Calypso Music, Inc. v. Commissioner ( 2000 )

T.C. Memo. 2000-293
UNITED STATES TAX COURT
CALYPSO MUSIC INCORPORATED, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12683-99. Filed September 20, 2000.
P was incorporated by K. K is a motion picture
music editor and P’s sole shareholder, director, and
officer. P contracted with motion picture studios for
K’s services as a music editor. Each of the contracts
was memorialized, in part, by a “loan-out agreement” or
a “deal memorandum”. Each contract made specific
reference to the services of K.
R determined P was a personal holding company as
defined in sec. 542 I.R.C. for its 1996 and 1997
taxable years. R also determined that P was liable for
accuracy related penalties under sec. 6662(a) I.R.C..
Held: P was a personal holding company for its
taxable years of 1996 and 1997.
Held, further: P in good faith and reasonably
relied on the return preparers for the position taken
on its returns and is not liable for penalties under
sec. 6662(a) I.R.C. pursuant to sec. 6664(c) I.R.C..
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Patrick E. McGinnis, for petitioner.
Jonathan H. Sloat, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Respondent determined deficiencies of $10,565
and $18,226 in petitioner’s personal holding company tax for 1996
and 1997, respectively. Respondent also determined accuracy-
related penalties under section 6662(a)1 of $2,113 and $3,6452
for 1996 and 1997 respectively. We must decide whether
petitioner is subject to the personal holding company tax imposed
by section 541 for its taxable years ending January 31, 1996, and
1997. Secondly, we must decide whether petitioner is liable for
the accuracy-related penalty pursuant to section 6662(a) for each
of those years.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of fact and attached exhibits are incorporated
herein by this reference. Petitioner’s principal place of
business was in the State of California when the petition was
filed.
1
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years in issue. Rule
references are to the Tax Court Rules of Practice and Procedure.
2
Dollar amounts are rounded to the nearest whole dollar.
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Daryl Kell is a highly regarded and eminently qualified
music editor. Petitioner, through Daryl Kell, rendered music
editing services for productions of feature films, television
movies, and programs. The music editing service that petitioner
provides involves the rental and use of petitioner’s computer
equipment. Music editing is an artistic and technical
undertaking requiring judgment, artistic ability, and discretion.
Daryl Kell's work as a music editor for petitioner’s clients
requires creative decision making. Music editing is a
collaborative effort by all involved in a given production and
involves forming very close relationships between music editors
and those with whom they work.
Petitioner had taxable years ending on January 31 for each
year in issue. At all times during the taxable years in issue,
Daryl Kell owned 100 percent of petitioner’s stock, and he was
petitioner’s sole officer and director. Other than officer’s
compensation paid to Daryl Kell, petitioner paid no salary or
compensation to employees.
The International Alliance of Theatrical and Stage Employees
(IATSE) is a union. In the productions in which petitioner was
involved music editors were required to be members of IATSE.
Daryl Kell was a member of IATSE. In order to employ a music
editor who was a member of IATSE the employer was required to be
a signatory to the IATSE agreement. Petitioner was not a
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signatory company to the IATSE agreement.
Petitioner’s music editing services were provided to the
studios in accordance with a deal memorandum or a loan-out
agreement which memorialized some of the terms of those
contracts. Daryl Kell’s personal services as a music editor were
specifically designated as required in the deal memorandum and
loan-out agreement. The loan-out agreement and deal memorandum
provide that Daryl Kell "render music editorial services,
whenever and wherever the producer may require." The payments
made to petitioner were supplemented by payments to IATSE for
benefits accruing to Daryl Kell under the IATSE agreement.
Petitioner's general ledgers were prepared by Jessica
Shields-Hamper. Jessica Shields-Hamper is petitioner's and Daryl
Kell's agent. Petitioner’s 1996 tax return was prepared by
Robert Fogelman, C.P.A. Petitioner’s 1997 return was prepared by
Steven McNulty of Feddersen & Co. C.P.A.(s).
