Pahl v. Commissioner

T.C. Memo. 1996-176

UNITED STATES TAX COURT

STEPHEN D. PAHL AND LOUISE A. PAHL, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7757-94. Filed April 11, 1996.

Petitioner husband (P), an attorney, claims that

he was not a shareholder in an S corporation organized

for the practice of law. P did not report any of the

income and other items of the S corporation; he also

received an item of nonemployee compensation from the

S corporation, which he claimed he did report.

1. Held: P was a shareholder of the S corporation

for the taxable year in issue and must report his pro

rata share of the income and other items of the

S corporation.

2. Held, further, P failed to report the

nonemployee compensation.

3. Held, further, R’s imposition of an accuracy-

related penalty for negligence under sec. 6662, I.R.C.,

is sustained.

Stephen D. Pahl, for petitioners.

Alan D. Hill, for respondent.

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MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: For petitioners’ taxable (calender) year

1990, respondent determined a deficiency in petitioners’ Federal

income tax liability of $28,694 and an accuracy-related penalty

of $371.

The issues remaining for decision are: (1) Whether, during

1990, petitioner husband was a shareholder in an S corporation so

that petitioners are required to report his pro rata share of the

corporation’s income and certain other items, (2) whether

petitioners failed to report $6,500 of nonemployee compensation

received by petitioner husband from the S corporation in 1990,

and (3) whether petitioners were negligent in filing their 1990

return.

Unless otherwise noted, all section references are to the

Internal Revenue Code in effect for the taxable year in issue,

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

FINDINGS OF FACT

Introduction

Petitioners are husband and wife, who, for 1990, made a

joint return of Federal income tax liability. Petitioners

resided in Los Altos Hills, California, at the time the petition

in this case was filed. Petitioner husband (hereafter,

petitioner) is an attorney and member of the California bar.

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Niesar Pahl

Niesar, Pahl, Cecchini & Gosselin, A Professional

Corporation (Niesar Pahl), a California corporation, was

organized in January 1987. Niesar Pahl was organized for the

practice of law. On April 28, 1987, Niesar Pahl filed an

election with the Internal Revenue Service to be treated as an

S corporation for Federal income tax purposes. During 1990, and

at all other times here relevant, Niesar Pahl’s election to be

treated as an S corporation remained effective. For 1990, Niesar

Pahl computed its taxable income on the basis of a calender year.

Niesar Pahl was known as Niesar, Pahl, Cecchini & Gosselin,

A Professional Corporation only from August 9, 1989, until

sometime after June 30, 1990. Immediately prior to that period,

Niesar Pahl was known as Niesar & Cecchini, and its only

shareholders were Gerald V. Niesar and Garrett L. Cecchini.

After that period, Niesar Pahl changed its name back to Niesar &

Cecchini.

Petitioner’s Association With Niesar Pahl

Prior to August 9, 1989, petitioner was not associated with

Niesar Pahl. Sometime prior to August 9, 1989, petitioner and

another lawyer, Thomas Gosselin (Gosselin), agreed to become

shareholders, officers, and directors of Niesar Pahl as of

August 9, 1989. Petitioner and Gosselin each agreed to become

25-percent shareholders of the firm by purchasing 1,000 shares of

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stock in Niesar Pahl. Each agreed to pay one-quarter of the

audited book value of the firm for his shares.

A meeting of the board of directors of Niesar Pahl (the

board) was held on August 3, 1989 (the August 3 meeting). At the

August 3 meeting, the board determined and resolved the following

(as evidenced in the minutes of the August 3 meeting):

WHEREAS, this Board of Directors has determined

that the issuance of additional stock in the

corporation would benefit the corporation; and

WHEREAS, this Board has determined that Thomas M.

Gosselin and Stephen D. Pahl are suitable shareholders

whose participation would benefit the corporation and

each is an active member of the California Bar; and

NOW, THEREFORE, BE IT RESOLVED, that the

corporation shall issue and sell to each of Thomas M.

Gosselin and Stephen D. Pahl one thousand (1,000)

shares of common stock, such action to take effect on

August 9, 1989; and

FURTHER RESOLVED, that the price to be paid by

Messrs, Pahl and Gosselin for such shares shall be

determined by an audit of this corporation’s balance

sheet as at July 31, 1989; and

FURTHER RESOLVED, that each of Messrs. Pahl and

Gosselin shall pay in cash, the amount equal to * * *

[one-quarter] of the net worth of the corporation as

determined by reference to such audited balance sheet

as at July 31, 1989, as and for the total purchase

price of said purchasers’ [sic] shares of common stock.

