Roland J. Thoma & Donna M. Thoma v. Commissioner

T.C. Memo. 2020-67
UNITED STATES TAX COURT
ROLAND J. THOMA AND DONNA M. THOMA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 21922-15. Filed May 27, 2020.
Roland J. Thoma and Donna M. Thoma, for themselves.
Alexander R. Roche and Mayer Y. Silber, for respondent.
CONTENTS
FINDINGS OF FACT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
1. General background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2. Mr. Thoma’s work for Thoma & Hjerpe and biweekly payments for his
accounting services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
3. Mr. Thoma’s sale of his interest in Thoma & Hjerpe and quarterly
installment payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
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[*2]
4. Thoma & Hjerpe’s SIMPLE IRA plan and Mr. Thoma’s contributions to his
SIMPLE IRA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
5. Mr. Thoma and Mr. Hjerpe’s falling out; Mr. Thoma’s professional
licensing authority complaint; Mr. Thoma’s lawsuit for remaining quarterly
installment payments; Mr. Thoma’s unemployment benefits claim . . . . . . 34
6. Tax reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
a. 2010 return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
b. 2011 return . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
7. Notice of deficiency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
OPINION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
I. Mr. Thoma’s self-employment-tax liability for 2010 and 2011 . . . . . . . . . 56
A. The parties’ positions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
B. Analysis: partnership and partner . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
1. Agreement governing Thoma & Hjerpe and conduct in
executing its terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
2. Contributions to Thoma & Hjerpe . . . . . . . . . . . . . . . . . . . . . 67
3. Control over income and capital of Thoma & Hjerpe and right
to make withdrawals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
4. Interest in net profits of Thoma & Hjerpe and obligation to
share losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
5. Whether Thoma & Hjerpe was conducted in the joint names of
Mr. Thoma and Mr. Hjerpe . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
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[*3] 6. Thoma & Hjerpe federal tax returns; representation of joint
venture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
7. Separate books for Thoma & Hjerpe. . . . . . . . . . . . . . . . . . . . 72
8. Mutual control of, and responsibilities over, Thoma
& Hjerpe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
C. Analysis: employee or independent contractor . . . . . . . . . . . . . . . . 74
II. Mr. Thoma’s business expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
A. Mr. Thoma’s expenses of working for Thoma & Hjerpe are
deductible only as employee-business expenses. . . . . . . . . . . . . . . . 83
B. The deductible amounts of Mr. Thoma’s expenses of working for
Thoma & Hjerpe are those determined in the notice of deficiency. . 83
III. Mr. Thoma’s health insurance expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
IV. Mr. Thoma’s SIMPLE IRA contributions . . . . . . . . . . . . . . . . . . . . . . . . . . 88
V. Quarterly installment payments during 2011 for the sale of Mr. Thoma’s
interest in Thoma & Hjerpe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
VI. Accuracy-related penalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
A. Underpayment of tax for 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
B. Underpayment of tax for 2011. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
C. Reasonable cause . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
1. Treatment of Mr. Thoma as a partner of Thoma & Hjerpe. . 100
2. Mr. Thoma’s unsubstantiated business expenses . . . . . . . . . 102
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[*4] 3. Gross profit percentage of 84.34% for 2011. . . . . . . . . . . . . 103
MEMORANDUM FINDINGS OF FACT AND OPINION
MORRISON, Judge: The petitioners, Roland J. Thoma and Donna M.
Thoma, filed joint income-tax returns for 2010 and 2011. On June 4, 2015, the
respondent (hereinafter, the “IRS”) issued a notice of deficiency to Mr. and Ms.
Thoma determining income-tax deficiencies and accuracy-related penalties under
section 6662(a), for tax years 2010 and 2011, as shown below.1
Penalty
Year Deficiency sec. 6662(a)
2010 $3,249 $650
2011 14,660 2,932
Mr. and Ms. Thoma filed a timely petition for redetermination of the
income-tax deficiencies and accuracy-related penalties for both years under
section 6213(a). We have jurisdiction under section 6214(a).2
1
Unless otherwise indicated, all section numbers refer to sections of the
Internal Revenue Code of 1986, as amended and in effect at all relevant times, and
all Rule numbers refer to the Tax Court Rules of Practice and Procedure. All
dollar amounts are rounded to the nearest dollar.
2
Mr. and Ms. Thoma resided in Illinois when they filed their petition.
Therefore, an appeal of our decision in this case would go to the U.S. Court of
(continued...)
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[*5] There are six issues for decision. The issues and our holdings are
summarized below.
1. Self-employment-tax liability and deduction for one-half of self-
employment tax. The accounting firm of Thoma & Hjerpe paid Mr. Thoma for
accounting services rendered in 2010 and 2011. These biweekly payments totaled
$69,156 in 2010 and $63,299 in 2011. On their tax returns for 2010 and 2011 Mr.
and Ms. Thoma took the position that Mr. Thoma was self-employed and that the
biweekly payments constituted self-employment income for each year, such that
Mr. Thoma was liable for self-employment tax. They also claimed an income-tax
deduction for one-half of the self-employment tax they reported for Mr. Thoma for
each year. The notice of deficiency determined that Mr. Thoma was not self-
employed, but rather an employee. The notice of deficiency recharacterized the
reported self-employment income as wages. It accordingly reduced self-
employment income for each year to zero, reduced self-employment tax for each
year to zero, and reduced the income-tax deduction for one-half of self-
employment tax for each year to zero. We agree that Mr. Thoma was an employee
2
(...continued)
Appeals for the Seventh Circuit, see sec. 7482(b)(1), unless the parties designate
the Court of Appeals for another circuit (except the Federal Circuit), see sec.
7482(b)(2).
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[*6] and sustain the self-employment tax and one-half of self-employment tax
deduction adjustments in the notice of deficiency. See infra part I, pp. 56-80.
2. Self-employed business-expense deductions. On their tax returns for
2010 and 2011 Mr. and Ms. Thoma claimed deductions of $7,396 and $20,867,
respectively, for business expenses Mr. Thoma paid in rendering accounting
services for Thoma & Hjerpe. They reported these deductions as affecting
adjusted gross income (“AGI”),3 which is consistent with the deductions being
categorized under section 62(a)(1) as attributable to a taxpayer’s business other
than the business of providing services as an employee. The notice of deficiency
determined that Mr. Thoma was an employee of Thoma & Hjerpe in 2010 and
2011, such that the expenses were not governed by section 62(a)(1) and not
deductible in arriving at AGI. The notice of deficiency determined that Mr.
Thoma’s expenses of working for Thoma & Hjerpe were deductible only as
unreimbursed-employee-business expenses under section 67(b). That deduction is
a subset of the miscellaneous itemized deductions allowed under section 67(b).
Under section 67(a), total miscellaneous itemized deductions are allowed only to
the extent they exceed 2% of AGI. The notice of deficiency determined that the
3
Deductions affecting AGI are also known as above-the-line deductions.
See infra p. 81.
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[*7] business expenses were deductible as miscellaneous itemized deductions in
the reduced amounts of $7,288 for 2010 and $14,406 for 2011, before application
of the 2% of AGI floor. We sustain the determination that the business expenses
are deductible only as unreimbursed-employee-business expenses. See infra part
II.A, p. 83. We also sustain the determination that the deductible amounts of Mr.
Thoma’s expenses of working for Thoma & Hjerpe are $7,288 for 2010 and
$14,406 for 2011, before application of the 2% of AGI floor, as determined in the
notice of deficiency. See infra part II.B, pp. 83-87.
3. Self-employed health insurance expense deductions. On their tax returns
for 2010 and 2011 Mr. and Ms. Thoma claimed self-employed health insurance
expense deductions under section 162(l). Section 162(l) allows self-employed
taxpayers a deduction for the cost of “insurance which constitutes medical care”,
i.e., the cost of health insurance. Mr. and Ms. Thoma reported that Mr. Thoma
paid health insurance expenses of $4,648 for 2010 and $5,580 for 2011. The
notice of deficiency determined that Mr. Thoma was an employee of Thoma &
Hjerpe and that the health insurance expenses were not properly deductible under
section 162(l), but only as deductions for medical expenses under section 213(a).
Section 213(a) allows a deduction for medical expenses, including health
insurance expenses, but subject to a 7.5% of AGI floor. We sustain the
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[*8] determination regarding the tax treatment of Mr. Thoma’s health insurance
expenses. See infra part III, pp. 87-88.
4. Self-employed SIMPLE IRA contribution deductions. Mr. Thoma
directly contributed $15,711 to his SIMPLE IRA in 2010 and $14,000 in 2011.
Mr. and Ms. Thoma claimed deductions for those contributions. The notice of
deficiency determined that the contributions were not deductible because Mr.
Thoma was an employee of Thoma & Hjerpe. We sustain the determination that
Mr. Thoma was an employee and sustain the disallowance of the SIMPLE IRA
contribution deductions. See infra part IV, pp. 88-89.
5. Recovery of basis and character of 2011 installment sale payments. In
2008 Mr. Thoma sold his interest in Thoma & Hjerpe to Mr. Hjerpe. In 2011 he
received installment sale payments from Mr. Hjerpe totaling $160,000. On their
2011 tax return Mr. and Ms. Thoma reported that the $160,000 installment sale
payments were composed of $131,637 in long-term capital gain, $3,921 in taxable
interest, and $24,442 in tax-free recovery of basis. The notice of deficiency
determined that the installment sale payments were instead composed of $134,001
in long-term capital gain, $19,700 in taxable interest, and $6,299 in tax-free
recovery of basis. We consider Mr. and Ms. Thoma to have eventually conceded
that this determination is correct. Therefore, we sustain the determination
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[*9] regarding the recovery of basis and character of the 2011 installment sale
payments. See infra part V, pp. 90-94.
6. Accuracy-related penalties. The notice of deficiency determined that Mr.
and Ms. Thoma were liable for accuracy-related penalties under section 6662(a)
for 2010 and 2011. We sustain that determination. See infra part VI, pp. 95-104.
FINDINGS OF FACT
Some facts are stipulated, and they are so found.
During the years at issue Mr. Thoma worked as a certified public accountant
and Ms. Thoma worked as a secretary.
1. General background
On October 1, 1976, Mr. Thoma purchased a partial ownership interest in an
accounting firm for $40,000. He worked as an accountant at the accounting firm.4
At some point after October 1, 1976, but before August 2005, Mr. Thoma became
the sole owner of the accounting firm, and he began operating the firm as a sole
proprietorship under the name “Thoma & Associates, CPAs”.
Around January 1, 2006, Mr. Thoma went into business with Eric Hjerpe,
another accountant. Their accounting business appears to have absorbed Mr.
4
At some point in his career and seemingly before 1976, Mr. Thoma was an
IRS revenue agent.
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[*10] Thoma’s sole proprietorship. Their business also appears to have initially
operated under the name of Mr. Thoma’s former sole proprietorship, Thoma &
Associates, CPAs, but by 2007, it was operating under the name Thoma & Hjerpe,
CPAs. We refer to Mr. Thoma’s and Mr. Hjerpe’s accounting firm business as
Thoma & Hjerpe.
Mr. Thoma and Mr. Hjerpe executed two contracts for their business. The
first contract was executed in August 2005, with a stated effective date of January
1, 2006. The second contract was executed on January 28, 2010, and according to
its recitals, “restated” the 2005 agreement.
The 2005 agreement provided as follows:
PARTNERSHIP AGREEMENT
1. Introduction. Agreement to form a Partnership made on
August 1, 2005, between Roland J. Thoma, residing at Bloomington,
Illinois, and Eric Hjerpe, residing at Normal, Illinois.
2. Partnership Purpose and Name. The parties agree to form a
partnership, on the terms set out below, to engage in the business of
public accounting. The partnership’s name shall be Thoma &
Associates, CPAs and its principal office shall be at 2425 E. Lincoln,
Bloomington, Illinois.
3. Duration of Partnership. The Partnership will begin on
January 1, 2006 and will continue in this form until January 1, 2008,
when it will change in accordance with this Agreement. The
partnership will then continue until it terminates in accordance with
the provisions of this Agreement.
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[*11] 4. Partners’ Capital Contributions. The partnership capital
shall be contributed by Roland J. Thoma, partly in cash, partly in
personal property, and partly in the form of the current work-in-
process of Thoma & Associates, a sole proprietorship. Until January
1, 2008, Thoma shall be sole general partner, and Hjerpe’s interest in
the partnership shall be limited to income established by agreement
under this document or by further agreement of the parties. Effective
January 1, 2008, Hjerpe shall become the sole general partner and
Thoma’s interest in the partnership will be as defined in paragraphs 7
and 12 below.
5. Thoma’s Capital Accounts. Until January 1, 2008, only
Thoma shall have a capital account. After January 1, 2008, both
Thoma and Hjerpe will have a capital account.
6. Division of Profits and Losses. Until January 1, 2008,
Thoma shall be entitled to all of the net profits and losses of the
partnership, and Hjerpe shall receive gross compensation of
$100,000.00 annually. “Gross compensation” shall be defined as:
“All guaranteed payments, continuing professional education,
retirement plan contributions, medical insurance and reimbursements,
all professional and business club dues and all financial incentives
previously established for new business generated.” Additionally,
until January 1, 2008, for any client Hjerpe has already brought to the
firm (listed on Exhibit B), and for any new client Hjerpe brings into
the firm, Hjerpe will be entitled to receive 20% of collected billings
from that client, in addition to his regular compensation.
7. Management of the Partnership. Until January 1, 2008,
Thoma shall have sole voice in the management of the partnership,
but each party shall devote his full time to the conduct of the
business. Without Thoma’s written consent, Hjerpe shall not, on the
partnership’s behalf:
a) Borrow or lend money;
b) Make, deliver, or accept commercial paper;
c) Execute any mortgage, security agreement, bond or
lease; or
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[*12] d) Buy or execute a purchase agreement, sell or execute a
sales agreement for any property other than that bought
or sold in the regular course of the partnership’s
business.
After January 1, 2008, Hjerpe shall be the managing partner. Hjerpe
shall devote his full time to the conduct of the business. Thoma shall
devote 300 to 500 hours of billable time during the period of January
1 to April 15 each year (until April 15, 2012), and shall devote such
additional time as may be agreed between Thoma and Hjerpe. After
January 1, 2008, without Hjerpe’s written consent, Thoma shall not,
on the partnership’s behalf:
a) Borrow or lend money;
b) Make, deliver, or accept commercial paper;
c) Execute any mortgage, security agreement, bond or
lease; or
d) Buy or execute a purchase agreement, sell or execute a
sales agreement for any property other than that bought
or sold in the regular course of the partnership’s
business.
8. No Sale or Assignment of, or Granting Lien on Partnership
Interest. Without the other’s written consent, no partner shall:
a) Assign, mortgage, give a security interest in, or sell his
or her partnership interest;
b) Agree with a party not privy to this agreement that the
outside party will have an interest in the partnership; or
c) Do anything that would be detrimental to the
partnership’s ability to conduct its business.
9. Partnership Bank Account. All partnership funds shall be
deposited in its name in an account with the Commerce Bank located
at Bloomington, IL, or such other bank or banks as the partners may
agree upon from time to time.
10. Partnership Books and Records. The partnership books of
account will be kept in accordance with generally accepted
accounting principles. The books and supporting records will be
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[*13] maintained at the partnership’s principal office. The partnership’s
fiscal year shall start on January 1 and close on December 31. The
partners shall prepare an income statement and balance sheet, for each
fiscal year, within two months after the end of the fiscal year. These
financial statements shall be binding upon the partners as to income
or losses and the balances in the partners’ income and capital
accounts. In the event of a dispute between Thoma and Hjerpe, they
shall retain Sherri Chinski, CPA to review the partnership records,
and to reconcile/resolve any disputed entries.
11. Voluntary Dissolution of Partnership. The Partners may
agree to dissolve the Partnership at any time. Should the Partners so
agree, they will liquidate the Partnership in an orderly fashion.
12. Modification of Partnership. Effective January 1, 2008,
Hjerpe shall become the general partner, and Thoma’s interest in the
partnership shall be limited. Effective January 1, 2008 (or earlier in
the event of the death of Thoma):
a) All accounts receivable, all unbilled work in process, and
all assets and liabilities not otherwise specifically
mentioned herein, as of December 31, 2007 shall remain
the property of Roland J. Thoma.
b) Hjerpe shall purchase, and Thoma shall sell, all of the
office furniture, fixtures, file cabinets, computers, copy
machines, fax machines, printers (essentially all
depreciable office equipment), and all leasehold
improvements, for a purchase price of $30,000.00. (The
parties may choose to have Hjerpe waive his interest in a
deferred compensation package and in return receive the
aforesaid personal property without further payment.)
c) Thoma shall assign to Hjerpe, the existing lease of the
business premises from State Farm Insurance, including
all early termination benefits, if any, or will sublease the
premises to Hjerpe on the same terms and conditions as
the existing lease.
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[*14] d) Hjerpe shall pay to Thoma, for the goodwill of Thoma &
Associates, CPAs, the following:
1) On or before the 15th day of each month following
the end of each calendar quarter (the first payment
being due April 15, 2008), Hjerpe shall pay to
Thoma twenty percent of the collected billings
from clients Thoma has brought to the firm (which
shall be established by a listing of clients shown
on Exhibit A attached hereto). Both parties
recognize that as Thoma brings further clients into
the business, this Exhibit may be expanded from
time to time.
2) On December 31, 2012 a detailed calculation of all
accounts receivable and work in process shall be
made and the full payment of twenty percent of
that amount shall be paid to Thoma by April 15,
2013.
3) For purposes of this agreement, a client at
December 31, 2007 who expands and forms other
businesses or who changes the current form of his
business shall be considered to remain that same
client.
