Catalano v. Commissioner

T.C. Memo. 1998-447

UNITED STATES TAX COURT

PATRICK E. CATALANO, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 10069-96. Filed December 23, 1998.

Patrick E. Catalano, pro se.

Margaret Rigg, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GALE, Judge: Respondent determined deficiencies and

accuracy-related penalties in petitioner's Federal income taxes

as follows:

- 2 -

Accuracy-Related Penalty

Year Deficiency Sec. 6662(a)1

1990 $9,743 $1,949

1991 7,289 808

1992 26,951 5,390

The issues for decision are: (1) Whether petitioner's

S corporation is entitled to deduct lease payments for the use of

petitioner's boats; (2) if the answer to the foregoing is in the

negative, whether the petitioner may exclude a portion of those

lease payments from income; and (3) whether petitioner is subject

to the accuracy-related penalties for negligence.

FINDINGS OF FACT2

Petitioner resided in San Francisco, California, at the time

the petition herein was filed. For the years in issue,

petitioner was the sole shareholder of an S corporation named

Patrick E. Catalano, a Professional Law Corporation.

Petitioner's corporation maintained law offices both in San

Francisco and in San Diego, California. Petitioner’s clients

were primarily from San Francisco, the adjacent Marin County

area, or the San Diego area.

1

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

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

Procedure.

2

Some of the facts have been stipulated and are so found.

The stipulation of facts and attached exhibits are incorporated

herein by this reference.

- 3 -

Petitioner, as an individual, owned three motorboats which

he leased to his corporation for various periods during the years

at issue pursuant to written lease agreements executed by

petitioner in his individual capacity as lessor and on behalf of

his corporation as lessee. From February 25, 1985, through

June 30, 1991, petitioner leased a 40-foot Mainship cabin cruiser

to the corporation. The Mainship had a galley and bedroom and

was equipped with a large television, a stereo, and a radio.

Petitioner berthed the Mainship in Sausalito, California (located

north of San Francisco in Marin County). From June 25, 1991

through 1992 petitioner leased to his corporation two Donzi

powerboats, which petitioner described as “pleasure boats”.

Petitioner berthed one of the Donzi powerboats in Sausalito and

the other in San Diego.

The boats were used mostly on weekends. Petitioner invited

clients of his legal practice and potential clients aboard his

boats. Business discussions took place on board. Occasionally,

the clients were accompanied by their spouses. Petitioner

watched television on the Mainship with his guests, and he used

the stereo whenever he was on board. He kept three sets of

binoculars on board which his guests could use. Occasionally, he

served food and beverages to his guests while they were on board.

After meeting on the boat, petitioner would take his clients or

other business contacts for a ride out on San Francisco Bay. He

- 4 -

taught one client, a Mr. Labruzzo, how to operate one of the

boats.

Petitioner reported his corporation's lease payments for the

boats as rental income on Schedule E of his individual Federal

income tax returns, against which he deducted expenses relating

to the boats, including repairs, maintenance, insurance,

interest, taxes, docking fees, and depreciation. Petitioner's

corporation deducted the boat lease payments on its Federal

corporate income tax returns. For its fiscal years, which ended

May 31, the corporation reported boat lease expenses in 1990 of

$57,995, in 1991 of $15,816, and in 1992 of $110,714 and deducted

80 percent of these amounts, pursuant to section 274(n). For the

same years it reported 1990 income of $40,346, a 1991 loss of

$218,390, and income in 1992 of $136,162.

Respondent accepted petitioner’s treatment of the boat lease

payments and related expenses on Schedule E of his individual

returns, but disallowed the corporation's deductions of the lease

payments for the years in issue. The disallowances increased the

corporation’s income, or decreased its losses, by the amounts

disallowed. Because an S corporation's income and losses are

passed through to its shareholders, the effect of the

disallowances was to increase the income, or decrease the loss,

- 5 -

that petitioner was required to report on his individual Federal

income tax returns for the years in issue.3

OPINION

In general, section 162 provides for the deductibility of

all ordinary and necessary expenses paid or incurred during the

taxable year in carrying on a trade or business. However,

section 274 prohibits deductions otherwise allowable for expenses

paid with respect to a facility used in connection with an

activity generally considered to constitute entertainment,

amusement, or recreation. Sec. 274(a)(1)(B); sec. 1.274-

2(a)(2)(i), Income Tax Regs. The provision of section 274

applicable to entertainment facilities (section 274(a)(1)(B)) was

specifically amended by section 361(a) of the Revenue Act of

1978, Pub. L. 95-600, 92 Stat 2847, to provide a flat prohibition

on deductions for such facilities--that is, deductions for

entertainment facilities are prohibited without regard to whether

the taxpayer can establish that the expenditure was directly

related to or associated with the active conduct of his trade or

business.

