).
Petitioners claimed on Schedule C a deduction in the amount
of $17,630 as "payroll taxes". Of that amount, $9,284 was
payment made for petitioners' 1993 Federal income tax liability.
Section 275(a)(1) provides: "No deduction shall be allowed for *
- 11 -
* * Federal income taxes". Petitioners do not dispute that the
deduction of $9,284 is not allowable. The deduction is clearly
prohibited by statute, and petitioner was aware that Federal
income taxes cannot be deducted.
"Negligence is a lack of due care or the failure to do what
a reasonable and ordinarily prudent person would do under the
circumstances." Freytag v. Commissioner, 89 T.C. 849, 887 (1987)
(quoting Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir.
1967), affg. on this issue 43 T.C. 168 (1964) and T.C. Memo.
1964-299, cert. denied 389 U.S. 1004 (1968)), affd. 904 F.2d 1011(5th Cir. 1990), affd. on other grounds 501 U.S. 868 (1991). The
question then is whether petitioner has established that his
conduct meets the reasonable or prudent person standard. See
Rule 142(a); see also Freytag v. Commissioner, 89 T.C. at 887.
Petitioner argues that the deduction was the result of a
reasonable mistake caused by an employee who erroneously posted
the amount of the check(s) to pay Federal income taxes to the
"payroll" account. We may agree that the posting mistake of the
employee was understandable, but we have difficulty with
petitioner's explanation. Petitioner either prepared or directly
supervised the preparation of the 1994 tax return. He is an
accountant, and a large part of his business related to tax
matters. The $9,284 in income taxes deducted as "payroll" taxes
constitutes approximately 17 percent of the taxable income of the
accounting practice. Moreover, it represents 53 percent of the
deduction claimed for "payroll" taxes. These are not
- 12 -
insignificant figures, and we find it hard to believe that, when
preparing or supervising the preparation of the return,
petitioner would not have questioned the deduction of this size.
This is particularly true because petitioner was aware that his
Federal income taxes had been paid from the bank account used for
the accounting practice, a practice which in and of itself is
suspect. Either he closed his eyes to the facts, or he simply
did not properly supervise the preparation of the return.
Petitioner has not established that he was not negligent.
Therefore, respondent's determination as to the accuracy-related
penalty under section 6662(a) is sustained.
Decision will be entered
for respondent.