Stephen R. Kelley & Isabelle Kelley ( 2023 )

United States Tax Court
T.C. Memo. 2023-126STEPHEN R. KELLEY AND ISABELLE KELLEY,
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
__________
Docket No. 15069-19. Filed October 23, 2023.
__________
Stephen R. Kelley and Isabelle Kelley, pro sese.
Robert P. Brown, Peter N. Tran, and Gordon P. Sanz, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COPELAND, Judge: Petitioners, Stephen and Isabelle Kelley,
reported zero gross income and zero taxable income on their 2017 joint
federal income tax return. On the basis of third-party information
returns indicating that the Kelleys received taxable income in 2017, the
Commissioner of Internal Revenue (Commissioner) determined a
deficiency and, in his Answer, asserted an accuracy-related penalty
under section 6662(a) and (b)(1) 1 for negligence or disregard of rules or
regulations. At trial and on brief, the Kelleys contested the procedural
validity of the notice of deficiency, the legal accuracy of the information
returns, the Commissioner’s grounds for the penalty, and whether the
penalty was properly authorized.
1 Unless otherwise indicated, statutory references are to the Internal Revenue
Code, Title 26 U.S.C. (I.R.C. or Code), in effect at all relevant times, regulation
references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all
relevant times, and Rule references are to the Tax Court Rules of Practice and
Procedure. Some dollar amounts are rounded.
Served 10/23/23
2
[*2] FINDINGS OF FACT
The Kelleys were residents of Texas when they timely filed their
Petition.
Mr. and Mrs. Kelley each hold master’s degrees in geology and
worked as geologists in 2017. Mr. Kelley worked for Sanchez Oil and
Gas Corp. (Sanchez Oil & Gas), Mrs. Kelley for Core Laboratories LP
(Core Labs). Mr. Kelley received $176,273 in compensation from
Sanchez Oil & Gas in 2017, from which $42,135 was withheld for federal
income tax. Sanchez Oil & Gas reported this information to Mr. Kelley
and the Internal Revenue Service (IRS) using Form W–2, Wage and Tax
Statement. Mrs. Kelley received $149,763 in compensation from Core
Labs in 2017, from which $33,610 was withheld for federal income tax.
Core Labs reported this information to Mrs. Kelley and the IRS using
Form W–2. Mrs. Kelley also received $817 in qualified dividends from
Core Labs in 2017. These dividends were received on Mrs. Kelley’s
behalf by Solium Capital LLC (Solium), which reported them to Mrs.
Kelley and the IRS using Form 1099–DIV, Dividends and Distributions.
On their timely filed joint 2017 Form 1040EZ, Income Tax Return
for Single and Joint Filers With No Dependents, the Kelleys reported
zero gross income, zero taxable income, and $96,290 in withholdings. 2
The Kelleys accordingly claimed a refund of $96,290. They attached to
their return two Forms 4852, Substitute for Form W–2, Wage and Tax
Statement, or Form 1099–R, Distributions From Pensions, Annuities,
Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,
reporting zero in “wages, tips, and other compensation” from Sanchez
Oil & Gas and Core Labs, respectively, but replicating the withholding
amounts for federal income tax and payroll taxes that Sanchez Oil &
Gas and Core Labs reported on the Forms W–2. On line 9 of their
respective Forms 4852 (asking how the taxpayer determined the
corrected amounts), Mr. and Mrs. Kelley wrote: “I did not receive any
‘wages’ as defined in IRC Section 3401(a) and 3121(a).” The Kelleys also
attached to their return a document titled “Statement to Correct
Incorrectly Reported 1099–DIV Information Return,” in which they
claimed that “[n]o dividends were received by [Mrs. Kelley] from
[Solium] which were connected with any ‘trade or business’ or otherwise
2 Line 7 of the 2017 Form 1040EZ reads: “Federal income tax withheld from
Form(s) W–2 and 1099.” The Kelleys crossed out “Federal income tax” and inserted
“All monies.” $96,290 is the sum of the federal income tax and payroll taxes (i.e., Social
Security tax and Medicare tax) withheld by Sanchez Oil & Gas and Core Labs from the
Kelleys’ 2017 compensation.
3
[*3] constituted gains, profits, or income within the meaning of relevant
law.”
On July 9, 2018, the IRS sent the Kelleys their claimed refund of
$96,290 plus interest. On May 28, 2019, the IRS issued to the Kelleys a
notice of deficiency, determining a $76,565 income tax deficiency 3 and a
$19,565 accuracy-related penalty for an underpayment due to a
substantial understatement of income tax (substantial understatement
penalty). See I.R.C. § 6662(a), (b)(2). The notice of deficiency based
these determinations on the Forms W–2 from Sanchez Oil & Gas and
Core Labs and the Form 1099–DIV from Solium. The first page of the
notice of deficiency lists an “AUR control number,” referring to the IRS’s
automated underreporter program (AUR), as further explained infra
p. 6.
In the Commissioner’s Answer to the Petition, he conceded that
the Kelleys are not liable for the substantial understatement penalty.