The test of whether an activity is an activity which “is of

a type generally considered to constitute entertainment,

amusement, or recreation” for purposes of the statute is an

3

By operation of a statutory formula, the increase in the

amount of petitioner's income also caused a decrease in the

amount of allowable itemized deductions for 1991 and 1992.

- 6 -

objective one. Sec. 1.274-2(b)(1)(ii), Income Tax Regs. That

regulation provides:

An objective test shall be used to determine whether an

activity is of a type generally considered to

constitute entertainment. Thus, if an activity is

generally considered to be entertainment, it will

constitute entertainment for purposes of * * * section

274(a) regardless of whether the expenditure can also

be described otherwise * * *. This objective test

precludes arguments such as * * * that an expenditure

for entertainment should be characterized as an

expenditure for advertising or public relations. * * *

There can be no dispute that, objectively, petitioner’s

boats, a cabin cruiser and two other “pleasure boats”, as he

termed them, constitute entertainment facilities. See Rutz v.

Commissioner, 66 T.C. 879 (1976); Nicholls, North, Buse Co. v.

Commissioner, 56 T.C. 1225 (1971); see also Gordon v.

Commissioner, T.C. Memo. 1992-449; Nguyen v. Commissioner, T.C.

Memo. 1989-101. Under an objective test, boats such as

petitioner’s are generally considered to be associated with

recreation. Petitioner's own testimony establishes that he used

the boats at least in some part for providing entertainment to

clients and potential clients. Petitioner has conceded that he

invited clients and potential clients aboard his boats, sometimes

accompanied by their spouses. On board, although some business

discussions may have taken place, petitioner also watched

television with his guests and used the stereo. There were three

sets of binoculars for his guests' use, and occasionally

petitioner served them food and beverages. Petitioner took his

- 7 -

clients or other business contacts for rides on San Francisco

Bay. He taught one client, a Mr. Labruzzo, how to operate one of

the boats.

We conclude that, because the boats meet the objective

criteria for entertainment facilities under section 274(a),

amounts expended to lease the boats do not qualify as business

expense deductions.

Petitioner has testified that the boats were used for

substantial business purposes in that he conducted meetings with

clients or potential clients. He maintains that the boats were,

in effect, second offices, the location of which was more

convenient for some clients. Such testimony is unavailing. The

1978 amendment of section 274(a)(1)(B), which is applicable here,

“indicates that any use of the facility, no matter how small, in

connection with entertainment is fatal to the claimed deduction.”

Ireland v. Commissioner, 89 T.C. 978, 983 (1987); see Gordon v.

Commissioner, supra. The legislative history accompanying the

1978 amendment to section 274 recognized “that some legitimate

business expenses may be incurred with respect to entertainment

facilities”. S. Rept. 95-1263 (1978), 1978-3 C.B. (Vol. 1) 321,

472. Congress nevertheless disallowed the deduction of such

expenses in view of the significant opportunities for abuse that

had existed when such deductions were permitted for entertainment

facilities. Id. Moreover, although there are some exceptions to

- 8 -

the disallowance provisions of section 274(a)(1)(B), see, e.g.,

section 274(e), none applies here. The expenses of leasing the

boats are not deductible.4

Petitioner alternatively contends that, if the corporation

is not allowed to deduct the boat lease payments, we should

accord him some relief because, as a result of the disallowance,

he is being taxed twice on the same income. He points out that

the disallowance of his corporation’s boat lease deductions

increases the passthrough income he is required to report on his

individual returns by the amount of the deductions. Because the

4

Petitioner argued at trial and on brief that his

substantiation of the business use of the boats met the

requirements of sec. 274(d). We disagree. Sec. 274(d) requires

a taxpayer to demonstrate the amount, the time and place, and the

business purposes which give rise to his claimed business

entertainment expenses “by adequate records or by sufficient

evidence corroborating * * * [his] own statement”. At trial

petitioner attempted to present summaries gleaned from office

records and prepared by someone on his staff. These summaries

failed to meet the requirements for admissibility under Fed. R.

