Judges: WHERRY
Attorneys: Cruz Saavedra and James E. Pratt , for petitioners. Shirley D. Chin and Scott W. Mentink , for respondent.
Filed: Jan. 19, 2012
Latest Update: Nov. 21, 2020
Summary: T.C. Memo. 2012-21 UNITED STATES TAX COURT JOHN P. OWEN AND LAURA L. HASKELL OWEN, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 930-07, 1384-07, Filed January 19, 2012. 13303-07, 29011-08, 29090-08. R determined deficiencies in Ps’ income tax on the basis of his disallowance of the individual Ps’ assignment of income to their personal service corporation. R also determined that Ps were liable for sec. 6663, I.R.C., fraud penalties, or, in the alternative, sec.
Summary: T.C. Memo. 2012-21 UNITED STATES TAX COURT JOHN P. OWEN AND LAURA L. HASKELL OWEN, ET AL.,1 Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket Nos. 930-07, 1384-07, Filed January 19, 2012. 13303-07, 29011-08, 29090-08. R determined deficiencies in Ps’ income tax on the basis of his disallowance of the individual Ps’ assignment of income to their personal service corporation. R also determined that Ps were liable for sec. 6663, I.R.C., fraud penalties, or, in the alternative, sec. ..
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T.C. Memo. 2012-21
UNITED STATES TAX COURT
JOHN P. OWEN AND LAURA L. HASKELL OWEN, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 930-07, 1384-07, Filed January 19, 2012.
13303-07, 29011-08,
29090-08.
R determined deficiencies in Ps’ income tax on the
basis of his disallowance of the individual Ps’ assignment
of income to their personal service corporation. R also
determined that Ps were liable for sec. 6663, I.R.C., fraud
penalties, or, in the alternative, sec. 6662(a) accuracy-
related penalties.
Held: Ps are liable for portions of the deficiencies
and sec. 6662(a) accuracy-related penalties in accordance
with this opinion.
1
Cases of the following petitioners are consolidated here-
with: J and L Owen, Inc., docket No. 1384-07; J & L Gems, Inc.,
docket No. 13303-07; John Owen and Laura L. Haskell Owen, docket
No. 29011-08; and J & L Owen, Inc., docket No. 29090-08.
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Cruz Saavedra and James E. Pratt, for petitioners.
Shirley D. Chin and Scott W. Mentink, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WHERRY, Judge: Respondent determined the following
deficiencies and penalties with respect to the Federal income tax
of (1) John P. and Laura L. Haskell Owen (the Owens), (2) J & L
Owen, Inc. (J&L Owen), and (3) J & L Gems, Inc. (J&L Gems):2
Penalty
Petitioners Year Deficiency Sec. 6663
John P. and Laura
L. Haskell Owen 2002 $1,499,732 $1,113,271.50
2003 657,118 492,838.50
2005 116,623 ---
Penalty
Petitioner TYE July 31 Deficiency Sec. 6662(a)
J & L Owen, Inc. 2003 $160,791 $32,158
2005 49,729 ---
Penalty
Petitioner TYE July 31 Deficiency Sec. 6662(a)
J & L Gems, Inc. 2003 $3,520 $704
2
All section references are to the Internal Revenue Code of
1986 (Code), as amended and in effect for the tax years at issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure. As an alternative to the sec. 6663 civil fraud
penalty in the event the Court decides it does not apply,
respondent determined a sec. 6662(a) accuracy-related penalty for
both the Owens’ 2002 and 2003 tax years.
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After concessions by petitioners and respondent,3 the issues
left for decision are:
3
Respondent concedes the sec. 6663 civil fraud penalties he
determined against the Owens for the 2002 and 2003 tax years but
not the sec. 6662(a) accuracy-related penalties for these 2 tax
years. Respondent concedes an adjustment to income of $27,074
for commissions and fees for Oxford Life proposed against the
Owens for their 2002 tax year. Respondent concedes that the
Owens reported $89,770 and $618,434 from Family First Advanced
Estate Planning (FFAEP), originally paid to J&L Owen, in their
taxable income in 2002, although respondent maintains that the
Owens improperly assigned these payments. The Owens concede that
they incorrectly reported $82,630 of interest income as capital
gain for their 2002 taxable year. The Owens concede that they
failed to include $1,500,000 of capital gain in income for their
2003 taxable year. The Owens concede that they failed to include
in income a State of California tax refund of $1,360 for their
2005 taxable year.
Respondent and petitioners concede all material issues with
respect to J&L Owen consistent with the stipulation of settled
issues filed on May 17, 2010, incorporated herein. Petitioners
concede that J&L Owen is liable for a sec. 6662(a) accuracy-
related penalty for the tax year ending July 31, 2003, and that
J&L Gems is liable for a sec. 6662(a) accuracy-related penalty
for the tax year ending July 31, 2003, consistent with the
stipulation of settled issues. Respondent did not determine a
sec. 6662(a) penalty for J&L Owen’s tax year ending July 31,
2005; however, petitioners also conceded a penalty for that year,
and on brief respondent seems to assume that the sec. 6662(a)
penalty for the tax year ended July 31, 2003, is still at issue.
We accept petitioners’ concession for the tax year ending July
31, 2003, and note that there was no penalty to concede for the
tax year ended July 31, 2005.
We note that respondent took protective alternative
positions in the notices of deficiency; however, after the issues
were defined for trial, respondent did not address many of the
protective positions at trial or on brief, and we deem them
conceded. See, e.g., Rule 151(e)(4) and (5); Bradley v.
Commissioner, 100 T.C. 367, 370 (1993); Rybak v. Commissioner,
91
T.C. 524, 566 n.19 (1988). We also note that consistent with the
findings in this opinion, the protective positions are no longer
necessary.
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(1) Whether the Owens failed to include $100,000 in income
from American Investor Life for the 2002 tax year;
(2) whether the Owens overreported their income by $910,454
for the 2002 tax year;
(3) whether the Owens failed to include $75,000 in income
from American Investor Life for the 2003 tax year;
(4) whether the Owens failed to include a management
incentive bonus of $322,375.27 from Family First Insurance
Services in income for the 2003 tax year;
(5) whether the Owens failed to include commission income of
$40,070.86 from Family First Insurance Services for the 2003 tax
year;
(6) whether the Owens failed to include an employment
termination payment from Amerus of $350,000 in their income for
the 2005 tax year;
(7) whether the Owens are entitled to defer $1,867,500 of
capital gain from the sale of their stock in Family First
Advanced Estate Planning (FFAEP) under section 1045(a); and
(8) whether the Owens are liable for the section 6662(a)
accuracy-related penalties for the 2002 and 2003 tax years.
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Summary of Concessions4
Notice of
Taxable Deficiency Respondent’s Petitioners’
Petitioners Year Category Adjustment Concessions Concessions
John P. 2002 Oxford Life $27,074 $27,074 ---
and income
Laura L.
Haskell FFAEP income 89,770 89,770 ---
Owen
Family First 618,434 618,434 ---
payments
Interest 82,630 --- $82,630
income
2003 Capital gain 1,500,000 --- 1,500,000
2005 Cal. tax 1,360 --- 1,360
refund
Total 2,319,268 735,278 1,583,990
Notice of
TYE Deficiency Respondent’s Petitioners’
Petitioner July 31 Category Adjustment Concessions Concessions
J & L 2003 Compensation $190,000 $190,000 ---
Owen, of officers
Inc.
Taxes and 15,251 14,652 $599
licenses
Pension, 226,902 113,451 113,451
profit
sharing
Employee 5,418 --- 5,418
benefit
Other 64,896 5,270 59,627
deductions
Interest 115 115 ---
expense
Depreciation 2,474 2,474 ---
expense
2005 Other 22,007 --- 22,007
deductions
Pension 77,600 38,800 38,800
NOL deduction 24,715 --- 24,715
Total 629,378 364,762 264,617
4
This summary does not include concessions of penalties.
All values have been rounded to the nearest whole dollar.
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Notice of
TYE Deficiency Respondent’s Petitioners’
Petitioner July 31 Category Adjustment Concessions Concessions
J & L 2003 Other $14,077 $2,004 $12,073
Gems, deductions
Inc.
Cost of goods 10,973 --- 10,973
sold
Total 25,050 2,004 23,046
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts and the accompanying exhibits are hereby incorporated by
reference into our findings. At the time they filed their
respective Tax Court petitions, all individual petitioners
resided in California and all corporate petitioners maintained
their principal place of business in California.
John and Laura Owen’s Background
John P. Owen (Mr. Owen) completed the 11th grade before he
entered the workforce. His early sales experience included the
sale of chemicals, contractor’s tools, mobile homes, manufactured
housing, and cars. In 1995 Mr. Owen entered the insurance
business, where he sold tax-deferred annuities, life insurance,
long-term care insurance, and whole life insurance. Mr. Owen had
a broker’s license to sell insurance products during all times
relevant to this litigation.
Laura L. Haskell Owen (Ms. Owen) completed high school and
then went to school in the medical field but quit before
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finishing. She then went into the sales field for a prominent
food sales organization until she met Mr. Owen in 1989.
Organization of Personal Service Corporation
In 1995 Mr. and Ms. Owen organized a wholly owned
corporation called J & L Owen, Inc. (J&L Owen). Each year Mr.
