Dunne v. Comm'r

T.C. Memo. 2008-63
UNITED STATES TAX COURT
JOSEPH D. DUNNE AND ELIZABETH M. DUNNE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24666-05. Filed March 12, 2008.
Steven D. Simpson, for petitioners.
J. Craig Young, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: Respondent determined deficiencies in
petitioners’ 1997 and 1999 Federal income taxes of $822,298 and
$2,566, respectively, and additions to tax under section
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6651(a)(1)1 of $205,028.25 and $592.50, respectively, for 1997
and 1999. After concessions,2 the issues for decision are:
(1) Whether respondent bears the burden of proof under
section 7491(a). We hold that respondent does not;
(2) whether petitioner Joseph Dunne was a shareholder of
FRC International, Inc. (FRC), in 1997 and whether petitioners
must pay income tax on FRC’s income under section 1366. We hold
that Mr. Dunne ceased to be a shareholder of FRC on May 8, 1997,
and therefore under section 1377(a)(1) petitioners are liable for
paying income tax only on Mr. Dunne’s pro rata share of FRC’s
income on the basis of the number of days in 1997 that he owned
the stock;
(3) whether Mrs. Dunne is eligible for relief from joint
liability under section 6015 for 1997. We hold that she is not;
(4) whether petitioners may claim as trade or business
expenses $20,000 of legal expenses that they incurred in 1999.
We hold that they may not, but they may claim the $20,000 as
miscellaneous itemized expenses;
1
All section references are to the Internal Revenue Code
(the Code) in effect for the years in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
2
Petitioners concede that the statute of limitations does
not bar the assessment or collection of any amount due for 1997
or 1999. Petitioners also concede that petitioner Elizabeth
Dunne does not qualify for innocent spouse relief under sec. 6015
for 1999.
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(5) whether petitioners failed to report a $15,000 capital
gain on their 1999 Federal income tax return. We hold that they
did not, because we find that respondent’s determination as to
this item was arbitrary; and
(6) whether petitioners are liable for additions to tax
under section 6651(a)(1) for 1997 and 1999. We hold that they
are.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulated facts and the accompanying exhibits are
incorporated herein by this reference.
Petitioners resided in Sanford, North Carolina, at the time
they filed their petition.
FRC International, Inc.
Mr. Dunne incorporated FRC in Delaware in 1982. FRC’s
principal place of business was Holland, Ohio. FRC was in the
business of selling fire protection material, particularly a
chemical called halon, through contracts with the Federal
Government. FRC was an S corporation for all relevant periods.
Mr. Dunne was FRC’s sole shareholder from the time of its
incorporation until 1993. Mr. Dunne was also a director and an
employee of FRC. In 1993, Richard Marcus became a 50-percent
shareholder of FRC while Mr. Dunne continued to own the remaining
50 percent. Mr. Marcus also became the president of FRC and
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remained in that position at all relevant times. Mr. Dunne and
Mr. Marcus were also coguarantors of a $4 million line of credit
from FRC’s bank that was set up in connection with a particular
contract that FRC had to provide halon to the Government (the
halon contract).
FRC did not hold any formal shareholder or board of
directors meetings during any relevant period. Before 1997 Mr.
Dunne was living in North Carolina, and he flew to FRC’s office
in Holland, Ohio, every 1 or 2 months. Mr. Dunne exercised only
limited managerial control over FRC at that time.
Problems Between Mr. Dunne and Mr. Marcus
Mr. Dunne and Mr. Marcus began to have disagreements about
the operation of FRC in 1995. They discussed possible buyout
arrangements--some where Mr. Marcus would buy Mr. Dunne’s shares
and some where the reverse was true.
On August 1, 1996, Mr. Dunne and Mr. Marcus met at the
Inverness Country Club. At this meeting, Mr. Dunne agreed
informally to sell Mr. Marcus or FRC his FRC stock on an
unspecified later date, but they anticipated the sale would occur
by December 31, 1996 (the Inverness agreement). The price was to
be based upon an independent valuation of FRC. Mr. Dunne agreed
that Mr. Marcus could conduct the business of FRC as he wished.
Mr. Dunne and Mr. Marcus did not make a binding agreement or sign
a contract at this time, and no sale occurred in 1996.
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On January 16, 1997, through their respective attorneys, Mr.
Marcus made an offer to Mr. Dunne, which was based on the
Inverness agreement and subsequently would end the relationship
between Mr. Dunne and FRC. Mr. Dunne did not accept this offer.
By letter dated January 24, 1997, as president of FRC, Mr.
Marcus terminated Mr. Dunne’s employment as of January 25, 1997.
Mr. Marcus wrote that he understood that Mr. Dunne would continue
to be an FRC shareholder and a member of the board of directors.
Mr. Dunne was not involved in the management or operation of FRC
after this date.
On February 3, 1997, Mr. Marcus e-mailed FRC’s employees
directing them not to discuss FRC’s business with or provide
information to Mr. Dunne but to refer such calls to him.
On February 26, 1997, Mr. Dunne filed a Verified Petition
for Appointment of a Custodian against FRC in the Chancery Court
of New Castle County, Delaware, pursuant to section 226 of
Delaware’s general corporate law. That section allows
shareholders of a corporation to have a custodian appointed for
that corporation in certain circumstances. In his petition, Mr.
Dunne stated that he was a 50-percent owner, the chairman of the
board, and the secretary of FRC. Mr. Dunne also stated that he
and Mr. Marcus did not reach an agreement at the Inverness
Country Club meeting.
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On March 18, 1997, Mr. Marcus mailed a letter to a potential
business partner. Mr. Marcus wrote: “As of January 25, 1997 Joe
Dunne was terminated as an employee of FRC, therefore he does not
speak for or represent the company in anyway. In addition, it is
our position that Joe has in effect sold his shares of stock to
me.”
The Settlement Agreement
On May 8, 1997, Mr. Dunne and Mr. Marcus executed a
settlement agreement. This agreement provided that in exchange
for his 50-percent interest in FRC, Mr. Dunne would receive
$175,000 plus 50 percent of FRC’s total net profit from the halon
contract. The parties agreed that the payment of $175,000
represented FRC’s net book value. The settlement agreement
provided that the $175,000 was payable as of the date of
settlement (the settlement date), but also that it was payable in
seven equal monthly payments beginning on June 1, 1997.
Regarding Mr. Dunne’s FRC stock, the settlement agreement
provided:
TO BE DELIVERED IN ESCROW FULLY ENDORSED PENDING FINAL
DISTRIBUTION OF ALL MONIES DUE UNDER HALON CONTRACT &
TWO ESCROW ACCTS, OR PAYMENT OF NET B.V. OF FRCI,
WHICHEVER IS LATER. NO SHAREHOLDER OR DIRECTOR RIGHTS
IN JDD AFTER DATE OF SETTLEMENT. ESCROW ACCT PROCEEDS
TO BE DISTRIBUTED NET OF ALL COSTS & EXPENSES 1/2 TO
JDD & 1/2 TO RMM.
* * * * * * *
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SETTLEMENT DATE IS DATE OF SIGNING MEMORIALIZING
DOCUMENT, ANTICIPATED TO BE COMPLETE NOT LATER THAN
5/16/97.
However, contrary to the agreement, Mr. Dunne did not escrow
his FRC stock certificates at that time. The settlement
agreement also provided that all disputes were to be resolved by
arbitration.
Soon after they executed the settlement agreement, Mr. Dunne
and Mr. Marcus began disputing its provisions. On October 7,
1997, Mr. Dunne, Mr. Marcus, and FRC executed an agreement to
arbitrate these disputes.
Mr. Dunne’s Relationship With FRC
FRC paid Mr. Dunne and Mr. Marcus equal dividends each month
from January through April of 1997, totaling between $20,000 and
$26,000 for each. FRC paid these dividends so that Mr. Dunne and
Mr. Marcus could satisfy their income tax liabilities.
In September of 1997, Mr. Dunne sent several letters and
reports regarding FRC to FRC’s bank, listing his titles as
“Director, Officer, Co-Owner of FRC, Int’l.” An officer of the
bank replied with correspondence acknowledging Mr. Dunne’s
titles.