Evid. 1006. Moreover, they failed to include information with

respect to the business purpose of the boat utilizations. See

S. Rept. 1881, 87th Cong., 2d Sess. (1962), 1962-3 C.B. 707, 741:

The requirement that the taxpayer's statements be

corroborated will insure that no deduction is allowed

solely on the basis of his own unsupported, self-

serving testimony. * * *

Generally, the substantiation requirements of the

bill contemplate more detailed recordkeeping than is

common today in business expense diaries. * * *

Thus, the boat lease deductions run afoul of both the

substantiation requirements of sec. 274(d) and the prohibition of

sec. 274(a)(1)(B).

- 9 -

corporation is an S corporation, he, and not the corporation, is

liable for payment of income taxes on the resulting additional

income. See secs. 1363(a), 1366. Petitioner further points out

that, as the lessor of the boats to the corporation, he has

previously reported the amount of the boat lease payments as

income on his individual returns. Thus, he concludes,

disallowance of the deductions at issue results in his being

taxed twice on the same income.5 To prevent this result, he

argues that his individual income for the years at issue should

be reduced by the amount that he reported as boat lease income

(that is, net of deductions previously claimed by him against

that income).6

We note at the outset that petitioner is selective in his

objection to double taxation. On the returns as filed for the

years at issue, petitioner took positions with respect to the

5

We note that the additional income of petitioner’s S

corporation resulting from the disallowance of the boat lease

deductions does not equal the boat lease net income reported by

petitioner in his individual capacity, because petitioner took

deductions for repairs, maintenance, insurance, interest, taxes,

docking fees, and depreciation against the boat lease income

reported on his individual returns.

6

At trial petitioner submitted amended returns for the

years at issue, apparently reflecting the removal of net boat

lease income (after deductions previously taken for interest,

maintenance, depreciation, etc.) from his individual returns. We

treated these submissions as petitioner's motion for leave to

amend petition, which we granted to permit consideration of

petitioner’s claim that his income should be reduced by the

amount reported as net boat lease income.

- 10 -

boat lease transactions that subjected him to the same kind of

double taxation that is the basis for his complaint herein. On

such returns, petitioner's corporation deducted only 80 percent

of the lease payments it made to him (as required by section

274(n)), whereas petitioner reported as income on his individual

return 100 percent of the lease payments, albeit reduced by the

expense deductions associated with providing the boats. Thus, to

the extent of 20 percent of the lease payments, there was no

reduction in the passthrough income from his corporation to

offset the lease income he reported in his individual capacity as

a lessor. Apparently petitioner structured the transaction to

produce, and was willing to accept, such double inclusion of

income so long as its magnitude was exceeded by the otherwise

unallowable deductions for the costs associated with the boats

that he was able to deduct as a lessor.

We believe petitioner's argument fails to take into account

two basic principles. First, the separate existence of

corporations is firmly established under the tax law. Moline

Properties, Inc. v. Commissioner, 319 U.S. 436 (1943). Second,

the business of a corporation--including that of an S

corporation--is separate and distinct from that of its

shareholders. Deputy v. duPont, 308 U.S. 488, 494 (1940);

Durando v. United States, 70 F.3d 548, 551-552 n.9 (9th Cir.

1995); see Crook v. Commissioner, 80 T.C. 27, 32 (1983), affd.

- 11 -

without published opinion 747 F.2d 1463 (5th Cir. 1984).

Accordingly, “Apart from certain situations permitting the

lifting of the corporate veil, the corporate entity and the legal

consequences flowing therefrom are controlling.” Amorient, Inc.

v. Commissioner, 103 T.C. 161, 169 (1994). In view of these

fundamental principles, courts have consistently required

shareholders to treat income received as passthroughs from their

S corporations as distinct from income the same shareholders

received for providing personal services to their corporations.

This requirement applies even though the shareholders, and not

their corporations, are liable for their pro rata shares of

corporate income on their individual income tax returns. See,

e.g., Durando v. United States, supra (passthrough income from an

S corporation is not net earnings from self-employment for

purpose of computing Keogh plan deductions); Crook v.

Commissioner, supra (passthrough income of S corporation is

dividend income, not wages or salary, to its shareholders for

purposes of investment interest deductions); Ding v.