At the August 3 meeting, the board also (1) elected

petitioner a director of Niesar Pahl, effective August 9, 1989,

and (2) authorized petitioner to negotiate an extension of credit

to Niesar Pahl of $500,000 from Silicon Valley Bank (the bank)

and to sign notes, agreements, or other documents as necessary to

secure such credit.

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Petitioner’s Noncompliance With the Agreement; Failure To Issue

Shares

Petitioner never paid the price (1) called for in his

agreement to purchase shares of Niesar Pahl and (2) as set forth

in the above-quoted resolutions of the board. Niesar Pahl never

issued any shares to petitioner. Moreover, Niesar Pahl never

issued any shares to Gosselin or Gerald V. Niesar.

State Filings

On August 29, 1989, Niesar Pahl filed a Certificate of

Amendment of Articles of Incorporation (the Certificate of

Amendment) with the secretary of state of the State of

California. Thereby, the name of the corporation was changed to

Niesar, Pahl, Cecchini & Gosselin, A Professional Corporation. A

declaration of Garrett L. Cecchini, president, accompanying the

Certificate of Amendment, executed under penalty of perjury, and

dated August 9, 1989, states that petitioner is a shareholder,

director, officer, and employee of Niesar Pahl. A guarantee

accompanies the Certificate of Amendment and guarantees payment

by Niesar Pahl of claims by clients for errors or omissions

arising out of the practice of law. That guarantee is dated

August 9, 1989, and is signed by petitioner as a shareholder of

Niesar Pahl.

Petitioner’s Tenure With Niesar Pahl

On or about August 8, 1989, petitioner commenced employment

with Niesar Pahl. Shortly thereafter, petitioner became

president, managing partner, and chief financial officer of

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Niesar Pahl. Petitioner’s duties, among other things, included

supervising Niesar Pahl’s billing and payment procedures,

establishing bank accounts, hiring and firing employees, and

attending to the line of credit with the bank. Petitioner

provided his own property as security for the line of credit with

the bank.

No other employees of Niesar Pahl who were not shareholders

received a compensation package equivalent to what petitioner

received. Among other items of compensation, petitioner received

an annual salary of $180,000 and an automobile allowance of

$6,500 (the automobile allowance). Petitioner’s receipt of the

automobile allowance for 1990 is reflected on a Form 1099-MISC,

Miscellaneous Income (the Form 1099), issued to petitioner for

1990 by Niesar Pahl and showing nonemployee compensation of

$6,500.

Petitioner’s Disassociation From Niesar Pahl

On June 30, 1990, petitioner and Gosselin left Niesar Pahl.

Petitioner and Gosselin departed pursuant to an agreement (the

separation agreement). Pursuant to the separation agreement,

Niesar Pahl transferred to petitioner and Gosselin furniture and

equipment with an agreed value of $34,875 and assigned accounts

receivable to them in the amount of $135,000. In consideration

thereof, among other things, Pahl and Gosselin assumed Niesar

Pahl’s credit line with the bank in the amount of $242,500,

agreed that the June 30, 1990, employee payroll of $105,539 would

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be funded from the credit line, and assumed certain accounts

payable in the amount of $62,641.

Niesar Pahl’s 1990 Return

For 1990, Niesar Pahl filed Form 1120S, U.S. Income Tax

Return for an S Corporation (Niesar Pahl 1990 return). Attached

to the Niesar Pahl 1990 return are four Schedules K-1,

Shareholder’s Share of Income, Credits, Deductions, Etc. One of

those Schedules K-1 identifies petitioner as a shareholder (the

petitioner K-1) and sets forth that petitioner’s pro rata share

of certain items is as follows: (1) $95,969 of ordinary income

from trade or business activities, (2) $236 of interest, and

(3) $200 of charitable contributions.

Petitioners’ 1990 Return

Petitioners made their joint return of income tax liability

for 1990 on Form 1040, U.S. Individual Income Tax Return

(petitioners’ 1990 return). Petitioners’ 1990 return fails to

include any of the items set forth on the petitioner K-1.

Petitioners’ 1990 return was prepared by a paid tax return

preparer, Clifford Fenske, Jr.