On October 6, 1997, the bank’s attorney sent Mr. Dunne a
letter stating that the bank was aware of Mr. Dunne’s agreement
to sell his interest in FRC and of the dispute between Mr. Dunne
and Mr. Marcus. Because the bank did not know what authority Mr.
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Dunne had concerning FRC’s affairs and did not wish to be a party
to the dispute, it informed Mr. Dunne through counsel that it
would provide Mr. Dunne with further financial information only
upon the request of FRC through its president.
Mr. Dunne responded in a letter dated October 8, 1997, in
which he asked the bank’s attorney for documentation showing that
he was not a director, officer, and coowner of FRC and therefore
not entitled to receive copies of FRC’s financial information
from the bank. Mr. Dunne also sent a letter to the bank
reasserting his position as a director, officer, and coowner of
FRC and asking for the documentation that the bank relied upon to
determine that he no longer held those positions. The attorney
for the bank responded by a fax dated October 15, 1997, that it
received no document indicating that Mr. Dunne was no longer a
director, officer, or coowner of FRC but that out of caution it
would like FRC’s president to be aware of Mr. Dunne’s requests
for FRC’s financial information. Mr. Dunne sent several more
letters to both the bank’s attorney and the bank asserting his
position as a director, officer, and coowner of FRC.
On April 15, 1998, Mr. Dunne wrote to an FRC employee
requesting copies of FRC’s Form 1120S, U.S. Income Tax Return for
an S Corporation, and Mr. Dunne’s Schedule K-1, Shareholder’s
Share of Income, Credits, Deductions, etc., for 1997. Mr. Dunne
stated that he understood that FRC’s taxable income for 1997
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would be about $4.3 million. Mr. Dunne also requested that FRC
continue its practice of depositing Mr. Dunne’s estimated tax
liability directly with respondent. He did not believe that this
would be a problem because FRC had over $3 million in cash. Mr.
Dunne signed this letter as “Co-Owner and Chairman of the Board”
of FRC.
On September 21, 1998, FRC filed a Form 1120S for 1997 and
attached Schedules K-1 for Mr. Dunne and Mr. Marcus. The
Schedules K-1 reported Mr. Dunne’s and Mr. Marcus’s shareholder
percentages for 1997 to be 50 percent each and reported their pro
rata shares of FRC’s income and loss as $2,116,600 of ordinary
income, $27,504 of interest income, and $1,953 of capital loss.
FRC sent Mr. Dunne a Schedule K-1 for 1997 identical to the
Schedule K-1 it submitted to respondent.
The Arbitration Award
In October of 1997, Mr. Marcus offered to pay Mr. Dunne $2.2
million in full satisfaction of all payments required by the
settlement agreement. Mr. Dunne responded with a $2.6 million
counteroffer, which he withdrew. Mr. Dunne decided to let the
arbitrator decide on the award because he thought he was entitled
to receive about $4.9 million under the settlement agreement.
The arbitrator entered an arbitration award (the arbitration
award) on June 8, 1998. The arbitrator determined that Mr.
Dunne’s share of the halon contract was $511,267.54, which was
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payable on the settlement date. Mr. Dunne was also entitled to
$175,000 for the sale of his FRC stock on the settlement date.
The arbitrator confirmed that the paragraph governing the
transfer of FRC stock required Mr. Dunne to escrow the stock
certificates on the settlement date, and that the certificates
would be held in escrow until Mr. Dunne had received the money
owed to him. The arbitrator noted that there was no settlement
date at that point because no memorializing document had been
signed. He directed that the settlement date would be June 22,
1998.
None of the parties involved complied with the arbitration
award. On June 9, 1998, FRC and Mr. Marcus filed a complaint in
the Court of Common Pleas of Lucas County, Ohio, to confirm the
arbitration award. The complaint was removed to the U.S.
District Court for the Northern District of Ohio. On August 10,
1998, Mr. Dunne filed an answer and counterclaim in which he
stated that he was a 50-percent shareholder of FRC. On May 6,
1999, the District Court confirmed the arbitration award. All
parties involved appealed.
Petitioners’ Returns
On September 1, 1999, petitioners jointly filed a Form 1040,
U.S. Individual Income Tax Return, for 1997. After an extension,
petitioners’ 1997 Form 1040 was due on August 15, 1998.
Petitioners attached a Form 8082, Notice of Inconsistent
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Treatment or Administrative Adjustment Request, to their 1997
return stating that they were not reporting the income or losses
listed on the Schedule K-1 from FRC. They explained that Mr.
Dunne filed a shareholder complaint regarding several issues:
(1) That Mr. Dunne was a 50-percent shareholder of FRC but was
frozen out of dividend distributions in 1997; (2) that FRC did
not provide Mr. Dunne with certain information; (3) that Mr.
Dunne was disengaged from FRC’s books, records, and resolutions;
and (4) that FRC may have made an unequal distribution of income
earned in 1997 that could require a revocation of its S
corporation status.
On September 17, 1999, FRC filed a Form 1120S for 1998 and
attached Schedules K-1 for Mr. Dunne and Mr. Marcus. The
Schedules K-1 reported that Mr. Dunne owned 23.69863 percent of
the stock and Mr. Marcus owned the rest. In computing the
ownership percentages shown on the 1998 Schedules K-1, FRC’s
accountants assumed that Mr. Dunne and Mr. Marcus each owned 50
percent of FRC’s stock until June 22, 1998, and that Mr. Marcus
became the sole shareholder after that date. FRC reported a net
loss in 1998.
FRC sent Mr. Dunne a Schedule K-1 for 1998 identical to the
Schedule K-1 that it submitted to respondent. In response to
receiving his Schedule K-1 for 1998, on September 22, 1999, Mr.
Dunne faxed a letter to FRC’s accountants stating that the
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Schedule K-1 was incorrect because Mr. Dunne still owned 50
percent of FRC.
On August 14, 2001, petitioners jointly filed a Form 1040
for 1999. This return was due on April 15, 2000.
The Transfer of Legal Title
On October 30, 2000, Mr. Dunne, Mr. Marcus, and FRC entered
into an agreement and release of claims to settle all disputes
between them. Pursuant to the agreement, Mr. Dunne endorsed and
delivered his FRC stock certificates to Mr. Marcus, and Mr.
Marcus and FRC paid Mr. Dunne the balance of the funds due to him
under the arbitration award.
Respondent’s Examination
In mid-2001 the Internal Revenue Service (IRS) began
examining petitioners’ 1997, 1998, and 1999 Federal income tax
returns. Petitioners provided the examining agent with a large
number of documents. Petitioners also gave the examining agent a
summary of their position, which concluded that Mr. Dunne
transferred beneficial ownership of his FRC shares on May 8,
1997. In her April 15, 2002, examination report the examining
agent concluded that petitioners had deficiencies of $822,298 and
$2,566 for 1997 and 1999, respectively. The examining agent also
concluded on the basis of the arbitration award that the
settlement date for the stock sale was June 22, 1998; thus
petitioners were required to include all of the amounts reported
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on Mr. Dunne’s Schedule K-1 on their 1997 tax return.
Furthermore, petitioners were liable for additions to tax under
section 6651(a)(1) and (2) for 1997 and 1999.
On August 18, 2005, Mrs. Dunne sent to respondent a Form
8857, Request for Innocent Spouse Relief, for the year 1997.
Mrs. Dunne stated that she signed the 1997 return but did not
review it because there had never been a problem previously.
Mrs. Dunne knew that her husband was selling his interest in a
corporation and was concerned about what the effect of the
litigation regarding the sale would be. When she told her
husband about her concerns, Mr. Dunne responded that he was
handling the sale according to his attorney’s written advice,
which was that Mr. Dunne had sold his interest in the corporation
and petitioners did not need to report the income listed on the
Schedule K-1. Because it was a complicated transaction, Mrs.
Dunne relied on Mr. Dunne and his attorney, and Mrs. Dunne was
not involved in the corporation at all.
Mrs. Dunne listed her average monthly household income as
$5,157 and expenses as $4,971.87. Petitioners were married and
living together at all relevant times, and Mrs. Dunne did not
suffer any spousal abuse or poor mental or physical health at any
relevant time. Mrs. Dunne has no knowledge of tax law except
that income tax returns are due on April 15.