4) During the period from January 1, 2008 to
December 31, 2012, Thoma shall be required to
work three hundred hours between January 1 and
April 15 of each year and shall be paid forty
percent of collected billings on work done by him.
5) During the period from January 1, 2008 to
December 31, 2012, (and particularly during the
period from April 15 to December 31 of each year
during that period), if a new client requires that
Thoma personally perform accounting services for
him or her, Thoma may do so, and may use the
offices and equipment of the partnership, and shall
pay to the partnership 20% of collected billings on
work done personally by him.
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[*15] 6) During the period January 1, 2008 to December
31, 2012, Thoma shall have access to all income
records (but not expense records), time records,
and billing records, and collection and client
records reasonable or necessary for Thoma to
verify the correctness of payments made to him.
7) By agreement of the parties the name of the firm
may be changed to Thoma and Hjerpe, CPAs.
13. Effect of Partner’s Death. In the event of the death of
Thoma, the parties will immediately put into effect the provisions of
paragraph 12 a), 12 b), and 12 c) l-3 above. The death of Hjerpe prior
to January 1, 2008 will terminate this agreement (with the sole
interest of Hjerpe’s estate in the partnership being Hjerpe’s earned but
unpaid compensation). Hjerpe’s death after January 1, 2008 but
before December 31, 2012 shall have the effect of making Thoma a
general partner solely for the purpose of carrying out the provisions
of this agreement and winding up the business affairs of the firm, for
the benefit of Hjerpe’s estate. If Hjerpe elects to obtain life insurance
on his life in order to satisfy, in whole or in part, his obligations to
Thoma under the terms of this agreement, then the amount of any life
insurance proceeds shall be deducted from the amount otherwise due
to Thoma under this agreement. Thoma shall be entitled to a
reasonable fee for winding up the affairs of the firm.
14. Arbitration of Disputes. Any controversy concerning this
contract will be settled by arbitration according to the rules of the
American Arbitration Association, and judgment upon the award may
be entered in any court.
As indicated above, the 2005 agreement required that from January 1, 2006,
until January 1, 2008, Mr. Hjerpe make quarterly payments to Mr. Thoma equal to
20% of the collected billings from Mr. Thoma’s clients listed on Exhibit A
attached to the contract. The 2005 agreement also required that from January 1,
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[*16] 2006, until January 1, 2008, Mr. Hjerpe be paid 20% of the collected
billings from any client that Mr. Hjerpe had brought to the firm and was listed on
Exhibit B attached to the contract. However, the 2005 agreement does not contain
any Exhibit A or B, or any document listing Mr. Thoma’s and Mr. Hjerpe’s
clients.
The 2010 agreement provided in relevant part as follows:
AGREEMENT FOR THE PURCHASE OF CERTAIN ASSETS
OF THOMA & HJERPE, CERTIFIED PUBLIC
ACCOUNTANTS, FORMERLY KNOWN AS THOMA &
ASSOCIATES, CPAs
THIS INTEGRATED ASSET PURCHASE AGREEMENT /
BUSINESS ACQUISITION AND EMPLOYMENT /
SUB-CONTRACTOR AGREEMENT is made and entered into this
28th day of January, 2010 by and between ROLAND J. THOMA, an
Illinois resident and ROLAND J. THOMA as owner/partner of
THOMA & HJERPE, CERTIFIED PUBLIC ACCOUNTANTS,
formerly known as THOMA & ASSOCIATES, CPAs (hereinafter
referred to as “SELLER”), and ERIC L. HJERPE, an Illinois
resident (hereinafter referred to as “PURCHASER”). The business
described above, and that which is the subject of this agreement, shall
be referred to throughout this agreement as “business”.
RECITALS
WHEREAS, The parties entered into an agreement dated August 1,
2005 providing for Seller’s sale of the business and its assets to
Purchaser and they both now wish to restate that agreement in its
entirety; and
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[*17] WHEREAS, Purchaser desires to purchase the business and certain
assets from the Seller upon the terms and conditions set forth herein
and to obtain from the Seller a covenant not to compete; and
WHEREAS, Seller is willing to sell the business and assign such
assets to the Purchaser, and to enter into a covenant not to compete
with Purchaser upon the terms and conditions set forth herein; and
WHEREAS, Seller, in addition to selling the business and certain of
its assets to Purchaser on the terms set forth herein, also desires to
obtain from the Purchaser an offer of employment, as an employee, or
independent contractor; and
NOW, THEREFORE, in consideration of the terms, conditions and
mutual agreements of the parties contained herein, and other good
and valuable consideration, the receipt and sufficiency of which is
hereby acknowledged, the parties hereby agree as follows:
ARTICLE I
Sale of Assets
Section 1.1 Assets to be Sold
Subject to all of the terms and conditions of this Agreement, Seller
hereby sells to Purchaser and Purchaser hereby agrees to purchase
from Seller the following assets of the business:
a. All leasehold improvements to the premises at 2425 E
Lincoln, Bloomington Illinois (the leased premises); and
b. All furniture, office equipment, office supplies and
miscellaneous tangible personal property on the leased
premises as of the date of this agreement; and
c. All rights and obligations of seller as lessee under his
lease of the leased premises; and
d. All rights in and to the name “Thoma & Associates,
CPAs, and Thoma & Hjerpe, Certified Public
Accountants”; and
e. All available data and records related to the operations of
Seller, including client and customer lists, billing records
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[*18] and fees charged to clients, referral sources, research and
development reports, production reports, service and
warranty records, equipment logs, operating guides and
manuals, financial and accounting records, creative
materials, advertising materials, promotional materials,
studies, reports, correspondence and other similar
documents and records and, subject to Legal
Requirements, copies of all personnel records; and
f. All of the intangible rights and property of Seller,
including Intellectual Property Assets, going concern
value, goodwill, telephone, telecopy and email addresses
and listings
All of the assets, property and rights of the Seller to be transferred to
the Purchaser pursuant hereto are collectively referred to as the
“Assets”.
* * * * * * *
ARTICLE II
Allocation of Purchase Price and Terms of Payment
Section 2.1 Purchase Price and Allocation
The purchase price to be paid by the Purchaser to the Seller for the
sale and transfer of the Assets to the Purchaser in accordance with the
provisions of this Agreement is the sum of Eight Hundred Ninety
One Thousand Ninety Four Dollars and Four Cents ($891,094.04)
and shall be allocated as follows:
a. $5,000 to Seller’s covenant not to compete and
b. $886,094.04 to Seller’s goodwill and other assets being
sold as set forth in Section1.1 hereof
Section 2.2 Payment of Purchase Price
The Purchaser shall pay the purchase price to the Seller as follows:
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[*19] a. An initial payment of $211,596.29 has been paid by
Purchaser and Seller acknowledges receipt thereof;
b. The balance of $679,497.75 shall be payable in
accordance with Purchaser’s promissory note attached
hereto as Exhibit A and shall be secured by a first
purchase money security interest against the assets of the
business.
ARTICLE III
Covenant Concerning Competition, Solicitation and
Disparagement
In order for this agreement to serve the best interests of all parties, it
is inherently important that the parties strive to continue to improve
the overall outlook of the business by way of its impression in the
community. Because this business is substantially a professional
services organization, it relies upon the very professionals, who work
for, under, on its behalf, in its employ, etc., to provide services to its
customers. Therefore, it is critical that the parties to this agreement
agree that this provision concerning nondisparagement is crucial.
Section 3.1 Mutual Non-Disparagement
The Seller and the Purchaser agree not to make any statements,
whether written or oral, or engage in any activity which is detrimental
to the name and/or reputation of the acquired business, or of the
personal reputations of the Purchaser and Seller, nor make any
disparaging comments concerning the business, including without
limitation its products, services, personnel, partner, accountants,
professionals, plans, operations or other such that it may potentially
be detrimental to the business.
Section 3.2 Covenant Not to Compete
Seller and Purchaser have agreed that Purchaser shall pay to the
Seller the sum of FIVE THOUSAND DOLLARS ($5,000) as
valuable consideration for the Seller’s acceptance of the terms of this
Covenant Not to Compete.
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[*20] Seller agrees not to compete with Purchaser in the practice of Public
Accounting, or providing Accounting Services, while working for
Purchaser, and for a period of four (4) years after Seller leaves the
employ, of Purchaser. Competing with Purchaser is defined to mean
engaging in Public Accounting or providing accounting services
within a radius of 100 miles of 2425 E. Lincoln, Bloomington,
Illinois 61701.
For purposes of this covenant not to compete, competition is also
defined as soliciting or accepting employment by, or rendering
professional services to, any person or organization that is or was a
client of the business.
§3.2.1 EXCEPTIONS TO COVENANT NOT
TO COMPETE
Purchaser hereby expressly authorizes the
following acts of Seller that would otherwise
violate the Covenant Not to Compete:
1. Seller may complete 1040's of his direct
descendants per stirpes and is entitled to
keep all sums earned for these transactions,
and
2. Upon express written permission of the
Purchaser, Seller may complete tax work of
clients personally requesting Seller as their
accountant. In the event this situation
arises, the Client(s) shall be billed through
the office of Thoma & Hjerpe and Seller
will be paid Fifty Percent (50%) of his
hourly rate upon the business being paid in
full for the service provided.
* * * * * * *
Section 5.6 Sale of Practice
Purchaser agrees that if he sells the business of Thoma & Hjerpe, all
amounts payable under this agreement shall become due immediately.
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[*21] Purchaser agrees to defend, indemnify, hold harmless and pay all
reasonable fees and expenses which may arise if Seller is required to
and is successful in enforcing any provisions of Purchaser’s
obligations to Seller as set forth herein.
* * * * * * *
ARTICLE IX
Employment Agreement
Section 9.1 Nature and Place of Employment
Thoma & Hjerpe, Certified Public Accountants is an accounting firm
with its principal place of business located in Bloomington, Illinois
doing business throughout the state of Illinois. In certain
circumstances, it is acknowledged that the firm may have, or in the
future may have, business interests outside of the state of Illinois.
Section 9.2 Manner of Performance of Employee’s Duties
Purchaser is principal employer. Seller/Employee, so long as
Purchaser is not in default under any term of this agreement retains no
management, supervisory, or other similar roles with respect to the
operation of the business. Seller/Employee will maintain professional
standards while also observing the rules and obligations as any
employee of the business as outlined in the Employee Manual, SOP
Manual, or other materials, or as otherwise directed by the
Purchaser/Employer. Any action to the contrary shall be construed as
a specific violation of this agreement. Seller/Employee’s status in
this agreement is to be considered an at will employee.
Section 9.3 Duration of Employment and Hours
! From January 1, 2008, until January 1, 2013.
! Seller/Employee shall work appoximately [sic] 40 hours a week
from February 1st through April 15th of each year.
! From April 16th through December 31st, Seller/Employee shall
work approximately 300-500 hours as needed.
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[*22] Section 9.4 Payment
Seller/Employee shall be paid Forty Percent (40%) of his standard
billing rate and be paid bi-weekly.
Section 9.5 Benefits
Effective January 1, 2009, Employer/Purchaser shall pay dues, &
educational expenses of Seller/Employee, up to $3,000.00 per year
provided documentation has been provided by Employee/Seller.
Seller/Employee shall also be provided an additional sum of Five
Hundred Dollars ($500.00) per year as an entertainment subsidy.
Purchaser/Employer shall have no say in what this sum of money is
spent on.
Seller/Employee shall continue to occupy his current office through
January 1, 2013. However, in the event of the purchase of a new
office for the business, he will be provided with a workspace
substantially similar to what he has been accustomed.
Section 9.6 Employee Obligations
A. CPE:
It is the responsibility of the Seller/Employee to maintain the
requirements for continued education as a CPA.
B. CODE OF CONDUCT:
Seller/Employee shall perform at the highest level of
professional conduct measured by the normal standards of the
accounting profession.
C. CONFIDENTIAL COMMUNICATION:
All information whether competitive or otherwise and
communications (written or oral) are considered confidential.
Seller/Employee agrees that any communications or
information relating to the business, and/or originating in the
business are completely confidential. At no time shall this
information be divulged to other parties.
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[*23] Section 9.7 Option to Terminate Contract for Permanent
Disability of Employee
Notwithstanding anything in this agreement to the contrary,
Purchaser/Employer has the option to terminate employment in the
event that during its term Seller/Employee becomes permanently
disabled as the term permanently disabled is defined below. The
option may be exercised by Purchaser/Employer giving notice to
Seller/Employee by registered mail to his home address of his
intention to terminate this employment on the last day of the month
during which notice is mailed, and on the giving of notice this
agreement and the term of this agreement comes to an end on the last
day of the month in which the notice is mailed, with the same force
and effect as if that day were originally stated as the termination date.
For the purposes of this employment, Seller/Employee will be
deemed to have become permanently disabled if, during any year of
the term of this employment, because of ill health, physical or mental
disability, or for other causes beyond his control, he will have been
continuously unable or unwilling or have failed to perform his duties
under this contract for 60 consecutive days, or if, during any year of
the term of this employment, he will have been unable or unwilling or
have failed to perform his duties for a total period of 120 days, either
consecutive or not. For the purposes of this employment, the term
“any year of the term of this employment” is defined to mean any
period of 12 calendar months commencing on the first day of January
and terminating on the 31st day of December.
Section 9.8 Discontinuance of Business as Termination of
Employment
Notwithstanding anything in this agreement to the contrary, in the
event that Purchaser/Employer discontinues operating its Firm in
Illinois, then this employment agreement will terminate as of the last
day of the month in which Purchaser/Employer ceases operations at
any location with the same force and effect as if that day were
originally stated as the termination date of this agreement.
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[*24] Section 9.9 Commitments Binding on Employer Only on Written
Consent
Anything contained in this agreement to the contrary notwithstanding,
it is understood and agreed that Seller/Employee will not have the
right to make any contracts or commitments for or on behalf of
Purchaser/Employer without the written consent of
Purchaser/Employer.
Section 9.10 Managerial Roles in Billing
Purchaser/Employer agrees to allow Seller/Employee discretion in
setting rates and times on client matters which he personally works
on. However, all billings must be approved by Purchaser/Employer.
This section is an attempt to allow for Seller/Employee to retain
certain agreements that he has had with past clients without any
interruption in business as usual.
Seller/Employee will have no access to files or billings of clients in
which he does not personally and substantially work. Furthermore,
he shall have no say in the billing rates and times of such files.
The last two pages of the 2010 agreement include a table titled
“Amortization Schedule--Normal Amortization”. The table sets forth a series of
20 installment sale payments that add up to $1 million.5 Above the table are two
notations: “Compound Period: Quarterly” and “Nominal Annual Rate: 4.000%”.
5
The 2010 agreement also includes a table titled “Cash Flow Data”.
Because all the information in the “Cash Flow Data” table is also reflected in the
“Amortization Schedule--Normal Amortization” table, and we reproduce the
information in the “Amortization Schedule--Normal Amortization” table, it is
unnecessary to separately reproduce the information in the “Cash Flow Data”
table.
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[*25] The information in the table attached to the 2010 agreement is reproduced
below, with figures rounded to the nearest dollar:
Date Payment Interest Principal Balance
Loan 4/15/2008 $891,094
1 4/15/2008 $32,706 -0- $32,706 858,388
2 7/15/2008 46,835 $8,584 38,251 820,137
3 10/15/2008 24,047 8,201 15,846 804,291
2008 Totals 103,588 16,785 86,803
4 1/15/2009 21,179 8,043 13,136 791,156
5 4/15/2009 40,912 7,912 33,001 758,155
6 7/15/2009 53,362 7,582 45,781 712,374
7 10/15/2009 40,000 7,124 32,876 679,498
2009 Totals 155,453 30,660 124,794
8 1/15/2010 40,000 6,795 33,205 646,293
9 4/15/2010 40,000 6,463 33,537 612,756
10 7/15/2010 40,000 6,128 33,872 578,883
11 10/15/2010 40,000 5,789 34,211 544,672
2010 Totals 160,000 25,174 134,826
12 1/15/2011 40,000 5,447 34,553 510,119
13 4/15/2011 40,000 5,101 34,899 475,220
14 7/15/2011 40,000 4,752 35,248 439,972
15 10/15/2011 40,000 4,400 35,600 404,372
2011 Totals 160,000 19,700 140,300
16 1/15/2012 40,000 4,044 35,956 368,416
17 4/15/2012 40,000 3,684 36,316 332,100
18 7/15/2012 40,000 3,321 36,679 295,421
19 10/15/2012 40,000 2,954 37,046 258,375
2012 Totals 160,000 14,003 145,997
20 1/15/2013 260,959 2,584 258,375
2013 Totals 260,959 2,584 258,375
Grand tot. 1,000,000 108,906 891,094
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[*26] As indicated above, the 2010 agreement required Mr. Hjerpe to pay Mr.
Thoma a “balance” of $679,498 in accordance with a promissory note from Mr.
Hjerpe that was attached to the 2010 agreement. However, no promissory note
from Mr. Hjerpe was attached to the 2010 agreement.
2. Mr. Thoma’s work for Thoma & Hjerpe and biweekly payments for his
accounting services
Mr. Thoma brought over clients from his sole proprietorship to Thoma &
Hjerpe, and he continued working for them through Thoma & Hjerpe. Mr. Hjerpe
also brought over his clients to Thoma & Hjerpe, and he continued working for
them through Thoma & Hjerpe.
From 2006 until November 2011 Mr. Thoma provided accounting services
solely through Thoma & Hjerpe. Mr. Thoma worked solely for his clients. In
November 2011 Mr. Thoma and Mr. Hjerpe had a falling out and Mr. Thoma left
Thoma & Hjerpe. The circumstances of the falling out are discussed in greater
detail infra pp. 34-38. Mr. Hjerpe also provided accounting services through
Thoma & Hjerpe, but he performed services only for his clients.