OPINION

I. Introduction

We must decide three issues. First, we must decide whether,

during 1990, petitioner husband (petitioner), an attorney, was a

shareholder in Niesar, Pahl, Cecchini & Gosselin, A Professional

Corporation (Niesar Pahl), a California corporation providing

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legal services. If he was a shareholder in Niesar Pahl, then

petitioners must take account of petitioner’s pro rata share of

Niesar Pahl’s income and certain other items. Second, we must

determine whether petitioners failed to report an automobile

allowance in the amount of $6,500 received by petitioner from

Niesar Pahl in 1990. Third, we must decide whether, in failing

to report such automobile allowance, petitioners were negligent.

II. Was Petitioner a Shareholder In Niesar Pahl?

Section 1366 requires a shareholder of an S corporation to

include in his gross income his pro rata share of the

corporation’s items of income and deduction. A shareholder of an

S corporation must include those items in his gross income in his

taxable year in which the taxable year of the S corporation ends.

Sec. 1366(a).

Courts look to beneficial ownership, and not merely to legal

title, in order to determine whether a taxpayer is a shareholder

of a corporation for Federal income tax purposes: “taxation is

not so much concerned with the refinements of title as it is with

actual command over the property taxed--the actual benefit for

which the tax is paid.” Frank Lyon Co. v. United States, 435

U.S. 561, 572 (1978) (quoting Corliss v. Bowers, 281 U.S. 376,

378 (1930)). We have described in the following terms the

inquiry necessary to determine whether, by purchase, an

individual has become the owner of shares of stock of a

corporation.

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A court must consider not only when the bare legal

title passed but also when the benefits and burdens of

the property, or the incidents of ownership were

acquired or disposed of in a closed transaction. In

deciding the question, the court looks to that party to

the transaction who has the greatest number of

attributes of ownership. A court should look to

practicalities, disregarding merely formal and not

useful rights and attributes. If it is found from all

the facts and surrounding circumstances that the

parties intended an agreement to result in the sale of

property, and the agreement transfers substantially all

the accouterments of ownership, the transaction will be

treated as a sale even though the parties intended the

legal title should not pass until later. Since courts

cannot successfully conjecture as to the subjective

intent of the parties, the objective evidence of intent

provided by the parties’ overt acts must be relied

upon. [Pacific Coast Music Jobbers, Inc. v.

Commissioner, 55 T.C. 866 (1971) (citations omitted),

affd. 457 F.2d 1165 (5th Cir. 1972).]

Although the tax consequences of owning shares of stock in

an S corporation are quite different than the tax consequences of

owning shares of stock in a corporation subject to tax under

subchapter C of the Internal Revenue Code, we must still look to

beneficial ownership in order to determine whether a taxpayer is

a shareholder of an S corporation. Hoffman v. Commissioner,

47 T.C. 218, 233 (1966) (“Our conclusion that beneficial

ownership of the stock, as opposed to technical legal title

thereto, is critical in determining who is a shareholder [of an

S corporation], is supported by * * * the general legislative

purpose underlying subchapter S.”), affd. 391 F.2d 930 (5th Cir.

1968) (fn. ref. omitted).

Petitioners’ argument is straightforward: Unless and until

petitioner paid for his stock, his agreement with Niesar Pahl was

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executory; since he never paid for his stock, he never became a

shareholder; since he never was a shareholder, he need not report

a pro rata share of Niesar Pahl’s income and other items.

We have found that petitioner neither made the payment

contemplated in his agreement to become a shareholder of Niesar

Pahl nor did he receive any shares of the corporation. To that

extent, the terms of his agreement with Niesar Pahl remained

unperformed. Nevertheless, petitioners concede: “there is no

question that one can own an interest in a corporation without

holding any physical evidence thereof, Richardson v. Shaw, 209

U.S. 365 (1908)”. Petitioners also concede that one can own

shares in a corporation before they are fully paid for: “Whether

PAHL acquired sufficient rights [of] ownership to make him the

owner of the stock depended upon the intent of the parties as

evidenced by their contract.” While it is no doubt true that

payment may be a precondition to obtaining ownership of shares in

some circumstances, see, e.g., Armstrong v. Commissioner, 6 T.C.

1166 (1946) (contract to purchase shares executory until delivery

of shares and payment therefor; long-term capital gains period

did not start to run until delivery), affd. 162 F.2d 199 (3d Cir.