For the 1996 tax year, petitioner reported total income of
$133,977, of which the following amounts were for music editing
services:
Film Editing Income
Fair Game $70,227
Moll Flanders 28,955
Other editing income 10,415
Total 109,597
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For the 1997 tax year, petitioner reported total income of
$282,124, of which the following amounts were for music editing
services:
Film Editing Income
Kazaam $75,629
The Associate 71,722
Breakdown 65,694
Moll Flanders 1,063
Other editing income 8,350
Total 222,458
Petitioner's general ledgers for the 1996 and 1997 tax years
reflect amounts received by petitioner from the studios for the
rental of music editing equipment owned by petitioner. For the
1996 and 1997 tax years, petitioner received rental income in the
amounts of $24,400 and $68,100, respectively.3
OPINION
The personal holding company tax was originally enacted in
1934 to remedy the effects of the "incorporated pocket book" and
“incorporated talent” which served to avoid the higher tax rates
imposed on individuals. Cedarburg Canning Co. v. Commissioner,
149 F.2d 526, 528 (7th Cir. 1945), affg. a Memorandum Opinion of
this Court. The purpose of the tax is to force corporations to
distribute personal holding company income through the imposition
of a tax in addition to the ordinary income tax imposed upon the
3
We have been unable to reconcile petitioner’s 1997 ledgers
which show editing income of $222,458 and rental income of
$68,100 totaling $290,557 with petitioner’s tax return which
shows gross sales of $281,746.
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corporation. See Fulman v. United States, 434 U.S. 528, 531
(1978). The additional tax is imposed by section 541, which
provides:
In addition to other taxes imposed by this
chapter, there is hereby imposed for each taxable year
on the undistributed personal holding company income
(as defined in section 545) of every personal holding
company (as defined in section 542) a personal holding
company tax equal to 39.6 percent of the undistributed
personal holding company income.
A corporation is a personal holding company if two
requirements are satisfied. See sec. 542(a). Those two
requirements have been described as the "stock ownership" and
"tainted income" tests. See Kenyatta Corp. v. Commissioner, 86
T.C. 171 (1986), affd. 812 F.2d 577 (9th Cir. 1987). The "stock
ownership" test is satisfied if "At any time during the last half
of the taxable year more than 50 percent in value of * * * [the
corporation's] outstanding stock is owned, directly or
indirectly, by or for not more than 5 individuals." Sec.
542(a)(2). The "tainted income" test is satisfied where "At
least 60 percent of [the corporation's] adjusted ordinary gross
income (as defined in section 543(b)(2)) for the taxable year is
personal holding company income (as defined in section 543(a))".
Sec. 542(a)(1). Section 543(a), which defines personal holding
company income, provides in pertinent part:
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SEC. 543(a) General Rule.--
For purposes of this subtitle, the term “personal
holding company income” means the portion of the
adjusted ordinary gross income which consists of:
* * * * * * *
(2) Rents.–The adjusted income from rents;
* * * * * * *
(7) Personal service contracts.--
(A) Amounts received under a contract under
which the corporation is to furnish
personal services; if some person other
than the corporation has the right to
designate (by name or by description) the
individual who is to perform the services,
or if the individual who is to perform the
services is designated (by name or by
description) in the contract; and
(B) amounts received from the sale or other
disposition of such a contract.
This paragraph shall apply with respect to
amounts received for services under a particular
contract only if at some time during the taxable
year 25 percent or more in value of the
outstanding stock of the corporation is owned,
directly or indirectly, by or for the individual
who has performed, is to perform, or may be
designated (by name or by description) as the
one to perform, such services.
At all material times, Daryl Kell owned all of the shares
in petitioner. We therefore find that the stock ownership
requirement of section 542(a)(2) was met for both the 1996 and
1997 tax years.
Next, we must determine whether the “tainted income”
requirement of section 542(a)(1) has also been met. At least
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60 percent of petitioner’s adjusted ordinary gross income4 for
the taxable year must be personal holding company income to
satisfy this requirement. Petitioner’s adjusted ordinary gross
income for 1996 and 1997 tax years was $133,977 and $282,124
respectively.
In pertinent part, section 543(a)(7) provides that
petitioner’s income from the performance of a contract for
music editing services will be personal holding company income
if the individual who is to perform the services is designated
(by name or by description) in the contract and at some time
during the taxable year 25 percent or more in value of the
outstanding stock of the corporation is owned, directly or
indirectly, by or for the individual who has performed, is to
perform, or may be designated (by name or by description) as
the one to perform, such services.