While working for Thoma & Hjerpe, Mr. Thoma performed accounting
services at the following locations: (1) the premises of Thoma & Hjerpe, (2) the
clients’ places of business, and (3) Mr. Thoma’s personal residence.
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[*27] Thoma & Hjerpe paid Mr. Thoma $69,156 and $63,299 for accounting
services rendered in 2010 and 2011, respectively. These amounts are separate and
distinct from the quarterly installment sale payments that Mr. Hjerpe paid to Mr.
Thoma in 2010 and 2011 for the purchase of Mr. Thoma’s ownership interest in
Thoma & Hjerpe. See infra pp. 29-32.
Thoma & Hjerpe reported the amounts paid to Mr. Thoma in 2010 and 2011
for his accounting services as guaranteed payments to a limited partner on
Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. The notice of
deficiency determined that the payments were not guaranteed payments, but rather
wages. See infra p. 53.
In 2010 and 2011 Thoma & Hjerpe usually paid Mr. Thoma for his
accounting services every two weeks. The parties agree that the biweekly
payments were calculated in accordance with the 2010 agreement, which
provided: “Seller/Employee [i.e., Mr. Thoma] shall be paid Forty Percent (40%)
of his standard billing rate and be paid bi-weekly.”6 The record shows (and we
6
The January 11 and 23, 2010, payments were likely governed by the 2005
agreement, and not the 2010 agreement, because the 2010 agreement was executed
on January 28, 2010. The 2005 agreement required that Mr. Thoma receive 40%
of “collected billings on work done by him.” However, despite this requirement, it
appears the two January 2010 payments were based on billings without regard to
client collections.
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[*28] find) that the biweekly payments were mathematically equal to a flat $68 per
hour rate multiplied by the number of hours in each biweekly period. Under the
2010 agreement, this means that the standard billing rate was $170, because $170
per hour × 40% = $68 per hour. We find that the standard billing rate used to
calculate Mr. Thoma’s biweekly payments was $170 per hour.7
Mr. and Ms. Thoma also assert that Mr. Thoma’s biweekly payments were
based on amounts collected from clients. The trial record does not support that
contention either. It shows that the payments were based on the number of hours
that Mr. Thoma billed, without regard to whether the amounts billed were
collected from clients.
The number of hours used to compute the biweekly payments to Mr.
Thoma, and the amount of the biweekly payments made to him, varied by season.
The number of hours and biweekly payment amounts were significantly greater
during February, March, and April of 2010 and 2011.
7
Mr. and Ms. Thoma assert that Mr. Thoma’s biweekly payments were
calculated using different billing rates. The trial record does not support that
contention. The trial record shows that Mr. Thoma’s biweekly payments were
calculated by multiplying Mr. Thoma’s number of hours by a uniform $68 hourly
rate. While it may be that Mr. Thoma’s clients were billed at different rates for
Mr. Thoma’s time, the billing rate upon which Mr. Thoma’s compensation was
calculated (i.e., the “standard billing rate” as that term was used in the 2010
agreement) did not vary.
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[*29] No amounts were withheld from the biweekly payments to Mr. Thoma. No
federal or state tax was withheld from Mr. Thoma’s biweekly payments. No
Federal Insurance Contributions Act tax or Medicare tax was withheld. No
amounts were withheld as SIMPLE IRA contributions.
While Mr. Thoma worked for Thoma & Hjerpe in 2010 and 2011, he did not
receive any paid sick leave or paid vacations.
Thoma & Hjerpe had professional liability insurance during 2010 and 2011,
and Mr. Thoma was included on the policy.
3. Mr. Thoma’s sale of his interest in Thoma & Hjerpe and quarterly
installment payments
Section 12(b) of the 2005 agreement called for Mr. Hjerpe to pay Mr.
Thoma $30,000 for office equipment and leasehold improvements. Section 12(d)
called for Mr. Hjerpe to make installment payments to Mr. Thoma for “the
goodwill of Thoma & Associates, CPAs”. According to the 2005 agreement, the
installment payments were to be made from April 15, 2008, to April 15, 2013,
covering the period January 1, 2008, to December 31, 2012. The amount of the
installment payments was to be equal to “twenty percent of the collected billings
from clients Thoma has brought to the firm”.
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[*30] The 2010 agreement acknowledged in its recitals that the 2005 agreement
provided for the sale of Mr. Thoma’s interest in Thoma & Hjerpe to Mr. Hjerpe.
The 2010 agreement stated that Mr. Thoma and Mr. Hjerpe “wish[ed] to restate
that [2005] agreement in its entirety.” Section 1.1 of the 2010 agreement required
that Mr. Thoma sell to Mr. Hjerpe various itemized assets of Thoma & Hjerpe
upon execution of the 2010 agreement. Section 3.2 required Mr. Thoma not to
compete with Mr. Hjerpe within a 100-mile radius for four years after leaving Mr.
Hjerpe’s employment. Section 2.1 required Mr. Hjerpe to pay Mr. Thoma
$891,094, composed of $886,094 for the assets of Thoma & Hjerpe and $5,000 for
the covenant not to compete. Section 2.2 stated that $211,596 of the $886,094 had
already been paid, leaving an unpaid balance of $679,498.
The table attached to the 2010 agreement listed 20 quarterly installment
payments. Their dates and amounts are such that the discounted present value of
the total, using a 4% quarterly interest rate, is $891,094 on April 15, 2008. The
table assumes as historical fact that Mr. Hjerpe had paid Mr. Thoma the first seven
installments in 2008 and 2009. The table divides each of these past payments into
principal and interest components. The table lists 13 future payments, also
divided into principal and interest components. The 2008 “Principal” total of
$86,803 and the 2009 “Principal” total of $124,794 add up to $211,596, which is
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[*31] the same amount as the “initial payment” specified in Section 2.2 of the
2010 agreement. See supra p. 19. The aggregate sum of the “Principal” totals for
2010, 2011, 2012, and 2013 is $679,498, the same amount as the balance of the
purchase price specified in Section 2.2 of the 2010 agreement. See supra p. 19.
There is no dispute that Mr. Hjerpe paid Mr. Thoma the first seven
installment payments listed in the table. Mr. Hjerpe paid three installment
payments in 2008, totaling $103,588, and four in 2009, totaling $155,453. These
seven installment payments add up to $259,041.
The IRS alleges that the first seven installment payments were computed in
accordance with the 2005 agreement, providing that the installment payments were
to equal 20% of the collected billings from Mr. Thoma’s clients. Though the trial
record discloses the amounts of the first seven installment payments, which were
made in 2008 and 2009, it does not disclose how these installment payments were
computed. The trial record does not indicate whether the seven installment
payments were calculated using the formula from the 2005 agreement.
For 2010 and 2011 the table lists eight $40,000 installment payments. The
parties do not dispute that Mr. Hjerpe paid Mr. Thoma all eight, for a total of
$320,000. From 2008 to 2011, inclusive, Mr. Hjerpe made payments of principal
and interest to Mr. Thoma totaling $579,041.
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[*32] Mr. Hjerpe stopped making installment payments to Mr. Thoma in 2012.
Accordingly, Mr. Thoma did not receive the $160,000 in installment payments
listed in the table attached to the 2010 agreement for 2012, nor the final $260,958
installment payment for 2013.
4. Thoma & Hjerpe’s SIMPLE IRA plan and Mr. Thoma’s contributions to his
SIMPLE IRA
At some point before 2010 Thoma & Hjerpe established a SIMPLE IRA
plan under section 408(p). A SIMPLE IRA plan is a small-employer-sponsored
individual retirement plan that is funded by employee compensation deferrals and
employer matching contributions.8 See sec. 408(p)(1) and (2).
A SIMPLE IRA plan can be established by executing a Form 5304-SIMPLE
or Form 5305-SIMPLE.9 Notice 97-6, 1997-1 C.B. 353; Notice 98-4, 1998-1 C.B.
269; I.R.S. News Release IR-96-55 (Dec. 30, 1996). The trial record does not
contain either form or any other documents about the establishment of the
SIMPLE IRA plan. Mr. Thoma had a SIMPLE IRA through Thoma & Hjerpe’s
8
A SIMPLE IRA plan can be either an individual retirement account
described in sec. 408(a) or an individual retirement annuity described in sec.
408(b). Secs. 408(p)(1), 7701(a)(37)(A) and (B).
9
Forms 5304-SIMPLE and 5305-SIMPLE are not filed with IRS. See I.R.S.
Form 5304-SIMPLE (December 1996); I.R.S. Form 5305-SIMPLE (October
1996). Instead, the creator of the SIMPLE IRA plan keeps a copy for its records.
Id.
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[*33] SIMPLE IRA plan before 2010. The trial record does not disclose when Mr.
Thoma opened his SIMPLE IRA. The trial record does not disclose any
information about the contributions to Mr. Thoma’s SIMPLE IRA in years before
2010. Thus, we do not know the dates or amounts of contributions, or who made
the contributions before 2010.
In 2010 and 2011 Thoma & Hjerpe withheld amounts from its employees’
compensation to fund deposits and make contributions on their behalf to their
SIMPLE IRAs. In 2010 and 2011 Mr. Hjerpe was the individual responsible for
making both the employer portion and employee portion of the SIMPLE IRA plan
contributions. However, Mr. Hjerpe did not make all the required SIMPLE IRA
plan contributions. In October 2011 Mr. Thoma reported to the U.S. Department
of Labor that Mr. Hjerpe had failed to make all the required SIMPLE IRA plan
contributions.
During the years at issue Mr. Thoma and Mr. Hjerpe had an understanding
that Thoma & Hjerpe, as plan sponsor, would not withhold amounts from Mr.
Thoma’s biweekly accounting services payments to fund deposits into his
SIMPLE IRA and that Thoma & Hjerpe would not make contributions on Mr.
Thoma’s behalf to his SIMPLE IRA. Instead, Mr. Thoma deposited funds from
his personal bank account via check into his SIMPLE IRA. The parties agree that
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[*34] the total amounts Mr. Thoma directly deposited into his SIMPLE IRA were
$15,711 in 2010 and $14,000 in 2011.
5. Mr. Thoma and Mr. Hjerpe’s falling out; Mr. Thoma’s professional
licensing authority complaint; Mr. Thoma’s lawsuit for remaining quarterly
installment payments; Mr. Thoma’s unemployment benefits claim
Around November 3, 2011, the U.S. Department of Justice sent a letter to
Thoma & Hjerpe. The trial record does not include a copy of the letter. At trial
Mr. Thoma described the letter as a civil investigative demand, issued personally
to him, that requested the records of one or more of his clients. We make no
findings as to contents of the letter. Mr. Thoma responded to the letter but never
informed Mr. Hjerpe about it. Mr. Hjerpe eventually learned about the letter. A
few weeks later, on November 20, 2011, Mr. Thoma arrived at the offices of
Thoma & Hjerpe and found that the locks had been changed. He also discovered
he no longer had access to the network, client files, and email accounts. That
same day Mr. Thoma received a letter from Mr. Hjerpe informing him that he was
being placed on administrative leave for his “gross mishandling” of the U.S.
Department of Justice letter and asking him to “refrain from contacting any of our
clients” until Mr. Hjerpe had “a better handle on what is going on”. Mr. Thoma
did not provide any accounting services to his clients at Thoma & Hjerpe after
receiving Mr. Hjerpe’s letter. His professional and business association with
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[*35] Thoma & Hjerpe ended on November 20, 2011, the day Mr. Hjerpe placed
him on administrative leave. We now discuss the relevant events that occurred
after Mr. Thoma left Thoma & Hjerpe.
Mr. and Ms. Thoma claim in their briefs that in 2010 and 2011 Thoma &
Hjerpe was issued a professional accounting license by the State of Illinois, that
the license listed Thoma & Hjerpe as a partnership (and Mr. Thoma and Mr.
Hjerpe as its partners), and that Mr. Hjerpe operated Thoma & Hjerpe under the
same license even after Mr. Thoma had left Thoma & Hjerpe in November 2011.
They further claim that after Mr. Thoma left Thoma & Hjerpe, he filed a complaint
with the Illinois professional licensing authority that requested removal of Mr.
Thoma’s name from Thoma & Hjerpe’s license. The trial record does not contain
the professional accounting license for Thoma & Hjerpe. It contains a
supplemental renewal form for public accounting firms licensed in Illinois, signed
by Mr. Hjerpe. The form is dated August 10, 2009, and under “firm name” lists
“Thoma & Hjerpe CPAs”. Mr. Hjerpe and Mr. Thoma’s names are listed under
the box that states: “The following is a list of changes in members of the above
firm as of this date”. At trial Mr. Thoma did not provide an explanation for the
information in this supplemental renewal form. Neither do Mr. and Ms. Thoma’s
briefs. The form itself does not suggest that this particular form was to be
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[*36] completed only by businesses seeking to be licensed as partnerships. The
trial record does not contain a complaint by Mr. Thoma to the Illinois professional
licensing authority. It does contain a letter to Mr. Thoma from the Illinois
professional licensing authority, dated December 27, 2011. The letter
acknowledges receipt of a complaint from Mr. Thoma but does not reveal the
nature of Mr. Thoma’s complaint. The IRS’ briefs contend that the information
shown on the license renewal form and the letter to Mr. Thoma from the Illinois
professional licensing authority are insufficient to support Mr. and Ms. Thoma’s
claims concerning the professional licensing of Thoma & Hjerpe in 2010 and
2011. We agree with the IRS. We do not find that Mr. and Ms. Thoma’s
assertions in their briefs concerning the professional licensing of Thoma & Hjerpe
in 2010 and 2011 are correct: that is, we do not find that Thoma & Hjerpe was
operated in 2010 and 2011 under a professional accounting license issued by the
State of Illinois naming Thoma & Hjerpe as a partnership and Mr. Thoma and Mr.
Hjerpe as its partners.
By the time Mr. Thoma left Thoma & Hjerpe, Mr. Hjerpe had paid him
principal and interest totaling $579,041 for his ownership interest in Thoma &
Hjerpe. Mr. Hjerpe was required to pay the remaining $420,959 balance in five
quarterly installment payments, four in 2012 and one in 2013. The first
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[*37] installment payment of 2012 was due on January 15, 2012, but Mr. Hjerpe
failed to make that payment. On or about January 23, 2012, Mr. Thoma filed a
lawsuit against Mr. Hjerpe for Mr. Hjerpe’s failure to make that quarterly
installment payment. Mr. Hjerpe also failed to make the other three payments due
in 2012 (April 15, July 15, and October 15), and the final payment due on January
15, 2013. By the time trial in this case took place in October 2016, Mr. Hjerpe
still had not paid Mr. Thoma the remaining $420,959.10
At some point after November 20, 2011, Mr. Thoma filed a claim for
unemployment benefits with the Illinois Department of Employment Security.
On March 7, 2012, the Illinois Department of Employment Security mailed
a letter to Mr. Thoma explaining that it was denying him unemployment benefits
on grounds that he had been discharged from Thoma & Hjerpe for misconduct
connected with work: specifically, his failure to inform Mr. Hjerpe about the letter
from the U.S. Department of Justice.
On March 19, 2012, Mr. Thoma submitted a “Request for Reconsideration”
appealing the March 7, 2012 decision of the Illinois Department of Employment
10
However, Mr. and Ms. Thoma state in their answering brief that “due to
recent court proceedings, * * * [Mr. Thoma] ended up getting the full payments on
* * * [his] contract some five years beyond the due dates.”
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[*38] Security. In the request Mr. Thoma stated that “[o]n November 21, 2011, I
was an employee of Thoma & Hjerpe, CPAs.”
On March 26, 2012, Mr. and Ms. Thoma, through their attorneys, filed a
complaint in the Circuit Court of McLean County, Illinois, against Thoma &
Hjerpe and Mr. Hjerpe. The complaint alleged that Thoma & Hjerpe’s termination
of Mr. Thoma was illegal.
On April 24, 2012, an Illinois administrative law judge reversed the
decision of the Illinois Department of Employment Security and held that Mr.
Thoma was eligible for unemployment benefits on grounds that he had not
engaged in misconduct connected with work.
On July 18, 2012, the Illinois Department of Employment Security Board of
Review affirmed the Illinois administrative law judge’s decision that Mr. Thoma
was eligible for unemployment benefits.
6. Tax reporting
a. 2010 return
Generally, a partnership files a Form 1065, “U.S. Return of Partnership
Income”, with the IRS for each tax year to report the partnership’s tax items. See
sec. 6031. The partnership also files a Schedule K-1 with the IRS to report each
partner’s share of the partnership’s tax items. Id.; sec. 1.6031(a)-1(a)(1) and (2),
- 39 -
[*39] Income Tax Regs.; see also Cambridge Partners, L.P. v. Commissioner, T.C.
Memo. 2017-194, at *11. The partnership also sends a copy of the partnership
return and partner’s Schedule K-1 to each partner. See sec. 6031(b); sec.
1.6031(b)-1T(a)(1), (3), Temporary Income Tax Regs., 53 Fed. Reg. 34490, 34491
(Sept. 7, 1988).
The trial record does not contain a Form 1065 for Thoma & Hjerpe’s 2010
tax year or any other year. It contains a Schedule K-1 that Thoma & Hjerpe issued
to Mr. Thoma for 2010, but it does not disclose who prepared the Schedule K-1.11
It does not contain the Schedule K-1 that Thoma & Hjerpe ostensibly issued to
Mr. Hjerpe for 2010.
Mr. Thoma’s Schedule K-1 for 2010 reported that the name of the
partnership was “Thoma & Hjerpe, CPAs” and the name of the partner was Mr.
Thoma. The Schedule K-1 stated that he was a limited partner, rather than a
general partner.