He represented that the IRS official who made the initial determination
to assess that penalty did not obtain the written supervisory approval
required by section 6751(b)(1). However, the Answer newly asserted an
accuracy-related penalty under section 6662(a) and (b)(1) for an
underpayment due to negligence or disregard of rules or regulations
(negligence/disregard penalty). The Answer was signed by both Yvette
Nunez, the IRS attorney initially assigned to the Kelleys’ case, and Paul
Feinberg, Ms. Nunez’s immediate supervisor at the time.
OPINION
I. Burden of Proof
Generally, the Commissioner’s determinations in a notice of
deficiency are presumed correct, and the taxpayer bears the burden of
proving that those determinations are erroneous. See Rule 142(a);
3 This deficiency amount appropriately does not include the payroll taxes
refunded to the Kelleys. See I.R.C. § 6211 (defining “deficiency” to encompass only
income, gift, estate, and certain excise taxes). Moreover, since this is a deficiency
proceeding, we do not have jurisdiction over those payroll taxes. See I.R.C. § 6214(a)
(granting the Tax Court “jurisdiction to redetermine the correct amount of the
deficiency” (emphasis added)); see also Ietto v. Commissioner, T.C. Memo. 1996-332, 72
T.C.M. (CCH) 166, 166 (“The United States Tax Court is a court of limited jurisdiction.
Generally, this jurisdiction is limited to income, estate, gift, and certain excise taxes
which are subject to the deficiency notice requirements of sections 6212(a) and 6213(a).
This Court has no jurisdiction over FICA [i.e., payroll] taxes imposed on an employee.”
(Citations omitted.)).
4
[*4] Welch v. Helvering, 290 U.S. 111, 115 (1933). In cases of unreported
income, the Commissioner must establish an evidentiary foundation
connecting the taxpayer with the income-producing activity or otherwise
demonstrate that the taxpayer actually received income. See Portillo v.
Commissioner, 932 F.2d 1128, 1133–34 (5th Cir. 1991), aff’g in part,
rev’g in part T.C. Memo. 1990-68; Walquist v. Commissioner, 152 T.C.
61, 67 (2019). Once the Commissioner makes the required threshold
showing, the burden typically shifts to the taxpayer to prove by a
preponderance of the evidence that the Commissioner’s determinations
are arbitrary or erroneous. See Portillo v. Commissioner, 932 F.2d at1133–34; Walquist, 152 T.C. at 67–68. The Commissioner’s threshold
showing generally must include “reasonable and probative information”
beyond a mere third-party information return, such as a Form W–2 or
Form 1099–DIV. See I.R.C. § 6201(d); see also Portillo v. Commissioner,
632 F.2d at 1134.
Even if the Commissioner makes the required threshold showing
with respect to an alleged item of unreported income, he will retain the
burden of proof with respect to that item if the taxpayer (1) introduces
credible evidence that he did not receive the income and (2) has
maintained all statutorily required records and cooperated with the
Commissioner. I.R.C. § 7491(a). Additionally, the Commissioner always
bears the initial burden of production with respect to any asserted
penalty against an individual. I.R.C. § 7491(c). Accordingly, the
Commissioner must come forward with sufficient evidence that it is at
least prima facie appropriate to impose the penalty. Higbee v.
Commissioner, 116 T.C. 438, 446 (2001). Moreover, in a case like this
one, where the Commissioner asserts a penalty in an answer (rather
than the notice of deficiency), the Commissioner bears the full burden of
proof regarding the penalty, including the taxpayer’s lack of reasonable
cause or any other applicable affirmative defense. See Rule 142(a)(1);
Estate of Hoensheid v. Commissioner, T.C. Memo. 2023-34, at *47; Full-
Circle Staffing, LLC v. Commissioner, T.C. Memo. 2018-66, at *42–43,
aff’d in part, appeal dismissed in part, 832 F. App’x 854 (5th Cir. 2020).
II. Procedural Validity of the Notice of Deficiency
The Kelleys raise the jurisdictional issue of whether the notice of
deficiency was validly issued, since it does not bear the name of any IRS
officer or employee. As we have repeatedly held, “[a] valid petition is
the basis of the Tax Court’s jurisdiction. To be valid, a petition must be
filed from a valid statutory notice.” Stamm Int’l Corp. v. Commissioner,
84 T.C. 248, 252 (1985) (first citing Midland Mortg. Co. v. Commissioner,
5
[*5] 73 T.C. 902, 907 (1980); and then citing McCue v. Commissioner,
1 T.C. 986, 988 (1943)).
Section 6212(a) authorizes the “Secretary” to send a notice of
deficiency if she “determines that there is a deficiency in respect of any
tax.” (Emphasis added.) (Section 7701(a)(11)(B) provides that the term
“Secretary,” as used in the Code, means “the Secretary of the Treasury
or [her] delegate.”) The U.S. Court of Appeals for the Fifth Circuit 4 has
indicated that such a determination means “a thoughtful and considered
determination that the United States is entitled to an amount not yet
paid.” Portillo v. Commissioner, 932 F.2d at 1132 (quoting Scar v.
Commissioner, 814 F.2d 1363, 1369 (9th Cir. 1987), rev’g 81 T.C. 855(1983)). The Fifth Circuit further indicated that “the word
‘determination’ irresistibly connotes consideration, resolution,
conclusion, and judgment.” Id. (quoting Terminal Wine Co. v.
Commissioner, 1 B.T.A. 697, 701 (1925)).
