DEVAULT v. COMMISSIONER

T.C. Summary Opinion 2004-122

UNITED STATES TAX COURT

RONALD L. DEVAULT, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 3946-03S. Filed September 7, 2004.

Ronald L. DeVault, pro se.

Robert V. Boeshaar, for respondent.

ARMEN, Special Trial Judge: This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in

effect at the time the petition was filed.1 The decision to be

entered is not reviewable by any other court, and this opinion

should not be cited as authority.

1

Unless otherwise indicated, all subsequent section

references are to the Internal Revenue Code in effect for 2000,

the taxable year in issue. All Rule references are to the Tax

Court Rules of Practice and Procedure.

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Respondent determined a deficiency in petitioner’s Federal

income tax of $7,981 for the taxable year 2000, as well as an

accuracy-related penalty under section 6662(a) in the amount of

$1,596.

The issues for decision are:

(1) Whether petitioner was a shareholder in an S

corporation during 2000 such that petitioner is required to

report his pro rata share of the corporation’s income. We hold

that he was.

(2) Whether petitioner is liable for the accuracy-related

penalty under section 6662(a). We hold that he is not.

Background

Some of the facts have been stipulated, and they are so

found. We incorporate by reference the parties’ stipulation of

facts and accompanying exhibits.

At the time that the petition was filed, petitioner resided

in Auburn, Washington.

Petitioner first met Philip Turner (Mr. Turner) in 1993 when

they both worked at Modern Manufacturing, Inc. (Modern).2 In

June 1995, petitioner and Mr. Turner formed Union Machine, which

they later incorporated in the State of Washington on December

21, 1995. Union Machine’s principal business was manufacturing

2

Around that time, petitioner worked as a first quality

inspector and quality control officer. By trade, petitioner and

Mr. Turner are machinists.

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aircraft parts. Petitioner and Mr. Turner each made initial

capital contributions to Union Machine. Petitioner contributed

$12,000 of inspection equipment and granite,3 and Mr. Turner

transferred his personally owned equipment. Mr. Turner became

president of Union Machine, and petitioner became vice

president.4

On January 10, 1996, Union Machine filed with the Internal

Revenue Service (IRS) a Form 2553, Election by a Small Business

Corporation, to be treated as an S corporation, which the IRS

accepted effective January 2, 1996.5 Since then, Union Machine

has operated as an S corporation on a calendar year basis. The

Form 2553 listed the shareholders as follows:

Date of

Name Shareholder Consent No. shares1 Date

Acquired

Philip L. Turner 6/28/95 51 1/2/96

Ronald L. DeVault 6/28/95 49 1/2/96

Gigi DeVault2 9/29/95 -- 1/2/96

1

At all relevant times, the number of shares owned by each

shareholder has remained the same.

2

At the time of the S corporation election, Gigi DeVault (Mrs.

DeVault) was petitioner’s spouse.

After the formation of Union Machine, Mr. Turner resigned

from Modern to manage Union Machine’s day-to-day operations.

Petitioner, on the other hand, continued to work full time at

3

Petitioner obtained a personal loan from Household

Finance to purchase these items.

4

At all relevant times, Mr. Turner has remained president

of Union Machine.

5

We note that Form 2553, Election by a Small Business

Corporation, incorrectly listed Union Machine’s date of

incorporation as Jan. 2, 1996.

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Modern,6 but worked at the end of the day at Union Machine to

help Mr. Turner with certain jobs. In mid-1997, petitioner began

working full time at Union Machine because of its increased

workload. Petitioner received an annual salary of $90,000 plus

yearend bonuses. In addition to petitioner and Mr. Turner, Union

Machine employed one full-time employee and some part-time

programmers.

Around 1998, petitioner began experiencing personal

hardships. On one occasion, Union Machine loaned petitioner

$6,000 to pay his tax liability to the IRS. In addition, Mrs.

DeVault filed for divorce after 30 years of marriage to

petitioner. Petitioner needed money to repair his house to sell

in the divorce. Union Machine lent him $16,000 for the repairs.

Petitioner’s personal hardships also began to negatively

affect his work performance at Union Machine, as well as his

business relationship with Mr. Turner. By late 1998, petitioner

left the employment of Union Machine.7 Petitioner stopped

receiving any form of compensation from Union Machine and was no

longer involved with its business-related matters. Around this

6

Petitioner continued to work at Modern because Union

Machine received most of its business from Modern.

7

Petitioner believed that Mr. Turner asked him to leave

because Mr. Turner was concerned that Mrs. DeVault would pursue

an interest in Union Machine. On the other hand, Mr. Turner

believed that petitioner was only taking a temporary leave of

absence. Nevertheless, they agree that petitioner left the

employment of Union Machine in late 1998.