11
In their briefs Mr. and Ms. Thoma assert that “Eric L. Hjerpe prepared the
partnership tax returns. The K-1 form is one page of that tax return.” Mr. Thoma
did not testify as to bookkeeping and return preparation for Thoma & Hjerpe. The
trial record does not contain evidence of return preparation and bookkeeping. The
record does not support a finding that Mr. Hjerpe prepared partnership returns for
Thoma & Hjerpe or the Schedules K-1.
- 40 -
[*40] The preprinted Schedule K-1 had the following lines to show changes in the
partner’s capital account: “Beginning capital account”, “Capital contributed
during the year”, “Current year increase (decrease)”, “Withdrawals and
distributions”, and “Ending Capital Account.” The beginning and ending capital
account lines had entries of zero; the other lines were blank. Mr. Thoma’s
Schedule K-1 also left blank the lines for year-begin and year-end percentages of
his share of profit, loss, and capital, and the line for his share of the liabilities at
year-end.
The $69,156 that Thoma & Hjerpe paid Mr. Thoma for accounting services
in 2010 appeared on two lines of Mr. Thoma’s Schedule K-1 for 2010. Line 4,
“Guaranteed payments”, had an entry of $69,156. Line 14, “Self-employment
earnings (loss)”, also had an entry of $69,156. The Schedule K-1 had 18
additional lines for a partner’s share of income or loss, e.g., “Ordinary, business
income (loss)”, “Credits”, and “Distributions”, but they were all blank.
Mr. Thoma prepared his and Ms. Thoma’s Form 1040, “U.S. Individual
Income Tax Return”, for 2010. The 2010 return reported total wage income of
$30,166, which was for Ms. Thoma’s work as an employee of Thoma & Hjerpe.
The 2010 return reported no wage income for Mr. Thoma.
- 41 -
[*41] Mr. and Ms. Thoma’s 2010 return claimed a deduction of $15,711 on line
28, “Self-employed SEP, SIMPLE, and qualified plans”, for amounts Mr. Thoma
directly deposited into his SIMPLE IRA in 2010.
The 2010 return claimed a deduction of $4,648 on line 29, “Self-employed
health insurance deduction”, for health insurance premiums that Mr.Thoma paid in
2010.
The 2010 return claimed a deduction for one-half of self-employment tax on
line 27. The deduction was $3,724, one-half of Mr. Thoma’s self-employment-tax
liability reported on Schedule SE, “Self-Employment Tax”, discussed infra p. 42.12
Mr. and Ms. Thoma attached a Schedule E, “Supplemental Income and
Loss”, to the 2010 return and reported that Mr. Thoma’s gross income inclusion
corresponding to “Thoma & Hjerpe, CPAs” was $69,156. It also reported a
$7,396 loss from “UPE”. The UPE description was intended by Mr. and Ms.
Thoma to refer to “unreimbursed partnership expenses”, that is, Mr. Thoma’s
expenses of working for Thoma & Hjerpe.
In reporting Mr. Thoma’s gross income pertaining to Thoma & Hjerpe on
their 2010 Form 1040, Mr. and Ms. Thoma reported $61,760 ($69,156 income
12
Mr. and Ms. Thoma did not attach a Schedule SE for Ms. Thoma to the
2010 and 2011 returns because she did not have net earnings from self-
employment.
- 42 -
[*42] share ! $7,396 UPE), such that the $7,396 was deducted in arriving at
adjusted gross income.
Mr. and Ms. Thoma attached a Schedule F, “Profit or Loss From Farming”,
to their 2010 return and reported a net farm loss of $4,396.
Mr. and Ms. Thoma also attached a Schedule SE for Mr. Thoma to the 2010
return. The Schedule SE reported that Mr. Thoma had net earnings from self-
employment of $52,716 and calculated a self-employment-tax liability for Mr.
Thoma of $7,448. The Schedule SE reported that Mr. Thoma’s $52,716 in net
earnings from self-employment was calculated as follows:
Self-employment income from Thoma & Hjerpe $69,156
Mr. Thoma’s unreimbursed partnership
expenses related to Thoma & Hjerpe (7,396)
Mr. Thoma’s net farm loss (4,396)
Mr. Thoma’s expenses for health insurance (4,648)
Mr. Thoma’s net earnings from self-employment 52,716
As explained previously, the 2010 return reported a $3,724 income-tax
deduction for one-half of the self-employment tax.
Mr. Thoma received $160,000 in installment sale payments from Mr. Hjerpe
during 2010, which were unrelated to the accounting services that Mr. Thoma
rendered to Thoma & Hjerpe. On their 2010 return Mr. and Ms. Thoma reported
that the $160,000 in installment payments was part of an installment sale of
- 43 -
[*43] goodwill that had taken place on December 31, 2008. They attached to their
return a Form 6252, “Installment Sale Income”, that reported the property sold was
“GOODWILL”, the “Date sold” was December 31, 2008, and the “Date acquired”
was October 1, 1976.
Form 6252 is used to report income from an installment sale using the
installment method of accounting. On the Form 6252 taxpayers report all
installment payments received during the year from the installment sale on line 21.
Taxpayers determine the income from these installment payments by multiplying
the amount on line 21 by the gross profit percentage.
Part I of the Form 6252 contains lines for computing the gross profit
percentage. Part I is only to be completed for the year of sale. Mathematically,
Part I calculates that the gross profit percentage is:
noninterest component of selling price ! basis
noninterest component of selling price
Consistent with the idea that the installment sale took place in 2008, the Form
6252 for 2010 did not contain any information in Part I.
In Part II of the Form 6252 for 2010, on line 21, Mr. and Ms. Thoma
reported that the installment payments they received during the year totaled
$134,826. The Form 6252 instructs taxpayers to exclude the interest component
- 44 -
[*44] of the installment payments when computing the amount to report on line
21. Note that the table attached to the 2010 agreement contained a schedule of
installment payments in which Mr. Hjerpe would pay Mr. Thoma $160,000 in
2010 and that the schedule showed $134,826 of these payments were principal and
$25,174 interest. Recall also that installment payments totaling $160,000 were in
fact made by Mr. Hjerpe to Mr. Thoma in 2010.
On the Form 6252 for 2010 Mr. and Ms. Thoma reported that the gross
profit percentage was 95.51%. The Form 6252 for 2010 does not indicate how the
gross profit percentage was computed. The trial record does not include the Form
6252 that they filed for 2008, the year they reported that the installment sale had
occurred.
Although the Form 6252 for 2010 does not state how the gross profit
percentage was computed, we can deduce from the 2010 agreement (and we find)
that the 95.51% gross profit percentage reported on the Form 6252 for 2010 was
equal to ($891,094 ! $40,000) ÷ $891,094. Recall that $891,094 was the
principal, i.e., the noninterest component, of the $1 million in installment
payments to be made by Mr. Hjerpe to Mr. Thoma for the assets of Thoma &
- 45 -
[*45] Hjerpe. Recall also that $40,000 was Mr. Thoma’s basis, the amount he paid
for a partial ownership interest in the accounting firm.13
On the Form 6252 for 2010 Mr. and Ms. Thoma reported that they had
$128,772 of income for 2010, corresponding to $134,826 in payments they
received in 2010. To get $128,772, they multiplied $134,826 by 95.51%. They
reported that the $128,772 was income on the main page of the Form 1040. They
also reported that they earned $25,174 in taxable interest on the main page of the
Form 1040.
Form 6252 requires taxpayers to report installment payments received in
prior years. On the Form 6252 for 2010 Mr. and Ms. Thoma reported that the
installment payments they had received in prior years totaled $211,597. Recall
that $211,597 is the amount of the principal component of installment payments
already received by Mr. Thoma from Mr. Hjerpe for the assets of Thoma &
Hjerpe, identified in the table attached to the 2010 agreement.
b. 2011 return
As with 2010, the trial record does not contain a Form 1065 for Thoma &
Hjerpe’s 2011 tax year. The trial record contains only the Schedule K-1 that
Thoma & Hjerpe issued to Mr. Thoma for 2011. The information on the Schedule
13
The parties agree that Mr. Thoma’s basis in Thoma & Hjerpe is $40,000.
- 46 -
[*46] K-1 for 2011 is similar to the information reported on Mr. Thoma’s
Schedule K-1 for 2010.
Mr. Thoma’s Schedule K-1 for 2011 is compared to his Schedule K-1 for
2010 in the table below:
Item 2010 2011
Thoma & Thoma &
Name of partnership Hjerpe, CPAs Hjerpe, CPAs
Name of partner Mr. Thoma Mr. Thoma
Limited or general partner Limited Limited
Beginning capital account -0- -0-
Capital contributed during the year -- --
Current year increase (decrease) -- --
Withdrawals and distributions -- --
Ending capital account -0- -0-
Year-begin percentages of partner share of
profit, loss, and capital -- --
Year-end percentages of partner share of
profit, loss, and capital -- --
Partner share of liabilities at year end -- --
Line 4, guaranteed payments $69,156 $63,299
Line 14, self-employment earnings (loss) 69,156 63,299
Additional lines for partner’s share of
income and loss -- --
- 47 -
[*47] Mr. Thoma prepared his and Ms. Thoma’s Form 1040 for tax year 2011.
The information reported on Form 1040 for 2011, and the schedules attached
thereto, are similar to the information reported for 2010. The following table
summarizes this information:
Item 2010 2011
Ms. Thoma’s wage income from
Thoma & Hjerpe $30,166 $36,492
Line 28 deduction for “Self-employed
SEP, SIMPLE, and qualified plans”
for amounts Mr. Thoma directly
deposited into his SIMPLE IRA 15,711 14,000
Line 29 deduction for “Self-employed
health insurance deduction” for
Mr. Thoma’s health insurance
premium expenses 4,648 5,580
Deduction for one-half of Mr. Thoma’s
self-employment tax reported on his
Schedule SE 3,724 2,915
Schedule E: Mr. Thoma’s share of
Thoma & Hjerpe’s income (a
partnership item) 69,156 63,299
Schedule E: Mr. Thoma’s
unreimbursed partnership expenses
from working for Thoma & Hjerpe 7,396 20,867
Net gross income inclusion 61,760 42,432
corresponding to Thoma & Hjerpe (69,145 ! 7,396) (63,299 ! 20,867)
Schedule F net farm loss 4,396 1,162
- 48 -
[*48] As reported, the $20,867 in unreimbursed partnership expenses affected net
earnings from self-employment. The Schedule SE for 2011 contained the
following information, which we compare to the Schedule SE for 2010:
Self-employment income from Thoma & Hjerpe $69,156 $63,299
Mr. Thoma’s unreimbursed partnership expenses
related to Thoma & Hjerpe (7,396) (20,867)
Mr. Thoma’s net farm loss (4,396) (1,162)
Mr. Thoma’s expenses for health insurance1 (4,648) -0-
Mr. Thoma’s net earnings from self-employment 52,716 41,270
Self-employment tax 7,448 5,069
1
This deduction in arriving at self-employment tax is allowed only for 2010.
Sec. 162(l)(4).
Mr. Thoma received $160,000 in quarterly installment payments from Mr.
Hjerpe during 2011, which were unrelated to the accounting services that Mr.
Thoma rendered to Thoma & Hjerpe in 2011. As with the 2010 return, Mr. and
Ms. Thoma attached a Form 6252 and reported that the $160,000 in quarterly
installment payments was part of an installment sale of goodwill that had been
acquired on October 1, 1976, and sold on December 31, 2018.
As with the Form 6252 for 2010, Part I of the Form 6252 for 2011 was left
blank. On line 21 of the Form 6252 for 2011, Mr. and Ms. Thoma reported that
the installment sale payments they had received during 2011 totaled $156,079.
The Form 6252 for 2011 reported that the gross profit percentage was 84.34%.
- 49 -
[*49] The amount of installment sale payments for 2011 and the gross profit
percentage were computed by Mr. Thoma. In short, Mr. Thoma took the table that
was attached to the 2010 agreement and modified it. Recall that the table attached
to the 2010 agreement listed 20 quarterly installment payments to be made by Mr.
Hjerpe to Mr. Thoma in the years 2008, 2009, 2010, 2011, 2012, and 2013. By the
time Mr. Thoma prepared the Form 6252 for 2011, Mr. Hjerpe had ceased making
quarterly installment payments. The first missed quarterly installment payment
was due on January 15, 2012. Mr. Thoma modified the table attached to the 2010
agreement to eliminate the four installment payments due in 2012 and the final
installment payment due in 2013. The first 15 installment payments shown on the
table attached to the 2010 agreement continued to be shown in the same amounts
in the modified table Mr. Thoma used to prepare the 2011 return. However, each
installment payment’s respective interest and principal components changed as a
computational matter. The principal components of the four 2011 installment
payments totaled $156,079. This is the amount that Mr. Thoma reported on line
21. The interest components of the four 2011 installment payments totaled
$3,921.
Below is the modified table that Mr. Thoma used to prepare the Form 6252
for 2011:
- 50 -
[*50] Date Payment Interest Principal Balance
Loan 4/15/2008 $539,305
1 4/15/2008 $32,706 -0- $32,706 506,600
2 7/15/2008 46,835 $5,066 41,769 464,831
3 10/15/2008 24,047 4,648 19,399 445,432
2008 Totals 103,588 9,714 93,874
4 1/15/2009 21,179 4,454 16,724 428,707
5 4/15/2009 40,912 4,287 36,625 392,082
6 7/15/2009 53,362 3,921 49,441 342,641
7 10/15/2009 40,000 3,426 36,574 306,067
2009 Totals 155,453 16,089 139,365
8 1/15/2010 40,000 3,061 36,939 269,128
9 4/15/2010 40,000 2,691 37,309 231,819
10 7/15/2010 40,000 2,318 37,682 194,137
11 10/15/2010 40,000 1,941 38,059 156,079
2010 Totals 160,000 10,012 149,988
12 1/15/2011 40,000 1,561 38,439 117,639
13 4/15/2011 40,000 1,176 38,824 78,816
14 7/15/2011 40,000 788 39,212 39,604
15 10/15/2011 40,000 396 39,604 -0-
2011 Totals 160,000 3,921 156,079
Grand tot. 579,041 39,736 539,305
In determining that the gross profit percentage was 84.34%, Mr. Thoma first
calculated how much of his $40,000 basis had been used, to determine the income
component of the quarterly installment payments in the years 2008, 2009, and
2010. As a result of these calculations, he figured that $24,442 of basis remained
at the beginning of 2011. The 84.34% gross profit percentage reported on the
Form 6252 for 2011 was equal to ($156,079 ! $24,442) ÷ $156,079.
- 51 -
[*51] On the Form 6252 for 2011, Mr. and Ms. Thoma reported $131,637 of
income for 2011 from the $156,079 in quarterly installment sale payments
received during 2011. To get $131,637, they multiplied $156,079 by 84.34%.
They reported the $131,637 as income on the main page of the Form 1040. They
also reported that they earned $3,921 of taxable interest on the main page of the
Form 1040. They reported that the payments they received in prior years totaled
$346,423. The $346,423 reported is equal to the principal components of the
quarterly installment payments in 2008, 2009, and 2010, shown in the table
attached to the 2010 agreement. The $346,423 is also equal to $211,597 (the
payments received in prior years reported on the Form 6252 for 2010) plus
$134,826 (the payments received in 2010 reported on the Form 6252 for 2010).
7. Notice of deficiency
The IRS examined Mr. and Ms. Thoma’s joint income-tax returns for tax
years 2010 and 2011. Revenue Agent Dana Ransdell conducted the examination.
On March 18, 2013, the IRS issued a 30-day letter to Mr. and Ms. Thoma
signed by Marilyn Clark, Supervisory Internal Revenue Agent at the IRS and
Ransdell’s immediate supervisor. The 30-day letter attached an examination
report dated March 18, 2013, and signed by Ransdell. It proposed income-tax
deficiencies for 2010 and 2011 and asserted section 6662(a) accuracy-related
- 52 -
[*52] penalties for both years on grounds of: (1) negligence or reckless disregard
of rules and regulations or (2) substantial understatements of income tax. The 30-
day letter offered Mr. and Ms. Thoma the opportunity to dispute the examination
report with the (then-called) IRS Office of Appeals.
On June 4, 2015, the IRS issued a notice of deficiency to Mr. and Ms.
Thoma determining that there were underpayments of tax for 2010 and 2011 due
to four alternative causes (negligence, a substantial understatement of income tax,
a substantial valuation misstatement, or a transaction lacking economic substance)
and that Mr. and Ms. Thoma were liable for section 6662(a) accuracy-related
penalties for 2010 and 2011. The underpayments are the result of the adjustments
described below.
The notice of deficiency determined that the gross profit percentage that
should be used in computing Mr. Thoma’s income for 2011 from the installment
sale was 95.51%. Recall that Mr. and Ms. Thoma reported on their 2011 return
that the gross profit percentage was 84.34%. As a result of this change, the notice
of deficiency increased capital gains by $2,364 and taxable interest by $15,779 for
2011, and reduced tax-free recovery of basis by $18,143.
- 53 -
[*53] The notice of deficiency also determined that Mr. Thoma was an employee
of Thoma & Hjerpe in 2010 and 2011; this determination resulted in the following
six adjustments.
First, the notice of deficiency determined that since Mr. Thoma was an
employee, the biweekly payments he received in 2010 and 2011 from Thoma &
Hjerpe for his accounting services were wages. These payments totaled $69,156
for 2010 and $63,299 for 2011. This recharacterization did not affect Mr. and Ms.
Thoma’s gross income for income-tax purposes.