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On October 7, 2005, respondent mailed petitioners a
statutory notice of deficiency for 1997 and 1999. Respondent
determined that Mr. Dunne remained a 50-percent shareholder of
FRC throughout 1997 and that petitioners should have reported Mr.
Dunne’s pro rata share of FRC’s items of income and loss as shown
on the Schedule K-1 for 1997.
Regarding 1999, respondent determined that $20,000 of legal
expenses that petitioners claimed as a deduction on their
Schedule C, Profit or Loss From Business, should be disallowed.
However, this amount should be included as a miscellaneous
itemized deduction on petitioners’ Schedule A, Itemized
Deductions. These legal expenses related to Mr. Dunne’s disputes
over the settlement agreement. Respondent further determined
that petitioners realized, but failed to report on their 1999
return, a $15,000 capital gain. However, there is no evidence in
the record as to the source of this alleged capital gain.
Respondent stated that Mrs. Dunne was not entitled to relief
from joint liability under section 6015 for either 1997 or 1999.3
Finally, respondent determined that petitioners were liable
for additions to tax for failure to file timely income tax
returns for both 1997 and 1999.
3
Respondent found that there were no grounds to grant Mrs.
Dunne relief for tax year 1999 because she did not submit a Form
8857 for that year, and Mrs. Dunne has conceded this issue.
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Petitioners timely petitioned this Court to redetermine all
of respondent’s adjustments.
OPINION
I. Burden of Proof
Petitioners contend that under section 7491(a), respondent
bears the burden of proof relating to all items in the notice of
deficiency. Petitioners also contend that respondent’s
determinations relating to 1999 are arbitrary and capricious, but
we will address that issue separately with respect to those
items.
As a general rule, taxpayers bear the burden of proving that
the Commissioner’s determinations are incorrect. Rule 142(a).
However, section 7491(a) may in specific circumstances place the
burden on the Commissioner with regard to any factual issue
relating to a taxpayer’s liability for tax if the taxpayers
produce credible evidence with respect to that issue and meet the
requirements found in section 7491(a)(2). The requirements
applicable here are that the taxpayers have (1) complied with all
substantiation requirements of the Code, (2) maintained all
required records, and (3) cooperated with reasonable requests by
the Secretary for witnesses, information, documents, meetings,
and interviews. The taxpayers bear the burden of proving that
they have met the requirements of section 7491(a)(2). Miner v.
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Commissioner, T.C. Memo. 2003-39; Nichols v. Commissioner, T.C.
Memo. 2003-24, affd. 79 Fed. Appx. 282 (9th Cir. 2003).
Petitioners raised the issue of whether section 7491(a)
applies for the first time in their posttrial brief. Respondent
argues that he would be prejudiced if we were to allow
petitioners to raise the section 7491(a)(2) requirements issue
for the first time on brief because had they raised the issue
earlier, respondent could have presented evidence showing that
petitioners have not satisfied the requirements. We agree with
respondent. See Smith v. Commissioner, T.C. Memo. 2007-368;
Deihl v. Commissioner, T.C. Memo. 2005-287. Furthermore, other
than the testimony of the examining agent that petitioners
provided her with a lot of information, the record contains no
specific evidence that petitioners have complied with all of the
substantiation and record maintenance requirements or cooperated
with respondent’s information requests. Therefore, the record is
insufficient for us to find that petitioners have satisfied the
requirements of section 7491(a)(2), and we conclude a shift of
the burden of proof is not appropriate in this case.
II. Whether Petitioners Must Pay Income Tax on FRC’s Income for
1997
Petitioners argue that they are not required to pay income
tax on any of FRC’s income or loss for 1997 because collateral
estoppel prevents respondent from taxing petitioners in an amount
in excess of what they received from the arbitration award and
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because Mr. Dunne was not a beneficial owner of FRC for any part
of 1997.
The doctrine of collateral estoppel provides that once an
issue of fact or law is “actually and necessarily determined by a
court of competent jurisdiction, that determination is conclusive
in subsequent suits based on a different cause of action
involving a party to the prior litigation.” Montana v. United
States, 440 U.S. 147, 153 (1979); Parklane Hosiery Co. v. Shore,
439 U.S. 322, 326 n.5 (1979). For collateral estoppel to apply,
the following five conditions must be satisfied:
(1) The issue in the second suit must be identical in all
respects to the one decided in the first suit;
(2) there must be a final judgment rendered by a court of
competent jurisdiction;
(3) collateral estoppel may be invoked against parties and
their privies to the prior judgment;
(4) the parties must actually have litigated the issue and
the resolution of the issue must have been essential to the prior
decision; and
(5) the controlling facts and applicable legal rules must
remain unchanged from those in the prior litigation.
Brotman v. Commissioner, 105 T.C. 141, 148 (1995); Peck v.
Commissioner, 90 T.C. 162, 166-167 (1988), affd. 904 F.2d 525
(9th Cir. 1990).
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Collateral estoppel does not apply against respondent in
this case. Collateral estoppel may be invoked against parties
and their privies to the prior judgment, but respondent was not a
party to the arbitration or a privy of Mr. Dunne, Mr. Marcus, or
FRC. While petitioners correctly point out that the Supreme
Court held in Parklane Hosiery Co. v. Shore, supra at 332-333,
that collateral estoppel can apply where a party to the second
proceeding was not a party to the first proceeding, they
misunderstand the scope of that rule. The U.S. Supreme Court
approved the use of collateral estoppel, whether mutual or
nonmutual, in cases where the party against whom collateral
estoppel is asserted has litigated and lost in the prior
proceeding. Id. at 329. Therefore, even assuming respondent
could have asserted that collateral estoppel applied against
petitioners in this case if all of the other conditions had been
satisfied, the reverse is not true.
Furthermore, neither the tax consequences of the settlement
agreement nor Mr. Dunne’s shareholder status were issues in the
arbitration. The arbitration merely dealt with the terms of the
settlement agreement, and the settlement agreement contained no
terms relating to the settlement agreement’s tax consequences
except that it provided that Mr. Dunne would have no shareholder
rights after the settlement date. Because petitioners are
arguing that Mr. Dunne ceased to be a shareholder of FRC for
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Federal income tax purposes before the settlement date of June
22, 1998, we assume that petitioners’ argument is only that the
amount of the arbitration award would somehow be relevant to Mr.
Dunne’s shareholder status or the amount of FRC’s income that is
taxable to petitioners. However, this is incorrect because the
amount that Mr. Dunne was entitled to receive from the
arbitration award is irrelevant for determining his shareholder
status or tax liability. See Chen v. Commissioner, T.C. Memo.
2006-160; Knott v. Commissioner, T.C. Memo. 1991-352. The amount
that Mr. Dunne received from the arbitration award may be
relevant for the purpose of determining Mr. Dunne’s basis in his
FRC stock, but that matter is not at issue in this case.
Petitioners also argue that they are not liable for tax on
FRC’s income in 1997 because Mr. Dunne was not the beneficial
owner of his FRC shares in 1997, and for that reason alone his
1997 Schedule K-1 is incorrect. Petitioners do not dispute that
FRC had a valid S corporation election in effect in 1997, that
the amount of FRC’s income and loss reported on its Form 1120S is
correct, or that the total amount of income and loss reported on
the Schedules K-1 is consistent with FRC’s Form 1120S.
Section 1366(a)(1) provides that in determining the income
tax liability of an S corporation shareholder, the shareholder
shall take into account his pro rata share of the S corporation’s
items of income, loss, deduction, and credit (tax items) for the
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S corporation’s taxable year ending with or in the shareholder’s
taxable year. The S corporation’s income is taxable to the
shareholder regardless of whether any income is distributed.
Chen v. Commissioner, supra; Knott v. Commissioner, supra.
Section 1377(a)(1) allocates each item of an S corporation’s
income or loss pro rata on a per share per day of ownership
basis. If a shareholder sells his stock during the S
corporation’s taxable year, he must take into account his pro
rata share of the total amount of the S corporation’s tax items
according to the number of days in that year that he held his
stock, regardless of whether the tax items arose before or after
the sale. Sec. 1377(a)(1). The shareholders may elect to
compute the selling shareholder’s pro rata share of the tax items
as if the S corporation’s taxable year ends on the date the
shareholder’s ownership interest terminates, but the FRC
shareholders did not make such an election. Sec. 1377(a)(2).