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time, Mr. Turner offered to forgive petitioner’s $22,000 debt to

Union Machine and to pay petitioner an additional $10,000 for his

ownership interest. Petitioner did not accept the offer.

Since leaving Union Machine, and through the year in issue,

petitioner did not sign any document purporting to relinquish his

interest as a shareholder in Union Machine, nor did he take any

legal action to terminate such interest in Union Machine. In

addition, Union Machine has not provided petitioner with any

consideration in exchange for redemption of his shares, and Mr.

Turner has not commenced a declaratory judgment action to become

the sole shareholder.8

In July 1999, petitioner filed for bankruptcy protection

under chapter 7 of the Bankruptcy Code. In his bankruptcy

filing, petitioner disclosed his shareholder interest in Union

Machine but did not assign a value to it. The bankruptcy court,

however, did not administer petitioner’s shareholder interest as

part of the bankruptcy estate. In November 1999, the bankruptcy

court discharged, inter alia, petitioner’s Household Finance loan

and his debt to Union Machine of $22,000.9

On December 7, 1999, Union Machine held its annual meeting

8

Since late 1998, Union Machine has not had an occasion

requiring action by a two-thirds vote of the stockholders.

9

Around this time, Mr. Turner again offered to buy

petitioner’s ownership interest. Petitioner did not accept this

offer.

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of stockholders and directors. Petitioner was not present at

this meeting.10 The minutes signed by Mr. Turner indicated that

petitioner was elected to serve as vice president and as a member

of the board of directors until the next annual meeting.

For the taxable year 1999, Union Machine filed a Form 1120S,

U.S. Income Tax Return for an S Corporation. The Form 1120S

reported that petitioner and Mr. Turner were its only

shareholders at the end of the taxable year 1999. Attached to

the Form 1120S, inter alia, was a Schedule K-1, Shareholder’s

Share of Income, Credits, Deductions, etc., for each shareholder.

Petitioner’s Schedule K-1 reported his pro rata share as follows:

Ordinary income of $8,375; investment interest income of $72;

depreciation of $1,343; and nondeductible expenses of $81.

On December 5, 2000, Union Machine held its annual meeting

of stockholders and directors. The minutes of this meeting

signed by Mr. Turner indicated that petitioner was not present at

the meeting, but that he was reelected to serve on the board of

directors until the next annual meeting.

For the taxable year 2000, Union Machine filed Form 1120S.

The Form 1120S reported that petitioner and Mr. Turner were its

only shareholders at the end of the taxable year 2000. Attached

10

Since leaving Union Machine in 1998, petitioner has not

received any written notice of the annual meetings. We note that

the 1999 minutes incorrectly stated that petitioner was present

at the meeting.

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to the Form 1120S, inter alia, was a Schedule K-1 for each

shareholder. Petitioner’s Schedule K-1 reported his pro rata

share as follows: Ordinary income of $27,489; charitable

contributions of $2,499; investment interest income of $20; and

depreciation of $1,690 (petitioner’s 2000 Schedule K-1).

Petitioner timely filed a Form 1040EZ, Income Tax Return for

Single and Joint Filers With No Dependents, for 2000. Petitioner

did not report any of the items reported on petitioner’s 2000

Schedule K-1.

In the notice of deficiency, respondent determined that

petitioner failed to report shareholder interest income of $20

and shareholder ordinary income of $27,489. Respondent further

determined that petitioner is liable for the accuracy-related

penalty under section 6662(a) for a substantial understatement of

tax.

Petitioner timely filed a petition with the Court disputing

the determined deficiency as well as the accuracy-related

penalty. Paragraph 4 of the petition states as follows:

The Notice of Deficiency was calculated based upon

information reported on IRS Form 1120S filed on behalf

of Union Machine, Inc., EIN XX-XXXXXXX, for the year

ending 2000. The Form 1120S erroneously reported that

I was a shareholder of Union Machine, Inc. I do not

believe that I was a shareholder of Union Machine for

the year ending 2000 (or for any part of the year

ending 2000). The Schedule K-1, which the IRS has

relied upon to determine the Notice of Deficiency,

should not have been issued in my name. Accordingly,

there is no basis for the Notice of Deficiency.

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After filing the petition, petitioner signed a declaration

on May 14, 2003, which states:

I, Ronald Leon DeVault, left Union Machine in September

of 1999. From September, 1999 until the present, I

have not had any transaction, communication, business,

or monetary action with Union Machine, Inc. or with

Phillip Turner, president and owner of Union Machine,

Inc.

As of September, 1999, I did forfeit all rights,

privileges, and my 49% share in Union Machine, Inc. to

Phillip Turner.