Second, the notice of deficiency determined that since Mr. Thoma was an
employee, the biweekly payments he received in 2010 and 2011 from Thoma &
Hjerpe for his accounting services were not self-employment income. Thus, the
notice of deficiency reduced self-employment income as compared to the amounts
reported on Schedule SE by $69,156 for 2010 and by $63,299 for 2011, to zero.14
On the basis of these reductions, Mr. Thoma’s self-employment-tax liability was
also reduced to zero for both years.
14
We need not determine the correctness of the net farm losses Mr. and Ms.
Thoma reported on their Schedules F and Mr. Thoma’s Schedules SE, see supra
pp. 42, 47-48, because the notice of deficiency did not propose any adjustments to
the losses reported and did not determine any corresponding deficiencies.
- 54 -
[*54] Third, the notice of deficiency determined that since Mr. Thoma did not
have self-employment-tax liability for 2010 or 2011, Mr. and Ms. Thoma were not
entitled to a deduction for one-half of self-employment tax for each year. It
disallowed the deductions claimed for one-half of self-employment tax for 2010
and 2011 of $3,724 and $2,915, respectively.
Fourth, the notice of deficiency determined that because Mr. Thoma was an
employee of Thoma & Hjerpe in 2010 and 2011, his expenses of working for
Thoma & Hjerpe were not expenses paid by a self-employed taxpayer and were
not deductions in arriving at AGI. The notice of deficiency determined that Mr.
Thoma’s expenses of working for Thoma & Hjerpe were deductible only as
unreimbursed-employee-business expenses, subject to the 2% of AGI floor for
miscellaneous deductions. The notice of deficiency allowed the business expenses
as miscellaneous itemized deductions of $7,288 for 2010 and $14,406 for 2011.
After taking into account the 2% of AGI floor for miscellaneous itemized
deductions, the notice of deficiency determined that deductions for those business
expenses should be allowed in the reduced amounts of $1,927 for 2010 and $7,906
for 2011.
Fifth, the notice of deficiency determined that since Mr. Thoma was an
employee of Thoma & Hjerpe in 2010 and 2011, his health insurance expenses
- 55 -
[*55] were not expenses paid by a self-employed taxpayer and were not deductible
in arriving at AGI. The notice of deficiency disallowed $4,648 and $5,580 in self-
employed health insurance deductions claimed for 2010 and 2011, respectively.
The notice of deficiency determined that the health insurance expenses were
allowable only as itemized deductions for medical and dental expenses, subject to
the 7.5% of AGI floor for medical and dental expenses. The notice of deficiency
determined that because Mr. and Ms. Thoma’s medical and dental expenses did
not exceed the 7.5% of AGI floor in 2010 or 2011, they were not entitled to any
deduction for the health insurance expenses.
Sixth, the notice of deficiency determined that since Mr. Thoma was an
employee of Thoma & Hjerpe in 2010 and 2011, Mr. and Ms. Thoma misreported
Mr. Thoma’s deductions for contributions to his SIMPLE IRA as contributions
from a self-employed taxpayer. The notice of deficiency disallowed the
deductions claimed for amounts Mr. Thoma directly deposited into his SIMPLE
IRA in 2010 and 2011, in the respective amounts of $15,711 and $14,000.
OPINION
The taxpayer generally bears the burden of proving that the determinations
in the notice of deficiency are erroneous. Rule 142(a); Welch v. Helvering, 290
U.S. 111, 115 (1933). The burden of proof is satisfied by a preponderance of the
- 56 -
[*56] evidence. Estate of Gilford v. Commissioner, 88 T.C. 38, 51 (1987). If the
taxpayer shows that the requirements of section 7491(a)(1) and (2) are satisfied for
a particular factual issue, then the burden of proof is imposed on the IRS as to that
issue. Higbee v. Commissioner, 116 T.C. 438, 442 (2001). Mr. and Ms. Thoma
do not argue that the requirements of section 7491(a)(1) and (2) are satisfied, nor
does the record show that they are. We hold that the burden does not shift to the
IRS as to any factual issue.
I. Mr. Thoma’s self-employment-tax liability for 2010 and 2011
On the 2010 return Mr. and Ms. Thoma reported that Mr. Thoma had net
earnings from self-employment of $52,716 and that he was liable for self-
employment tax of $7,448, and they claimed a deduction of $3,724 for one-half of
Mr. Thoma’s self-employment-tax liability.
On the 2011 return Mr. and Ms. Thoma reported that Mr. Thoma had net
earnings from self-employment of $41,270 and that he was liable for self-
employment tax of $5,069, and they claimed a deduction of $2,915 for one-half of
Mr. Thoma’s self-employment-tax liability.
The notice of deficiency determined that Mr. Thoma was an employee of
Thoma & Hjerpe and, as a consequence, reduced Mr. Thoma’s net earnings from
self-employment from $52,716 for 2010 and $41,270 for 2011 to zero for both
- 57 -
[*57] years, reduced his self-employment-tax liability from $7,448 for 2010 and
$5,069 for 2011 to zero for both years, and disallowed the deductions claimed for
one-half of Mr. Thoma’s self-employment-tax liability for both years.
The amounts of Mr. and Ms. Thoma’s income-tax liabilities are based on
their taxable income. See sec. 1(a). Taxable income for taxpayers who itemize
deductions (such as Mr. and Ms. Thoma) is equal to AGI (i.e., gross income minus
above-the-line deductions) minus itemized deductions and the personal-exemption
deduction. Sec. 63(a). AGI is defined as gross income minus certain deductions
known as above-the-line deductions. Sec. 62(a). Gross income is defined as all
income from whatever source derived. Sec. 61(a). Itemized deductions are
deductions other than the deductions allowable in arriving at AGI and the
deduction for personal exemptions. Sec. 63(d).
Taxpayers are subject to self-employment tax on their self-employment
income during a taxable year, sec. 1401(a), (b)(2), and are allowed to deduct as an
above-the-line income-tax deduction (i.e., a deduction in arriving at AGI) an
amount equal to one-half of the self-employment tax, sec. 164(f).
Self-employment income is generally defined as “the net earnings from
self-employment derived by an individual”. Sec. 1402(b). “Net earnings from
self-employment” are defined as “the gross income derived by an individual from
- 58 -
[*58] any trade or business carried on by such individual, less the deductions
allowed by this subtitle which are attributable to such trade or business”.15 Sec.
1402(a). The term “trade or business”, for purposes of the definition of net
earnings from self-employment, has the same meaning as when used in section
162, except that the performance of services by an individual as an employee is
not included in the term “trade or business”. Sec. 1402(c)(2).16 The term
“employee” for purposes of self-employment tax has the same meaning as under
the Federal Insurance Contributions Act. Sec. 1402(d). Under the Federal
Insurance Contributions Act, an “employee” (as relevant here) is “any individual
who, under the usual common law rules applicable in determining the
employer-employee relationship, has the status of an employee”. Sec. 3121(d)(2).
The term “net earnings from self-employment” generally includes an
individual partner’s share of partnership income or loss. Sec. 1402(a). An
15
For 2010 only, the deduction for the cost of health insurance of self-
employed individuals is taken into account in computing “net earnings from self-
employment”. Sec. 162(l)(4).
16
There are several exceptions to the exclusion of the performance of
services by an individual as an employee from the term “trade or business”, for
purposes of the definition of net earnings from self-employment. See sec. 1402(c).
Mr. and Ms. Thoma’s briefs do not argue that an exception applies, and therefore
they have waived the argument that an exception under sec. 1402(c) applies for
Mr. Thoma for 2010 and 2011.
- 59 -
[*59] individual who is a limited partner generally excludes from net earnings
from self-employment his or her share of partnership income or loss, with the
exception of guaranteed payments for services actually rendered to or on behalf of
the partnership to the extent that the guaranteed payments are established to be in
the nature of remuneration for those services. Sec. 1402(a)(13).
Mr. and Ms. Thoma are entitled to deductions for one-half of Mr. Thoma’s
self-employment-tax liability for 2010 and 2011 only if the Court does not sustain
the determination in the notice of deficiency that Mr. Thoma was an employee of
Thoma & Hjerpe in 2010 and 2011 and that the amounts Thoma & Hjerpe paid
Mr. Thoma for his accounting services in 2010 and 2011 were wages.17
A. The parties’ positions
Mr. and Ms. Thoma’s briefs assert that Mr. Thoma and Mr. Hjerpe
consistently operated Thoma & Hjerpe as a partnership for federal tax purposes
and that they were partners. According to their briefs, Mr. Hjerpe was a limited
partner and Mr. Thoma was the general partner before 2008. According to Mr.
and Ms. Thoma, from 2008 to 2011 Mr. Thoma was the limited partner and Mr.
Hjerpe was the general partner. Mr. and Ms. Thoma’s briefs claim that the
17
Mr. and Ms. Thoma’s briefs do not argue that Mr. Thoma had self-
employment income other than the amounts Thoma & Hjerpe paid him for his
accounting services in 2010 and 2011.
- 60 -
[*60] amounts Mr. Thoma received from Thoma & Hjerpe in 2010 and 2011 for
his accounting services were guaranteed payments. They therefore assert that Mr.
Thoma had net earnings from self-employment and was subject to self-
employment tax for 2010 and 2011 under section 1402(a)(13). They conclude that
they correctly reported deductions of one-half of Mr. Thoma’s self-employment-
tax liability on the 2010 and 2011 returns. In support of their claims that Thoma
& Hjerpe was a partnership and Mr. Thoma was a limited partner in 2010 and
2011, Mr. and Ms. Thoma argue in their briefs that the IRS is estopped from
challenging the manner in which Thoma & Hjerpe reported Mr. Thoma’s income
to him because the IRS moved for the admission of the 2010 and 2011 Schedules
K-1 into evidence.18 Mr. and Ms. Thoma’s briefs point to the Schedules K-1,
which stated that the name of the partnership was “Thoma & Hjerpe, CPAs” in
18
Mr. and Ms. Thoma’s opening brief claims that “Respondent argued
vehemently that * * * [Mr. Thoma] was not a partner, yet * * * [the IRS] provided
as evidence an IRS partnership tax form ‘K-1’ that was prepared for the
partnership of ‘Thoma and Hjerpe CPAs’.” Their answering brief claims that
“[t]he IRS had * * * [the Schedules K-1] admitted as evidence” and “[t]he IRS has
used all of these tax form documents and numbers as evidence, on one hand to
support their argument that * * * [Mr. Thoma] was not a ‘limited partner’, and
then in the same breath argue that this ‘partnership’ tax return document is a false
document that shouldn’t have been prepared by * * * [Mr. Hjerpe].” We construe
the claims in Mr. and Ms. Thoma’s briefs described above to mean that the IRS is
estopped from challenging the correctness of the Schedules K-1 because it
introduced the forms in the trial record. As explained infra p. 71 note 24, we
reject this estoppel argument.
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[*61] Part I, “Information About the Partnership”, and that the name of the partner
was “Roland Thoma” in Part II, “Information about the Partner”. Therefore, Mr.
and Ms. Thoma claim, it must be true that Thoma & Hjerpe was a partnership and
that Mr. Thoma was a partner in 2010 and 2011. Furthermore, Mr. and Ms.
Thoma’s briefs claim that “the substance of the work relationship, not the
contractual designation determines the worker’s status” and that Mr. Thoma and
Mr. Hjerpe operated Thoma & Hjerpe as a partnership. But their briefs also claim
that Mr. Thoma and Mr. Hjerpe “operated as two separate business under one
roof”.
Mr. and Ms. Thoma’s briefs do not rely on the 2005 agreement in support of
their argument that Mr. Thoma was a limited partner of Thoma & Hjerpe in 2010
and 2011. Instead, they argue that the 2010 agreement supports their argument.
In particular, they refer to the purchase money security interest provisions of the
2010 agreement we quoted supra p. 19. One provision concerning the purchase
money security interest is as follows: “Seller/Employee [Mr. Thoma], so long as
Purchaser [Mr. Hjerpe] is not in default under any term of this agreement retains
no management, supervisory, or other similar roles with respect to the operation of
the business.” Their brief proposes that this sentence “means that upon * * * [Mr.
Hjerpe’s] default * * * [Mr. Thoma] was to immediately become the managing
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[*62] partner, basically a role reversal again.” They further argue that “[a] non
partner couldn’t just suddenly become the managing partner.” Mr. and Ms.
Thoma’s briefs also point to the expense-reimbursement provision of the 2010
agreement. See supra p. 22. Their brief proposes that this provision shows that
Mr. Thoma could “have a tax deductible loss”. We understand this claim to mean
that Mr. Thoma was at a risk of loss by working at Thoma & Hjerpe.19
Mr. and Ms. Thoma’s briefs include an alternative argument to their
partnership-partner argument. They claim that even if the Court holds that Mr.
Thoma was not a partner in 2010 and 2011, the Court should still conclude that he
was an independent contractor. Mr. and Ms. Thoma assert that Mr. Hjerpe did not
control the way Mr. Thoma performed his accounting services and that Mr. Thoma
did not receive benefits of the type that support employee status. Thus, should the
Court hold that Mr. Thoma was not a partner in 2010 and 2011, Mr. and Ms.
Thoma’s briefs argue that the relationship between Mr. Thoma and Mr. Hjerpe is
properly characterized as that of a contracting party and an independent
19
Mr. and Ms. Thoma’s briefs argue in particular that “if * * * [Mr.
Thoma’s] professional licensing fees as a certified public accountant and certified
financial planner, and * * * [his] continuing education fees and other business
expenses exceeded * * * [his] agreed to maximum reimbursement, then * * * [Mr.
Thoma] would have a tax deductible loss.”
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[*63] contractor.20 If Mr. Thoma were indeed an independent contractor in 2010
and 2011, he would have net earnings from self-employment. See sec. 1402(c)(2)
and (3); Jackson v. Commissioner, 108 T.C. 130, 133-134 (1997). Mr. and Ms.
Thoma’s partnership-partner and independent-contractor arguments reach the
same conclusion, which is that in 2010 and 2011 Mr. Thoma had net earnings
from self-employment, was subject to self-employment tax, and correctly reported
deductions for one-half of his self-employment tax, for 2010 and 2011.
The IRS’ briefs argue that Thoma & Hjerpe was not a partnership and that
Mr. Thoma not a partner in 2010 and 2011. Among other things, the IRS’ briefs
claim that the 2005 agreement did not provide that Mr. Thoma and Mr. Hjerpe
were partners, that Mr. Thoma and Mr. Hjerpe’s conduct was not that of partners
sharing the profits and losses of Thoma & Hjerpe, and that the 2010 agreement
established that Mr. Thoma was an employee after he and Mr. Hjerpe signed it.
With respect to Mr. and Ms. Thoma’s independent-contractor argument, the IRS’
briefs claim that Mr. Hjerpe exercised enough control over Mr. Thoma in 2010
and 2011 for their relationship to be that of an employer and employee. In
summary, the IRS’ briefs argue that Mr. Thoma was an employee in 2010 and
20
Mr. and Ms. Thoma’s briefs do not take a position as to what type of entity
Thoma & Hjerpe was in 2010 and 2011 (e.g., a sole proprietorship) if the Court
were to hold that it was not a partnership.
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[*64] 2011, did not have net earnings from self-employment, and consequently
was not liable for self-employment tax. The IRS also argues we should sustain the
disallowance in the notice of deficiency of the deductions for one-half of Mr.
Thoma’s self-employment-tax liability for 2010 and 2011.
We first discuss whether Mr. Thoma carried on a trade or business as a
limited partner of a partnership in 2010 and 2011. We conclude that he did not.
We then discuss whether he carried on a trade or business as an independent
contractor in 2010 and 2011. We conclude that he did not.
B. Analysis: partnership and partner
Section 761(b) defines a “partner” as a member of a partnership. Section
761(a) defines a “partnership” as a “syndicate, group, pool, joint venture, or other
unincorporated organization through or by means of which any business, financial
operation, or venture is carried on, and which is not * * * a corporation or a trust
or estate.” Therefore, if Thoma & Hjerpe was not a partnership in 2010 and 2011,
then Mr. Thoma did not carry on a trade or business as a limited partner of a
partnership.
Federal law controls the question of whether an entity is classified as a
partnership for federal tax purposes. Luna v. Commissioner, 42 T.C. 1067, 1077
(1964). We must therefore determine whether Thoma & Hjerpe was a bona fide
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[*65] partnership in 2010 and 2011 under federal law.21 A bona fide partnership
exists under the Code if the putative partners “really and truly intended to join
together for the purpose of carrying on business and sharing in the profits or losses
or both.” Commissioner v. Tower, 327 U.S. 280, 287 (1946). The following
factors are relevant in evaluating whether the putative partners intended to create a
partnership for federal-income-tax purposes:
[1] The agreement of the parties and their conduct in executing its
terms; [2] the contributions, if any, which each party has made to the
venture; [3] the parties’ control over income and capital and the right
of each to make withdrawals; [4] whether each party was a principal
and coproprietor, sharing a mutual proprietary interest in the net
profits and having an obligation to share losses, or whether one party
was the agent or employee of the other, receiving for his services
contingent compensation in the form of a percentage of income; [5]
whether business was conducted in the joint names of the parties; [6]
whether the parties filed Federal partnership returns or otherwise
represented to respondent [i.e., the IRS] or to persons with whom they
dealt that they were joint venturers; [7] whether separate books of
account were maintained for the venture; and [8] whether the parties
exercised mutual control over and assumed mutual responsibilities for
the enterprise.
21
In support of their position that Mr. Thoma was the limited partner of
Thoma & Hjerpe in 2010 and 2011, Mr. and Ms. Thoma’s briefs claim that “the
local licensing and State of Illinois laws should dictate the tax treatment” of
Thoma & Hjerpe. We disagree with that claim because we must determine
whether Thoma & Hjerpe was a partnership under the Code. See Luna v.
Commissioner, 42 T.C. 1067, 1077 (1964).