In the 1996 taxable year $99,182 was received by
petitioner for the editing services of Daryl Kell on the
pictures Fair Game and Moll Flanders. The loan-out agreement
and deal memoranda for these two pictures specifically
4
“Adjusted ordinary gross income” is defined in sec. 543(b)
as gross income minus gains from the sale or other disposition of
capital assets or sec. 1231(b) assets, and minus depreciation,
taxes, interest, and rent incurred in connection with certain
rental income and mineral royalties. In the instant case,
petitioner's adjusted ordinary gross income would equal its gross
income.
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designate Daryl Kell to perform the editing services.5 In the
1997 taxable year $214,106 was received by petitioner for the
editing services of Daryl Kell on the pictures Kazaam, The
Associate, Breakdown, and Moll Flanders. The deal memoranda
for these pictures also specifically designate Daryl Kell to
perform the editing services.6 In the 1996 and 1997 taxable
years Daryl Kell, the individual designated to perform the
services for petitioner, owned more than 25 percent of the
shares in petitioner. Therefore, we find that the income
received from the enumerated motion picture contracts was
personal holding company income. See Kenyatta Corp. v.
Commissioner, supra at 184 (and cases cited therein).
5
The deal memorandum for Fair Game provides: “EMPLOYER
[Petitioner] hereby lends to PRODUCER [Warner Bros.] the
exclusive services of EMPLOYEE [Daryl Kell]”. The deal
memorandum for Moll Flanders provides: “Daryl Kell will provide
music editing services for O’Trilogy Productions”. Additionally
the Executive Vice President-Post production of Warner Bros.
testified that Daryl Kell was the only person to perform the
required services under the loan-out agreement.
6
The deal memorandum for Kazaam provides: “Daryl B.
Kell/Calypso Music Inc. will provide music editing services for
Interscope Communications * * *”; “Daryl Kell will render music
editorial services”. The deal memorandum for The Associate
provides: “Daryl B. Kell/Calypso Music Inc. will provide music
editing services for Interscope Communications * * *”; “Daryl
Kell will render music editorial services”. The deal memorandum
for Breakdown provides: “Daryl Kell (Editor) Calypso Music, Inc.
(Lender) will provide music editing services to Dino DeLaurentiis
Co. (Producer)”; “Editor [Daryl Kell] will render music editorial
services”. The deal memorandum for Moll Flanders provides:
“Daryl Kell will provide music editing services for O’Trilogy
Productions”.
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The income received for editing services for Fair Game and
Moll Flanders, personal holding company income, constitutes 74
percent of petitioner’s adjusted ordinary gross income in the
1996 taxable year. The income received for editing services
for Kazaam, The Associate, Breakdown, and Moll Flanders,
personal holding company income, amounts to 76 percent of
petitioner’s adjusted ordinary gross income for 1997.
For the 1996 and 1997 tax years, petitioner’s ledgers
indicate it received rental income in the amounts of $24,400
and $68,100 respectively. Respondent determined that these
amounts constitute personal holding company income as defined
in section 542(a)(2). Respondent’s determination is entitled
to a presumption of correctness; petitioner bears the burden of
proof to establish the determination is in error. See Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
Petitioner advances no meaningful argument on brief that
respondent’s determination is erroneous. We therefore find
that the rental income in the years in issue is personal
holding company income.
We hold that petitioner is a personal holding company, as
defined in section 542, for the 1996 and 1997 taxable years.
As a consequence, petitioner is liable for personal holding
company tax, imposed by section 541, equal to 39.6 percent of
the undistributed personal holding company income for each of
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the years in issue.
Respondent determined that petitioner was liable for an
accuracy-related penalty, under section 6662(a) and (b)(1) or
(2), for negligence or intentional disregard of rules and
regulations or substantial understatement of income tax.
Petitioner argues that it is not so liable. Petitioner asserts
that a certified public accountant prepared its returns and
that the accountant had access to all of the materials now
before the Court. Petitioner argues that it reasonably relied
on professional advice in preparing its returns and therefore
should not be held liable for the accuracy-related penalty.
Section 6662(a) imposes a 20-percent accuracy-related
penalty on the portion of an underpayment that is due to one or
more of the causes enumerated in section 6662(b). Respondent
relies on subsections (b)(1) (negligence or intentional
disregard of rules or regulations) and/or (b)(2) (substantial
understatement of income tax).
Negligence includes a failure to attempt reasonably to
comply with the Code. See sec. 6662(c). Disregard includes a
careless, reckless, or intentional disregard. See id.