Petitioner provided this declaration to respondent’s agent as

well as to Union Machine’s accountants. Before doing so,

however, petitioner invited Mr. Turner to also sign the

declaration, but Mr. Turner declined to do so on the ground that

it was not truthful because petitioner never signed a release of

his interest in Union Machine.

Discussion

Generally, the Commissioner’s determinations are presumed

correct, and the taxpayer bears the burden of proving that those

determinations are erroneous. Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933).11

11

Sec. 7491(a) does not apply in this case to shift the

burden of proof to respondent because petitioner neither alleged

that sec. 7491(a) is applicable nor introduced credible evidence

with respect to any factual issue relevant to ascertaining his

income tax liability. See Higbee v. Commissioner, 116 T.C. 438,

442 (2001).

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A. S Corporation Pro Rata Distributive Share

Generally, a shareholder of an S corporation must include in

gross income his or her pro rata share of the corporation’s

income, loss, deduction, or credit. Sec. 1366(a), (c); see also

sec. 61(a). Consequently, we must decide whether petitioner was

a shareholder of Union Machine during 2000 such that he is

required to report his pro rata share of Union Machine’s interest

and ordinary income.

Generally, a shareholder of a corporation remains a

shareholder until he or she is validly divested of his or her

shares despite any announcement of resignation or abandonment of

that status. 18A Am. Jur. 2d, Corporations, secs. 772, 778

(2004); see Owyhee Grazing Association, Inc. v. Field, 637 F.2d

694 (9th Cir. 1981). Under the Washington Business Corporation

Act, Wash. Rev. Code Ann. tit. 23B (West 2001), a shareholder may

be validly divested of his or her shares by transferring his or

her shares in accordance with the articles of incorporation, the

bylaws, or a restriction agreement,12 Wash. Rev. Code Ann. sec.

23B.06.270 (West 2001), or, if the shareholder dissents from a

corporate action, the dissenting shareholder may obtain payment

of the fair value of his or her shares, Wash. Rev. Code Ann. sec.

23B.13.020 (West 2001). Furthermore, the corporation may divest

12

We note that no such corporate documents were introduced

into evidence.

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a shareholder of his or her shares by redeeming a shareholder’s

shares subject to certain limitations, Wash. Rev. Code Ann. sec.

23B.06.400(1), (4)(b)(i) (West 2001), or by seeking judicial

dissolution of the corporation, Wash. Rev. Code Ann. sec.

23B.14.300 (West 2001).

Petitioner contends that he was not a shareholder of Union

Machine in 2000 because he forfeited his ownership interest in

Union Machine in September 1999. In support of his contention,

petitioner relies on his declaration stating that he forfeited to

Mr. Turner his 49-percent share in Union Machine in September

1999. However, the May 14, 2003, declaration signed by

petitioner after the filing of the petition, which declaration

Mr. Turner refused to sign, is nothing more than a self-serving

statement. We are not compelled to accept petitioner’s

unsubstantiated, conclusory, and self-serving statement without

additional evidence. See Johnson v. Commissioner, T.C. Memo.

1999-127, affd. 246 F.3d 674 (9th Cir. 2000).

In addition, the evidence in the record contradicts

petitioner’s declaration. Petitioner testified at trial that he

actually left Union Machine in 1998, but that he wrote down

September 1999 only because he was instructed by an IRS agent

during an audit to list a date for the time period at issue.

Therefore, we do not regard petitioner’s declaration to be

determinative that petitioner was not a shareholder in 2000.

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Petitioner’s assertion that he abandoned his interest also

is not supported by the evidence. There is no dispute that

petitioner left the employment of Union Machine in 1998.

Nonetheless, petitioner was aware that he still had an ownership

interest in Union Machine. Indeed, petitioner listed in his

bankruptcy filing in July 1999 that he owned an interest in Union

Machine. The bankruptcy estate, however, abandoned petitioner’s

shareholder interest in Union Machine, and, therefore, title to

the shares reverted to petitioner. See 11 U.S.C. sec. 541

(2000); Brown v. O’Keefe, 300 U.S. 598, 602 (1937); Mason v.

Commissioner, 646 F.2d 1309, 1310 (9th Cir. 1980), affg. 68 T.C.

163 (1977). Even assuming that petitioner initially thought such

interest passed to the bankruptcy estate, petitioner was aware by

the time of his discharge in November 1999 that the bankruptcy

court did not administer his ownership interest in Union Machine

as part of the bankruptcy estate.