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[*66] Luna v. Commissioner, 42 T.C. 1077-1078. No single factor is
conclusive as to the existence of a partnership. Burde v. Commissioner, 352 F.2d
995, 1002 (2d Cir. 1965), aff’g 43 T.C. 252 (1964); McDougal v. Commissioner,
62 T.C. 720, 725 (1974). We address each factor in turn.
1. Agreement governing Thoma & Hjerpe and conduct in
executing its terms
The years at issue are 2010 and 2011. The 2005 agreement arguably
governed Thoma & Hjerpe during most of the month of January 2010. (The 2010
agreement, the preamble of which stated that the 2010 agreement “restated” the
2005 agreement, was not executed until January 28, 2010.) However, Mr. and Ms.
Thoma’s briefs do not rely on the 2005 agreement in support of their argument
that Thoma & Hjerpe was a partnership, and we therefore do not discuss whether it
weighs in favor of Thoma & Hjerpe being a partnership in 2010 and 2011. Mr.
and Ms. Thoma’s briefs rely on the security-interest provision of the 2010
agreement22 for the proposition that Mr. Thoma was a partner, which is related or
identical to their contention that Thoma & Hjerpe was a partnership. The IRS
contends that this provision does not support the argument that Mr. Thoma was a
22
Section 2.2 of the 2010 agreement required Mr. Hjerpe to pay Mr. Thoma
$679,498 and payment was to be secured by a “first purchase money security
interest” against the assets of Thoma & Hjerpe.
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[*67] partner. The IRS argues in its briefs that even if Mr. Thoma had a valid
purchase money security interest in the assets of Thoma & Hjerpe, at most this
meant that Mr. Thoma was a creditor of Mr. Hjerpe, not that Mr. Thoma had a
possessory right to the assets secured with the interest. We agree with the IRS that
even if the record supported a finding that Mr. Thoma had a valid purchase money
security interest in the assets of Thoma & Hjerpe, Mr. Thoma would not have had
a possessory right to the assets secured by the interest in 2010 and 2011.
The 2010 agreement weighs against concluding that Thoma & Hjerpe was a
partnership because it unambiguously provided that Mr. Thoma was an at-will
employee of Mr. Hjerpe, effective 2008. Overall, this factor does not support
classifying the relationship between Mr. Hjerpe and Mr. Thoma as a partnership
for 2010 and 2011.
2. Contributions to Thoma & Hjerpe
Mr. Thoma and Mr. Hjerpe each had their own client groups before they
operated Thoma & Hjerpe. They brought over their clients to, and contributed
their services to, Thoma & Hjerpe. Mr. and Ms. Thoma’s briefs do not argue that
there were additional contributions by Mr. Thoma and Mr. Hjerpe to Thoma &
Hjerpe, such as contributions of capital. Nor does the trial record show additional
contributions, such as contributions of capital provided for under the 2005
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[*68] agreement. The 2010 agreement does not provide for contributions of
capital. Mr. Thoma’s Schedules K-1 for 2010 and 2011 reported no capital
contributions during the year and had beginning and ending capital account
balances of zero. This factor is neutral.
3. Control over income and capital of Thoma & Hjerpe and right
to make withdrawals
By 2010 Mr. Thoma did not have any management authority and Mr. Hjerpe
controlled the affairs of Thoma & Hjerpe. Mr. and Ms. Thoma’s briefs do not
argue, and the record does not support a finding, that Mr. Thoma had control over
the income and capital of Thoma & Hjerpe, or the right to make withdrawals, in
2010 and 2011. This factor does not support finding a partnership arrangement
between Mr. Hjerpe and Mr. Thoma for 2010 and 2011.
4. Interest in net profits of Thoma & Hjerpe and obligation to
share losses
Mr. Thoma testified that he “was a limited partner with no ownership” in
Thoma & Hjerpe during the years at issue. He further testified that he “would not
profit if * * * [Thoma & Hjerpe] lost money or made money” and he “would not
get a percentage of that profit”. He also testified that by the years at issue, he had
“removed * * * [his] entire capital account from the firm.” All of these statements,
in our view, amount to admissions that, by 2010, Mr. Thoma had no interest in the
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[*69] profits of Thoma & Hjerpe. Thus, we find that by 2010, Mr. Hjerpe was the
100% owner of Thoma & Hjerpe and entitled to all its profits and losses. And we
find that Mr. Thoma had no proprietary interest in the profits and losses of Thoma
& Hjerpe in 2010 and 2011.
Mr. and Ms. Thoma’s briefs contend that Mr. Thoma had to pay
professional expenses that could have exceeded the $3,000 that Mr. Hjerpe was
obligated to reimburse for professional expenses under the 2010 agreement.
(Section 9.5 of the 2010 agreement required Mr. Hjerpe to pay up to $3,000 of Mr.
Thoma’s dues and educational expenses.) As explained infra part II, pp. 82, 84,
Mr. and Ms. Thoma reported that Mr. Thoma paid business expenses for Thoma &
Hjerpe of $7,396 in 2010 and $20,867 in 2011. The evidence in the record does
not corroborate any of these amounts. The notice of deficiency allowed
deductions for these expenses of $7,288 for 2010 and $14,406 for 2011.23 The
IRS is bound to this concession, but there is no independent corroboration of these
amounts in the record. We are unable to conclude on this record that Mr. Thoma’s
payment of professional expenses showed that he shared in the losses of Thoma &
Hjerpe.
23
The notice of deficiency determined, however, that the deductions were of
a type different from that reported on the returns.
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[*70] This factor does not militate in favor of finding that there was a partnership
arrangement between Mr. Hjerpe and Mr. Thoma for 2010 and 2011.
5. Whether Thoma & Hjerpe was conducted in the joint names of
Mr. Thoma and Mr. Hjerpe
During and before the years at issue Mr. Thoma and Mr. Hjerpe held
themselves out as operating Thoma & Hjerpe in their joint names. Several
documents in the trial record support this conclusion, such as the letter that Mr.
Thoma received from Mr. Hjerpe placing Mr. Thoma on administrative leave.
This letter shows Mr. Thoma’s name and business email address in the upper left-
hand corner of the letterhead and Mr. Hjerpe’s name and business email address in
the upper right-hand corner of the letterhead. It shows a logo with both of their
last names. Mr. Hjerpe signed the letter as “Managing Partner”. This factor
supports finding a partnership arrangement between Mr. Hjerpe and Mr. Thoma
for 2010 and 2011.
6. Thoma & Hjerpe federal tax returns; representation of joint
venture
The trial record does not contain federal or state partnership returns for
Thoma & Hjerpe. Nor does it contain Schedules K-1 for Mr. Hjerpe. It contains
only the Schedules K-1 issued by Thoma & Hjerpe to Mr. Thoma for 2010 and
2011. We disagree with Mr. and Ms. Thoma’s claim, see supra p. 60, that the
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[*71] Schedules K-1 are controlling merely because the IRS introduced them as
evidence. The manner in which Thoma & Hjerpe reported Mr. Thoma’s income is
relevant to one factor under Luna; and even though the Schedules K-1 weigh in
favor of the existence of a partnership arrangement, no single factor is conclusive
of the existence of a partnership. Burde v. Commissioner, 352 F.2d at 1002;
McDougal v. Commissioner, 62 T.C. 725.24 Mr. and Ms. Thoma claim on brief
that the professional license issued by the State of Illinois (which, according to
them, listed Thoma & Hjerpe as a partnership) “alone should be sufficient
evidence that the firm of Thoma and Hjerpe CPAs was in fact a partnership, both
in name and in practice.” Even if the record showed that Thoma & Hjerpe had a
professional license that identified it as a partnership in 2010 and 2011, a state-
issued professional license alone is not conclusive evidence of a partnership for
24
In support of their contention that the Schedules K-1 are controlling and
that therefore Mr. Thoma was a partner in 2010 and 2011, Mr. and Ms. Thoma’s
briefs claim that Rev. Rul. 69-184, 1969-1 C.B. 256, stands for the proposition
that “a limited partner cannot be treated as an employee”. Their briefs argue that
the notice of deficiency incorrectly determined that Mr. Thoma was an employee
because, according to Mr. and Ms. Thoma’s briefs, the Schedules K-1 reported
that Mr. Thoma was a limited partner and thus he cannot be an employee. As we
already discussed supra, the manner in which the Schedules K-1 reported Mr.
Thoma’s income is relevant to one factor for determining the existence of a
partnership, but is not conclusive evidence of a partnership.
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[*72] federal tax purposes. See Luna v. Commissioner, 42 T.C. 1077. Overall,
this factor is neutral.
7. Separate books for Thoma & Hjerpe
The trial record does not contain books and records of Thoma & Hjerpe,
such as income statements. Mr. Thoma offered no testimony as to the contents of
Thoma & Hjerpe’s books and records. The trial record does not reveal the names
of the account holders for the bank accounts that were used to make biweekly
payments to Mr. Thoma or pay the business expenses of Thoma & Hjerpe. This
factor does not support the existence of a partnership arrangement between Mr.
Hjerpe and Mr. Thoma for 2010 and 2011.
8. Mutual control of, and responsibilities over, Thoma & Hjerpe
In 2010 and 2011 Mr. Hjerpe managed Thoma & Hjerpe; Mr. Thoma was
responsible only for providing accounting services to his clients.25 At trial Mr.
Thoma explained that he and Mr. Hjerpe did not have a “partnership meeting”
25
In its opening brief, the IRS asserts that in 2010 and 2011 “[Mr.] Thoma
no longer had managerial or supervisory authority”. Mr. and Ms. Thoma, in their
answering brief, do not refute the IRS’ assertion that Mr. Thoma had neither
managerial nor supervisory authority in 2010 and 2011, but instead they argue that
a lack of managerial and supervisory authority is consistent with the definition of a
limited partner under Illinois law. Even if Mr. Thoma’s conduct in 2010 and 2011
was consistent with his being a limited partner under Illinois law, federal law
governs our analysis. See Luna v. Commissioner, 42 T.C. 1077.
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[*73] from January 2010 until November 2011. There was no mutual control or
mutual responsibilities in 2010 and 2011. Mr. and Ms. Thoma’s claim on brief
that the work relationship between Mr. Thoma and Mr. Hjerpe was like “two
separate business under one roof” weighs against Thoma & Hjerpe being a
partnership because such a work arrangement evinces a complete absence of intent
to join together for the purposes of carrying on a business and sharing profits and
losses. See Commissioner v. Tower, 327 U.S. at 286-287. This factor does not
support the existence of a partnership arrangement between Mr. Hjerpe and Mr.
Thoma for 2010 and 2011.
Considering the record as a whole, we conclude that in 2010 and 2011 Mr.
Thoma and Mr. Hjerpe did not intend to join together for the purpose of carrying
on a business, or share in the profits or losses, or both. See id. at 287. Therefore,
Thoma & Hjerpe was not a partnership under federal law in 2010 and 2011.
Consequently, Mr. Thoma did not carry on a trade or business as a limited partner
of a partnership in 2010 and 2011. See sec. 1402(b)(2), (a), (c); sec. 1.1402(c)-1,
Income Tax Regs.26 Thus, Mr. Thoma did not receive guaranteed payments
26
Mr. and Ms. Thoma’s post-trial briefs rely on Exhibit 12-P for their
argument that the relationship between Mr. Thoma and Mr. Hjerpe was that of
partners in 2010 and 2011. They argue that the Court must reverse its decision as
to the admission of Exhibit 12-P. We see no grounds for revisiting our ruling on
(continued...)
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[*74] subject to self-employment tax as reported on the returns at issue. See sec.
1402(a)(13).
Next, we discuss whether the relationship between Mr. Thoma and Mr.
Hjerpe in 2010 and 2011 was that of an employee and employer, as the notice of
deficiency determined, or Mr. Thoma was an independent contractor, as Mr. and
Ms. Thoma assert on brief. Because Mr. and Ms. Thoma do not carry their burden
of proving that Mr. Thoma was an independent contractor in the years at issue, we
sustain the notice of deficiency’s determination that he was an employee.
C. Analysis: employee or independent contractor
In general, a taxpayer does not have income from self-employment for
compensation earned from the performance of services as an employee and is not
subject to self-employment tax on such compensation. See supra p. 58. Section
1402(d) defines the term “employee” as having the same meaning as under the
Federal Insurance Contributions Act. The definition of “employee” under the
Federal Insurance Contributions Act has been held to be identical to the common-
law definition of employee. Simpson v. Commissioner, 64 T.C. 974, 984 (1975);
Pariani v. Commissioner, T.C. Memo. 1997-427, slip op. at 9. Consequently, we
26
(...continued)
the admissibility of Exhibit 12-P, and we do not rely on the exhibit in reaching our
holdings.
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[*75] apply common law rules to determine whether a worker is an employee
under section 1402(d). See sec. 3121(d)(2); Prof’l & Exec. Leasing, Inc. v.
Commissioner, 89 T.C. 225, 231 (1987), aff’d, 862 F.2d 751 (9th Cir. 1988);
Simpson v. Commissioner, 64 T.C. 984. Whether a worker is an employee is a
factual question. Weber v. Commissioner, 103 T.C. 378, 386 (1994), aff’d per
curiam, 60 F.3d 1104 (4th Cir. 1995). We generally consider several factors in
making this determination: (1) whether the relationship between the worker and
the one to whom the worker provides services (i.e., the principal) was permanent;
(2) whether the worker had an opportunity for profit or loss; (3) whether the
principal had the right to discharge the worker; (4) whether the principal or the
worker invested in the facilities the worker used; (5) whether the work was part of
the principal’s regular business; (6) whether the principal could exercise control
over the details of the work; and (7) whether the worker and the principal believed
that they were creating an employment relationship. Id. at 387. No one factor is
determinative; we look at all relevant facts. Id.
Four of the above-listed factors weigh strongly in favor of the conclusion
that Mr. Thoma was an employee in 2010 and 2011.
1. Permanency of the relationship. The relationship between Mr. Thoma
and Thoma & Hjerpe was ultimately not permanent, given that Mr. Hjerpe caused
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[*76] Mr. Thoma to part ways with Thoma & Hjerpe in November 2011. Yet we
find that the relationship was more permanent than that of an independent
contractor. Mr. Thoma had worked for Thoma & Hjerpe for many years. The
relationship, which ended only with the falling out in November 2011, was as
permanent as any other employment relationship.
2. Right to discharge. On November 21, 2011, Mr. Hjerpe, on behalf of
Thoma & Hjerpe, exercised his right to discharge Mr. Thoma from Thoma &
Hjerpe.
3. Principal’s investment in the facilities. In 2010 and 2011 Thoma &
Hjerpe provided Mr. Thoma with professional liability insurance, office space on
its business premises, and tax preparation software. Mr. Thoma did not have any
investment in Thoma & Hjerpe. See supra pp. 67-68.
4. Part of the principal’s regular work. In 2010 and 2011 Thoma & Hjerpe
was in the business of accounting, and the work Mr. Thoma performed for his
clients in 2010 and 2011 was within the scope of Thoma & Hjerpe’s regular
business.
We now explain why the remaining three factors also support (although less
strongly) the conclusion that Mr. Thoma was an employee in 2010 and 2011.
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[*77] 5. Opportunity for profit or loss. If Mr. Thoma had increased his efforts
and billed more hours in 2010 and 2011, then his biweekly payments from Thoma
& Hjerpe would have been greater. This seems to indicate he had an opportunity
for profit. However, Mr. Thoma received his biweekly payments regardless of
whether his clients paid Thoma & Hjerpe. Furthermore, his biweekly payments
were calculated by multiplying each hour he billed a client by 40% of his $170
standard billing rate. This is similar to an hourly wage, which indicates he was an
employee. See James v. Commissioner, 25 T.C. 1296, 1300 (1956).
6. Control over details of the work. Mr. and Ms. Thoma claim in their
briefs that Mr. Hjerpe did not control or review Mr. Thoma’s work for his clients.
They further claim that Mr. Thoma and Mr. Hjerpe operated independently of each
other. The amount of control required to find an employer-employee relationship
varies by occupation. United States v. W.M. Webb, Inc., 397 U.S. 179, 192-193
(1970). The level of control necessary to find employee status is in most
circumstances lower for professional services than for nonprofessional services.
Azad v. United States, 388 F.2d 74, 77 (8th Cir. 1968); Prof’l & Exec. Leasing,
Inc. v. Commissioner, 89 T.C. 234. “From the very nature of the services
rendered by * * * professionals, it would be wholly unrealistic to suggest that an
employer should undertake the task of controlling the manner in which the
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[*78] professional conducts his activities.” Azad, 388 F.2d at 77; Weber v.
Commissioner, 103 T.C. 388. Mr. Thoma was a professional who had
performed accounting services for his clients for many years and was likely more
familiar with them than Mr. Hjerpe. It was not necessary for Mr. Hjerpe to
oversee when and how Mr. Thoma performed accounting services for his clients.
See Azad, 388 F.2d at 77; Weber v. Commissioner, 103 T.C. 388.
7. Belief about creation of employment relationship. Mr. and Ms. Thoma
claim that Mr. Hjerpe did not treat Mr Thoma like an employee. We agree, see
supra p. 29, with their assertion on brief that Mr. Thoma did not receive paid time
off and paid sick days. We do not, however, agree with their claim that Exhibit
10-J, which consists of a table showing time off and sick days, “clearly shows [Mr.
Thoma] was not employee”. This is because the overall evidence in the record
supports a conclusion that Mr. Thoma was treated as an employee in 2010 and
2011.