A substantial understatement of income tax is defined to
be the greater of 10 percent of the income tax required to be
shown on the return for the taxable year or $5,000. See sec.
6662(d). In the instant case $5,000 is the greater amount for
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the 1996 and 1997 taxable years. Respondent determined
understatements of tax of $10,565 and $18,226 for the 1996 and
1997 taxable years, respectively.
No penalty shall be imposed, however, for either
negligence or intentional disregard of rules or regulations or
a substantial understatement of income tax to the extent that
the taxpayer shows that the underpayment is due to the
taxpayer's reasonable cause and good faith. See sec. 6664(c);
secs. 1.6662-3(a), 1.6664-4(a), Income Tax Regs.
Reasonable cause requires that the taxpayer have exercised
ordinary business care and prudence as to the disputed item.
See United States v. Boyle, 469 U.S. 241 (1985); see also
Estate of Young v. Commissioner, 110 T.C. 297, 317 (1998). The
good faith, reasonable reliance on the advice of an
independent, competent professional as to the tax treatment of
an item may meet this requirement. See United States v. Boyle,
supra; sec. 1.6664-4(b), Income Tax Regs.; see also Ewing v.
Commissioner, 91 T.C. 396, 423 (1988), affd. without published
opinion 940 F.2d 1534 (9th Cir. 1991).
Whether a taxpayer relies on advice and whether such
reliance is reasonable hinge on the facts and circumstances of
the case and the law that applies to those facts and
circumstances. See sec. 1.6664-4(c)(i), Income Tax Regs. A
professional may render advice that may be relied upon
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reasonably when he or she arrives at that advice independently,
taking into account, among other things, the taxpayer's
purposes for entering into the underlying transaction. See
sec. 1.6664-4(c)(i), Income Tax Regs.; see also Leonhart v.
Commissioner, 414 F.2d 749 (4th Cir. 1969), affg. T.C. Memo.
1968-98. Reliance may be unreasonable when it is placed upon
insiders, promoters, or their offering materials, or when the
person relied upon has an inherent conflict of interest that
the taxpayer knew or should have known about. See Goldman v.
Commissioner, 39 F.3d 402 (2d Cir. 1994), affg. T.C. Memo.
1993-480; LaVerne v. Commissioner, 94 T.C. 637, 652-653 (1990),
affd. without published opinion 956 F.2d 274 (9th Cir. 1992),
affd. in part without published opinion sub nom. Cowles v.
Commissioner, 949 F.2d 401 (10th Cir. 1991). Reliance also is
unreasonable when the taxpayer knew, or should have known, that
the adviser lacked the requisite expertise to opine on the tax
treatment of the disputed item. See sec. 1.6664-4(c), Income
Tax Regs.
In sum, for a taxpayer to rely reasonably upon advice so
as possibly to negate a section 6662(a) accuracy-related
penalty determined by the Commissioner, the taxpayer must prove
by a preponderance of the evidence that the taxpayer meets each
requirement of the following three-prong test: (1) The adviser
was a competent professional who had sufficient expertise to
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justify reliance, (2) the taxpayer provided necessary and
accurate information to the adviser, and (3) the taxpayer
actually relied in good faith on the adviser's judgment. See
Ellwest Stereo Theatres, Inc. v. Commissioner, T.C. Memo. 1995-
610; see also Rule 142(a).
We have no doubt on the record before us that Daryl Kell,
petitioner’s only officer, actually relied in good faith on the
certified public accountants who prepared the returns. We note
that the 1996 and 1997 returns were prepared by different firms
of public accountants.7 Petitioner was justified in its
reliance on its advisers. We find credible Mr. Kell’s
testimony that he made available all necessary information to
the return preparers. In this circumstance, we shall not
sustain respondent’s determination of the accuracy-related
penalties.
Accordingly,
Decision will be entered
under Rule 155.
7
Respondent argues petitioner did not offer the testimony
of its return preparers, Robert Fogleman and Steven McNulty. The
failure to introduce the testimony of the return preparers which
if true would have been favorable to petitioner, gives rise to
the presumption that such testimony would not have been
favorable. See Wichita Terminal Elevator Co. v. Commissioner, 6
T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th Cir. 1947).
Having found Mr. Kell’s testimony in this regard credible, we
find the presumption overcome.
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