Owen was elected president and Ms. Owen was elected secretary of
J&L Owen. Mr. and Ms. Owen were the sole shareholders,
directors, and officers of J&L Owen. During the relevant period
J&L Owen did not have any other employees and it operated out of
the Owens’ home. The Owens occasionally used J&L Owen’s accounts
to pay personal expenses.5
On their 2002 Form 1040, U.S. Individual Income Tax Return,
the Owens reported $910,454 in wages from Form W-2, Wage and Tax
Statement. Specifically, Mr. Owen received a Form W-2 from J&L
Owen reporting wages of $643,408; Ms. Owen received a Form W-2
from J&L Owen reporting wages of $225,000 and a Form W-2 from
FFAEP reporting wages of $42,045.60. During this period J&L Owen
was on a fiscal year and a tax year ending on July 31, 2002. J&L
Owen reported as wage expense the $643,408 and $225,000 paid to
5
For example J&L Owen paid $6,993.19 in fees related to the
Owens’ personal boat. J&L Owen paid for the insurance on all of
the Owens’ six cars and two motorcycles. When asked whether she
ever used J&L Owen’s accounts to pay personal expenses, Ms. Owen
testified that “If I didn’t have another credit card or if I
didn’t have my checkbook, if I had theirs at hand, yes.” Ms.
Owen even used a J&L Owen check to pay her personal credit card
balance of $11,907.11.
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Mr. and Ms. Owen, respectively, during its tax year ending July
31, 2002.
Formation of Family First Companies
In 1997 Mr. Owen, along with his 50-percent partner, Nick
Michaels (Mr. Michaels), an experienced insurance salesperson and
former division manager for a different company, formed and then
founded Family First Insurance Services (FFIS) and FFAEP,
collectively the Family First Companies. During the years at
issue FFIS was an insurance-related operation and FFAEP sold
prepaid legal service policies, including estate planning
services.6 At trial Mr. Owen explained that FFIS created and
offered financial products such as tax deferred annuities, long-
term care insurance, and whole life insurance to its client
consumers. He also explained that, in the industry, independent
contractors generally sold the products and services offered by
the Family First Companies.
The Family First Companies began with four individuals: Mr.
and Ms. Owen, Mr. Michaels, and Christine Larson, a friend of Mr.
Michaels. Within a few years the Family First Companies grew
rapidly to about 150 employees and around 350 independent sales
agents and achieved $20 million of gross receipts by December 31,
2001.
6
Mr. Owen described the prepaid legal plan “like the
insurance. * * * [Purchasers] would get a reduced fee in legal
cost by joining this prepaid legal membership.”
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During the years at issue Mr. Owen performed services as an
executive and as a sales representative and Ms. Owen was employed
as an executive for the Family First Companies. It was Mr.
Owen’s understanding that he was entitled to be paid in two
capacities: One as an officer of the Family First Companies,
compensated with wages reported on Form W-2, and the other as an
independent consultant who furnished services through his
personal service corporation, J&L Owen. The compensation for
these services was reported on a Form 1099-MISC, Miscellaneous
Income, issued to Mr. Owen by J&L Owen.7
Sale of the Family First Companies
On June 17, 2002, Mr. Owen and Mr. Michaels sold their 50-
percent ownership interests in the Family First Companies to
Amerus Annuity Group Co. (Amerus). Once Mr. Owen had decided to
sell his stock in the Family First Companies, he began
contemplating how to minimize the tax impact of the transaction.
To that effect, Mr. Owen explored different methods of deferral
with his accountant Gregory Mogab (Mr. Mogab), who at that time
was a partner at White, Zuckerman, Warsavely, Luna and Wolf
(White Zuckerman). Mr. Mogab had a bachelor’s degree in
7
Respondent conducted an employment tax audit of FFIS for
the tax year ending in 1998. On Apr. 29, 2002, by letter,
respondent informed FFIS: “Per Revenue Ruling 58-505, when a
corporate officer also sells insurance and there is no
interrelation in the two capacities the commissions should be
treated separately from the officer’s salary.”
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accounting and a master’s degree in taxation. He was a certified
public accountant (C.P.A.) and had worked in the accounting and
tax field since 1985. Mr. Owen never consulted an attorney or
anyone else on this tax matter but did receive assistance with
the stock sales transactions from the law firm Greenberg and
Bass, LLC.
The stock purchase agreement was dated January 1, 2002, and
governed the terms of the sale.8 Mr. Owen’s 50-percent share of
the initial total purchase price of $7,500,000 plus interest of
$82,630 for the sale of the Family First Companies was
$3,832,630.21 paid in the form of a cashier’s check. The Owens
allocated and reported their sale proceeds in the following
manner:
Sale Price Basis Reported Treatment
FFIS $1,916,315 $7,500 $1,908,815 Capital gain (taxable)
FFAEP 1,916,315 7,500 1,908,815 Sec. 1045 rollover (not
taxable)
1
Total 3,832,630 15,000 3,817,630
1
The amount received on June 17, 2002, from the sale of the
stock was $3,832,630, minus $82,630 of interest incorrectly
included in the stock sale price, for a total of $3,750,000.
One-half of that, $1,875,000 minus a basis of $7,500, equaling
$1,867,500 should be allocated to FFAEP. We note that the
parties improperly subtracted the interest from the actual sale
price of $3,750,000 before allocating half of the gain to FFAEP
and consequently were using $1,826,185 as the claimed deferred
amount rather than $1,867,500.
8
At trial Mr. Owen explained that the agreement was dated
Jan. 1, 2002, in order to calculate bonuses and pay out amounts
with respect to subsequent years.
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In addition to the $7,500,000 initial purchase price, the
stock purchase agreement also included a “Payout Amount (as
defined in Schedule 2.2)”. The “Payout Amount Schedule” provided
Mr. Owen and Mr. Michaels a combined additional purchase payment
of $3 million per year for 5 years from 2002 through 2006 if the
Family First Companies achieved 100 percent of the target
operating earnings. Reduced payouts were provided for on a
graduated scale if at least 70 but less than 100 percent of
target earnings was achieved in any payout year. In addition, if
100 percent of the payout earnings was achieved in all 5 payout
years, an additional $3 million payout bonus would be earned.
Pursuant to schedule 2.2, on January 31, 2003, Amerus paid
the John & Laura Owen Family Trust $1,500,000 by wire transfer
directly into the trust’s account.9 In January 2003 Mr. Owen
called Mr. Mogab and informed him that the Family First Companies
had met the target operating earnings and that he would be
receiving an additional $1,500,000 for the sale of the Family
First Companies. However, because Mr. Mogab did not yet have a
2003 tax return file for the Owens, he did not make a written
record of this fact for future use.
At trial Mr. Mogab explained that by mistake the accounting
firm did not report the $1,500,000 capital gain on the Owens’
9
As discussed above, petitioners have conceded that this
payment should have been included as capital gain income for the
Owens’ 2003 taxable year.
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personal tax return for 2003. He explained that “A year and a
half later when we prepared the ‘03 return honestly it was not
recalled by me. There was not a 1099 issued by the company. If
there were a 1099 they would have given me the 1099 and I would
have had that document and it darn well would have been picked
up.”10
Mr. Owen’s Postsale Compensation
Employment Agreement
The stock purchase agreement governing the sale of the
Family First Companies expressly required Mr. Owen to enter into
an employment agreement. Mr. Owen entered into the “EMPLOYMENT
AND NONCOMPETITION AGREEMENT” (employment agreement) with FFAEP
and FFIS.11 The employment agreement, dated June 17, 2002,
between Mr. Owen, as an employee, and FFAEP and FFIS, as
10
The banking records relating to the $1,500,000 deposit
were not presented at trial, and even after multiple requests by
respondent they were never produced during the audit. We also
note that $1,500,000, together with an additional $39,223, was
reported as additional paid-in capital on the J&L Gems tax return
for the year ending July 31, 2003, which was signed by Mr. Owen.
11
The first page of the employment agreement, recital “A”,
refers to Employee, Nicky A. Michaels; however, because the first
paragraph of this document states “THIS EMPLOYMENT AND
NONCOMPETITION AGREEMENT (‘Agreement’) is entered into as of the
17th day of June, 2002, between FAMILY FIRST INSURANCE SERVICES,
a California corporation, FAMILY FIRST ADVANCED ESTATE PLANNING,
a California corporation (collectively, the ‘Companies’) and JOHN
P. OWEN (‘Employee’)” and the document is signed by Mr. Owen, we
are satisfied that this document is the contract controlling Mr.
Owen’s employment relationship with the Family First Companies.
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employers, governed the postsale terms of Mr. Owen’s employment
relationship with FFAEP and FFIS.
The employment agreement included provisions for an annual
salary of $625,000. It also included provisions pertaining to
the nature of the employment, listing the “Duties. As the
President of Family First Insurance Services and Vice President
of Family First Advanced Estate Planning, Employee shall be
responsible for the normal and customary duties associated with
an executive level position.”
Under the heading “Miscellaneous Provisions” the employment
agreement contained provision 10.(j):
Assignment. The Companies may assign all of its [sic]
rights, title, interest, and obligations in, to, and
under this Agreement to any corporation or partnership
currently controlling, controlled by or under common
control with the Companies whether by equity ownership
or otherwise. The Companies may not otherwise assign
the rights or obligations under this Agreement without
the written consent of the Employee. Employee may not
assign any of his rights or obligations under this
Agreement without the written consent of the Companies.