An employer usually withholds federal (and state) income tax and
employment taxes from employees’ wages. No taxes or amounts for contributions
to Mr. Thoma’s SIMPLE IRA were withheld in 2010 and 2011 from the biweekly
payments he received for his accounting services. This can be indicative of
independent contractor status. See Packard v. Commissioner, 63 T.C. 621, 632
- 79 -
[*79] (1975) (“But in this case the payment of salaries, insurance benefits, and
withholding of taxes by the corporation on behalf of the employees in question
gives a clear indication that they were employees of the corporation and those
factors must be given considerable weight.” (Emphasis added.)). Any favorable
weight accorded to the fact that no taxes were withheld from Mr. Thoma’s
biweekly payments is negated by Mr. Thoma’s own representations that he was an
employee in his application for unemployment benefits and in his complaint
against Mr. Hjerpe seeking compensation for wage income.
On the basis of all the evidence in the record, we conclude that Mr. Thoma
was not an independent contractor in 2010 and 2011. Consequently, Mr. Thoma
did not carry on a trade or business as an individual, did not have income from
self-employment as an independent contractor, and was not liable for self-
employment tax. See secs. 1402(a) and (b), 1401(a); sec. 1.1402(c)-1, Income Tax
Regs. We sustain the determination in the notice of deficiency that Mr. Thoma
was an employee in 2010 and 2011, and we sustain the following related
determinations:
! increases to wage income for Mr. Thoma by $69,156 for 2010 and by
$63,299 for 2011; and corresponding reductions in the nonwage income
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[*80] reported in identical amounts on the 2010 and 2011 Schedules E for Thoma
& Hjerpe;
! decreases to self-employment income by $69,156 and $63,299, reported on
Mr. Thoma’s 2010 and 2011 Schedules SE, respectively;
! disallowance of deductions of $3,724 for 2010 and $2,915 for 2011 for one-
half of Mr. Thoma’s self-employment tax.
We discussed supra Mr. Thoma’s income from Thoma & Hjerpe. We next
discuss infra the business expenses that Mr. Thoma paid in working for Thoma &
Hjerpe in 2010 and 2011.
II. Mr. Thoma’s business expenses
An individual taxpayer’s income-tax liability depends on the taxpayer’s
taxable income. Sec. 1(a)-(d). Taxable income is equal to gross income (defined
as “all income” from whatever source derived) minus deductions. Secs. 61, 63.
Section 162(a) allows a deduction for the expenses of carrying on a trade or
business. A business for this purpose includes the business of providing services
as an employee. Lucas v. Commissioner, 79 T.C. 1, 6 (1982). Thus, the expenses
of performing services as an employee are deductible under section 162(a).
Primuth v. Commissioner, 54 T.C. 374, 377-378 (1970). A business can also
include providing services as a nonemployee. Feaster v. Commissioner, T.C.
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[*81] Memo. 2010-157, slip op. at 5. A person providing services as a
nonemployee can deduct the related expenses. Id.
While various items are deducted in arriving at taxable income, some other
items are deducted in arriving at AGI. Sec. 62(a). These deductions are known as
above-the-line deductions. See Cutler v. Commissioner, T.C. Memo. 2015-73, at
*5. One type of deduction in arriving at AGI is the deduction attributable to
carrying on a trade or business other than the performance of services as an
employee. Sec. 62(a)(1).
Itemized deductions are deductions made in arriving at taxable income but
not AGI. Sec. 63(d). One type of itemized deduction is the deduction for the
expense of performing services as an employee. This type of deduction is referred
to as an employee-business-expense deduction.
A subset of itemized deductions is miscellaneous itemized deductions. Sec.
67(b). The employee-business-expense deduction is a miscellaneous itemized
deduction. Secs. 67(b), 63(d)(1), 62. Miscellaneous itemized deductions are
allowable only to the extent that the total of such deductions exceeds 2% of AGI.
Sec. 67(a) and (b).
AGI is incorporated into rules that limit the amounts of certain deductions
in arriving at taxable income. An example is the 2% of AGI floor for
- 82 -
[*82] miscellaneous itemized deductions mentioned above. Sec. 67(a). Another
example is medical and dental expenses, which are deductible only to the extent
that they exceed 7.5% of AGI. Sec. 213(a).
Mr. and Ms. Thoma reported the expenses of Mr. Thoma’s work for Thoma
& Hjerpe as losses of $7,396 and $20,867 on their Schedules E for 2010 and 2011,
respectively. They reduced their reported gross income for each year by these
amounts. Thus, their computations of AGI reflected reductions for these amounts.
Mathematically, this reporting would be consistent with the amounts being
deductions in arriving at AGI. Indeed, Mr. and Ms. Thoma contend that these
amounts should be treated as such.
The notice of deficiency determined that Mr. Thoma was an employee of
Thoma & Hjerpe in 2010 and 2011. Consequently, the notice of deficiency
determined that Mr. Thoma’s expenses of working for Thoma & Hjerpe were
deductible only as employee-business expenses, which are a type of miscellaneous
itemized deduction, and not a deduction in arriving at AGI. The notice of
deficiency also determined that the amounts of the deductions were $7,288 for
2010 and $14,406 for 2011, before application of the 2% of AGI floor for
miscellaneous itemized deductions.
- 83 -
[*83] We hold infra part II.A, p. 83, that Mr. Thoma’s expenses of working for
Thoma & Hjerpe are deductible only as employee-business expenses, and not as
deductions in arriving at AGI. We explain infra part II.B, pp. 83-87, that the
deductible amounts of Mr. Thoma’s expenses of working for Thoma & Hjerpe are
those amounts determined in the notice of deficiency.
A. Mr. Thoma’s expenses of working for Thoma & Hjerpe are
deductible only as employee-business expenses.
Mr. and Ms. Thoma argue that Mr. Thoma worked for Thoma & Hjerpe in
2010 and 2011 as a self-employed partner or independent contractor, and therefore
the deductions for the expenses of Mr. Thoma’s work for Thoma & Hjerpe are
deductions in arriving at AGI, rather than employee-business-expense deductions.
But we held supra part I, p. 79, that Mr. Thoma was an employee of Thoma &
Hjerpe in 2010 and 2011. Therefore, Mr. Thoma’s expenses of working for
Thoma & Hjerpe are not deductible in arriving at adjusted gross income, but rather
deductible only as employee-business expenses.
B. The deductible amounts of Mr. Thoma’s expenses of working for
Thoma & Hjerpe are those determined in the notice of deficiency.
We hold that Mr. and Ms. Thoma are entitled to deductions for employee-
business expenses of $7,288 for 2010 and $14,406 for 2011, as determined in the
notice of deficiency. We explain below.
- 84 -
[*84] For 2010 Mr. and Ms. Thoma claimed a $7,396 deduction that affected AGI
for Mr. Thoma’s expenses of working for Thoma & Hjerpe. The notice of
deficiency disallowed the deduction as a deduction in arriving at AGI and instead
allowed $7,288 in employee-business-expense deductions, before application of
the 2% of AGI floor for miscellaneous itemized deductions. The difference
between $7,396 and $7,288 is $108. Mr. and Ms. Thoma argue that (1) Mr.
Thoma paid $108 for internet access and that (2) Mr. Thoma regularly conducted
internet research to provide his accounting services. However, neither of these
claims is supported by evidence. Mr. and Ms. Thoma have failed to carry their
burden of proof regarding the $108 deduction they seek.27
For 2011 Mr. and Ms. Thoma claimed a $20,867 deduction that affected
AGI for Mr. Thoma’s expenses of working for Thoma & Hjerpe. The notice of
deficiency disallowed the deduction as a deduction in arriving at AGI and instead
allowed $14,406 in employee-business-expense deductions, before application of
the 2% of AGI floor for miscellaneous itemized deductions. The difference
between $20,867 and $14,406 is $6,461.
27
We need not reach the issue of whether the $108 deduction sought by Mr.
and Ms. Thoma was already allowed in the notice of deficiency as part of the
$7,288 employee-business-expense deduction.
- 85 -
[*85] Mr. and Ms. Thoma argue that they are entitled to deduct $5,000 for an
event Mr. Thoma held on December 28, 2011. Mr. and Ms. Thoma characterize
this expense as an advertising expense and argue that the event was a “meeting” of
Mr. Thoma’s “business associates, attorneys, and bankers” to inform them of Mr.
Thoma’s falling out with Mr. Hjerpe and to “explain * * * [Mr. Thoma’s] business
plans”. The record contains an invoice from the Bloomington Country Club to
Mr. Thoma for a $5,805 “Celebration of Life” event that occurred on December
28, 2011. The invoice does not state whose life was being celebrated. The
invoice shows that the $5,805 figure was composed of $2,750 for food, $1,359 for
bar, $200 for room, $210 for piano player, $822 for surcharge, and $464 for sales
tax. A document accompanying this invoice shows that $5,000 of the $5,805
invoiced was paid on December 29, 2011. The record also includes a list of
approximately 120 guests who attended the event. Mr. and Ms. Thoma did not
testify during the trial about this event.
The IRS does not contest that Mr. Thoma paid the $5,000 expense for the
event, but contends that Mr. and Ms. Thoma have not proven that it is a deductible
business expense. The IRS states that the notice of deficiency did not allow the
$5,000 as an employee-business-expense deduction.
- 86 -
[*86] Theoretically, a big event at a country club could serve a business purpose,
and its cost could constitute a business-expense deduction. But on this record we
have trouble concluding that the December 28, 2011 event was a business
meeting. At the time, Mr. Thoma was professionally separated from Thoma &
Hjerpe. We do not know whether the event was designed to help Mr. Thoma
rejoin Thoma & Hjerpe, start his own business, or simply entertain his friends.
Mr. and Ms. Thoma have the burden of proving that the expense was a business
expense, rather than a personal one. They have failed to satisfy that burden of
proof.
Mr. and Ms. Thoma also argue that they are entitled to deduct $200 for
telephone expenses, $62 for travel expenses, and $1,199 for supplies and
miscellaneous items. However, there is no evidence, testimonial or documentary,
regarding these expenses. They have failed to carry their burden of proving
entitlement to such deductions.28
For the reasons stated above, we sustain the allowance in the notice of
deficiency of unreimbursed employee expense deductions for Mr. Thoma of
$7,288 for 2010 and $14,406 for 2011. Mr. and Ms. Thoma are not entitled to
28
We need not reach the issue of whether these deduction were already
allowed in the notice of deficiency as part of the $14,406 employee-business-
expense deduction.
- 87 -
[*87] deduct unreimbursed employee expenses in excess of the amounts
determined in the notice of deficiency.
III. Mr. Thoma’s health insurance expenses
Mr. and Ms. Thoma claimed deductions for health insurance expenses for
Mr. Thoma, on line 29, of $4,648 for 2010 and $5,580 for 2011. These deductions
were based on the treatment of Mr. Thoma as a self-employed individual, and
consequently Mr. and Ms. Thoma did not treat the expenses as subject to the 7.5%
of AGI floor for medical expense deductions. The notice of deficiency determined
that Mr. Thoma was an employee of Thoma & Hjerpe and consequently
disallowed the self-employed health insurance deductions for both years. On
brief, Mr. and Ms. Thoma’s sole argument for the deduction is that Mr. Thoma
was self-employed in 2010 and 2011 and that the returns correctly claimed the
deductions. An individual who is self-employed is generally entitled to a
deduction in arriving at AGI for amounts paid during the taxable year for health
insurance. Secs. 62(a)(1), 162(l). We held supra part I, p. 79, that Mr. Thoma was
an employee of Thoma & Hjerpe in 2010 and 2011 and not self-employed.
Accordingly, we sustain the disallowance in the notice of deficiency of deductions
of $4,648 for 2010 and $5,580 for 2011 for Mr. Thoma’s health insurance
expenses as deductions of a self-employed individual.
- 88 -
[*88] The notice of deficiency determined that the amounts were allowable
instead as itemized deductions for medical expenses for 2010 and 2011. No
dispute exists as to the amounts--$4,648 for 2010 and $5,580 for 2011. We
sustain the allowance of itemized deductions for medical expenses of $4,648 for
2010 and $5,580 for 2011, subject to the 7.5% of AGI floor. See sec. 213(a). Mr.
and Ms. Thoma are entitled to deductions for the health insurance expenses as
itemized deductions to the extent the expenses exceed the 7.5% of AGI floor for
each year.29
IV. Mr. Thoma’s SIMPLE IRA contributions
Mr. and Ms. Thoma’s returns claimed deductions on line 28 of $15,271 for
2010 and $14,000 for 2011, for amounts Mr. Thoma directly deposited into his
SIMPLE IRA. Their claims were based on their position that Mr. Thoma was self-
employed as a partner of Thoma & Hjerpe in 2010 and 2011. The notice of
deficiency determined that Mr. Thoma was an employee of Thoma & Hjerpe in
2010 and 2011 and on that basis disallowed the deductions claimed on line 28 for
both years.
29
However, taking into account our other holdings, it does not appear that
the medical and dental expenses exceed the 7.5% of AGI floor for each year.
- 89 -
[*89] Mr. and Ms. Thoma’s main argument with respect to the SIMPLE IRA
contribution deductions is that Mr. Thoma was self-employed in 2010 and 2011
(either as a partner of Thoma & Hjerpe, or alternatively, as an independent
contractor30 of Thoma & Hjerpe) and that therefore the “amounts * * * [Mr.
Thoma] paid * * * [to his SIMPLE IRA] were fully within the parameters under
the IRS regulations.” On brief the IRS asserts that if Mr. Thoma was an employee
of Thoma & Hjerpe, he is not entitled to a deduction for the contributions to his
SIMPLE IRA. Mr. and Ms. Thoma do not disagree. As explained supra part I, pp.
56-79, Mr. Thoma was an employee of Thoma & Hjerpe in 2010 and 2011.
We hold that Mr. and Ms. Thoma are not entitled to deductions for the
amounts Mr. Thoma directly deposited into his SIMPLE IRA for 2010 and 2011
as deductions of a self-employed individual.
30
On brief the IRS argues that only if the Court holds Mr. Thoma was a
partner in 2010 and 2011 are Mr. and Ms. Thoma entitled to deductions for Mr.
Thoma’s SIMPLE IRA contributions. The IRS further claims on brief that if the
Court holds Mr. Thoma was an independent contractor, then Mr. and Ms. Thoma
are not entitled to the deductions. We sustained supra part I, p. 79, the
determination in the notice of deficiency that Mr. Thoma was an employee of
Thoma & Hjerpe in 2010 and 2011. Therefore, we need not discuss in greater
detail the IRS’ argument concerning Mr. Thoma’s SIMPLE IRA contributions
under a view that Mr. Thoma was self-employed as a partner or an independent
contractor.
- 90 -
[*90] V. Quarterly installment payments during 2011 for the sale of Mr.
Thoma’s interest in Thoma & Hjerpe
It is undisputed that Mr. Thoma received installment payments from Mr.
Hjerpe for Mr. Thoma’s interest in Thoma & Hjerpe in 2008, 2009, 2010, and
2011. It is further undisputed that Mr. Thoma sold his entire ownership interest in
Thoma & Hjerpe to Mr. Hjerpe in 2008. One confusing aspect of Mr. Thoma’s
sale of his entire ownership interest in Thoma & Hjerpe is that the record is
unclear as to what Mr. Thoma’s interest was before he sold it in 2008. Mr. and
Ms. Thoma’s briefs are inconsistent on the subject. In one part they describe the
ownership interest sale to Mr. Hjerpe as “the installment sale of * * * [Mr.
Thoma’s] business”, which suggests the view that Mr. Thoma was the sole owner
of Thoma & Hjerpe before selling it to Mr. Hjerpe in 2008. But in other parts they
assert that Thoma & Hjerpe was a partnership during its entire existence (from
2006 or 2007 through November 2011) and Mr. Thoma was always one of its two
partners. If their assertions that Thoma & Hjerpe had been a partnership since its
formation and Mr. Thoma was a partner are true, then Mr. Thoma would have had
a partnership interest to sell to Mr. Hjerpe in 2008. We need not determine Mr.
Thoma’s ownership interest (i.e., 100% or less than 100%) in Thoma & Hjerpe
- 91 -
[*91] before he sold it to Mr. Hjerpe in 2008. That is because in 2010 and 2011,
the years before us, Mr. Thoma had no ownership interest in Thoma & Hjerpe.
Mr. and Ms. Thoma reported the installment payments using the installment
method for all years, and the IRS agrees that the method of reporting the income
from Mr. Thoma’s sale was the installment method. See supra pp. 43-45 for
discussion of the Form 6252 for 2010 and pp. 48-51 for discussion of the Form
6252 for 2011. In general, the term “installment sale” means “a disposition of
property where at least 1 payment is to be received after the close of the taxable
year in which the disposition occurs.” Sec. 453(b)(1). “[I]ncome from an
installment sale shall be taken into account for purposes of this title under the
installment method.” Sec. 453(a). The term “installment method” means “a
method under which the income recognized for any taxable year from a disposition
is that proportion of the payments received in that year which the gross profit
(realized or to be realized when payment is completed) bears to the total contract
price.” Sec. 453(c). The gross profit is equal to the contract price less adjusted
basis. Sec. 15A.453-1(b)(2)(v), Temporary Income Tax Regs., 46 Fed. Reg.
10710 (Feb. 4, 1981). Interest is not part of the gross profit, and it is excluded
from the selling price, the contract price, and the installment sale payment. Id.
subdiv. (ii), 46 Fed. Reg. 10709. The gross profit (realized or to be realized when
- 92 -
[*92] payment is completed) divided by the total contract price is also referred to
as the gross profit percentage. The income for the year is equal to the payments
received in that year multiplied by the gross profit percentage. Sec. 453(c); sec.
15A.453-1(b)(2)(i), Temporary Income Tax Regs., supra.