Section 7701(a)(12)(A) clarifies that the Secretary of the
Treasury’s (Secretary) powers may be delegated both directly and
“indirectly by one or more redelegations of authority.” The Secretary
has delegated the authority to determine deficiencies and to issue
notices of deficiency to the Commissioner and to IRS district directors,
directors of service centers, and regional directors of appeals. See Treas.
Reg. § 301.6212-1(a); Treas. Order 150-10 (Apr. 22, 1982). Moreover,
Treasury Regulation § 301.7701-9(c) authorizes the Commissioner to
redelegate these powers to other officers or employees under his
supervision and control and to authorize further delegation of these
powers by his delegates. The Commissioner has redelegated the
authority to issue notices of deficiency to various managers, directors,
and other officials of the IRS, identified by job title. See I.R.S. Deleg.
Order 4-8 (Rev. 1), Internal Revenue Manual (IRM) 1.2.43.9 (Sept. 4,
2012).
The notice of deficiency sent to the Kelleys does not list the name
of any IRS officer or employee but does bear an “AUR control number.”
4 This Court follows a court of appeals decision that is squarely in point if
appeal from our decision lies to that court of appeals alone. Golsen v. Commissioner,
54 T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971). Appeal of the present case
would lie exclusively to the Fifth Circuit, absent a stipulation by the parties to the
contrary. See I.R.C. § 7482(b)(1)(A).
6
[*6] See IRM 4.19.2 (Aug. 7, 2018) (“IMF Automated Underreporter
(AUR) Control”). 5 The IRM explains:
Potential AUR cases are systemically identified through
computer matching of tax returns with corresponding
Information Returns Master File (IRMF) payer
information documents. Cases are selected for inventory
in a manner determined to provide overall compliance
coverage. Selected cases undergo an in-depth review by a
tax examiner to identify underreported and/or over-
deducted issues which require further explanation to
resolve the discrepancy.
IRM 4.19.3.1.1 (Aug. 22, 2017).
The Kelleys point out that the AUR is not listed as a delegate in
Delegation Order 4-8. They further contend that computer algorithms
are not capable of “thoughtful and considered determination,” nor of
“consideration, resolution, conclusion, and judgment.” Portillo v.
Commissioner, 932 F.2d at 1132. However, the IRM specifies:
Tax examiners perform an in-depth analysis of each case
[flagged by the AUR] and determine if the discrepant
income or deduction(s) in question are satisfactorily
identified or addressed on the tax return. If so, they close
the case. If reasonable doubt remains, they send the
[taxpayer] either:
• An AUR Notice, CP 2000 or
• An Initial Contact Letter, CP 2501
IRM 4.19.3.2(11) (Dec. 15, 2017). By reason of the presumption of
regularity, we presume that the IRS followed these provisions of the
IRM when issuing to the Kelleys first a CP 2501, then a CP 2000, and
finally a notice of deficiency. 6 “The presumption of regularity supports
5 Citations of provisions of the IRM relating to the AUR are of those provisions
in effect when the notice of deficiency was issued (viz, May 28, 2019).
6 No CP 2501 is in the record. However, the record includes the first page of a
CP 2000 addressed to the Kelleys and dated March 11, 2019. The CP 2000 states in
part: “Thank you for your response to our previous notice. Based on your response,
we’ve determined you owe $122,392 . . . .” It is evident that the Kelleys had received a
prior notice and responded and that the Commissioner, through his authorized
delegates, considered their response before issuing the notice of deficiency.
7
[*7] the official acts of public officers and, in the absence of clear
evidence to the contrary, courts presume that they have properly
discharged their official duties.” United States v. Chem. Found., Inc.,
272 U.S. 1, 14–15 (1926). A corollary principle is that “all necessary
prerequisites to the validity of official action are presumed to have been
complied with, and that where the contrary is asserted it must be
affirmatively shown.” Lewis v. United States, 279 U.S. 63, 73 (1929); see
also Harriss v. Commissioner, T.C. Memo. 2021-31, at *10. Given these
presumptions, we find by a preponderance of the evidence that the
notice of deficiency sent to the Kelleys reflected a “thoughtful and
considered determination,” made by a duly authorized delegate of the
Secretary, that the Kelleys understated the amount of tax due on their
2017 return.
We thus hold that the notice of deficiency is valid and that we
have jurisdiction over this case.
III. 2017 Gross Income
The Kelleys do not dispute receiving the amounts reported on the
Forms W–2 from Sanchez Oil & Gas and Core Labs and the Form 1099–
DIV from Solium. The Kelleys do not dispute that the payments from
Sanchez Oil & Gas and Core Labs were made in exchange for the
Kelleys’ labor, nor that the payments reported by Solium were corporate
dividends. They make no contention that any of these amounts
constituted a gift, a loan repayment, or any other transaction that falls
within an exclusion from gross income.