The employment agreement in schedule B also contained
provisions for management incentive bonus (MIB) payments to Mr.
Owen as follows:
1. As bonus compensation for Employee’s services
during the Initial Term of Employee’s Employment
Agreement, Employee shall be entitled to a Management
Incentive Bonus Amount based on the Companies’ combined
attainment of earnings goals (“Target Operating
Earnings”) during the Initial Term. The Management
Incentive Bonus Amount for each Period, as defined in
the target operating earnings schedule, during the
Initial Term shall be a portion of the amount by which
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the Companies’ combined Earnings, as defined below, for
such Period exceeds eighty percent (80%) of the Target
Operating Earnings for that Period. The term
“Operating Earnings” means combined earnings of the
Companies before Total Officer Compensation payable
under this Schedule B and taxes computed on a basis
consistent with that historically used by the
Companies. * * * “Total Officer Compensation” shall
mean the total compensation of the Sellers, including,
but not limited to, base salary, bonuses, consulting
fees, commissions, or other compensation of any kind;
provided, however, that commissions on life insurance
and annuity products shall not be included in Total
Officer Compensation. [Emphasis added.]
In addition to the compensation discussed above, if the
Family First Companies reached 100 percent of the target
operating earnings, Mr. Owen was entitled to commissions of up to
$1 million per calendar year (i.e., 2002 to 2006) under the
employment agreement.
Following the closing of the stock sale on June 18, 2002,
Tom Fogt (Mr. Fogt), chief financial officer for Amerus, emailed
Anthony Tosatto, the general manager of the Family First
Companies, requesting that he initiate a practice of forwarding
the financial documentation of the Family First Companies to Mr.
Fogt for review. The financial reports show that the Family
First Companies paid J&L Owen for consulting services for the
year ending December 31, 2002.
Before the stock sale, Amerus was aware that the Family
First Companies had paid Mr. Owen individually and J&L Owen for
his services as an officer and as an independent consultant,
respectively. Amerus, informally but not in writing, acquiesced
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to this compensation structure for the 2002 tax year by allowing
the Family First Companies to continue to pay Mr. Owen in that
manner even after the financial statements were reviewed by Mr.
Fogt. In practice this was accomplished with an addendum, dated
December 27, 2002 (addendum), to the Employment and
Noncompetition agreements between the Family First Companies, Mr.
Owen and J&L Owen which was executed by Mr. Owen for the two
Family First corporations as “CEO” of FFIS and as “Vice
President” of FFAEP.
The payment matter and the December 27, 2002, addendum
resulted in a dispute with Amerus as to whether Mr. Owen had
authority and was authorized to sign the addendum despite his
general authority as CEO and president of FFIS and as vice
president of FFAEP. The final status and outcome of this dispute
was resolved in 2003 by informal actions of the parties.
In April 2003 Amerus began enforcing the salary and
commission recipient payment terms of the employment agreement
retroactively to January 1, 2003, when Mr. Fogt called Anthony
Tosatto and instructed him that Mr. Owen was to be paid directly
as an employee with wages reported on Form W-2. At that time,
J&L Owen was required to repay $133,269.22 of funds paid to it
earlier in the 2003 calendar year, and those funds were recast as
salary to Mr. Owen for the 2003 taxable year.
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Marketing Allowance Agreement
On June 17, 2002, American Investors Life Insurance Co.
(AIL), Inc. (an Amerus company), entered into a marketing
allowance agreement with Mr. Owen that provided for the payment
of $250,000 for consulting services over 10 quarters. The
pertinent section of the marketing allowance agreement is as
follows:
This letter shall evidence the agreement by
American Investors Life Insurance Company, Inc. (“AIL”)
providing a marketing allowance to John Owen (“Owen”)
and Nick Michaels (“Michaels”) for consulting services
in the combined amount of $500,000 payable in the
manner described herein.
AIL desires to expand the annuity marketing,
recruiting, and sales efforts of Owen and Michaels in
their capacities as officers of Family First Services
(“FFIS”). AIL agrees to pay Twenty-five Thousand
Dollars ($25,000) each to Owen and Michaels
individually for ten (10) consecutive calendar quarters
beginning the first quarter, 2002 and ending the second
quarter, 2004.
Payment for the first two calendar quarters of
2002 shall consist of payments of $50,000 each to Owen
and Michaels individually by June 30, 2002.
Thereafter, payments in the amount of $25,000 each
shall by payable to Owen and Michaels within five (5)
days of the first day of every calendar quarter through
the second calendar quarter of 2004.
Mr. Owen’s first payment under the marketing allowance
agreement, in the amount of $50,000, was made payable to the
order of “John P. Owen” and dated June 21, 2002. Mr. Owen then
notified Amerus that he wanted future payments made payable to
his corporation, J&L Owen. Afterwards, all checks issued in
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connection with the marketing allowance agreement were made
payable to “J & L Owen, Inc.”
Addendum to Employment Agreement
As previously stated, on December 27, 2002, Mr. Owen signed
the addendum in his capacity as “CEO” and president of FFIS and
as “Vice President” of FFAEP. The addendum stated that it was
“limited to an expansion of the method by which Owen and his
wholly-owned personal service corporation known as J and L Owen
Inc. * * * [was] to be compensated under the Employment and Non-
Competition Agreement.” By email dated January 22, 2003, Mr.
Fogt acknowledged Mr. Owen’s request for the addendum. He
indicated: “Perhaps the employment agreements can be amended to
have the services to be provided by your respective personal
service companies.” But he then went on to state that the
addendum “does not get the job done in my opinion. I would
suggest your tax counsel contact the AmerUs [sic] Tax
Department.”
Mr. Owen in his capacity as an officer of the Family First
companies is the only signatory on the addendum. According to
Mr. Fogt, any changes to the employment agreement would have
required approval of the Amerus board of directors. Mr. Fogt had
communicated this approval requirement to Mr. Owen sometime in
the third or fourth quarter of 2002. Further, the bylaws of both
of the Family First Companies require board authorization in
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determining officer compensation. “The compensation of the
officers of the Corporation shall be fixed from time to time by
the Board of Directors.” The Family First Companies and the
board of directors of Amerus never formally approved any of the
changes the addendum would have made to the employment agreement.
Separation Agreement
Effective December 31, 2004, the “CONFIDENTIAL SEPARATION
AGREEMENT AND GENERAL RELEASE” (separation agreement)
“[terminated]” Mr. Owen’s employment relationship with the Family
First Companies. The separation agreement explained that “the
Companies [FFIS, FFAEP, Amerus, and AIL] and Employee desire to
mutually terminate Employee’s employment relationship with the
Companies and his business relationships with AmerUs and AIL, as
of December 31, 2004 (the ‘Separation Date’), except as provided
* * * [in the Consulting Agreement]”.12
The separation agreement was signed my Mr. Owen as
“Employee” and by Mr. Fogt for FFIS and FFAP and included an
illegible signature by an “Executive VP” for Amerus and AIL. The
separation agreement contained the following provision with
respect to “Cooperation and Consulting”:
2.1 Consulting Agreement. In exchange for the
severance compensation set forth in Section 3
herein, Employee agrees to make himself available
to the Companies during calendar year 2005 as an
12
The record does not explain or shed any further light on
the causes or motivations behind the separation agreement.
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executive consultant. Employee shall function in
this capacity upon reasonable notice on an “as-
needed” basis (as determined in the Companies’
discretion) up to a maximum of twenty (20) hours
per month * * * .
Section 3 of the separation agreement provided $350,000 of
consideration. It stated that “This payment shall be made by
providing Employee a check in said amount payable to J&L Owen
Inc.” On March 7, 2005, Amerus paid $350,000 to the order of “J
& L Owen Inc”. The payment was deposited in a J&L Owen corporate
account and was included in gross income reported on J&L Owen’s
corporate tax return for the tax year ended on July 31, 2005.
Section 1045 Rollover
Tax Planning With Mr. Mogab
As a part of his tax planning for the FFIS and FFAEP stock
sale Mr. Owen discussed various options suggested by Mr. Mogab.
The Owens elected to structure their transactions in a manner
they intended would defer recognition of the income received from
the sale of FFAEP under section 1045. At trial Mr. Owen
explained that his understanding with regard to the requirements
of the section 1045 deferral was that he “needed to open up a
corporation within a 60-day period and run the business, put the
money into the corporation within a certain time frame and to
operate the business.” The Owens did not engage Mr. Mogab to
provide a written opinion as to the section 1045 stock sale’s
treatment.
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J & L Gems, Inc.
As part of the section 1045 deferral planning, the Owens
believed that stock in a retail jewelry business would qualify as
replacement stock for their Family First Companies stock for
income tax deferral. On August 12, 2002, the Owens formed J&L
Gems for that purpose. On August 14, 2002, the Owens deposited
$1,916,827.07 of the proceeds of the stock sale into a J&L Gems
financial account.
After Mr. Owen decided to form J&L Gems, he met with two
individuals involved in the jewelry business, Michael Kazanjian
(Mr. Kazanjian) and Stephen Polacheck (Mr. Polacheck). Mr.
Kazanjian is a wholesale jeweler, with inventory in excess of $5
million, who has been a family friend of the Owens’ for many
years. Mr. Polacheck owns two retail jewelry stores and has been
engaged in the jewelry business for more than 50 years. On one
occasion Mr. Polacheck selected about 20 pieces of jewelry that
he would display on consignment for Mr. Owen.