It is well settled that beneficial ownership, not legal
title, determines stock ownership for Federal income tax
purposes. Ragghianti v. Commissioner, 71 T.C. 346, 349 (1978),
affd. 652 F.2d 65 (9th Cir. 1981); Pacific Coast Music Jobbers,
Inc. v. Commissioner, 55 T.C. 866, 874 (1971), affd. without
published opinion 457 F.2d 1165 (5th Cir. 1972). Therefore, we
must determine whether Mr. Dunne was the beneficial owner of any
of FRC’s stock during 1997.
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To determine when beneficial ownership has passed from one
person to another, a court generally must determine at what point
the transferee acquires more attributes of ownership than the
transferor. Ragghianti v. Commissioner, supra at 349; Pacific
Coast Music Jobbers, Inc. v. Commissioner, supra at 874; Cordes
v. Commissioner, T.C. Memo. 1994-377. Where there is a written
agreement that is intended to result in the sale of stock but
provides for the transfer of legal title at a later date, we will
consider whether that agreement suffices to transfer
“substantially all” of the accouterments of ownership at the time
of its execution. Ragghianti v. Commissioner, supra at 349;
Pacific Coast Music Jobbers, Inc. v. Commissioner, supra at 874.
However, if a taxpayer has entered into an unambiguous written
agreement providing that a sale of stock is to occur at a
specific date, the taxpayer must provide “strong proof” that
beneficial ownership of the stock occurred at a time other than
the date set in the agreement. Danenberg v. Commissioner, 73
T.C. 370, 391-392 (1979); Lucas v. Commissioner, 58 T.C. 1022,
1032 (1972).
Petitioners argue that Mr. Dunne was not a shareholder of
FRC at any time during 1997 because the Inverness agreement,
which petitioners claim was merely memorialized by the settlement
agreement, transferred beneficial ownership of Mr. Dunne’s shares
to Mr. Marcus no later than December 31, 1996. We disagree.
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When beneficial ownership of stock is transferred, with or
without legal title, the transfer generally occurs pursuant to an
agreement between the transferor and the transferee. Reitz v.
Commissioner, 61 T.C. 443, 447 (1974), affd. 507 F.2d 1279 (5th
Cir. 1975). Petitioners argue that “Mr. Dunne was stripped of
his beneficial ownership rights” in FRC after the Inverness
agreement, but they have not cited any cases, nor are we aware of
any, where one shareholder was able to take beneficial ownership
of stock away from another shareholder absent an agreement
between the two shareholders or a provision in the corporation’s
governing articles to that effect. On the contrary, we have held
that when one shareholder merely interferes with another
shareholder’s participation in the corporation as a result of a
poor relationship between the shareholders, such interference
does not amount to a deprivation of the economic benefit of the
shares. Hightower v. Commissioner, T.C. Memo. 2005-274, affd.
without published opinion 2008-1 USTC par. 50,185 (9th Cir.
2008).
We do not believe that the Inverness agreement gave Mr.
Marcus any rights to Mr. Dunne’s stock either by December 31,
1996, or on some other date. Clearly, Mr. Dunne and Mr. Marcus
intended a sale to occur at some point, but they did not set any
concrete terms or make any binding agreement. It is apparent
from the testimony that the Inverness agreement was merely an
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agreement to make a more formal agreement at a later date. It
appears that Mr. Marcus attempted to memorialize this by
extending a settlement offer in his January 16, 1997, letter to
Mr. Dunne, but Mr. Dunne did not accept that offer.
The other facts and circumstances also indicate that the
Inverness agreement did not transfer any accouterments of owning
Mr. Dunne’s shares to Mr. Marcus. While Mr. Dunne told Mr.
Marcus that he could conduct business as he wished at the
Inverness meeting, Mr. Marcus appears to have already had that
power as president of FRC. Furthermore, Mr. Dunne was not
exercising significant managerial control before 1997. In
addition, after the Inverness agreement, Mr. Dunne continued to
receive dividends from FRC and he continued to enjoy the benefits
and burdens of being a shareholder because he had not fixed a
selling price for his shares. Mr. Dunne also exercised his right
as a shareholder to petition for appointment of a custodian for
FRC in a State court. Finally, Mr. Dunne repeatedly asserted to
FRC and third parties that he continued to be a shareholder of
FRC after 1996. Therefore, we find that Mr. Dunne retained
beneficial ownership of FRC for at least part of 1997.
We next consider whether the May 8, 1997, settlement
agreement transferred beneficial ownership of Mr. Dunne’s stock
- 24 -
to Mr. Marcus.4 The parties do not dispute that the settlement
agreement, unlike the Inverness agreement, was a valid and
legally enforceable contract under which Mr. Dunne agreed to sell
his FRC stock. However, because the settlement agreement did not
terminate Mr. Dunne’s interest in FRC until the settlement date,
which in 1997 was still some unspecified date in the future, we
must consider whether Mr. Marcus nonetheless possessed
substantially all of the accouterments of ownership by May 8,
1997.
The key provisions of the settlement agreement are that in
exchange for his stock Mr. Dunne would receive the book value of
FRC, set at $175,000, and half of the profit from the halon
contract. Mr. Dunne’s FRC stock would be held in escrow until he
received his share of the halon contract and the book value of
his stock. The settlement agreement also provided that Mr. Dunne
would have no shareholder or director rights after the settlement
date, which was to be the date of signing a memorializing
document anticipated to be no later than May 16, 1997.
Respondent argues that because the settlement agreement
expressly provided that Mr. Dunne would hold no shareholder
4
While respondent argues that petitioners have abandoned
this alternative argument because they did not argue it in their
posttrial brief, we believe that it is in the best interest of
justice to consider this alternative argument. During the trial,
we raised the issue of whether it was appropriate to consider the
settlement date as the date of sale, and respondent addressed
this issue on brief.
- 25 -
rights after the settlement date, Mr. Dunne would retain
beneficial ownership of his shares until the settlement date, and
therefore petitioners must come forward with “strong proof” to
contradict this language. While we agree that respondent’s
interpretation of this language is plausible, we find that this
language is ambiguous and therefore petitioners need not refute
it with “strong proof”. See Danenberg v. Commissioner, 73 T.C.
at 391-392; Lucas v. Commissioner, 58 T.C. 1032. It is
undisputed that Mr. Dunne retained the right to keep legal title
to the stock after he signed the settlement agreement. Mr.
Marcus testified at trial that he and Mr. Dunne intended that Mr.
Dunne would retain beneficial ownership of his shares until the
settlement date, but we did not find his testimony to be any more
credible than Mr. Dunne’s testimony that this was not his
intention, particularly because of the animosity between the two
witnesses. Because the settlement agreement does not specify
whether the “shareholder rights” include more than the retention
of legal title to the stock, we will not require a higher
standard of proof because of this statement.
To determine whether an agreement that does not itself
transfer legal title nonetheless transfers substantially all of
the accouterments of ownership, we look at all of the facts and
circumstances surrounding the transfer, relying on objective
evidence of the parties’ intentions provided by their overt acts.
- 26 -
Ragghianti v. Commissioner, 71 T.C. 349-350; Pacific Coast
Music Jobbers, Inc. v. Commissioner, 55 T.C. 874. Some of the
factors that we have considered in determining whether a person
holds the accouterments of stock ownership for Federal income tax
purposes are:
(1) Whether the person has legal title or a contractual
right to obtain legal title in the future, Ragghianti v.
Commissioner, supra at 349;
(2) whether the person has the right to receive
consideration from the transferee of the stock, Hook v.
Commissioner, 58 T.C. 267, 275 (1972); Willie v. Commissioner,
T.C. Memo. 1991-182;
(3) whether the person enjoys the economic benefits and
burdens of being a shareholder, Pacific Coast Music Jobbers, Inc.
v. Commissioner, supra at 875-876; Yelencsics v. Commissioner, 74
T.C. 1513, 1527 (1980);
(4) whether the person has the power to control the
company, Yelencsics v. Commissioner, supra at 1527; Cepeda v.