Gross income is generally defined by section 61 as “income from
whatever source derived.” The Supreme Court long ago established that
gross income includes all “accessions to wealth, clearly realized, and
over which the taxpayers have complete dominion,” absent an explicit
exclusion. Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431
(1955). The Court in Glenshaw Glass clarified that gross income is not
limited to “the gain derived from capital, from labor, or from both
combined.” Id. at 430–31 (quoting Eisner v. Macomber, 252 U.S. 189,
207 (1920)). Here, the evidence clearly shows that all the amounts
reported on the Forms W–2 and Form 1099–DIV were unexcluded,
realized accessions to the Kelleys’ wealth—and, in fact, that these
amounts were gains derived from their capital and/or labor. Therefore,
we find by a preponderance of the evidence that all these amounts were
gross income that the Kelleys should have reported on their 2017 tax
return. It is irrelevant whether the burdens of production or proof
8
[*8] shifted to the Commissioner under section 6201(d) or 7491(a). See
Knudsen v. Commissioner, 131 T.C. 185, 189 (2008) (“In a case where
the standard of proof is preponderance of the evidence and the
preponderance of the evidence favors one party, we may decide the case
on the weight of the evidence and not on an allocation of the burden of
proof.”), supplementing T.C. Memo. 2007-340.
IV. Section 6662(a) Penalty
A. Section 6751(b)(1) Supervisory Approval
1. Timing of Approval
Section 6751(b)(1) provides that “[n]o penalty under this title [i.e.,
the Code] shall be assessed unless the initial determination of such
assessment is personally approved (in writing) by the immediate
supervisor of the individual making such determination.” This Court
has held that section 6751(b)(1) requires supervisory approval to be
procured before the first formal communication to the taxpayer of the
decision to assert the penalty at issue. See, e.g., Clay v. Commissioner,
152 T.C. 223, 249 (2019), aff’d, 990 F.3d 1296 (11th Cir. 2021).
Here, in the notice of deficiency, the Commissioner determined a
substantial understatement penalty. The Commissioner conceded that
penalty in his Answer, stating that the IRS official who initially
determined the penalty did not obtain written supervisory approval.
The Answer newly asserted a negligence/disregard penalty. Moreover,
the Answer was signed by both Ms. Nunez, the IRS attorney who drafted
the Answer, and Mr. Feinberg, her immediate supervisor. Thus, before
the first formal communication to the Kelleys regarding the
negligence/disregard penalty, that penalty had been approved by the
immediate supervisor of the official who proposed it. 7
7 The IRS sent the Kelleys a Notice CP 2000, or “30-day letter,” on March 11,
2019, before issuing the notice of deficiency. The record includes only the first page of
the CP 2000, but that page contains the entire “Summary of proposed changes.”
Within that summary, only one penalty is listed: “Substantial tax understatement
penalty.” Because that phrase reasonably corresponds only to the substantial
understatement penalty, we are satisfied that the Commissioner did not formally
communicate his decision to assert the negligence/disregard penalty until he filed the
Answer. Below we discuss whether the Commissioner’s earlier communication
regarding the substantial understatement penalty precluded the later communication
regarding the negligence/disregard penalty from satisfying the section 6751(b)(1)
requirement.
9
[*9] 2. Individuation of Penalties Under Section 6662
The Kelleys do not agree that the negligence/disregard penalty
asserted in the Answer was asserted for the first time in the Answer, in
light of the wording and structure of section 6662. Section 6662(a)
imposes a penalty equal to 20% of any portion of an underpayment of
tax attributable to “1 or more of” the eight causes listed in section
6662(b). Accordingly, even if more than one of the causes applies to a
given portion of an underpayment, the taxpayer must pay an additional
20% of that portion only once. See Treas. Reg. § 1.6662-2(c). 8 On the
face of the statute, then, section 6662(a) imposes a single penalty, albeit
one whose rationale may differ between taxpayers, or between different
portions of a particular taxpayer’s overall underpayment. If this
interpretation of the statute is correct, then the Commissioner’s
assertion of a penalty in the Answer (under section 6662(a) by reason of
subsection (b)(1)) was not the “initial determination” of that penalty,
since it had already been determined (albeit by reason of subsection
(b)(2)) in the notice of deficiency. Accordingly, Mr. Feinberg’s approval
of Ms. Nunez’s draft of the Answer would not suffice for purposes of
section 6751(b)(1).
However, we cannot accept the Kelleys’ interpretation of what
constitutes “the penalty” under section 6662 (at least for purposes of
section 6751(b)(1)). The Kelleys’ interpretation would give carte blanche
to IRS officials to assert additional causes under section 6662(b) after a
supervisor approved a penalty under one or more other causes. For
instance, an IRS revenue agent might get approval to penalize a
taxpayer by reason of section 6662(b)(1) (negligence or disregard of rules
or regulations) but, upon receiving convincing rebuttal from the
taxpayer, assert a penalty by reason of section 6662(b)(3) (substantial
valuation misstatement)—perhaps even enhanced to a 40% penalty for
gross valuation misstatements under section 6662(h). If the Kelleys are
correct, then the revenue agent would not need further supervisory
approval for the second penalty assertion, because the second penalty
would be the “same” as the first (approved) penalty.
8 The penalty is increased to 40% of the relevant portion of the underpayment
if at least one of the causes is a “gross valuation misstatement” (as defined in section
6662(h)) or a “nondisclosed noneconomic substance transaction” (as defined in section
6662(i)), neither of which is at issue in this case. However, the same “nonstacking”
principle governs: The 40% penalty is imposed only once, regardless of how many of
the eight causes under section 6662(b) apply.
10
[*10] This result would fly in the face of Congress’s stated purpose in
enacting section 6751(b)(1): to ensure that penalties “only be imposed
where appropriate and not as a bargaining chip.” Williams v.