During the meeting with Mr. Polacheck and Mr. Kazanjian, Mr.
Owen made his first purchase of sixteen pieces of jewelry for a
total cost of $147,026.20. According to J&L Gems’ Cost of Sales
schedule for the fiscal year ending July 31, 2003, J&L Gems had
six sales transactions during the period from August of 2002 July
of 2003. Of those six sales, one was to the Family First
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Companies and two were to Mr. Owen’s business partner,
Mr. Michaels.
Tax Preparation, Assistance, and Advice
At the time Mr. Owen incorporated J&L Owen he was using the
services of Robert Hall, an enrolled agent, in Glendale,
California. Robert Hall prepared the Owens’ individual and
corporate returns before the Owens had employed the services of
White Zuckerman.
The Owens also engaged the help of a bookkeeper, Sharon
Marshall (Ms. Marshall), for business and personal recordkeeping.
At trial Mr. Owen explained that Ms. Owen collected the receipts
(both personal and business together), organized and filed them,
and then handed the receipts over to Ms. Marshall for accounting
and entry into Quickbooks. After Ms. Marshall recorded the
information, she gave it to the accountants for tax preparation.
Once Mr. Owen realized that the stock sale of the Family
First Companies would come to fruition, he felt that “it was a
large transaction, and I thought we needed a little bit more
experience with those kind of things. Robert really didn’t
handle acquisitions, and so that’s when we sought after a larger
firm.” Mr. Owen inquired of C.P.A.s and enrolled agents and
found that White Zuckerman was “a very reputable firm.” William
F. Wolf, a senior partner for White Zuckerman, explained that the
firm performed tax planning for individual and business clients,
- 22 -
prepared tax returns, made presentations before the IRS, and
testified as experts in litigation. He also explained that White
Zuckerman’s particular tax niche was wealthy clients who required
sophisticated tax advice.
Debby Britton (Ms. Britton) was the tax manager at White
Zuckerman for the Owens’ individual and corporate tax returns.
At trial she explained that during 2002 through 2005 White
Zuckerman would receive the books and records from the client or
their bookkeeper, review them, make any necessary tax
adjustments, and prepare the tax returns. After a return was
prepared it would be submitted to a partner for review. Ms.
Britton would make any changes requested by the partner, and the
partner would sign the return. The return would then be mailed
to the client for review. She also explained that if the return
was prepared during the years that White Zuckerman began
electronic filing, the return and an authorization form were
mailed to the client and the client would have to sign the
authorization form before White Zuckerman could file the return.
Ms. Britton believed that White Zuckerman prepared Forms W-2
for J&L Owen. She explained that she would look at the books and
records of J&L Owen and determine “what was appropriate for them
as employees of the company and based on the income that the
company was generating.” The Forms W-2 for J&L Owen were used as
- 23 -
a tool to reduce the corporate taxes J&L Owen would have had to
pay.
Mr. Owen explained that once he received his tax materials
from White Zuckerman he took the information seriously. Ms. Owen
explained that she also looked at the returns for J&L Owen. Both
Mr. and Ms. Owen signed their individual tax return for 2002.
However, after that, White Zuckerman switched to efiling, and the
Owens’ signatures do not appear on the later individual tax
returns. The Owens were mailed their completed tax return and an
efile signature authorization form for the 2003 tax year. They
returned the signed efile authorization on May 13, 2004.
Procedural Background
Respondent issued notices of deficiency determining the
income tax deficiencies and penalties listed above. Petitioners
filed timely petitions with this Court.
On January 27, 2010, the Court granted petitioners’ motion
for leave to file amendment to petition in which
Petitioners contend that if the Court were to sustain
Respondent’s assignment of income adjustment, a
substantial portion, if not all, of Petitioners’ Form
1040 reported income * * * must be excluded as a
duplication of the assigned income at issue since it
merely passed through J & L Owen, Inc. before ultimate
reporting by petitioners.
In this motion the Owens also contended that in addition to
the capital gain from the stock sale of FFAEP, they were entitled
to defer capital gain from the stock sale of FFIS under section
- 24 -
1045.13 A 5-day trial was held starting on March 2, 2010, in Los
Angeles, California.
OPINION
I. Burden of Proof
The Commissioner’s determination of a deficiency is presumed
correct, and the taxpayer bears the burden of proving that the
determination is improper. See Rule 142(a); Welch v. Helvering,
290 U.S. 111, 115 (1933). However, pursuant to section
7491(a)(1), the burden of proof on a factual issue that affects
the taxpayer’s tax liability may be shifted to the Commissioner
where the “taxpayer introduces credible evidence with respect to
* * * such issue.” The burden will shift only if the taxpayer
has, inter alia, complied with substantiation requirements
pursuant to the Code and “maintained all records required under
this title and has cooperated with reasonable requests by the
Secretary for witnesses, information, documents, meetings, and
interviews”. Sec. 7491(a)(2).
Petitioners did not argue that the burden should shift, and
they failed to cooperate with the reasonable requests of
13
As to the deferral of capital gain on the FFIS stock sale,
this position was abandoned at trial, was not raised in
petitioners’ opening brief, and was specifically abandoned in
their reply brief. Petitioners also abandoned the position that
they overreported income in the 2003 tax year, maintaining only
that if the Court finds that they had assigned income during 2002
then they will have overreported their personal income for 2002.
- 25 -
respondent.14 Accordingly, the burden of proof as to the tax
deficiencies remains with petitioners. Respondent bears the
burden of production with respect to petitioners’ liability for
the section 6662(a) penalties. Sec. 7491(c).
II. Assignment of Income
Respondent’s main theory stems from disallowance of the
Owens’ assignment of income to their personal service
corporation, J&L Owen. A fundamental principle of tax law is
that income is taxed to the person who earns it. See Lucas v.
Earl, 281 U.S. 111, 114-115 (1930).
“Attempts to subvert * * * [the fundamental principle
that income is taxed to the person who earns it] by
diverting income away from its true earner to another
entity by means of contractual arrangements, however
cleverly drafted, are not recognized as dispositive for
Federal income tax purposes, regardless of whether such
arrangements are otherwise valid under State law.
* * *”
Residential Mgmt. Servs. Trust v. Commissioner, T.C. Memo. 2001-
297 (quoting Barmes v. Commissioner, T.C. Memo. 2001-155, affd.
89 AFTR 2d 2002-2249, 2002-1 USTC par. 50,312 (7th Cir. 2002).
Under the assignment of income doctrine, gross income from
14
Petitioners failed to cooperate with respondent on
multiple occasions. The examination of Mr. and Ms. Owen’s
returns began in June 2005. In November 2005 the examining agent
had to fly to California to examine the Owens’ tax records in the
office of their tax attorney, at which time no receipts were
provided to the agent. Following this meeting the examining
agent issued a formal information document request (IDR) for more
documentation. After petitioners failed to comply with the IDR,
the examining agent had to issue Mr. and Ms. Owen a formal
summons for documentation and testimony in August 2006.
- 26 -
personal services must be included in the income of the person
who earned it. Lucas v. Earl, supra at 114. However, a more
refined inquiry requires a determination of who controls the
earning of the income. Johnson v. Commissioner, 78 T.C. 882, 891
(1982), affd. without published opinion
734 F.2d 20 (9th Cir.
1984). Under Johnson two requirements must be met before a
corporation, instead of the service provider, is considered the
controller of the earning of the income. First, the service
provider must be an employee of the corporation who the
corporation has the right to control in some meaningful sense.
Second, there must be a contract or similar indicium between the
corporation and the entity using the employee’s services which
recognizes the corporation’s control of the employee service
provider.15 Id. at 891.
Petitioners bear the burden of proving that J&L Owen
controlled the earning of the income in dispute. See Welch v.
15
We note that this Court has also applied a similar
employee versus independent contractor analysis in answering the
question of whether the income was properly or improperly
assigned to a personal service corporation. See Leavell v.
Commissioner, 104 T.C. 140 (1995). Under this test “The primary
consideration for determining whether an individual is an
employee of one organization or another is which of the two has
the right to control the activities of the individual person
whose status is in issue.” Leavell v. Commissioner, supra at 150
(citing Sargent v. Commissioner,
93 T.C. 572 (1989), revd.
929
F.2d 1252 (8th Cir. 1991)). In its analysis the Court then
discussed the two requirements of the test laid out in Johnson v.
Commissioner,
78 T.C. 882, 891 (1982), affd. without published
opinion
734 F.2d 20 (9th Cir. 1984). Therefore, under either
method the result in these consolidated cases is the same.
- 27 -
Helvering, supra at 115. Therefore, petitioners must present
evidence “from which it might be inferred that such entity
controlled petitioner’s performance of consulting services.”
Bagley v. Commissioner, 85 T.C. 663, 676 (1985), affd.
806 F.2d
169 (8th Cir. 1986). We must “examine all the facts and
circumstances in order to determine the reality of who has
control over the manner and means by which the individual service
provider delivers services.” Leavell v. Commissioner,
104 T.C.
140, 155 (1995).