Commissioner, T.C. Memo. 1997-435 (for purposes of self-

employment tax, passthrough losses from an S corporation cannot

be used to reduce shareholder's self-employment income paid by

the corporation). As the Court of Appeals for the Ninth Circuit

has explained, it is improper

to treat income earned by a corporation through its

trade or business as though it were earned directly by

- 12 -

its shareholders, even when, as here, the shareholders'

services helped to produce that income. An S

corporation's income passes through to its shareholders

not because they helped to create that income, but

because they are shareholders. [Durando v. United

States, supra at 552.]

Here petitioner had accession to taxable income from two

separate sources--one, as passthrough income from his S

corporation, and the other as rental income from his individual

activity of leasing boats to his corporation. The impact on

petitioner, as a shareholder, of the disallowance of his S

corporation’s deductions for the boat lease payments under

section 274 is unrelated to his recognition of income as a lessor

with respect to those same payments. “[S]ection 274 does not

affect the includability of an item in, or the excludability of

an item from, the gross income of any taxpayer.” Sec. 1.274-1,

Income Tax Regs. The separate existence of petitioner’s S

corporation means that petitioner as an individual generally can

enter a transaction with the corporation as if he were unrelated

to it, which petitioner has chosen to do in the case of the boat

leasing transactions, but as a consequence petitioner’s distinct

positions as shareholder and as unrelated lessor with respect to

the corporation must be kept separate for tax purposes.

The taxable incomes of a shareholder and his S corporation

are computed separately, even though the corporation's taxable

income is passed through to, and the tax thereon imposed upon,

the shareholder. See sec. 1363(a) and (b). This separate

- 13 -

computation of taxable income means that the disallowance of a

deduction for a lease payment by the lessee-corporation has no

impact on the lessor-shareholder's recognition of the lease

payment as income. “There is no necessary correlation between

the payor’s right to a deduction for a payment and the taxability

of the payment to the recipient.” 1 Mertens, Law of Federal

Taxation, sec. 5A.11, at 22 (1998 rev.); see also Smith v.

Manning, 189 F.2d 345 (3d Cir. 1951); Sterno Sales Corp. v.

United States, 170 Ct. Cl. 506, 345 F.2d 552 (1965); Reynard

Corp. v. Commissioner, 30 B.T.A. 451 (1934); Mosby v.

Commissioner, T.C. Memo. 1984-90; Zeunen Corp. v. United States,

227 F. Supp. 952 (E.D. Mich. 1964). This separate treatment of a

payment’s deductibility and recognition as income obtains even

where the payor and payee are a corporation and its sole

shareholder, Reynard Corp. v. Commissioner, supra; Mosby v.

Commissioner, supra; a parent corporation and its wholly owned

subsidiary, Zeunen Corp. v. United States, supra; or two wholly

owned subsidiaries of a common parent. Sterno Sales Corp. v.

United States, supra. Petitioner has taxable income arising from

two capacities, as leasing income from his individual activity of

leasing boats and as a shareholder receiving the passthrough

income of his S corporation conducting a law practice.

Petitioner contends that the “tax benefit rule” provides the

relief he seeks--that is, the exclusion of the boat lease income

- 14 -

from his individual income. He claims that the disallowance of

the corporation's boat lease deductions entitles him to exclude

the boat lease income from the income reported on his individual

return.

Petitioner misreads the scope of the tax benefit rule. The

tax benefit rule permits a taxpayer to exclude from taxable

income the amount received as a recovery of an amount deducted in

an earlier year, but only to the extent that the deducted amount

did not give rise to a tax benefit in that earlier year. Dobson

v. Commissioner, 320 U.S. 489, 505-506 (1943); see Hudspeth v.

Commissioner, 914 F.2d 1207 (9th Cir. 1990), revg. and remanding

on other ground T.C. Memo. 1985-628. Petitioner’s receipt of the

income he received as lessor is not a “recovery” within the

meaning of the tax benefit rule; it was not “fundamentally

inconsistent” with the corporation’s taking a deduction. See

Hillsboro Natl. Bank v. Commissioner, 460 U.S. 370, 383 (1983).

Nor does the tax benefit rule permit a taxpayer to offset the

impact of one adjustment against another where both pertain to

the same taxable year. As the Supreme Court explained in

Hillsboro Natl. Bank v. Commissioner, supra at 378 n.10:

Changes on audit reflect the proper tax treatment of

items under the facts as they were known at the end of

the taxable year. The tax benefit rule is addressed to

a different problem--that of events that occur after

the close of the taxable year.