Commissioner, 151 T.C. 1, 8 (2018) (quoting S. Rep. No. 105-174, at 65
(1998), as reprinted in 1998-3 C.B. 537, 601). The revenue agent in our
example would have free rein to use the second penalty assertion (and
further assertions as needed), even if unjustified, to encourage the
taxpayer to settle. This posturing is precisely what Congress evidently
sought to prevent. See Chai v. Commissioner, 851 F.3d 190, 219 (2d Cir.
2017), aff’g in part, rev’g in part T.C. Memo. 2015-42. Indeed, we have
repeatedly held that if the first formal communication of penalties to a
taxpayer indicates a section 6662(a) penalty by reason of some of the
section 6662(b) causes but not others, then the Commissioner is barred
from later asserting a penalty by reason of any of the initially excluded
causes without further supervisory approval. (He would not be so
barred if all the section 6662(b) causes amounted to the “same” penalty.)
See, e.g., Conrad v. Commissioner, T.C. Memo. 2023-100, at *82–83;
Estate of Ronning v. Commissioner, T.C. Memo. 2019-38, at *12–13,
*45–46, aff’d, 830 F. App’x 279 (11th Cir. 2020); see also Palmolive Bldg.
Invs., LLC v. Commissioner, 152 T.C. 75, 87 (2019) (“Although the title
of section 6662 refers to a (singular) ‘penalty’, section 6662 imposes
various distinct penalties, each subpart of which must be separately
approved for purposes of section 6751(b)(1).”); McCarthy v.
Commissioner, T.C. Memo. 2020-74, at *26–29 (finding the supervisory
approval requirement unmet for the penalty under section 6662(a) and
(b)(2) when the alleged approval stated simply “6662 penalty approved”
without identifying any causes under section 6662(b)).
We therefore hold that each of the eight causes of an
underpayment listed in section 6662(b) yields a distinct penalty for
purposes of the supervisory approval requirement under section
6751(b)(1). Accordingly, the Commissioner was on firm procedural
ground in asserting the negligence/disregard penalty against the
Kelleys after determining the substantial understatement penalty
without supervisory approval.
3. Authority to Assert Penalty
Section 6214(a) impliedly authorizes the Secretary and her
delegates to assert penalties in pleadings before this Court. 9 The
9 Section 6214(a) provides, in relevant part, that “the Tax Court shall have
jurisdiction to . . . determine whether any additional amount, or any addition to the
11
[*11] Commissioner is a delegate of the Secretary for this purpose, and
the IRS Chief Counsel is likewise a delegate of the Commissioner. See
I.R.C. § 7803(b)(2)(D) (authorizing the Chief Counsel “to represent the
Commissioner in cases before the Tax Court”). Therefore, Ms. Nunez
had authority, as a Chief Counsel attorney, to make the “initial
determination” of the negligence/disregard penalty against the Kelleys
in the Answer, such that Mr. Feinberg’s signature on the Answer
satisfied the requirement of section 6751(b)(1).
The Kelleys contend that attorneys in the IRS Office of Chief
Counsel lack authority to assert penalties. They refer us to Graev v.
Commissioner, 149 T.C. 485, 527–34 (2017) (Buch, J., concurring in part
and dissenting in part), supplementing and overruling in part 147 T.C.
460 (2016), where Judge Buch argued that Chief Counsel attorneys lack
delegated authority to issue notices of deficiency and therefore may not
make the “initial determination” of a penalty asserted in such a notice.
That argument has no applicability here; this case does not involve Chief
Counsel attorneys issuing a notice of deficiency. Rather, here, the Chief
Counsel attorney asserted penalties for the first time in the Answer filed
in this Court. We have held that the Chief Counsel or his delegates (i.e.,
attorneys in the IRS Office of Chief Counsel) are authorized, by virtue
of their role as the Commissioner’s representatives in this Court, see
I.R.C. §§ 7803(b), 7452, to assert penalties in an answer. “It is well
established that the Commissioner may assert penalties in his answer.”
Koh v. Commissioner, T.C. Memo. 2020-77, at *5 (first citing I.R.C. §
6214(a); then citing Chai v. Commissioner, 851 F.3d at 221; and then
citing Graev, 149 T.C. 485). “It follows that his representative in this
Court also has this authority.” Id. (first citing Roth v. Commissioner,
T.C. Memo. 2017-248, at *11, aff’d, 922 F.3d 1126 (10th Cir. 2019); then
citing Rule 142(a); then citing Graev, 149 T.C. at 491–92, 498; and then
citing Estate of Jung v. Commissioner, 101 T.C. 412, 448 (1993)). Thus,
we reject the Kelleys’ argument.
B. “Underpayment”
Section 6662(a) imposes a penalty equal to 20% of any
underpayment of tax attributable to one or more of the eight causes
listed in section 6662(b). Section 6664(a) defines “underpayment” of a
tax should be assessed, if claim therefor is asserted by the Secretary at or before the
hearing or a rehearing.” (Emphasis added.)
12
[*12] particular tax to mean the amount by which the correct amount of
the tax exceeds the excess of
(1) the sum of—
(A) the amount shown as tax by the taxpayer
on his return, plus
(B) amounts not so shown [but] previously
assessed (or collected without assessment),[10] over
(2) the amount of rebates [already] made [with
respect to the tax period at issue].