Commissioner, T.C. Memo. 1994-62, affd. without published opinion
56 F.3d 1384 (5th Cir. 1995);
(5) whether the person has the right to attend shareholder
meetings, Yelencsics v. Commissioner, supra at 1528; Ragghianti
v. Commissioner, supra at 350-351;
- 27 -
(6) whether the person has the ability to vote the shares,
Yelencsics v. Commissioner, supra at 1528; Pacific Coast Music
Jobbers, Inc. v. Commissioner, supra at 874;
(7) whether the stock certificates are in the person’s
possession or are being held in escrow for the benefit of that
person, Pacific Coast Music Jobbers, Inc. v. Commissioner, supra
at 874;
(8) whether the corporation lists the person as a
shareholder on its tax returns, Feraco v. Commissioner, T.C.
Memo. 2000-312; Pahl v. Commissioner, T.C. Memo. 1996-176, affd.
150 F.3d 1124 (9th Cir. 1998);
(9) whether the person lists himself as a shareholder on
his individual tax return, Willie v. Commissioner, supra; Wilson
v. Commissioner, T.C. Memo. 1975-92, affd. 560 F.2d 687 (5th Cir.
1977);
(10) whether the person has been compensated for the amount
of income taxes due by reason of the person’s shareholder status,
Hightower v. Commissioner, T.C. Memo. 2005-274;
(11) whether the person has access to the corporate books,
Haskel v. Commissioner, T.C. Memo. 1980-243; and
(12) whether the person shows by his overt acts that he
believes he is the owner of the stock, Pahl v. Commissioner,
supra; Willie v. Commissioner, supra.
- 28 -
None of these factors alone is determinative, and their
weight in each case depends on the surrounding facts and
circumstances. One difficulty in this case is that it is not
clear what rights an FRC shareholder was supposed to possess
because FRC did not observe any corporate formalities.
Furthermore, Mr. Marcus was a shareholder both before and after
Mr. Dunne transferred beneficial ownership of his stock.
Therefore, we will consider these factors in light of the rights
Mr. Dunne had as a shareholder of FRC before the settlement
agreement that he no longer had afterward, and where relevant,
what rights Mr. Marcus did or did not gain as a result of the
settlement agreement.
The fact that the settlement agreement gave Mr. Marcus the
right to obtain legal title to the stock upon the satisfaction of
certain conditions, which were likely to be satisfied at some
point, weighs in favor of petitioners. See Pacific Coast Music
Jobbers, Inc. v. Commissioner, supra at 874. While there was
certainly much dispute over some of the terms of the settlement
agreement, particularly the amount due to Mr. Dunne under the
halon contract, it is undisputed that the settlement agreement
contained Mr. Dunne’s binding agreement to sell his stock for an
amount that could be objectively determined and that Mr. Marcus
had the intention and ability to comply with the terms of the
sale once the disputes were settled. It appears that the signing
- 29 -
of a memorializing document was intended to be a mere formality.
The settlement date was anticipated to be no more than 8 days
after the signing of the agreement and there were no contract
terms left to be decided on the settlement date, which suggests
that the memorializing document would not contain any terms
additional to or different from those contained in the settlement
agreement. Furthermore, the arbitrator found the settlement
agreement sufficiently definite to order the parties to comply
with its terms in the arbitration award without requiring the
parties to draw up a new memorializing document. Therefore,
while under the terms of the settlement agreement Mr. Dunne had
the right to retain legal title of his stock until the settlement
date, the fact that the settlement agreement gave Mr. Marcus the
right to legal title upon the satisfaction of certain conditions
is a stronger indicium of beneficial ownership. See id. at 874.
Similarly, the fact that the settlement agreement gave Mr.
Dunne a contractual right to obtain $175,000 and his share of the
halon contract from Mr. Marcus as consideration for his shares
weighs in favor of petitioners. We have recognized that a
transfer of beneficial ownership can occur before the entire sale
price has been paid. See Pacific Coast Music Jobbers, Inc. v.
Commissioner, 55 T.C. 866 (1971).
The next factor we consider is whether Mr. Dunne continued
to enjoy the economic benefits and burdens of being a shareholder
- 30 -
after the settlement agreement. Benefits and burdens of stock
ownership generally include sharing in the successes and failures
of the corporation and receiving dividends. Id. at 875-876;
Yelencsics v. Commissioner, 74 T.C. 1528.
Before the settlement agreement, Mr. Dunne shared in the
successes and failures of FRC because those successes and
failures affected the value of his stock. After the settlement
agreement, Mr. Dunne ceased to share in most of the business
successes and failures of FRC because he agreed to sell his stock
for the book value of FRC and his share of the halon contract.
Mr. Dunne and Mr. Marcus agreed to set the book value of FRC at
$175,000, and there is no indication that either Mr. Dunne or Mr.
Marcus could renegotiate that amount if the value of FRC were to
change substantially between May 8, 1997, and the settlement
date. Therefore, with the exception of FRC’s performance on the
halon contract, FRC’s successes and failures had no economic
effect on Mr. Dunne after May 8, 1997.
Mr. Dunne received monthly dividends from FRC from January
through April of 1997, but he received no dividends after the
settlement agreement. Had Mr. Dunne retained beneficial
ownership of FRC, we would expect these dividends to have
continued through the end of 1997. However, Mr. Marcus also
ceased receiving dividends after April 1997. Had the settlement
agreement transferred beneficial ownership of Mr. Dunne’s shares
- 31 -
to Mr. Marcus, we would expect FRC to have paid Mr. Marcus double
the amount of monthly dividends that it had previously been
paying. Therefore, the nonpayment of dividends after April 1997
merely indicates that FRC was not sure what Mr. Dunne’s status
was after the settlement agreement.
The fact that Mr. Dunne was not compensated for any taxes
relating to FRC’s income after the settlement agreement favors
petitioners. FRC generally had a practice of compensating its
shareholders for the income taxes they owed by virtue of their
stock ownership. Had FRC considered Mr. Dunne to be a
shareholder, it would have paid the amount of the taxes either to
or on behalf of Mr. Dunne.
Throughout Mr. Dunne’s correspondence with FRC’s bank and
the bank’s attorney in September and October 1997, Mr. Dunne
repeatedly asserted that he was a director, officer, and coowner
of FRC. Mr. Dunne’s request for proof that he did not have those
titles after the bank denied him access to certain records
suggests that he asserted those titles with the belief that they
entitled them to this access. Mr. Dunne also used those titles
when he wrote to an FRC employee to request copies of FRC’s Form
1120S and his Schedule K-1 for 1997.
Petitioners argue that Mr. Dunne asserted these titles
because he retained legal ownership of FRC and he believed he had
rights as a creditor of FRC. Petitioners also rely on Mr.
- 32 -
Marcus’s statement in his March 18, 1997, letter that it was his
position that Mr. Dunne had in effect already sold his shares.
While Mr. Dunne’s actions indicate he believed he retained an
interest in his FRC stock after signing the settlement agreement,
we find that his belief was not based on a clear understanding of
the law or the nature of his interest and is not controlling.
While petitioners argue that Mr. Dunne’s lack of managerial
control over FRC after the settlement agreement favors them, we
disagree. It is not clear whether Mr. Dunne exercised any
managerial control at all before 1997 or, if he did, whether he
exercised control as a shareholder as opposed to an employee.
See Pacific Coast Music Jobbers, Inc. v. Commissioner, supra at
877. Furthermore, any decrease in Mr. Dunne’s control over FRC
is consistent with Mr. Marcus’s termination of Mr. Dunne’s
employment on January 25, 1997. The fact that Mr. Marcus was in
complete control of FRC in 1997 is consistent with his status as
FRC’s president. Therefore, in the absence of evidence that
shareholders of FRC had a right to manage, this factor is
neutral.
The facts that Mr. Dunne did not participate in shareholder
meetings or vote his shares are neutral because FRC never
maintained these corporate formalities.
The fact that Mr. Dunne retained possession of the FRC stock
certificates is also neutral. While a transfer of the stock
- 33 -
certificates would have helped petitioners’ case, retaining
possession of stock merely as security to ensure payment for the
stock does not indicate retained beneficial ownership in this
case. Hook v. Commissioner, 58 T.C. 275; Pacific Coast Music
Jobbers, Inc. v. Commissioner, supra at 875.