This question is important because an employee cannot serve
two masters. If he is controlled by the entity receiving his
services, then he cannot be controlled by his personal service
corporation. However, as petitioners correctly point out,
certain officers can “wear two hats” with regard to insurance
corporations. An officer who sells insurance policies aside from
and independent of his duties as an officer where “The company
has no right to control or direct the individual in the selling
activities either as to result or as to details and means by
which that result is accomplished” is not an employee with
respect to his selling activities. Rev. Rul. 58-505, 1958-2 C.B.
728.
Therefore, we hold that for the activities where Mr. Owen
was engaged in selling independent of his position as an officer
of the Family First Companies, he was an independent contractor,
- 28 -
and consequently, J&L Owen meets the control requirement. See,
for example, Leavell v. Commissioner, supra at 150:
As an independent contractor, the individual service
provider retains control over his activities. This
control generally includes the right to grant an
intermediate entity the right to control his services.
Thus, individual persons who are independent
contractors generally retain the right to choose to do
business as a corporation.
Our main inquiry with respect to many of the payments Mr.
Owen assigned to J&L Owen is, therefore, whether the payments
were made to Mr. Owen in his capacity as an officer of the Family
First Companies or in his capacity as an independent sales agent
working as an independent contractor for the Family First
Companies.
III. Whether the Owens Failed To Include $100,000 in Income From
American Investor Life for the 2002 Tax Year
Under the marketing allowance agreement, AIL paid $100,000
for Mr. Owen’s services during 2002. The marketing allowance
agreement explains that the payment was for “consulting services”
but then explains that AIL’s desire was to “expand the annuity
marketing, recruiting, and sales efforts of Owen and Michaels in
their capacities as officers.” (Emphasis added.) This letter
was signed by John P. Owen, and there is no reference to J&L Owen
anywhere in the document. At trial Mr. Owen explained that “This
is another agreement to be able to promote their products. * * *
It was just more money to pay us as consulting.”
- 29 -
The first payment, of $50,000, was payable to the order of
“John P. Owen”. Mr. Owen deposited the check into one of J&L
Owen’s accounts and notified Amerus that he wanted future
payments made payable to his corporation, J&L Owen. Afterwards,
all checks issued in connection with the marketing allowance were
made payable to “J & L Owen, Inc.”
Mr. Fogt had “nothing he could offer” as to why the first
check was made payable to John Owen and then the other checks
were changed to J&L Owen.16 The Owens did not include the
$100,000 marketing allowance on their 2002 income tax return.
The marketing allowance was not structured as commission or
as a sales incentive bonus, and Mr. Owen did not need to perform
any sales or acts normally associated with commissions in order
to receive the money. We find Mr. Owen’s testimony limited and
self-serving, and the testimony of Mr. Fogt sheds no light on the
purpose for these payments. All we are left with is the written
agreement, which references both Mr. Owen’s services as a
consultant and as an officer. We note that pursuant to section
3121(d)(1) an officer is a statutory employee for purposes of
16
Petitioners emphasize the importance of the fact that
Amerus acquiesced to Mr. Owen’s request as to the recipient of
the checks. We are not convinced that this created a contract
with J&L Owen or somehow converted Mr. Owen’s fiduciary duties as
an officer to his duties as an independent contractor. The
payments were made in this manner at the direction of Mr. Owen.
Payment of money due Mr. Owen to J&L Owen at the direction of Mr.
Owen in this context constitutes constructive payment to Mr.
Owen, thus this argument begs the question and is not persuasive.
- 30 -
chapter 21 of the Code. As discussed above, petitioners had the
burden of proving that these payments were made to Mr. Owen in
his capacity as an independent contractor, and they have failed
to meet that burden.17 Therefore the Owens failed to include
$100,000 in income from AIL for the 2002 tax year, but we
conclude they should have.
IV. Whether the Owens Overreported Their Income by $910,454 for
the 2002 Tax Year
In their amended petition, filed January 27, 2010, the Owens
argued that if the Court were to sustain respondent’s assignment
of income adjustment for 2002, they would have overreported their
personal income for 2002. The Owens argue that because J&L Owen
paid them a salary of $868,408 and FFAEP paid $42,045 (rounded to
nearest dollar) which they included in their personal income, any
of the payments made to J&L Owen that the Owens subsequently must
include in their personal income would cause double counting of
the same money.
17
We find that the marketing allowance was paid to Mr. Owen
in his capacity as an officer. The agreement does not recognize
his personal service corporation even though AIL was aware of how
Mr. Owen structured his employment when he owned the Family First
Companies. The purpose of the marketing allowance was to
incentivize Mr. Owen and Mr. Michaels “in their capacities as
officers” payable “to each Owen and Michaels individually”.
(Emphasis added.) Finally, Mr. Owen signed the letter agreement
as an individual and made no reference that he was contracting on
behalf of J&L Owen, therefore failing to meet the second
requirement of the Johnson test discussed above. See Johnson v.
Commissioner, supra at 891.
- 31 -
On their 2002 individual tax return the Owens reported
$910,454 in wages from Forms W-2 received from J&L Owen and
FFAEP. In their opening brief, the Owens have asked the Court to
disregard the Forms W-2 they were issued by J&L Owen in 2002 on
the basis of Ms. Britton’s testimony that the amounts reported on
the Forms W-2 were not based on actual money paid to the Owens
but were reported in order to claim a deduction to completely
offset the income of J&L Owen so that it would not have to pay
corporate income tax. Mr. Owen received a Form W-2 from J&L Owen
reporting wages of $643,408 and Ms. Owen received a Form W-2 from
J&L Owen reporting wages of $225,000.
Although respondent continues to assert that the Owens
improperly assigned the original payments to J&L Owen in 2002, he
has conceded that the Owens already reported $89,770 and $618,434
in their personal income and is no longer claiming that it must
be re-included in the Owens’ personal income. Therefore $160,205
remains of the Form W-2 amounts that could possibly be double
counted.18
Generally, a taxpayer may conduct his business in whatever
form he chooses and “must accept the [resulting] tax
disadvantages.” Higgins v. Smith, 308 U.S. 473, 477 (1940); see
18
$910,454 - ($89,770 + $618,434) = $202,250. Then we
subtracted the $42,045 reported on the Form W-2 issued to Ms.
Owen by FFAEP because the Owens do not dispute the accuracy of
the FFAEP Form W-2 and this money was never assigned to J&L Owen,
leaving $160,205.
- 32 -
also Commissioner v. Natl. Alfalfa Dehydrating & Milling Co., 417
U.S. 134, 148 (1974). The very testimony petitioners rely on to
assert that the amounts reported on the Forms W-2 should be
disregarded highlights the extensive tax planning revolving
around J&L Owen. Petitioners chose to conduct their business
through J&L Owen, and they chose to allow White Zuckerman to zero
out the income of J&L Owen in order to avoid corporate income
tax. J&L Owen’s corporate tax return for the fiscal year ending
July 31, 2002 (the year that J&L Owen deducted wages to Mr. and
Ms. Owen of $868,408), shows gross receipts of $1,325,147 and a
negative taxable income.19 It is obvious that Mr. and Ms. Owen
improperly used J&L Owen as their personal piggy bank, paying
personal bills with corporate checks and the corporate credit
card. It is quite possible that the Forms W-2 reflected, as
income, personal expenses that the corporation could not deduct.
What little evidence exists does not show that the Owens have
been hoisted by their own petard.
As discussed above, petitioners bear the burden of proving
that the amounts originally included on the Owens’ tax return
were improperly included, and the Owens have presented no
19
We do note that J&L Owen operated on a fiscal year and Mr.
and Ms. Owen reported their individual taxes on the calendar
year. Therefore it is possible that some of the income earned by
J&L Owen in its fiscal year was actually paid to the Owens in
2001. However because the Owens did not include their 2001 tax
return in evidence, this Court has no way of knowing how much of
the money the Family First Companies paid to J&L Owen was
included in income for the prior tax year.
- 33 -
evidence that they did not receive this money. Petitioners have
not met their burden, and therefore we find that the Owens did
not overreport their income by $910,454 for 2002.20
V. Whether the Owens Failed To Include $75,000 in Income From
American Investor Life for the 2003 Tax Year
Under the marketing allowance agreement, American Investor
Life paid $75,000 to J&L Owen for Mr. Owen’s services during
2003. Under the same analysis discussed supra part III of this
opinion, petitioners did not meet their burden of proof, and
therefore we find that the Owens failed to include $75,000 in
income from American Investor Life for the 2003 tax year.
VI. Whether the Owens Failed To Include a Management Incentive
Bonus of $322,375.27 From Family First Insurance Services in
Income for the 2003 Tax Year
As part of Mr. Owen’s employment agreement with the Family
First Companies he was entitled to an MIB “based on the
Companies’ combined attainment of earnings goals (“Target
Operating Earnings”) during the Initial Term.” The MIB was to be
20
We note that
“Arithmetic precision was originally and exclusively in
* * * [petitioners’] hands, and [they] had a statutory
duty to provide it...[H]aving defaulted in [their]
duty, [they] cannot frustrate the Commissioner’s
reasonable attempts by compelling investigation and
recomputation under every means of income
determination. Nor should [they] be overly chagrined
at the Tax Court’s reluctance to credit every word of
[their] negative wails.”
Page v. Commissioner, 58 F.3d 1342, 1348 n.6 (8th Cir. 1995)
(quoting Rowell v. Commissioner,
884 F.2d 1085, 1088 (8th Cir.
1989), affg. T.C. Memo. 1988-410), affg. T.C. Memo. 1993-398.