“Rebates” include abatements, credits, and refunds. Treas. Reg.
§ 1.6664-2(e).
Here, given our determination of unreported gross income, the
Kelleys had an underpayment for their 2017 tax year within the
meaning of section 6664(a): Their correct tax liability was well above the
zero tax liability reported on their return (and the record indicates no
amounts previously assessed or collected without assessment). For
clarity, we emphasize that the Kelleys had an underpayment at the time
they submitted their return; when they requested and received a refund
of the withholdings made by Sanchez Oil & Gas and Core Labs, their
underpayment increased.
C. Negligence and Disregard
Section 6662(a) and (b)(1) imposes a penalty for an underpayment
of tax attributable to “[n]egligence or disregard of rules or regulations.”
Section 6662(c) provides that for this purpose, “the term ‘negligence’
includes any failure to make a reasonable attempt to comply with the
provisions of this title [i.e., the Code], and the term ‘disregard’ includes
any careless, reckless, or intentional disregard.”
The Kelleys’ failure to report the amounts shown as gross income
on the Forms W–2 and Form 1099–DIV was a clear disregard of the clear
rule that gross income includes “all income from whatever source
derived.” I.R.C. § 61(a); see also Treas. Reg. § 1.61-1(a) (“Gross income
10 Amounts are considered “previously assessed” only if the IRS assessed those
amounts before the taxpayer filed a return, such as occurs with jeopardy assessments
under section 6861. See Treas. Reg. § 1.6664-2(d). The amount considered “collected
without assessment” is only the unrefunded and uncredited portion of the excess (if
any) of tax payments made before the filing of the return (including wage withholding
and estimated tax payments) over the tax shown on the return. Id. On the basis of
the record, neither of these definitions applies to the Kelleys’ 2017 income tax.
13
[*13] means all income from whatever source derived, unless excluded
by law.”). The general definition of taxable “gross income” in section 61
explicitly includes “[c]ompensation for services . . . [and] [d]ividends.”
I.R.C. § 61(a)(1), (7). The Code could not have more clarity. For the
Kelleys, gross income included the compensation from Sanchez Oil &
Gas and Core Labs and the dividends reported by Solium, and the
Kelleys were at least careless in disregarding the rules requiring them
to report these amounts.
D. Adequate Disclosure and Reasonable Basis
The Kelleys believe that they qualify for the exception to the
section 6662(a) penalty by virtue of their making an adequate disclosure
in their return. Treasury Regulation § 1.6662-3(c) excuses a taxpayer’s
disregard of rules or regulations if the underpayment is attributable to
a position that the taxpayer adequately disclosed on the return. Treas.
Reg. §§ 1.6662-3(c), 1.6662-7. However, the disclosure must be made
using Form 8275, Disclosure Statement, or Form 8275–R, Regulation
Disclosure Statement, see Treas. Reg. § 1.6662-3(c)(1), neither of which
the Kelleys filed with their return. In any event, the adequate disclosure
exception does not apply if the taxpayer’s position lacks a “reasonable
basis.” Id. Reasonable basis is defined as “a relatively high standard of
tax reporting, that is, significantly higher than not frivolous or not
patently improper. The reasonable basis standard is not satisfied by a
return position that is merely arguable or that is merely a colorable
claim.” Id. para. (b)(3). Thus, although the reasonable basis standard
is less stringent than the “substantial authority” standard of section
6662(d)(2)(B)(i), see Treas. Reg. § 1.6662-4(d)(2), it is nonetheless an
objective criterion, based on the actual terrain of relevant legal
authorities and not on the taxpayer’s degree of knowledge or personal
circumstances. 11
The Kelleys point to the fact that on their Forms 4852 they wrote:
“I did not receive any ‘wages’ as defined in IRC Section 3401(a) and
3121(a).” Further, on the document attached to their return entitled
“Statement to Correct Incorrectly Reported 1099–DIV Information
Return,” they claimed that “[n]o dividends were received by [Mrs.
Kelley] from [Solium] which were connected with any ‘trade or business’
or otherwise constituted gains, profits, or income within the meaning of
11 These latter subjective factors are relevant to the reasonable cause
exception, discussed below.
14
[*14] relevant law.” Again, the Kelleys failed to use the prescribed form
of disclosure (i.e., Form 8275 or 8275–R).
Furthermore, as to their attempted disclosure regarding wages,
the Kelleys presented no plausible argument—whether on their return
or in this litigation—that the payments from Sanchez Oil & Gas and
Core Labs did not qualify as wages under section 3401(a) or 3121(a).
Those sections define “wages” for purposes of income tax withholding
and payroll taxes, respectively. Section 3401(a) defines “wages” as
“remuneration . . . for services performed by an employee for his
employer,” while section 3121(a) defines “wages” as “all remuneration
for employment.” Section 3401(c) provides that “the term ‘employee’
includes an officer, employee, or elected official of the United States, a
State, or any political subdivision thereof.” Section 3121(b) generally
defines the term “employment” within that section to mean services
performed within the United States or services performed outside the
United States by a U.S. citizen; section 3121(e)(2) provides that “[t]he
term ‘United States’ . . . includes the Commonwealth of Puerto Rico, the
Virgin Islands, Guam, and America Samoa.” The Kelleys imply that
because they did not work for a government entity, and because they did
not perform their work in one of the listed American territories, the
payments from Sanchez Oil & Gas and Core Labs did not fall under the
definition of “wages” in either section 3401 or section 3121.