The facts that FRC listed Mr. Dunne as a shareholder on its
return and petitioners did not list Mr. Dunne as a shareholder on
their return are neutral when examined together because there is
no reason to believe that either return is probative.
Because Mr. Dunne had access to some of FRC’s records after
the settlement agreement but then was denied access to others,
these facts together are neutral. The most likely explanation is
the one given by FRC’s bank--that the bank was unsure whether Mr.
Dunne continued to be a shareholder after the settlement
agreement and it did not want to take unnecessary risks.
It is clear from the record that no one involved was sure
whether Mr. Dunne was a shareholder of FRC after May 8, 1997,
including Mr. Dunne himself. While we find that Mr. Dunne
believed that he was a still a shareholder in 1997 when he
thought that was his most advantageous position, his belief was
not based on a clear understanding of the law and is not
controlling. The halon contract was Mr. Dunne’s only interest in
FRC after the settlement agreement. In light of our analysis of
the above factors, we find that Mr. Dunne’s retention of an
- 34 -
interest in a single contract, over which he was exercising no
managerial control after May 8, 1997, did not prevent him from
transferring substantially all of the accouterments of ownership
of FRC to Mr. Marcus in the settlement agreement.
Considering all of these factors, we hold, on the basis of
our finding that Mr. Dunne ceased to be a shareholder of FRC on
May 8, 1997, that petitioners must pay tax on their pro rata
share of FRC’s tax items.
III. Whether Mrs. Dunne Qualifies for Relief From Joint
Liability Under Section 6015 for 1997
Section 6013(d)(3) provides that taxpayers filing a joint
return are jointly and severally liable for the taxes due.
Section 6015 provides that notwithstanding section 6013(d)(3),
under certain facts and circumstances a taxpayer may be relieved
of joint and several liability. Except as otherwise provided in
section 6015, the requesting spouse bears the burden of proof.
Rule 142(a); Alt v. Commissioner, 119 T.C. 306, 311 (2002), affd.
101 Fed. Appx. 34 (6th Cir. 2004).
Mrs. Dunne argues that she is entitled to relief under
section 6015(b) or (f). Relief under section 6015(b)(1) is
available if:
(A) a joint return has been made for a taxable
year;
(B) on such return there is an understatement of
tax attributable to erroneous items of 1 individual
filing the joint return;
- 35 -
(C) the other individual filing the joint return
establishes that in signing the return he or she did
not know, and had no reason to know, that there was
such understatement;
(D) taking into account all the facts and
circumstances, it is inequitable to hold the other
individual liable for the deficiency in tax for such
taxable year attributable to such understatement; and
(E) the other individual elects (in such form as
the Secretary may prescribe) the benefits of this subsection not
later than the date which is 2 years after the date the Secretary
has begun collection activities with respect to the individual
making the election * * *
Respondent concedes that Mrs. Dunne meets all of these conditions
except for those found in section 6015(b)(1)(C) and (D).
Under section 6015(b)(1)(C), Mrs. Dunne is eligible for
relief under this section only if she did not know or have reason
to know at the time she signed the joint return that there was an
understatement of tax on the return.
Petitioners’ omission of income in 1997 arose because Mr.
Dunne was a shareholder of FRC until May 8, 1997, but petitioners
treated Mr. Dunne as ceasing to be a shareholder no later than
December 31, 1996. Mrs. Dunne’s Form 8857 makes it clear that
she was aware that there were some issues regarding Mr. Dunne’s
connection with FRC, but she did not know any of the
circumstances of the sale because she relied upon Mr. Dunne to
handle the tax return, and Mr. Dunne relied upon the advice of an
attorney that petitioners were not required to report the income
on the Schedule K-1.
- 36 -
Generally, blind reliance upon the other spouse to handle
tax issues is not sufficient to allow the requesting spouse to
avoid liability under section 6015. See Butler v. Commissioner,
114 T.C. 276, 283-284 (2000). However, Mrs. Dunne asked Mr.
Dunne whether the sale of his FRC stock would create any problems
relating to their taxes, and Mr. Dunne assured her that he was
handling the sale properly according to advice from his attorney.
This is a unique case with complicated facts and legal issues,
and we find that Mrs. Dunne satisfied her duty of inquiry. See
Juell v. Commissioner, T.C. Memo. 2007-219. Therefore, we find
that Mrs. Dunne did not have actual or constructive knowledge
that there was an omission on petitioners’ 1997 tax return and
thus satisfies the section 6015(b)(1)(C) requirement.
However, Mrs. Dunne fails to satisfy the fourth condition.
Under section 6015(b)(1)(D), relief is available under that
section only if, taking into account all the facts and
circumstances, it would be inequitable to hold the requesting
spouse liable for the deficiency. The two most often cited
factors to be considered are: (1) Whether there has been a
significant benefit to the spouse claiming relief, and (2)
whether the failure to report the correct tax liability on the
joint return results from concealment, overreaching, or any other
wrongdoing on the part of the other spouse. Alt v. Commissioner,
supra at 314.
- 37 -
Mrs. Dunne had full access to petitioners’ joint checking
and savings accounts, and she offered no evidence that Mr. Dunne
deposited the dividends he received from FRC into a separate
account that she could not access. Since it appears Mrs. Dunne
financially benefited as much as did Mr. Dunne from ownership of
FRC and from avoiding taxation on his share of income, the
significant benefit factor does not favor Mrs. Dunne’s position.
See Richardson v. Commissioner, T.C. Memo. 2006-69, affd. 509
F.3d 736 (6th Cir. 2007). Furthermore, Mrs. Dunne has offered no
evidence that Mr. Dunne concealed anything from her or committed
any wrongdoing.
We may also consider factors used in determining “inequity”
in the context of section 6015(f). Juell v. Commissioner, T.C.
Memo. 2007-219. However, because we find without relying on the
other factors that Mrs. Dunne has not shown that she is eligible
for relief under section 6015(b), and because we find that taken
together those factors weigh against relief for Mrs. Dunne, as
discussed below, we need not consider them here also.
Section 6015(f) provides that the Secretary may relieve an
individual of joint and several liability if relief is not
available to the individual under section 6015(b) or (c) and it
is inequitable to hold the individual liable for any deficiency
taking into account all the facts and circumstances under
procedures prescribed by the Secretary. These procedures are
- 38 -
found in Rev. Proc. 2003-61, 2003-2 C.B. 296. We review
respondent’s denial of relief under section 6015(f) for abuse of
discretion. See Alt v. Commissioner, 119 T.C. 315-316.
Rev. Proc. 2003-61, sec. 4.01, 2003-2 C.B. at 297, provides
seven threshold conditions to determine relief. Respondent
concedes that Mrs. Dunne satisfies these conditions. Mrs. Dunne
mistakenly argues that she is entitled to relief by satisfying
these threshold conditions alone. On the contrary, after a
taxpayer satisfies the threshold requirements, Rev. Proc. 2003-
61, sec. 4.03, 2003-2 C.B. at 298, provides the Commissioner a
nonexclusive list of factors that the Commissioner uses in
determining whether the individual is entitled to relief on the
basis of all the facts and circumstances in the case. The
relevant factors to be considered here are marital status,
economic hardship, knowledge or reason to know, significant
benefit, and compliance with the income tax laws.
The fact that petitioners have been married and living
together at all relevant times is neutral.
The economic hardship factor also weighs against Mrs. Dunne.
Mrs. Dunne’s only argument regarding this factor is that the
amount of tax due is large. However, Mrs. Dunne has not provided
any evidence that (1) she will suffer economic hardship if we do
not grant her relief, (2) she does not have sufficient assets to
- 39 -
pay this liability, or (3) the burden of paying this liability
will fall on her instead of Mr. Dunne.
The knowledge factor weighs in favor of Mrs. Dunne. As we
stated in our discussion of section 6015(b)(1)(C), given the
circumstances of this case, Mrs. Dunne had no reason to know that
Mr. Dunne held beneficial ownership of FRC through May 8, 1997,
and she satisfied her duty of inquiry.