- 34 -
determined as a portion of the Family First Companies’ combined
earnings if the Family First Companies earned more than 80
percent of the “Target Operating Earnings.” “Operating Earnings”
were computed before “Total Officer Compensation”, which included
“base salary, bonuses, consulting fees, commissions, or other
compensation of any kind; provided, however, that commissions on
life insurance and annuity products shall not be included in
Total Officer Compensation.” For the 2003 tax year Mr. Owen
earned $322,375.27 under the MIB and did not include it in his
personal income, but rather he reported it as income to J&L Owen.
Mr. Owen testified that the MIB was paid “beyond” his salary
and that it related to the sale of the products. He claimed that
the MIB was for his consulting services. Mr. Fogt testified that
the MIB was “part of the purchase price.” He explained that the
purchase price was inclusive of the MIB in order to make the
price congruent with the possible earnings of the purchased
company and to spread the price out over a number of years.
The Court notes that the MIB was included in the employment
agreement, while the purchase price, including the additional
payout amount, was defined in the stock purchase agreement.
Schedule 2.2, titled Calculation of payout amount, attached to
the stock purchase agreement, explicitly provides that “all
references to ‘Payout Amounts’ shall be deemed part of the
consideration paid by buyers to sellers for the payment of shares
- 35 -
purchased, and not connected in any way with compensation under
Seller’s Employment Agreements.”21 Therefore we infer that
because the MIB was included in the employment agreement and not
the payout amounts, it was not part of the purchase price. We
now turn to whether the amount paid under the MIB was for Mr.
Owen’s compensation as an employee or as an independent
contractor.
The Court concludes the MIB was paid to Mr. Owen in his
capacity as an employee of the Family First Companies. First,
given the name of the bonus plan, the “Management Incentive
Bonus”, and the first line of the document which explains that
“as bonus compensation for Employee’s services”, the document
states that this payment is additional compensation for Mr.
Owen’s services as a manager or officer of the Family First
Companies. The clause incorporating schedule B into the
employment agreement explicitly states that “The Companies shall
pay to Employee the bonus compensation described in, and subject
to the further terms and conditions of, Schedule B attached
hereto.” (Emphasis added.) Further, this clause directly follows
the clause defining the salary that the Family First Companies
were required to pay Mr. Owen in his capacity as an employee.
21
We note that both the schedule 2.2, payout, and the
schedule B, MIB, reference the same target operating earnings but
find no issue with the fact that the purchasers wanted to tie
both the purchase price and officer compensation to one goal.
- 36 -
Although Mr. Owen testified that the MIB was for consulting
fees, his testimony is self-serving and not supported by the
record. See Page v. Commissioner, 58 F.3d 1342, 1346 (8th Cir.
1995), affg. T.C. Memo. 1993-398; Schneebalg v. Commissioner,
T.C. Memo. 1988-563. Mr. Owen also explained that the MIB “was
supposed to be above my salary, that if we hit certain targets,
that I could get paid this additional money.” This testimony
reflects Mr. Owen’s understanding that this was compensation
related to his salary and payable to him as an employee if, under
his management, the Family First Companies reached certain
targets.
Because Mr. Owen was paid the MIB in his role as an employee
of the Family First Companies and not as an independent
contractor, the assignment of the MIB payment to J&L Owen fails
the first prong of the Johnson control test described above, and
therefore the Owens cannot assign this income to J&L Owen. See
Johnson v. Commissioner, 78 T.C. 882 (1982). The Owens must
include in income the MIB of $322,375.27 from Family First
Insurance Services for the 2003 tax year.
VII. Whether the Owens Failed To Include Commission Income of
$40,070.86 From Family First Insurance Services for the 2003
Tax Year
As part of Mr. Owen’s employment agreement with the Family
First Companies he was entitled to “solicit and earn commissions
for the sale of life and annuity insurance products.” Mr. Owen
- 37 -
explained at trial that he would also receive a portion of the
commissions that the subagents earned. He stated: “My company,
J&L Owen, Inc., had that agreement that anything they would sell
my company could make a portion of. J&L Owen would make a piece
of every commission.” Mr. Owen also testified that in 2002 he
“[believed]” he personally sold insurance policies, stating that
“I did a lot of things, and I did sell. So I could have in 2002
and 2003 sold policies.” By check, FFIS paid J&L Owen $40,070.86
on January 31, 2003, and the memo line stated that the check was
for “2002 Commissions”. At trial Mr. Tosatto, the general
manager of the Family First Companies, testified that this amount
was “commissions on personal business I believe that John had
sold in 2002”.
Although it is unclear from the record whether this payment
was made to Mr. Owen for personally selling insurance policies or
was a percentage of his subagents’ commissions, it is clear that
this payment was made to J&L Owen as commission for Mr. Owen’s
role as an independent contractor. As an independent contractor
who furnished services through J&L Owen, Mr. Owen was entitled to
assign control of his income to his personal service corporation,
J&L Owen. See Leavell v. Commissioner, 104 T.C. 140 (1995).
Whether Mr. Owen actually assigned that control to J&L Owen is
not clear. The record is sparse as to Mr. Owen’s relationship
with J&L Owen. As we have previously observed, the Owens used
- 38 -
J&L Owen to pay personal expenses, and the Forms W-2 that J&L
Owen issued to Mr. and Ms. Owen did not actually represent the
amounts of money paid to the Owens. Consequently it is unclear
whether the $40,070.86 commission payment made to J&L Owen passes
the first requirement of the Johnson control test discussed
above. See Leavell v. Commissioner, supra; Johnson v.
Commissioner, supra.
Assuming arguendo that the commission payment met the first
test under Johnson, it fails the second requirement. Under the
second requirement of Johnson there must be a contract or similar
indicium between the personal service corporation and the entity
using the services which recognizes the personal service
corporation’s control of the employee service provider. Johnson
v. Commissioner, supra.
First, we note that the employment agreement was made
between Mr. Owen and the Family First Companies and does not
reference J&L Owen. The addendum to the employment agreement,
which attempted to change Mr. Owen’s pay structure to include
payments to J&L Owen, was never adopted by the board of directors
of Amerus and in its view could not formally function to change
the terms of the employment agreement.
Petitioners point out that “the lack of a written contract
between the individual and his professional corporation is not
fatal to the assertion that the professional corporation had the
- 39 -
right to control that individual.” See Idaho Ambucare Ctr., Inc.
v. United States, 57 F.3d 752, 755 (9th Cir. 1995) (citing Pflug
v. Commissioner, T.C. Memo. 1989-615). However, the second prong
of the Johnson test does not require that the individual and his
professional service corporation have a written contract between
them. Rather this prong contemplates that the personal service
corporation and the entity hiring the independent contractor
through the personal service corporation have a contract or
similar indicium of the personal service corporation’s right to
control the individual. Johnson v. Commissioner, supra at 891.
Even if this second requirement of Johnson could be met with
evidence of a contract between the individual and the personal
service corporation, as Idaho Ambucare Ctr., Inc. v. United
States, supra at 755, seems to suggest, there is no mention
anywhere in the record that such a contract existed between Mr.
Owen and J&L Owen.
Because the assignment of the commission income of
$40,070.86 to J&L Owen fails the second prong of the Johnson
control test described above, the Owens cannot assign this income
to J&L Owen. See Johnson v. Commissioner, supra at 891. The
Owens must include the commission income of $40,070.86 from
Family First Insurance Services for their 2003 tax year.
- 40 -
VIII. Whether the Owens Failed To Include an Employment
Termination Payment From Amerus of $350,000 in Income for
the 2005 Tax Year
On December 31, 2004, Mr. Owen’s employment relationship
with the Family First Companies was terminated under the
separation agreement. The separation agreement provided for Mr.
Owen’s continued consulting services in exchange for $350,000
“payable to J&L Owen Inc.” The separation agreement is very
explicit in stating that the $350,000 separation payment was “In
exchange” for Mr. Owen’s agreeing to “make himself available to
the Companies during calendar year 2005 as an executive
consultant”. (Emphasis added.) This payment was made to J&L
Owen as a consulting fee for Mr. Owen’s future role as an
independent contractor advising the Family First Companies. It
is much clearer that Mr. Owen assigned control of this income to
J&L Owen. Therefore the $350,000 separation payment made to J&L
Owen passes the first requirement of the Johnson control test
discussed above.
Because the separation payment meets the first requirement
under Johnson we must examine the assignment of the separation
payment under the second requirement. We have found that Amerus
was aware of Mr. Owen’s “two-hats” compensation scheme and
acquiesced to it. Further, the separation agreement specifically
references J&L Owen and specifies that the consideration will be
“payable to J&L Owen Inc.” There was both a significant indicium
- 41 -
and a contract between J&L Owen and Amerus which, as to these
services, recognized J&L Owen’s control over Mr. Owen.
Therefore, we find that Mr. Owen’s income with respect to the
separation payment of $350,000 was properly received by J&L Owen
and the Owens are not required to include this payment in their
personal income for 2005.
IX. Whether the Owens Are Entitled To Defer $1,867,50022 of
Capital Gain From the Sale of Their Stock in FFAEP
Under section 1045, a taxpayer, other than a corporation,
may defer recognition of gain on the sale of qualified small
business stock held by the taxpayer for more than 6 months. If a
taxpayer elects the application of section 1045 within the
specified 60-day section 1045(a)(1) timeframe, gain from the sale
shall be recognized only to the extent that the amount realized
exceeds: “(1) The cost of any qualified small business stock
purchased by the taxpayer during the 60-day period beginning on
the date of such sale, reduced by (2) any portion of such cost
previously taken into account under this section.” Sec. 1045(a).