However, section 7701(c) clarifies that “[t]he terms ‘includes’ and
‘including’ when used in a definition contained in this title [i.e., the
Code] shall not be deemed to exclude other things otherwise within the
meaning of the term defined.” Workers for private companies are
undeniably within the meaning of “the term defined” in section 3401(c)
(employee), and the 50 states of the United States are undeniably within
the meaning of “the term defined” in section 3121(e) (United
States). There is no reasonable basis for contending that, in 2017, the
Kelleys did not receive “wages” for services performed within the
“United States” as those terms are defined for purposes of income tax
withholding and payroll taxes.
Additionally, the payments the Kelleys received from Sanchez Oil
& Gas and Core Labs were “compensation for services,” which is
explicitly included in gross income by section 61(a)(1). The Kelleys do
not dispute that they performed work for Sanchez Oil & Gas and Core
Labs, nor that the payments from Sanchez Oil & Gas and Core Labs
were given in exchange for that work. Thus, those payments fall under
15
[*15] the plain meaning of “compensation for services” (a phrase that is
not specially defined in the Code or the regulations).
The Kelleys attempt to exclude the Sanchez Oil & Gas and Core
Labs payments from gross income by pointing to two alleged statutory
precedents to the current section 61: the Classification Act of 1923, ch.
265, 42 Stat. 1488, and the Revenue Act of 1938, ch. 289, § 22(a), 52 Stat.
447, 457. The definition of “compensation” in section 2 of the
Classification Act of 1923 was restricted to amounts paid to federal
government employees. However, that Act (which was repealed by the
Classification Act of 1949, ch. 782, 63 Stat. 954) by its terms provided
only for the creation of compensation schedules for certain federal
employees; it was emphatically not a tax bill. The Kelleys point out that
the Classification Act of 1923 was still in effect when the Revenue Act
of 1938 was enacted and that section 22 of the latter defined “gross
income” to “include[] gains, profits, and income derived from salaries,
wages, or compensation.” The Kelleys evidently believe that Congress
must have intended “compensation” to bear the same definition in the
Revenue Act of 1938 as it bore in the Classification Act of 1923 and that
that definition was carried forward to the current section 61 of the Code.
But this contention has no reasonable basis in the canons of
statutory construction consistently applied by the courts of this country.
As the Supreme Court has explained “many times over many years . . .
when the meaning of the statute’s terms is plain, our job is at an end.
The people are entitled to rely on the law as written, without fearing
that courts might disregard its plain terms based on some extratextual
consideration.” Bostock v. Clayton Cnty., Ga., 140 S. Ct. 1731, 1749
(2020). The term “compensation for services,” as used in both the
Revenue Act of 1938 and the current section 61, is undefined, and we
therefore accord it its plain meaning—viz, any type of payment or
remuneration given in exchange for labor. See, e.g., Compensation,
Merriam-Webster’s Online Dictionary, https://www.merriam-
webster.com/dictionary/compensation (last updated Oct. 16, 2023);
Service, Merriam-Webster’s Online Dictionary, https://www.merriam-
webster.com/dictionary/service (last visited Oct. 19, 2023). It would be
bizarre if Congress, once it gave a special definition for a term in a
particular context, were then forever barred from using that term in its
ordinary meaning.
As to the Kelleys’ attempted disclosure regarding dividends, they
apparently believe that dividends must be connected with a “trade or
business” in order to be taxable. However, this is contrary to the plain
16
[*16] text of section 61(a)(7), which includes no such qualifier. The
Kelleys never clarified on their return or in this litigation why the
definition of “trade or business” is relevant to determining whether the
Core Labs dividends are taxable. 12 Likewise, their argument that
dividends from Solium are not taxable because Solium is a “global
company” has no discernible basis in legal authority. (Moreover, the
record indicates that both Solium and Core Labs are registered to do
business in the United States and/or are doing business here.)
The Kelleys have made various other contentions resembling the
sorts of frivolous tax-protester arguments that we have dismissed on
many previous occasions. Although we could diagnose the patent faults
of these further arguments in detail, we generally decline to refute
frivolous arguments “with somber reasoning and copious citation of
precedent; to do so might suggest that these arguments have some
colorable merit.” Funk v. Commissioner, 123 T.C. 213, 217 (2004)
(quoting Crain v. Commissioner, 737 F.2d 1417, 1417 (5th Cir. 1984)).
In Wnuck v. Commissioner, 136 T.C. 498, 501–13 (2011), we explained
at length why we generally decline to refute tax-protester arguments,
and we explained the fallacies of the precise argument regarding section
3121(a) that the Kelleys advance here.
The arguments offered by the Kelleys do not constitute a
reasonable basis for their underpayment and so do not afford them the
protection of the adequate disclosure exception.