As discussed above, Mrs. Dunne presumably received some
benefit from Mr. Dunne’s status as a shareholder during 1997
because she shared bank accounts with Mr. Dunne, most likely had
access to the dividends he received from FRC, and benefited as he
did from avoiding tax on his share of its income. This factor
weighs against Mrs. Dunne. See Richardson v. Commissioner,
supra.
The compliance with the income tax law factor weighs
slightly against Mrs. Dunne. Mrs. Dunne testified that the one
thing she knows about the tax law is that income tax returns are
due on April 15, yet as discussed below she failed to file her
1999 tax return on time without any reasonable cause.
Mrs. Dunne has not argued that there are any other factors
that we should consider. We find on the basis of all the facts
and circumstances Mrs. Dunne has failed to carry her burden and
thus is not entitled to equitable relief under section 6015(f),
- 40 -
and we find respondent did not abuse his discretion in denying
Mrs. Dunne such relief.
IV. Whether Petitioners May Claim $20,000 of Legal Expenses That
They Incurred in 1999 as Trade or Business Expenses
In the notice of deficiency respondent disallowed a
deduction for $20,000 that petitioners listed on their Schedule C
as a business expense but added the $20,000 deduction to their
Schedule A as a miscellaneous itemized expense. If the $20,000
is deductible on petitioners’ Schedule C, then it is not subject
to the 2-percent floor generally applicable to miscellaneous
itemized deductions under section 67.
Deductions are a matter of legislative grace, and taxpayers
bear the burden of proving entitlement to the deductions claimed.
Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440
(1934). In addition, taxpayers must maintain sufficient records
to substantiate any deductions claimed. Sec. 6001.
Petitioners argue that the notice of deficiency is arbitrary
as to the tax items for 1999. As discussed below, in certain
cases we have found that the Commissioner’s presumption of
correctness does not attach when a determination is found to be a
“naked” assessment and therefore arbitrary and excessive.
However, this doctrine applies only to unreported income, and the
usual presumption of correctness attaches when taxpayers assert
that the notice of deficiency is incorrect as to disallowed
- 41 -
deductions. Hutchinson v. Commissioner, T.C. Memo. 1980-551.
Furthermore, if taxpayers do not substantiate their claimed
deductions, the Commissioner is not arbitrary or unreasonable in
denying them. Roberts v. Commissioner, 62 T.C. 834, 837 (1974);
Taylor v. Commissioner, T.C. Memo. 2006-67.
Petitioners offered no evidence regarding any expenditures
they made that would be eligible for a trade or business expense
deduction on their Schedule C. Petitioners argue on brief that
these expenses were incurred for the collection of income, but
they offered no evidence to substantiate that the income was from
a trade or business they conducted. Therefore, petitioners’
legal expenses are properly deductible only on their Schedule A.
V. Whether Petitioners Had $15,000 of Unreported Income in 1999
In the notice of deficiency, respondent determined that
petitioners failed to report a $15,000 capital gain. In general,
the Commissioner’s determinations are presumed correct, and the
taxpayers bear the burden of proving that they are wrong. Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The Court
generally will not look behind a notice of deficiency to examine
the evidence used or the propriety of the Commissioner’s motives
or procedures in making his determination. Greenberg’s Express,
Inc. v. Commissioner, 62 T.C. 324, 327 (1974). To overcome this
presumption of correctness, taxpayers may produce evidence that
the statutory notice is arbitrary or without foundation.
- 42 -
Helvering v. Taylor, 293 U.S. 507, 515 (1935); Cebollero v.
Commissioner, 967 F.2d 986, 990 (4th Cir. 1992), affg. T.C. Memo.
1990-618.
On rare occasions, this Court has recognized an exception to
these rules in cases involving unreported income where the
Commissioner introduces no substantive evidence but relies solely
on the presumption of correctness. Jackson v. Commissioner, 73
T.C. 394, 401 (1979). In such cases, if the taxpayers challenge
the notice of deficiency on the ground that it is arbitrary, then
the determination is treated as a “naked” assessment and the
presumption of correctness does not attach. Id. However, this
is a limited exception, and it does not apply when the
Commissioner has provided a minimal evidentiary foundation.
Petzoldt v. Commissioner, 92 T.C. 661, 687-688 (1989); Fankhanel
v. Commissioner, T.C. Memo. 1998-403, affd. without published
opinion 205 F.3d 1333 (4th Cir. 2000).
This exception to the presumption of correctness (the
exception) has been widely accepted among the Courts of Appeals.
See Blohm v. Commissioner, 994 F.2d 1542, 1549 (11th Cir. 1993),
affg. T.C. Memo. 1991-636; Dodge v. Commissioner, 981 F.2d 350,
353 (8th Cir. 1992), affg. in part and revg. in part 96 T.C. 172
(1991); Portillo v. Commissioner, 932 F.2d 1128, 1133-1134 (5th
Cir. 1991), affg. in part and revg. in part T.C. Memo. 1990-68;
United States v. Walton, 909 F.2d 915, 919 (6th Cir. 1990); Ruth
- 43 -
v. United States, 823 F.2d 1091, 1094 (7th Cir. 1987); Llorente
v. Commissioner, 649 F.2d 152, 156 (2d Cir. 1981), affg. in part
and revg. in part 74 T.C. 260 (1980); Weimerskirch v.
Commissioner, 596 F.2d 358, 362 (9th Cir. 1979), revg. 67 T.C.
672 (1977); Gerardo v. Commissioner, 552 F.2d 549, 554 (3d Cir.
1977), affg. in part and revg. in part T.C. Memo. 1975-341.
The Court of Appeals for the Fourth Circuit, to which this
case is appealable, has recognized the use of this exception by
other courts but has not had the occasion to expressly adopt or
reject it. See Williams v. Commissioner, 999 F.2d 760, 763-764
(4th Cir. 1993), affg. T.C. Memo. 1992-153. Because the Court of
Appeals for the Fourth Circuit has not expressly resolved the
issue of whether the Commissioner’s failure to present a minimal
evidentiary foundation prevents the presumption of correctness
from attaching,5 we apply the rule we stated in Jackson that has
5
In Cebollero v. Commissioner, 967 F.2d 986, 990 (4th Cir.
1992), affg. T.C. Memo. 1990-618, the Court of Appeals for the
Fourth Circuit stated:
in the first phase of a deficiency suit, the issue is
the arbitrariness of the Commissioner's determination,
and the taxpayer bears the burden of persuasion by a
preponderance of the evidence. That burden remains
with the taxpayer, and never shifts to the government.
If the taxpayer proves that the determination is
arbitrary, the presumption of correctness vanishes.* * *
However, the Court of Appeals has not clarified whether the
taxpayer satisfies the initial burden of persuading the court
that the determination is arbitrary by alleging that the
Commissioner has not introduced any substantive evidence and is
relying solely on the presumption of correctness, or if the
(continued...)
- 44 -
been approved by the majority of the Courts of Appeals. See
Golsen v. Commissioner, 54 T.C. 742, 757 (1970), affd. 445 F.2d
985 (10th Cir. 1971).
The first requirement for the exception to apply is that the
taxpayers challenge the notice of deficiency on grounds that it
is arbitrary. In addition to raising the argument, this
generally requires that the taxpayers actually dispute that they
received the unreported income, either by filing a Form 1040 that
they signed under penalty of perjury for the year at issue or by
stating facts that tend to show that they did not in fact receive
the disputed income. Andrews v. Commissioner, T.C. Memo. 1998-
316; White v. Commissioner, T.C. Memo. 1997-459. But see Senter
v. Commissioner, T.C. Memo. 1995-311.
Petitioners have satisfied this requirement. They allege in
their petition that the notice of deficiency was arbitrary as to
all determinations relating to 1999, and they filed a signed Form
1040 for 1999 that did not include a $15,000 capital gain.
The second requirement for the exception to apply is that
the Commissioner introduced no substantive evidence but relied
solely on the presumption of correctness. Jackson v.
Commissioner, supra. The presumption of correctness will apply
5
(...continued)
taxpayer must come forward with substantive evidence that the
determination is arbitrary to satisfy that initial burden.
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if the Commissioner provides a minimal evidentiary foundation
showing that there is a link between the taxpayers and either the
taxable income or the income-producing activity. Petzoldt v.