Section 1045(b)(1) provides that the term “qualified small
business stock” has the same meaning as in section 1202(c).
Section 1202(c)(2) contains an active business requirement,
as defined in section 1202(e), for qualified small business
stock. Section 1202(e)(1)(A) requires that during the relevant
period “at least 80 percent (by value) of the assets of such
22
See supra p. 10, table note 1.
- 42 -
corporation are used by such corporation in the active conduct of
1 or more qualified trades or businesses”. Section 1202(e)(3)(A)
defines a “qualified trade or business” as any trade or business
other than
(A) any trade or business involving the
performance of services in the fields of health, law,
engineering, architecture, accounting, actuarial
science, performing arts, consulting, athletics,
financial services, brokerage services, or any trade or
business where the principal asset of such trade or
business is the reputation or skill of 1 or more of its
employees,
Section 1202(e)(6) provides an exception to the 80 percent
requirement of section 1202(e)(1), explaining that for the
purposes of section 1202(e)(1)(A) any assets which
(A) are held as part of the reasonably required
working capital needs of a qualified trade or business
of the corporation
* * * * * * *
shall be treated as used in the active conduct of a
qualified trade or business. For periods after the
corporation has been in existence for at least 2 years,
in no event may more than 50 percent of the assets of
the corporation qualify as used in the active conduct
of a qualified trade or business by reason of this
paragraph.
We agree with petitioners that FFAEP was a qualified small
business under section 1045 and the Owens timely made an
election. Although respondent argues that FFAEP is not qualified
because one of the principal assets is the skill of Mr. Owen, the
Court disagrees. While we have no doubt that the success of the
Family First Companies is properly attributable to Mr. Owen and
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Mr. Michaels, the principal asset of the companies was the
training and organizational structure; after all, it was the
independent contractors, including Mr. Owen and Mr. Michaels in
their commission sales hats, who sold the policies that earned
the premiums, not Mr. Owen in his personal capacity.
Rev. Proc. 98-48, 1998-2 C.B. 367, requires that the section
1045 election be made by the due date for the filing of the
income tax return for the taxable year in which the qualified
small business stock was sold, and the Owens made the election on
their 2002 individual income tax return. We agree the Owens met
the 60-day requirement of section 1045(a)(1) when they signed the
stock purchase agreement on June 17, 2002, and then deposited
$1,916,827.07 into a J&L Gems corporate account on August 14,
2002.
However, the Owens do not qualify for the section 1045
nonrecognition because J&L Gems never met the active business
requirement of section 1202(c)(2). As stated above, section
1202(e)(1)(A) requires that at least 80 percent of the assets of
the new corporation be used in an active trade or business.
During the first 6 months J&L Gems purchased 16 pieces of jewelry
for a total cost of $147,026.20. This is a mere 8 percent of the
$1,916,827.07 deposited into J&L Gems’ account from the sale of
FFAEP. According to J&L Gems’ cost of sales schedule for the
fiscal year ending July 31, 2003, J&L Gems had six sales
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transactions during the period from August 2002 to July 2003,
with gross receipts of $12,069. Of those six sales, one was to
the Family First Companies and two were to Mr. Owen’s business
partner, Mr. Michaels.
At trial Mr. Owen attempted to justify his lack of inventory
by explaining that he did not believe it was prudent to purchase
more inventory without first learning the business. However, it
is clear from the record that Mr. Owen simply did not follow the
advice of his accountant and appears to have been unaware of or
misunderstood the 80 percent active business requirement. Mr.
Owen testified that
My view of active business is just that. I went out
and I purchased. I took the stock of this company and
put it into the stock of this other company. I put the
money from the sale of the company within the 60-day
period he told me to put it in, and I started buying up
gems. So in my opinion, I thought I was doing
everything correctly.
It is apparent that J&L Gems was never an active business
within the meaning of section 1202(e). We note that as of August
1, 2004 (about 2 years after the initial deposit), J&L Gems had
16 pieces of jewelry. Although Mr. Owen explained at trial that
his goal was to develop the business and indicated that it took
time for a jewelry business to become established, 2 years after
the money was injected, J&L Gems was still not using it.
Petitioners contend that extensive cash on hand is an asset
in active use in a trade or business. We recognize that section
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1202(e)(6) apparently contemplates that even after 2 years up to
50 percent of a corporation’s assets might in some circumstances
be held as part of the reasonably required working capital needs
of the business. But we leave for another day what amount of
cash on hand can be considered actively used in a trade or
business under section 1045 that has been in existence for less
than 2 years. We hold that under the surrounding facts here the
fact that 92 percent of J&L Gems’ assets were held in cash causes
it to fail the active business requirement.23 Because J&L Gems
did not meet the active business requirement during the requisite
period under section 1202, the sale proceeds of FFAEP do not
qualify for deferral under section 1045.
X. Accuracy-Related Penalty
Under section 7491(c), respondent bears the burden of
production with respect to petitioners’ liability for the section
6662(a) penalties. This means that respondent “must come forward
with sufficient evidence indicating that it is appropriate to
impose the relevant penalty.” See Higbee v. Commissioner, 116
T.C. 438, 446 (2001). Respondent has met the section 7491(c)
burden of production with respect to the accuracy-related
penalty.
23
The balance of the assets were held in the form of
wholesale jewelry consisting of precious metals and precious
stones, a form of liquidity favored by some over currency.
- 46 -
Subsection (a) of section 6662 imposes an accuracy-related
penalty of 20 percent of any underpayment that is attributable to
causes specified in subsection (b). Respondent determined that
one or both of two causes justify the imposition of the penalty
for each year: A substantial understatement of income tax and
negligence. See sec. 6662(b)(1) and (2).
There is a “substantial understatement” of income tax for
any tax year where in the case of an individual the amount of the
understatement exceeds the greater of (1) 10 percent of the tax
required to be shown on the return for the tax year or (2)
$5,000. Sec. 6662(d)(1)(A). In the case of corporations (other
than S corporations or personal holding companies) the amount of
the understatement exceeds the greater of (1) 10 percent of the
tax required to be shown on the return for the tax year or (2)
$10 million. Sec. 6662(d)(1)(B).
Section 6662(a) also imposes a penalty for negligence or
disregard of rules or regulations. Under this section
“negligence includes any failure to make a reasonable attempt to
comply with the provisions of this title”. Sec. 6662(c). Under
caselaw, “‘Negligence is a lack of due care or the failure to do
what a reasonable and ordinarily prudent person would do under
the circumstances.’” Freytag v. Commissioner, 89 T.C. 849, 887
(1987) (quoting Marcello v. Commissioner,
380 F.2d 499, 506 (5th
Cir. 1967), affg. on this issue
43 T.C. 168 (1964) and T.C. Memo.
- 47 -
1964-299), affd. 904 F.2d 1011 (5th Cir. 1990), affd.
501 U.S.
868 (1991).
There is an exception to the section 6662(a) penalty when a
taxpayer can demonstrate (1) reasonable cause for the
underpayment and (2) that the taxpayer acted in good faith with
respect to the underpayment. Sec. 6664(c)(1). Regulations
promulgated under section 6664(c) further provide that the
determination of reasonable cause and good faith “is made on a
case-by-case basis, taking into account all pertinent facts and
circumstances.” Sec. 1.6664-4(b)(1), Income Tax Regs.
Reliance on the advice of a tax professional may, but does
not necessarily, establish reasonable cause and good faith for
the purpose of avoiding a section 6662(a) penalty. See United
States v. Boyle, 469 U.S. 241, 251 (1985) (“Reliance by a lay
person on a lawyer [or an accountant] is of course common; but
that reliance cannot function as a substitute for compliance with
an unambiguous statute.”). Such reliance does not serve as an
“absolute defense”; it is merely a “factor to be considered.”
Freytag v. Commissioner, supra at 888.
The caselaw sets forth the following three requirements in
order for a taxpayer to use reliance on a tax professional to
avoid liability for a section 6662(a) penalty: “(1) The adviser
was a competent professional who had sufficient expertise to
justify reliance, (2) the taxpayer provided necessary and
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accurate information to the adviser, and (3) the taxpayer
actually relied in good faith on the adviser’s judgment.” See
Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 99
(2000), affd.
299 F.3d 221 (3d Cir. 2002); see also, e.g.,
Charlotte’s Office Boutique, Inc. v. Commissioner,
425 F.3d 1203,
1212 & n.8 (9th Cir. 2005) (quoting with approval the above
three-prong test), affg.
121 T.C. 89 (2003).
A fortiori, unconditional reliance on a preparer or adviser
does not always, by itself, constitute reasonable reliance; the
taxpayer must also exercise “Diligence and prudence”. Marine v.
Commissioner, 92 T.C. 958, 992-993 (1989), affd. without
published opinion
921 F.2d 280 (9th Cir. 1991). “The general
rule is that the duty of filing accurate returns cannot be
avoided by placing responsibility on an agent.” Pritchett v.