- 15 -

In his reply brief, petitioner further invokes the doctrine

of equitable recoupment as a basis for the relief he seeks. The

doctrine of equitable recoupment applies if “‘a single

transaction constitutes the taxable event claimed upon and the

one considered in recoupment.’ The single transaction must also

be subject to two taxes based on inconsistent legal theories.”

Parker v. United States, 110 F.3d 678, 683 (9th Cir. 1997); Kolom

v. United States, 791 F.2d 762, 767 (9th Cir. 1986).

Assuming, without deciding, that we have jurisdiction to

apply the doctrine and that it was properly raised by petitioner,

petitioner's situation fails to qualify for equitable recoupment.

Although a “single transaction”--the lease of boats--is involved,

petitioner participates in that transaction in two capacities:

as lessor/payee and as sole shareholder of the lessee/payor, due

to the separate recognition of the corporate entity. The taxes

he pays in each capacity are not based on “inconsistent

theories”. The disallowance to the payor of a deduction is not

inconsistent with the payee's receipt of income in respect of the

same payment.

In the final analysis, there is no reason to reduce

petitioner's income by the amount he reported from leasing his

boats to his corporation. The fact that petitioner misconstrued

the tax effects of doing business both individually and through a

corporation does not provide a basis to ignore the tax

- 16 -

consequences of doing so. Petitioner chose to employ the

corporate form, and “having elected to do some business as a

corporation, he must accept the tax disadvantages.” Higgins v.

Smith, 308 U.S. 473, 477-478 (1940). He also chose to obtain the

use of boats for his business through a leasing transaction, and

while a taxpayer is free to organize his affairs as he

chooses, nevertheless, once having done so, he must

accept the tax consequences of his choice, whether

contemplated or not and may not enjoy the benefit of

some other route he might have chosen to follow but did

not. * * * [Commissioner v. National Alfalfa

Dehydrating & Milling Co., 417 U.S. 134, 149 (1974);

citations omitted.]

We hold that petitioner is liable for the deficiencies

determined by respondent7 and cannot exclude the boat lease

income from his individual returns.

We must additionally decide whether petitioner is liable for

accuracy-related penalties under section 6662(a) and (b)(1) for

each of the years at issue. These sections provide that if any

portion of an underpayment of tax is attributable to negligence

or disregard of rules or regulations, there shall be added to the

tax an amount equal to 20 percent of the underpayment which is so

attributable. The term “negligence” includes any failure to make

a reasonable attempt to comply with the statute, and the term

7

It appears, however, that respondent may have disallowed a

greater amount than was actually deducted as boat rental expense

on the corporation’s return for its taxable year ended May 31,

1992. We expect the parties to address this matter in their Rule

155 computations.

- 17 -

“disregard” includes any careless, reckless, or intentional

disregard. Sec. 6662(c).

Petitioner bears the burden of proving that respondent's

determination as to the accuracy-related penalties is in error.

Rule 142(a). Petitioner argues that respondent has waived the

penalties by not addressing them at trial. Petitioner is

mistaken. The issue of the penalties arose in the pleadings, and

petitioner retained the burden of proving the penalties

inapplicable, regardless of whether the issue was addressed at

trial. See Bixby v. Commissioner, 58 T.C. 757, 791 (1972).

In this case, petitioner, an attorney, repeatedly caused his

wholly owned S corporation to deduct expenses relating to

entertainment facilities without regard to the explicit

prohibition of such deductions in the Internal Revenue Code.

Petitioner’s attempt to treat the rent for two Donzi powerboats

and a cabin cruiser as business expenses of his law practice

strikes us as the kind of abuse that Congress sought to curb in

enacting the absolute prohibition on entertainment facilities

deductions contained in section 274(a)(1)(B).

Petitioner urges that he conferred with his accountant

concerning the boat leasing activities. We are not persuaded

that this action suffices to avoid the negligence penalties.

Reliance upon disinterested expert advice may satisfy the prudent

person standard, but only when the taxpayer has shown that he

- 18 -

provided correct and complete information to an adviser who has

expertise regarding the tax ramifications of the transactions

involved. See Collins v. Commissioner, 857 F.2d 1383, 1386 (9th

Cir. 1988), affg. Dister v. Commissioner, T.C. Memo. 1987-217.

Here petitioner has failed to make that showing. We conclude

that petitioner is liable for the accuracy-related penalties for

the years in issue.

In view of the foregoing,

Decision will be entered

under Rule 155.