E. Reasonable Cause Exception
Section 6664(c)(1) provides a further exception to the
negligence/disregard penalty “if it is shown that there was a reasonable
cause for such portion [of the underpayment] and that the taxpayer
acted in good faith with respect to such portion.” The determination as
to whether a taxpayer acted with reasonable cause and in good faith is
made on a case-by-case basis, considering all pertinent facts and
circumstances. Treas. Reg. § 1.6664-4(b)(1). Generally, the most
important factor in determining the existence of reasonable cause is the
12 At any rate, Core Labs’ 2019 registration statement with the U.S. Securities
and Exchange Commission—a copy of which the Kelleys provided to this Court—states
in relevant part that Core Labs “is an oil-services company that helps oil and gas
companies better understand how to improve production levels and economics with
core and reservoir analysis. Additionally, the company sells a number of products
helping its customers to maximize production levels from their oil and gas assets.”
Core Labs clearly was conducting a trade or business.
17
[*17] taxpayer’s effort to ascertain his or her correct tax liability. Id.Circumstances that may signal reasonable cause and good faith “include
an honest misunderstanding of fact or law that is reasonable in light of
all of the facts and circumstances, including the experience, knowledge,
and education of the taxpayer.” Id.The Kelleys explained in this litigation that they conducted a
significant amount of research into current and historical tax law and
concluded that (1) labor compensation paid by private firms is not
taxable and (2) dividends reported by a company that conducts business
globally are not taxable. These erroneous conclusions conceivably could
reflect misunderstanding of the law, but they are nonetheless manifestly
unreasonable in light of the Kelleys’ educational backgrounds and
knowledge of tax law.
For instance, the Kelleys rely on congressional history to make
their case. They direct us to a portion of the 1943 Congressional Record
in which Congressman Frank Carlson, in the course of debate on the
Individual Income Tax Collection Bill of 1943, H.R. 2218, 78th Cong. (an
amended version of which was enacted as the Current Tax Payment Act
of 1943, ch. 120, 57 Stat. 126), stated the following:
The income tax is, therefore, not a tax on income as
such. It is an excise tax with respect to certain activities
and privileges which is measured by reference to the
income which they produce. The income is not the subject
of the tax: it is the basis for determining the amount of tax.
89 Cong. Rec. 2578–80 (1943) (statement of Rep. Frank Carlson).
Congressman Carlson’s remarks here are part of an extended quotation
of an “early history of the income-tax law” written by a former legislative
draftsman for the Treasury Department, which Congressman Carlson
excerpted primarily to show that an early version of the federal income
tax provided for withholding at the source. The Kelleys nonetheless
imply that Congressman Carlson intended to represent that the income
tax does not encompass income from labor in general. However, we note
first that legislative history is not to be consulted unless the statutory
text is ambiguous, which is not the case with respect to section 61(a)(1).
See Chevron, U.S.A., Inc. v. Nat. Res. Def. Council, Inc., 467 U.S. 837,
842–43 (1984). Secondly, the quoted text actually clarifies that gross
income is “the basis for determining the amount of tax.” The Kelleys
have misinterpreted the Congressman’s import. The Kelleys’ suggestion
18
[*18] that the entire U.S. legal system has been mistaken for over 100
years about the taxability of labor compensation is unreasonable.
It was likewise unreasonable for the Kelleys to draw any
conclusion about the taxability of dividends from a regulation about the
informational reporting of dividends. The Kelleys cite Treasury
Regulation § 1.6042-2(a)(2), which provides that the “person[s]” who
must file Form 1099–DIV upon paying dividends (or receiving dividends
as nominee for another person) do not include “international
organization[s].” The Kelleys note that Solium is a “global company”
and thereby conclude that it falls under the exception of Treasury
Regulation § 1.6042-2(a)(2). However, section 7701(a)(18) defines
“international organization” to mean “a public international
organization entitled to enjoy privileges, exemptions, and immunities as
an international organization under the International Organizations
Immunities Act (22 U.S.C. 288–288f).” The record shows that Solium is
not such an organization. Moreover, even if Solium were somehow
exempt from reporting the Core Labs dividends it received as nominee
for the Kelleys, that fact would have no logical bearing on the taxable
nature of the dividends in the Kelleys’ hands. To the extent the Kelleys
believe that U.S. citizens are exempt from tax on foreign-based income,
they offered no grounds for deeming that belief to be reasonable. It is
well established, and commonly known, that the United States taxes its
citizens, living and working here, on their worldwide income, from
whatever source derived, domestic or foreign. See I.R.C. § 61(a); Crow
v. Commissioner, 85 T.C. 376, 380 (1985). Furthermore, setting aside
the unreasonableness of the Kelleys’ apparent conclusion that dividends
must be connected with a “trade or business” in order to be taxable, it
defies reason to conclude that the Core Labs dividends were not
connected with Core Labs’ (very evident) trade or business. All of these
inferences and misreadings were gravely erroneous and unbefitting for
scientific professionals.
Although the Kelleys evidently exerted considerable effort to
validate their return positions, the unreasonableness of those positions
outweighs the effort. We hold that the Kelleys lack reasonable cause for
their careless disregard of the foundational rules of section 61
(regardless of the Commissioner’s burden of proof on this issue), and
they are liable for the negligence/disregard penalty.
We have considered all the arguments made by the parties, and
to the extent they are not addressed herein, we consider them moot,
irrelevant, or without merit.
19
[*19] To reflect the foregoing,
Decision will be entered for respondent.