Although petitioner has not been involved in the active

conduct of any of Union Machine’s corporate matters, including

annual shareholder meetings, since September 1998, petitioner did

not present any evidence, other than his own testimony, to refute

the fact that he remained a shareholder of record. Indeed, Union

Machine issued Schedules K-1 for the taxable years 1999 and 2000

reporting that petitioner was a 49-percent shareholder in Union

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Machine.13

Although petitioner alleges that he abandoned or forfeited

his interest in Union Machine before the year in issue, he did

not affirmatively transfer his shares to another person in

accordance with the Washington Business Corporation Act. In

particular, petitioner had opportunities in both 1998 and 1999 to

transfer his shares to Mr. Turner for valuable consideration, but

petitioner rejected those offers. Moreover, petitioner does not

claim that he was a dissenting shareholder who demanded a fair

value payment for his shares. Likewise, Mr. Turner has not

sought a declaratory judgment that he is the sole shareholder,

nor has he sought judicial dissolution of the corporation, and

Union Machine has not redeemed petitioner’s shares.

Based on the entirety of the record, petitioner failed to

satisfy his burden to prove that he was not a shareholder of

Union Machine for the taxable year 2000. Accordingly, we sustain

respondent’s determination on this issue.

B. Section 6662(a) Substantial Understatement of Tax

Respondent determined in the notice of deficiency that

petitioner is liable for the accuracy-related penalty under

section 6662(a) for a substantial understatement of income tax

for the taxable year 2000.

13

The record does not indicate whether petitioner received

these Schedules K-1.

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Section 6662(a) imposes a penalty equal to 20-percent of any

underpayment of tax that is due to a substantial understatement

of income tax. See sec. 6662(a) and (b)(2). An individual

substantially understates his or her income tax when the reported

tax is understated by the greater of 10-percent of the tax

required to be shown on the return or $5,000. Sec.

6662(d)(1)(A).

The accuracy-related penalty does not apply to any portion

of an underpayment, however, if it is shown that there was

reasonable cause for the taxpayer’s position and that the

taxpayer acted in good faith with respect to that portion. Sec.

6664(c)(1); sec. 1.6664-4(b), Income Tax Regs. The determination

of whether a taxpayer acted with reasonable cause and in good

faith is made on a case-by-case basis, taking into account all

the pertinent facts and circumstances. Sec. 1.6664-4(b)(1),

Income Tax Regs. The most important factor is the extent of the

taxpayer’s effort to assess his proper tax liability for such

year. Id. Circumstances that may indicate reasonable cause and

good faith include an honest misunderstanding of fact or law that

is reasonable in light of the experience, knowledge, and

education of the taxpayer. Sec. 1.6664-4(b), Income Tax Regs.;

see Higbee v. Commissioner, 116 T.C. 438, 449 (2001) (citing

Remy v. Commissioner, T.C. Memo. 1997-72).

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Section 7491(c) places on the Commissioner the burden of

production with respect to a taxpayer’s liability for any

penalty. Respondent satisfied his burden of production because

the record shows that petitioner substantially understated his

income tax for 2000 by $7,981, which amount is greater than

$5,000. See sec. 6662(d)(1)(A)(ii); Higbee v. Commissioner,

supra at 442. Accordingly, petitioner bears the burden of

proving that the accuracy-related penalty should not be imposed

with respect to any portion of the understatement for which he

acted with reasonable cause and in good faith. See sec.

6664(c)(1); Higbee v. Commissioner, supra at 446. The mere fact

that we held against petitioner with respect to his status as a

shareholder of Union Machine does not, in and of itself, require

holding for respondent on the accuracy-related penalty. See

Hitchins v. Commissioner, 103 T.C. 711, 719 (1994).

Petitioner by trade is a machinist with no formal training

or experience in organizing or managing a business, let alone how

to wind up his business affairs.14 Since petitioner left the

employment of Union Machine, he has had no further contact with

Union Machine. Indeed, after petitioner left the employment of

Union Machine, he stopped receiving any form of compensation and

any communication from Union Machine, including upcoming annual

14

Petitioner testified that “because of my own lack of

knowledge in these things, I wasn’t aware of what actions I was

supposed to take.”

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meetings wherein he was consistently reelected to serve on the

board of directors until the next annual meeting.

In light of petitioner’s lack of business acumen and the

circumstances of this case, we find that petitioner had

reasonable cause to believe that he did not have an interest in

Union Machine in 2000 and acted in good faith with respect to the

underpayment.

Accordingly, we hold that petitioner is not liable for the

accuracy-related penalty under section 6662(a).

C. Conclusion

Reviewed and adopted as the report of the Small Tax Case

Division.

To reflect the foregoing,

Decision will be entered

for respondent with respect to

the deficiency and for

petitioner with respect to the

penalty under section 6662(a).