1947), we do not believe that was the case here.

Clearly, Niesar Pahl did not treat payment as a precondition

to petitioner’s becoming a shareholder. The corporation caused

its name to be changed to Niesar, Pahl, Cecchini & Gosselin, A

Professional Corporation. The Certificate of Amendment filed

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with the California Secretary of State has attached to it a

declaration by Garrett L. Cecchini, president of Niesar Pahl,

which recites that petitioner is a shareholder.1 On a schedule

1

At trial, petitioners objected to respondent’s Exhibit O,

which consists of the Certificate of Amendment and two

attachments, the declaration of Garrett L. Cecchini and the

guarantee signed by petitioner (the guarantee). We overruled

that objection, but petitioners renew their objection on brief.

Because of the importance petitioners attach to their objection,

we shall elaborate on our reasons for overruling petitioners’

objection. Petitioners’ objection is based “on the grounds of

Best Evidence”. Petitioners claim that, at trial, respondent,

promised to provide an original or certified copy of Exhibit O

and failed to do so. We have examined the transcript of the

trial and, although we did hold the record open so that

respondent could submit certain documents, we cannot conclude

that respondent promised to submit an original or certified copy

of Exhibit O. In any event, we do not believe that an original

or certified copy is necessary to satisfy the Federal Rules of

Evidence. We need not be concerned with Fed. R. Evid. 1005,

which deals with public records. Respondent is not attempting to

establish the contents of the Certificate of Amendment as a

public record, but rather she is trying to prove the contents of

the Certificate of Amendment and attached documents regardless of

whether or not they are public records. The rationale behind

Fed. R. Evid. 1005 is inapplicable, and the rule does not apply.

United States v. Childs, 5 F.3d 1328, 1335 (9th Cir. 1993).

Exhibit O was proffered to prove that petitioner was a

shareholder of Niesar Pahl. Fed. R. Evid. 1003 provides that “A

duplicate is admissible to the same extent as an original unless

(1) a genuine question is raised as to the authenticity of the

original or (2) in the circumstances it would be unfair to admit

the duplicate in lieu of the original.” At trial, petitioner as

much as alleged that his signature had been forged to the

guarantee. Nevertheless, Gerald V. Niesar (Niesar), secretary of

Niesar Pahl testified that he prepared the guarantee, watched

petitioner sign it, and recognized his signature. Fed. R. Evid.

901(b)(1) and (2) provides that a document can be authenticated

by the testimony of a witness with knowledge and nonexpert

testimony is sufficient as to the genuiness of handwriting.

Although a coworker may testify as to the handwriting of an

employee if he had the opportunity to observe it, United States

v. Tipton, 964 F.2d 650 (7th Cir. 1992), we need not concern

ourselves with Niesar’s familiarity with petitioner’s signature,

(continued...)

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(the petitioner K-1) attached to the Niesar Pahl 1990 return,

petitioner is identified as a shareholder of the corporation.

Petitioner is likewise identified as a shareholder on a Schedule

K-1 attached to Niesar Pahl’s 1989 income tax return.

Petitioner’s compensation package resembled that of a

shareholder-employee, not a nonshareholder-employee. Niesar Pahl

was engaged in a service business, the practice of law, and, as

law firms go, it was not particularly large. Petitioner’s

positions, as president, managing partner, and chief financial

officer, strike us as typical of an owner (partner) or principal,

rather than as a mere employee.

Indeed, the minutes of the August 3 meeting of the board of

Niesar Pahl state that the corporation “shall issue and sell to

* * * [petitioner] one thousand (1,000) shares of common stock,

such action to take effect on August 9, 1989". (Emphasis added.)

There is no explicit date for satisfaction of the price term:

the price to be paid by * * * [petitioner] for such

shares shall be determined by an audit of the

corporation’s balance sheet as at July 31, 1989; and

* * * [petitioner] shall pay in cash, the amount equal

to * * * [one-quarter] of the net worth of the

corporation as determined by reference to such audited

balance sheet as at July 31, 1989, as and for the total

purchase price of said purchasers’ [sic] 1000 shares of

common stock.

1

(...continued)

since Niesar testified that he actually saw Pahl sign the

guarantee. We disbelieve petitioner’s testimony to the contrary.

The requirements of Fed. R. Evid. 1003 are met, and Exhibit O was

properly received into evidence.