Commissioner, supra; Kaufman v. Commissioner, T.C. Memo. 2003-
262; Fankhanel v. Commissioner, supra; Prindle Intl. Mktg. v.
Commissioner, T.C. Memo. 1998-164, affd. without published
opinion sub nom. Fox v. Commissioner, 229 F.3d 1157 (9th Cir.
2000).
The only evidence either party submitted regarding the
unreported capital gain issue was a copy of petitioners’ 1999
Form 1040, the examination report, and the notice of deficiency.
In these documents, the only explanation of respondent’s
determination that petitioners received unreported income in 1999
is the following statement made to petitioners in the notice of
deficiency: “It is determined that you realized a capital gain
in the amount of $15,000.00 for tax year 1999. Accordingly,
taxable income is increased $15,000.00 for the tax year ending
December 31, 1999.”
The examination report contains an explanation section for
capital gains and losses, but the entire discussion in that
section relates to Mr. Dunne’s issues with FRC, and there is no
reference to a $15,000 capital gain in 1999 in either the facts
or conclusion of that section. The examination report did state
in its conclusion that it will be necessary to compute the
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gain/loss on the sale of the FRC stock, but respondent has not
argued that the alleged unreported income relates to the sale of
Mr. Dunne’s FRC stock. Because respondent has not shown us any
link between petitioners and either the $15,000 of unreported
income or any income-producing activity that could have generated
a $15,000 capital gain, respondent has not provided the minimal
evidentiary foundation required for the presumption of
correctness to attach on this issue. Therefore, respondent has
not met the initial burden of showing that petitioners had
unreported income in 1999 that is normally satisfied by the
presumption of correctness, and we find for petitioners on this
issue. See Foster v. Commissioner, 391 F.2d 727, 735 (4th Cir.
1968), affg. in part and revg. in part T.C. Memo. 1965-246.
VI. Whether Petitioners are Liable for Additions to Tax Under
Section 6651(a)(1) for 1997 and 1999
Section 6651(a)(1) imposes an addition to tax of up to 25
percent of the amount required to be shown as tax for failure to
timely file a Federal income tax return unless the taxpayers show
that the failure was due to reasonable cause and not due to
willful neglect.
Section 7491(c) places the burden of production on the
Commissioner to show that the imposition of an addition to tax is
appropriate. To satisfy this burden, the Commissioner must
present sufficient evidence that the particular addition to tax
is appropriate. Higbee v. Commissioner, 116 T.C. 438, 446
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(2001). If the Commissioner makes such a showing, the burden of
proof is on the taxpayers to raise any issues that would negate
the appropriateness of the penalty, such as reasonable cause.
Id. Reasonable cause exists if the taxpayers “‘exercised
ordinary business care and prudence and [were] nevertheless
unable to file the return within the prescribed time’.” United
States v. Boyle, 469 U.S. 241, 243 (1985) (quoting sec. 301.6651-
1(c)(1), Proced. & Admin. Regs.).
The parties stipulated that petitioners did not timely file
their 1997 or 1999 Federal income tax return. Furthermore, it is
undisputed that petitioners had an obligation to file income tax
returns for 1997 and 1999 under section 6012. Therefore,
respondent has satisfied the initial burden of producing evidence
to show that the addition to tax is appropriate.
Petitioners assert three reasons they had reasonable cause
for failing to file their tax returns on time: (1) The ongoing
litigation between Mr. Dunne, Mr. Marcus, and FRC prevented them
from filing on time; (2) they did not receive Mr. Dunne’s
Schedule K-1 in time; and (3) they received legal advice to
exclude FRC’s income from their 1997 return. Because the 1999
return contained no items that were related to FRC, only the
first reason may provide any reasonable cause for petitioners’
failure to file their 1999 tax return on time.
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As we discussed above, the ongoing litigation between Mr.
Dunne, Mr. Marcus, and FRC was not determinative of the issue of
when Mr. Dunne ceased to be a beneficial owner of FRC and the
related income tax consequences. While we agree that Mr. Dunne’s
shareholder status was a confusing issue, we are not persuaded
that this litigation prevented petitioners from filing their
returns on time.
Contrary to petitioners’ arguments, being involved in
litigation does not excuse them from filing their Federal income
tax returns on time. The cases they cite do not support their
argument because petitioners would have been required to file
income tax returns even if they had been awarded nothing under
the arbitration and subsequent litigation, and petitioners were
not suffering from incapacitating illnesses or otherwise disabled
from filing a return during any relevant time. See Commissioner
v. Walker, 326 F.2d 261 (9th Cir. 1964), affg. in part and revg.
in part 37 T.C. 962 (1962); Adams v. Commissioner, T.C. Memo.
1990-478; Harris v. Commissioner, T.C. Memo. 1969-49.
Petitioners’ argument that they did not have all of the
necessary records to file their 1997 return because they did not
receive Mr. Dunne’s Schedule K-1 in time is also unpersuasive.
Petitioners correctly point out that the Internal Revenue Manual
(IRM) states that the inability to obtain records may constitute
reasonable cause. 6 Administration, Internal Revenue Manual
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(CCH), pt. 20.1.1.3.1.2.5, at 45,014 (Aug. 20, 1998). The IRM
states that whether the inability to obtain necessary records
constitutes reasonable cause depends on the facts and
circumstances in each case, considering factors including: (1)
Why the records were needed to comply; (2) what steps the
taxpayers took to secure the records; (3) when the taxpayers
became aware that they did not have the necessary records; (4) if
other means were explored to secure the needed information; (5)
why the taxpayers did not estimate the information; (6) if the
taxpayers contacted the IRS for instructions on what to do about
missing information; and (7) if the taxpayers complied once the
missing information was received.
The IRM does not help petitioners. They provided no
explanation as to: (1) Why they thought that they needed the
Schedule K-1 to file their return if they were taking the
position that Mr. Dunne was not a shareholder in 1997; (2) why
they did not request a Schedule K-1 until April 15, 1998; (3)
whether they considered any other ways of obtaining the
information on the Schedule K-1; (4) why they did not estimate
the information, especially since Mr. Dunne knew about how much
income FRC earned in 1997 and, regardless of that amount,
petitioners took the position that Mr. Dunne was not an FRC
shareholder in 1997; (5) whether they contacted the IRS for
instructions and, if so, whether they followed those
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instructions; or (6) when they actually received the Schedule K-1
and how long it took them to file their return after receiving
it.
It is well settled that taxpayers must file timely income
tax returns on the basis of the best information available to
them at the time, and they may file amended returns if necessary.
Estate of Vriniotis v. Commissioner, 79 T.C. 298, 311 (1982);
Elec. & Neon, Inc. v. Commissioner, 56 T.C. 1324, 1342-1344
(1971), affd. without published opinion 496 F.2d 876 (5th Cir.
1974); Ruddel v. Commissioner, T.C. Memo. 1996-125. Petitioners
knew approximately what FRC’s income was for 1997, and there is
no reason they could not have used that information to timely
file their 1997 tax return and then file an amended return once
they received the Schedule K-1. Furthermore, petitioners have
not provided us any evidence of when they received the Schedule
K-1. Thus, we are not convinced that they did not have it in
time to file their 1997 return. Even if this was the case, the
fact that petitioners filed their 1997 return on September 1,
1999, over a year after it was due after the extension, suggests
that they did not exercise ordinary business care and prudence to
file their return on time.
Petitioners’ argument that they received legal advice to
exclude the amounts reported on the Schedule K-1 is without
merit. Whether or not petitioners should have excluded the
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Schedule K-1 is irrelevant to the issue of whether they were
required to file their returns on time. Furthermore, even if the
advice had provided a reasonable cause for not filing on time,
the memorandum containing the written advice was dated October 9,
1998, almost two months after petitioners were required to file
their 1997 return. Thus, it is unlikely that petitioners
actually relied upon any legal advice when making the decision
not to file their 1997 tax return on time. See Estate of Hinz v.
Commissioner, T.C. Memo. 2000-6.
Accordingly, we find that petitioners did not have
reasonable cause for failure to file their 1997 and 1999 income
tax returns on time and therefore sustain respondent’s
determination that petitioners are liable for the additions to
tax under section 6651(a)(1).
To reflect the foregoing and concessions of the parties,
Decision will be entered
under Rule 155.