Mr. and Ms. Thoma reported on Form 6252 the income from the $160,000
in installment payments that Mr. Hjerpe made in 2011. They reported that the
$160,000 was composed of $131,637 in long-term capital gain, $3,921 in taxable
interest, and $24,442 in tax-free recovery of basis. The Form 6252 for 2011 stated
that the gross profit percentage was 84.34%. (The 2010 Form 6252 stated that the
gross profit percentage was 95.51%.) Mr. Thoma used the modified table to report
the installment income for 2011.
The notice of deficiency determined that the gross profit percentage to be
used in computing the income from the 2011 installment payments was 95.51%,
and correspondingly increased capital gains for 2011 by $2,364 and taxable
interest for 2011 by $15,779. The notice of deficiency determined that for 2011,
$140,300 of the installment payments was the noninterest component and $19,700
was the interest component. According to the notice of deficiency, Mr. and Ms.
Thoma would recover only $6,299 of tax-free basis for 2011, $140,300 !
($140,300 x 95.51%). Thus, the amounts as determined by the notice of
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[*93] deficiency for principal and interest for the 2011 installment payments are
the same as the table attached to the 2010 agreement showed for 2011 (of the
$160,000 in installment payments, $140,300 was principal and $19,700 was
interest). See supra p. 25.
Mr. and Ms. Thoma argue in their opening brief that the gross profit
percentage for 2011 was 84.34%. They assert that when Mr. Thoma prepared the
2011 return in October 2012, he believed Mr. Hjerpe would not make the quarterly
installment payments for 2012 by the time he prepared the 2011 return, or the final
quarterly installment payment due in 2013. (Recall that on or about January 23,
2012, Mr. Thoma filed a lawsuit against Mr Hjerpe for his failure to pay the
quarterly installment payment due on January 15, 2012.) In their opening brief,
Mr. and Ms. Thoma claim that they are allowed to recover the remaining amount
of the $40,000 basis with the installment payments for 2011. According to Mr.
and Ms. Thoma, a taxpayer is allowed to adjust the gross profit percentage when
an “intervening event” occurs. They point to section 15A.453-1(c)(2)(i)(A),
Temporary Income Tax Regs., 46 Fed. Reg. 10712 (Feb. 4, 1981), in support of
their claim. However, this regulation pertains to “contingent payment sales”. A
“contingent payment sale” is defined as “a sale or other disposition of property in
which the aggregate selling price cannot be determined by the close of the taxable
- 94 -
[*94] year in which such sale or other disposition occurs.” Id. subpara. (1), 46
Fed. Reg. 10711. Mr. and Ms. Thoma do not argue in their opening brief that Mr.
Thoma’s sale of his ownership interest in Thoma & Hjerpe to Mr. Hjerpe was a
contingent payment sale. Nor did Mr. Thoma testify that his sale was a contingent
payment sale. In any event, Mr. Thoma’s sale of his ownership interest in Thoma
& Hjerpe could not have been a contingent payment sale because the selling price
could be, and in fact was, determined by the close of the taxable year in which the
sale occurred. The total selling price of $1 million was clearly stated in the 2010
agreement.
Although Mr. and Ms. Thoma claim in their opening brief that the gross
profit percentage for 2011 was properly recalculated, they concede the adjustments
in the notice of deficiency for long-term capital gains and taxable interest for 2011
in their answering brief. In their answering brief, they assert that Mr. Thoma
received the “full payments on * * * [his] contract” from Mr. Hjerpe. We
therefore sustain the determination in the notice of deficiency and hold that for
2011 Mr. and Ms. Thoma underreported long-term capital gains by $2,364 and
taxable interest by $15,779. (We discuss infra part VI.C.3, pp. 103-104, whether
Mr. and Ms. Thoma had reasonable cause and acted in good faith for the way they
reported the installment sale payments.)
- 95 -
[*95] VI. Accuracy-related penalties
The IRS takes the position that Mr. and Ms. Thoma are liable for the 20%
accuracy-related penalty under section 6662(a) for 2010 because the
underpayment of tax for that year is attributable to negligence, one of the causes
set forth in section 6662(b). See sec. 6662(b)(1).31 The IRS takes the position that
Mr. and Ms. Thoma are liable for the 20% accuracy-related penalty under section
6662(a) for 2011 because the underpayment of tax for that year is attributable to
two of the causes set forth in section 6662(b): negligence or, alternatively, a
substantial understatement of income tax. See sec. 6662(b)(1) and (2).32
Section 6662(a) imposes a 20% penalty on the portion of an underpayment
of tax that is attributable to negligence, or to a substantial understatement of
income tax, or to various other causes. Sec. 6662(b). An understatement of tax is
generally the difference between the correct tax and the tax reported on the return.
31
The notice of deficiency determined that the underpayment of tax for 2010
is attributable to one or more of four causes. See supra p. 52. In its briefs the IRS
does not take the position that the underpayment of tax for 2010 is attributable to a
cause other than negligence. We therefore discuss only negligence for 2010.
32
The notice of deficiency determined that the underpayment of tax for 2011
is attributable to one or more of four causes. See supra p. 52. In its briefs the IRS
does not take the position that the underpayment of tax for 2011 is attributable to
causes other than negligence and a substantial understatement. We therefore
discuss only negligence and a substantial understatement for 2011.
- 96 -
[*96] Sec. 6662(d)(2)(A). Negligence includes any failure to make a reasonable
attempt to comply with the tax laws. Sec. 6662(c); sec. 1.6662-3(b), Income Tax
Regs. Negligence is strongly indicated where a taxpayer fails to make a
reasonable attempt to determine the correctness of a deduction, credit, or exclusion
that would seem to a reasonable person to be “too good to be true”. Sec.
1.6662-3(b)(1)(ii), Income Tax Regs. Negligence also includes a failure to
maintain accurate records or to substantiate items properly. Sec. 1.6662-3(b)(1),
Income Tax Regs. An understatement is substantial if it exceeds the greater of “(i)
10 percent of the tax required to be shown on the return for the taxable year, or (ii)
$5,000.” Sec. 6662(d)(1)(A).33
The IRS has the burden of producing evidence that it is appropriate to
impose the penalty. Sec. 7491(c); Higbee v. Commissioner, 116 T.C. 446.34
33
An understatement is reduced, however, by the portion attributable to the
treatment of any item for which the taxpayer had “substantial authority” or
disclosed the relevant facts and had a reasonable basis. Sec. 6662(d)(2)(B). In
their briefs Mr. and Ms. Thoma do not argue that the understatement of tax for
2011 should be reduced because of substantial authority or disclosure and
reasonable basis. They have waived any argument that the understatement of tax
for 2011 should be reduced under sec. 6662(d)(2)(B).
34
The section 6662(a) accuracy-related penalty can be imposed only if the
initial determination to assess the penalty is personally approved by the immediate
supervisor of the individual making the determination. Sec. 6751(b); see Graev v.
Commissioner, 149 T.C. 485, 493 (2017), supplementing and overruling in part
(continued...)
- 97 -
[*97] A. Underpayment of tax for 2010
For the reasons stated below, we find the IRS has met its burden of showing
that the underpayment of tax for 2010 is attributable to negligence. Mr. and Ms.
Thoma were negligent with respect to the portion of the underpayment of tax for
34
(...continued)
147 T.C. 460 (2016). Written supervisory approval of the initial penalty
determination under sec. 6751(b)(1) must be obtained before the first formal
communication to the taxpayer proposing the penalty and advising the taxpayer of
his right to appeal the penalty with the IRS Office of Appeals. Clay v.
Commissioner, 152 T.C. 223, 249 (2019). In Belair Woods, LLC v.
Commissioner, 154 T.C. __, __ (slip op. at 24-25) (Jan. 6, 2020), we recently held
that “the ‘initial determination’ of a penalty assessment * * * is embodied in the
document by which the Examination Division formally notifies the taxpayer, in
writing, that it has completed its work and made an unequivocal decision to assert
penalties.” Compliance with sec. 6751(b)(1) is part of the IRS’ initial burden of
production in any deficiency case in which a penalty subject to sec. 6751(b)(1) is
asserted. Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), aff’g in part,
rev’g in part T.C. Memo. 2015-42; Frost v. Commissioner, 154 T.C. __, __ (slip
op. at 16) (Jan. 7, 2020). If the IRS meets its initial burden of production, then
“the taxpayer must come forward with contrary evidence.” Frost v.
Commissioner, 154 T.C. at __ (slip op. at 20). RA Ransdell made the initial
determination to impose the sec. 6662(a) penalties in her examination report. The
examination report was attached to a 30-day letter sent to Mr. and Ms. Thoma.
The 30-day letter was signed by RA Ransdell’s immediate supervisor, Marilyn
Clark. The IRS has met its initial burden of production of showing that the initial
determination to impose the sec. 6662(a) penalties was approved in writing before
Mr. and Ms. Thoma received the first formal communication informing them of
the penalties and giving them an opportunity to dispute the penalties with the IRS
Office of Appeals. Mr. and Ms. Thoma have not offered any contrary evidence
(e.g., a prior formal communication). Accordingly, we hold that the IRS complied
with the sec. 6751(b)(1) procedural requirements for imposition of the sec.
6662(a) accuracy-related penalties.
- 98 -
[*98] 2010 that is attributable to the partially disallowed business-expense
deduction because, despite his long career as an accountant, Mr. Thoma did not
maintain adequate records to substantiate the partially disallowed amounts for
2010. See sec. 6001; secs. 1.6001-1(a), 1.6662-3(b)(1), Income Tax Regs. Mr.
and Ms. Thoma reported that Mr. Thoma was a partner in an entity, but he did not
share in its profits and losses, did not have any responsibility for its debts, and had
no equity investment in the entity. They should have realized it was too good to
be true that they could report Mr. Thoma as a partner when Mr. Hjerpe had
authority to terminate Mr. Thoma’s business relationship with Thoma & Hjerpe.
See sec. 1.6662-3(b)(1)(ii), Income Tax Regs. Because Mr. and Ms. Thoma were
negligent as to Mr. Thoma’s employee status in 2010, they were negligent in
reporting deductions for business expenses, health insurance expenses, SIMPLE
IRA contributions, and one-half of self-employment tax, on the purported grounds
that Mr. Thoma was a self-employed individual. See id.
B. Underpayment of tax for 2011
The IRS has met its burden of showing that the underpayment of tax for
2011 is attributable to a substantial understatement of income tax. See Avrahami
v. Commissioner, 149 T.C. 144, 204 (2017) (“The Commissioner has the initial
burden of production to show that the understatement of income tax was
- 99 -
[*99] substantial.” (citing section 7491(c)). The notice of deficiency determined
that the 2011 understatement of tax is equal to $14,660, which is $57,655 (the
correct amount of tax determined by the notice) minus $42,995 (the tax reported
on the 2011 return). The understatement for 2011, $14,660, exceeds $5,000 and
10% of the correct amount of tax (10% of $57,655, or $5,766). Mr. and Ms.
Thoma’s understatement of tax for 2011 is thus substantial. See sec.
6662(d)(1)(A). Consequently, we do not discuss whether the underpayment of tax
for 2011 is attributable to negligence.
C. Reasonable cause
Once the IRS has met its burden of producing evidence that a taxpayer is
liable for a penalty, the taxpayer bears the burden of proving that the penalty is
inappropriate because, for example, the taxpayer acted with reasonable cause and
in good faith. Sec. 6664(c)(1); Higbee v. Commissioner, 116 T.C. 447. The
existence of reasonable cause and good faith is determined on a case-by-case
basis, taking into account all pertinent facts and circumstances. Sec. 1.6664-
4(b)(1), Income Tax Regs. Generally, the most important factor is the extent of
the taxpayer’s effort to assess the proper tax liability. Id. Circumstances that may
indicate reasonable cause and good faith include an honest misunderstanding of
- 100 -
[*100] fact or law that is reasonable in the light of all the facts and circumstances,
including the experience, knowledge, and education of the taxpayer. Id.
1. Treatment of Mr. Thoma as a partner of Thoma & Hjerpe
Mr. and Ms. Thoma argue on brief that they relied on the Schedules K-1 in
reporting on the 2010 and 2011 returns that Mr. Thoma was a self-employed
individual and partner of Thoma & Hjerpe. The IRS contends that the evidence in
the trial record does not support a finding that Mr. and Ms. Thoma relied on the
Schedules K-1. We agree with the IRS about reliance. At trial, when counsel for
the IRS asked Mr. Thoma questions about the information shown on the Schedules
K-1, Mr. Thoma’s response consisted of his acknowledgment that counsel for the
IRS correctly read the information shown on the forms. For example, counsel for
the IRS pointed out that the 2010 Schedule K-1 reported nothing in box 1,
“Ordinary business income (loss)”, and Mr. Thoma responded: “That’s correct.”
Mr. Thoma did not testify that he relied on the Schedules K-1 when he prepared
the returns at issue.
Even if Mr. Thoma had relied on the Schedules K-1 in preparing the 2010
and 2011 returns, his reliance would not be reasonable. A taxpayer may not rely
on the information on an information return (e.g., a Schedule K-1) if the taxpayer
knows, or has reason to know, that the information is incorrect. Sec. 1.6664-
- 101 -
[*101] 4(b)(1), Income Tax Regs. Generally, a taxpayer knows, or has reason to
know, that the information on an information return is incorrect if the information
is inconsistent with the taxpayer’s knowledge of the transaction, including, for
example, the taxpayer’s knowledge of the terms of his employment relationship.
Id. We find that Mr. Thoma had reason to know that the information reported on
the Schedules K-1 was incorrect. As an accountant with years of experience, Mr.
Thoma had reason to know it was inconsistent to treat himself as a partner in an
entity in which he had no ownership interest, no liability for the entity’s debts, and
no right to its profits. We also find that Mr. and Ms. Thoma did not act in good
faith when they reported that Mr. Thoma was a partner. In Mr. Thoma’s complaint
that his termination from Thoma & Hjerpe was illegal, see supra p. 38, he alleged
he was “employed” by Thoma & Hjerpe “for several years prior and up to
November 21, 2011”. Mr. Thoma’s statement in the complaint that he was an
employee of Thoma & Hjerpe “for several years prior to November 21, 2011”
indicates that Mr. Thoma considered himself an employee of Thoma & Hjerpe in
2010 and 2011--the years before us. Further, in Mr. Thoma’s claim for
unemployment benefits (filed in early 2012 and before the filing of the 2011
return) he took the position that he was employed, and eventually fired, by Thoma
& Hjerpe. These two instances of Mr. Thoma representing that he was an
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[*102] employee of Thoma & Hjerpe in nontax contexts where being an employee
was favorable to him undermine Mr. and Ms. Thoma’s argument in their briefs
that they acted in good faith when they reported that he was a partner. Mr. and
Ms. Thoma have not carried their burden of showing reasonable cause and good
faith with respect to the portions of the underpayments of tax for 2010 and 2011
that are attributable to their position that Mr. Thoma was a partner. Consequently,
we find that they did not have reasonable cause or act in good faith with respect to
the portions of the underpayments of tax for 2010 and 2011 attributable to the
business expenses, health insurance expenses, SIMPLE IRA contributions, and
one-half of self-employment tax deductions.
2. Mr. Thoma’s unsubstantiated business expenses
Mr. and Ms. Thoma argue on brief that they deducted only business
expenses of Mr. Thoma’s that were “properly and fully substantiated to the IRS.”
But we concluded supra part II.B, pp. 83-87, that they did not substantiate all the
business expenses reported on the returns. Nothing in the record shows that Mr.
Thoma took reasonable steps to comply with recordkeeping requirements. Mr.
and Ms. Thoma have not carried their burden of showing reasonable cause and
good faith with respect to the portions of the underpayments of tax for 2010 and
2011 attributable to the partially unsubstantiated business expenses.
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[*103] 3. Gross profit percentage of 84.34% for 2011
Mr. and Ms. Thoma argue on brief that they “properly reported [the] interest
and capital gains from * * * [Mr. Thoma’s] sale * * * based on the facts at that
time” and that Mr. Thoma “thoroughly researched the tax law with respect to the
handling of the catastrophic event affecting * * * [his] contract”. Their briefs
point to Exhibit 28-P, a treatise on contingent payment sales, in support of their
claim that they took reasonable steps in reporting the 2011 installment payments
with a gross profit percentage of 84.34%. The treatise identified was not admitted
into evidence. Mr. and Ms. Thoma do not convince us that Mr. Thoma relied on
Exhibit 28-P when he prepared the 2011 return.35 Even if Mr. Thoma relied on
Exhibit 28-P, Mr. and Ms. Thoma have not shown that his reliance was
reasonable. They offered no evidence to show that Mr. Thoma took reasonable
steps to determine that the treatise applied to the installment sale. Mr. and Ms.
35
Mr. Thoma used the modified table to prepare the 2011 return, including
the 2011 Form 6252, “Installment Sale Income”. See supra pp. 49-51. At trial,
Mr. Thoma testified that his “calculations [the modified table] were all based on
document 28 [i.e., Exhibit 28-P]”. This testimony suggests that Mr. Thoma
created the modified table after he read Exhibit 28-P. However, Mr. Thoma also
testified that he “re-ran an amortization schedule [i.e., the modified table] based on
what I was paid”. This testimony suggests that Mr. Thoma did not rely on Exhibit
28-P in reporting the 2011 installment payments. We find that Mr. Thoma’s
testimony is unclear as to whether he created the modified table after reading
Exhibit 28-P, or prepared the modified table, filed the 2011 return, and read
Exhibit 28-P after the filing of the return.
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[*104] Thoma have not carried their burden of showing reasonable cause and
good faith with respect to the portion of the underpayment of tax for 2011
attributable to the installment sale income reporting.
We hold that Mr. and Ms. Thoma are liable for accuracy-related penalties
under section 6662(a) on the underpayments of tax for 2010 and 2011.
To reflect the foregoing,
Decision will be entered for
respondent.