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Apparently, the board understood that petitioner would become a

shareholder on August 9, 1989, and would pay for his shares when

the price could be determined by an audit of the corporation’s

balance sheet as of July 31, 1989. While it is true that no

shares were issued to petitioner on August 9, 1989, we do not

find that dispositive: There is no evidence that Niesar Pahl

ever issued shares to any shareholder. We believe that the board

intended petitioner to become a shareholder of Niesar Pahl on

August 9, 1989, notwithstanding that he may not have then paid

for his shares.

Petitioner’s testimony that he was not a shareholder of

Niesar Pahl was unconvincing. Petitioner’s actions were those of

an owner at all times during his tenure with Niesar Pahl.

Moreover, the guarantee that accompanied the Certificate of

Amendment filed when Niesar Pahl changed its name is signed by

petitioner as a shareholder. We are convinced that petitioner

understood, and intended, that he would become a shareholder of

Niesar Pahl on or about August 9, 1989.

We find that petitioner became a shareholder of Niesar Pahl

on or about August 9, 1989, and remained a shareholder until he

left Niesar Pahl on June 30, 1990. Petitioners have not argued

that, if we find that petitioner was a shareholder of Niesar Pahl

during 1990, respondent erred in increasing petitioners’ income

on account thereof in the amounts set forth in respondent’s

notice of deficiency. Accordingly, we sustain respondent’s

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determination of a deficiency to the extent attributable to

petitioner’s pro rata share of the income and other items of

Niesar Pahl for 1990.

III. Automobile Allowance

Respondent determined a deficiency based, in part, on her

adjustment increasing petitioners’ gross income on account of the

omission of nonemployee compensation of $6,500 received by

petitioner from Niesar Pahl. Petitioner did receive $6,500 from

Niesar Pahl as an automobile allowance, which amount is reflected

on the Form 1099 issued to petitioner by Niesar Pahl. The

automobile allowance is the nonemployee compensation in question.

Petitioner testified that the automobile allowance is reflected

on Schedule C, Profit or Loss From Business (Schedule C),

attached to petitioners’ 1990 return. Petitioner’s testimony was

unconvincing. Schedule C states that it relates to “Attorney

Legal Service-Leasing”, and it shows gross receipts of $8,530.

We fail to see the connection between the automobile allowance

and any attorney legal service-leasing business of petitioner’s.

Petitioners’ 1990 return was prepared by a paid tax return

preparer, Clifford Fenske, Jr. Petitioners neither called Mr.

Fenske to testify nor showed that he was unavailable to testify.

Mr. Fenske may have had working papers or other knowledge that

would have explained the nature of the gross receipts of $8,530

reported on Schedule C. We infer from his failure to testify

that his testimony would have been negative to petitioner. McKay

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v. Commissioner, 886 F.2d 1237, 1238 (9th Cir. 1989), affg. 89

T.C. 1063 (1987); Wichita Terminal Elevator Co. v. Commissioner,

6 T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th Cir. 1947).

We find that petitioner omitted the automobile allowance, in the

amount of $6,500, from the petitioners’ 1990 return, and we

sustain respondent’s determination of a deficiency to the extent

that it relates to such omission.

IV. Negligence

Section 6662 provides for an accuracy-related penalty in the

amount of 20 percent of the portion of any underpayment

attributable to, among other things, negligence or intentional

disregard of rules or regulations. Respondent determined a

section 6662 penalty against petitioners for their negligence in

omitting from gross income the nonemployee compensation discussed

above. Negligence has been defined as the failure to exercise

the due care of a reasonable and ordinarily prudent person under

like circumstances. Neely v. Commissioner, 85 T.C. 934, 947

(1985). In the petition, petitioners assign error to

respondent’s determination of a section 6662 penalty. However,

petitioners do not aver any specific facts in support of their

assignment of error. On brief, petitioners propose no findings

of fact specifically relating to the penalty, nor do they set

forth any arguments with regard thereto. We assume that, in

defense to respondent’s determination of a penalty, petitioners

rely exclusively on the assumption that we shall determine no

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deficiency with respect to the item of nonemployee compensation.

We have determined such a deficiency. Petitioners have failed to

prove that they were not negligent in omitting the nonemployee

compensation from gross income. Rule 142(a). Respondent’s

determination of a section 6662 penalty is therefore sustained.

Decision will be entered

for respondent.