Commissioner,
63 T.C. 149, 174 (1974). Taxpayers have a duty to
read their returns to ensure that all income items are included
and all claimed deductions are justified. Reliance on a preparer
with complete information regarding a taxpayer’s business
activities does not constitute reasonable cause if the taxpayer’s
cursory review of the return should have revealed errors. Metra
Chem Corp. v. Commissioner,
88 T.C. 654, 662-663 (1987). “Even
if all data is furnished to the preparer, the taxpayer still has
a duty to read the return and make sure all income items are
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included.” Magill v. Commissioner, 70 T.C. 465, 479-480 (1978),
affd.
651 F.2d 1233 (6th Cir. 1981).
Because deciding whether exceptions to the section 6662(a)
accuracy-related penalty apply is a fact-specific inquiry, we
discuss certain underpayments of tax either conceded by the Owens
or determined in accordance with this opinion, individually
below. See, e.g., Kaufman v. Commissioner, 136 T.C. 294 (2011)
(breaking up the discussion of the penalty as it pertains to each
issue); sec. 1.6664-3, Income Tax Regs. (rules and examples for
determining the total amount of penalties imposed when penalties
apply to different adjustments).
A. $100,000 Marketing Allowance in 2002
As discussed above we found that the Owens failed to include
$100,000 in income from American Investor Life for the 2002 tax
year. Taking into account all the facts and circumstances
surrounding this payment, we find the Owens’ belief that this
payment was made to Mr. Owen in his capacity as an independent
contractor to be unreasonable. The marketing allowance was not
structured as an incentive bonus, and Mr. Owen did not need to
perform any sales or acts associated with commissions to receive
it. It is therefore not reasonable that the Owens believed that
this payment was compensation to Mr. Owen in his role as an
independent contractor. Even if they relied on the past letter
from the Internal Revenue Service (IRS) and its references to
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Rev. Rul. 58-505, supra, it was still unreasonable because Mr.
Owen was not required to perform services associated with sales
or commissions. Accordingly, the Owens are liable for the
section 6662(a) accuracy-related penalty with respect to the
underpayment resulting from the $100,000 marketing allowance.
B. $1,867,500 Capital Gain in 2002
Because we found that J&L Gems did not meet the active
business requirement during the requisite period under section
1202, the sale proceeds of FFAEP do not qualify for deferral
under section 1045 and the Owens must include the proceeds in
income for 2002. The Owens argue that they are not liable for
the accuracy-related penalty because they acted with reasonable
cause and in good faith in relying on their accountant to
structure and report this transaction.
In order for the Owens to use reliance on a tax professional
to avoid liability for a section 6662(a) penalty they must show
that the adviser was a competent professional, that they provided
necessary and accurate information, and that they actually relied
on their adviser’s judgment. See Neonatology Associates, P.A. v.
Commissioner, supra at 99. We agree with the Owens that they
chose their accounting firm, White Zuckerman, carefully and that
their adviser was a competent professional. We also agree that,
with respect to the section 1045 rollover, the Owens provided the
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necessary and accurate information to Mr. Mogab to accomplish tax
planning.
However, we do not find that the Owens actually relied on
their adviser’s judgment. Mr. Owen testified that he believed
that in order to meet the requirements of section 1045 he “needed
to open up a corporation within a 60-day period and run the
business, put the money into the corporation within a certain
time frame and to operate the business.” Mr. Owen then explained
that it was not until the return was audited that he became aware
that there was an 80-percent active business requirement under
the section 1045 requirements.
The testimony of Mr. Mogab conflicts with Mr. Owen’s
testimony in that he stated that he advised Mr. Owen that “a
certain percentage of the invested dollars had to be employed in
the company. * * * And that was 80 percent and that the rollover
or the reinvestment in the new business had to have been done
within a certain time frame of the receipt of the proceeds from
the sale.” We find that the Owens failed to follow the advice of
their adviser with respect to the active business requirement
applicable to J&L Gems and therefore did not act reasonably with
respect to this failure to include these sale proceeds in income.
We also find that the Owens did not act with good faith with
respect to the section 1045 transaction. Mr. Owen explained that
it was his vision to build up J&L Gems as he had the Family First
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Companies; yet even as late as 2 years after the money had been
deposited in the company, J&L Gems had only 16 pieces of jewelry.
Mr. Owen should not in good faith have believed that deferring
income tax under section 1045, by operating a business, merely
involved depositing a large amount of cash in an account. Nor
could he reasonably believe that using less than 8 percent of
that cash to purchase inventory and selling only a part of what
little inventory he did buy to his friends and coworkers was
sufficient to defer the tax. Even under Mr. Owen’s understanding
of section 1045, that he had “to operate the business” in good
faith and reasonably, he failed to meet that requirement.
Accordingly, the Owens are liable for the section 6662(a)
accuracy-related penalty with respect to the underpayment
relating to sale proceeds of FFAEP.
C. $75,000 Marketing Allowance in 2003
The Owens failed to include $75,000 in income from American
Investor Life for the 2003 tax year. As early as the third or
fourth quarter of 2002, Mr. Fogt advised the Owens that the
assignment of income to J&L Owen may not have been proper. At
this time Mr. Owen had at least been warned that it would be
unlikely that he would be permitted to indefinitely bifurcate his
compensation from the Family First Companies. He was certainly
aware of this fact, as to the 2003 payments, by April 2003 when
J&L Owen was required to return $133,269.22 received in the
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beginning of the 2003 calendar year so that the money could be
paid to Mr. Owen as wage income. At this time Mr. Owen knew that
he would not receive any of the compensation related to his
salary as consulting fees paid to J&L Owen. He had clearly been
put on notice that this income was to be included in his personal
income, and therefore we do not find that the Owens acted in good
faith or with reasonable cause in 2003. They are liable for the
section 6662(a) accuracy-related penalty as applicable to the
underpayment relating to the $75,000 paid in 2003.
D. $40,070.86 Commission Income in 2003
The assignment of the commission income of $40,070.86 to J&L
Owen failed the second prong of the Johnson control test.
Consequently, the Owens could not assign this income to J&L Owen
and must include it in their 2003 taxable income. The Owens are
not excused under section 6664(c)(1) with respect to the section
6662(a) accuracy-related penalty. They did not act with
reasonable cause or good faith with respect to this income
because they ignored the lack of a contract or other indicia of
J&L Owen’s right to control the personal services of Mr. Owen.
E. $322,375.27 Management Incentive Bonus in 2003
Because we found that Mr. Owen was paid the MIB in his role
as an employee, the Owens must include in income the Management
Incentive Bonus of $322,375.27 from Family First Insurance
Services for the 2003 tax year. We again find that the Owens are
- 54 -
not excused under section 6664(c)(1) with respect to the section
6662(a) accuracy-related penalty because they did not act with
reasonable cause or good faith with respect to this income. As
discussed above the Owens had been put on clear notice that Mr.
Owen’s compensation could not be bifurcated and that he was to
include his compensation in his personal income. The Owens’
causing J&L Owen to return the $133,269.22 clearly indicates that
they knew and had acquiesced in the ultimate resolution of this
related issue.
F. $1,500,000 Capital Gain in 2003
The Owens argue that they are not liable for the section
6662(a) penalty because they relied on White Zuckerman’s staff to
accurately prepare their return. We conclude that the Owens did
not rely in good faith on their accountants’ advice because their
reporting of this payment was oral and was long before the return
was prepared. Further, they did not carefully examine their
return before it was submitted to the IRS, and this standing
alone, given the material amount involved, would trigger the
penalty under these facts. See Woodsum v. Commissioner, 136 T.C.
584, 595 (2011) (“In signing the return thus erroneously
prepared, petitioners were not deliberately following substantive
professional advice; they were instead unwittingly (they contend)
perpetuating a clerical mistake. The defense of reliance on
professional advice has no application here.”); Neonatology
- 55 -
Associates, P.A. v. Commissioner, 115 T.C. at 99. Although the
Owens attempted to convince the Court at trial that they were
simply unsophisticated taxpayers at the mercy of their
accountants, we find this extremely hard to accept given that Mr.
Owen with Mr. Michaels built a company from four people into one
that garnered over $7,500,000 when it was sold. A cursory glance
at the return would have shown that the amount reported was less
than half of the amount required.
As a result the Owens failed to ensure that all of their
income items, particularly their taxable capital gains, were
included on the return. See Metra Chem Corp. v. Commissioner, 88
T.C. at 662-663; Magill v. Commissioner, 70 T.C. at 479-480. The
Owens’ unconditional reliance on their accountants does not, on
these facts, constitute reasonable good-faith reliance and does
not excuse their failure to closely examine their return. The
Owens’ reliance defense is also undercut by the fact that they
did not provide Mr. Mogab with the necessary written
documentation regarding the additional income from the sale of
the Family First Companies. See Neonatology Associates, P.A. v.
Commissioner, supra at 99 (second prong). The Owens have not
demonstrated good faith and reasonable cause for their
underpayment. Accordingly, they are liable for the section
6662(a) accuracy-related penalty on the underpayment relating to
the $1,500,000 adjustment. The Owens are also liable for any
- 56 -
penalties related to their concessions that have not been
specifically discussed. See sec. 6662(a) and (b)(1) and (2).
The Court has considered all of petitioners’ and
respondent’s contentions, arguments, requests, and statements.
To the extent not discussed herein, we conclude that they are
meritless, moot, or irrelevant.
To reflect the foregoing,
Decisions will be entered
under Rule 155.
