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T.C. Memo. 2011-29

UNITED STATES TAX COURT

DKD ENTERPRISES a.k.a. DKD ENTERPRISES,

INC., ET AL.,1

Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos.

24403-07,

10818-08,

24404-07,

10819-08.

Filed January 31,

2011,

James R. Monroe, for petitioners.

Catherine S. Tyson, for respondent.

Cases of the following petitioners are consolidated herewith: , Debra K. Dursky, docket Nos. 24404-07 and 10819-08; and

DKD Enterprises "a.k.a. DKD Enterprises, Inc., docket No. 1081808.

EVED JAN 31 2011

- 2 MEMORANDUM FINDINGS OF FACT AND OPINION

CH ECHI, Judge:

Respondent determined the following defi-

ciencies in, additions under section 6651(a) (1)2 to, and

accurac -related penalties under section 6662 (a) on each petitioner' s Federal income tax (tax) :

Accuracy-Related

Penalty

Petitioner

Year

Deficiency

Addition to Tax

Under Sec. 6651(a) (1)

DKD

2003

$23,458.61

$2,345.86

2004

47,740.00

4,774.00

$9,548.00

2005

42,376.00

8,475.00

2003

17,476.00

2004

16,403.00

3,280.60

2005

12,604.00

2,520.80

Ms. Dursky

Under Sec.

6662(a)

The issues remaining for decision for the years at issue

are:S

Is DKD Enterprises, Inc.

(DKD), entitled to deduct

under section 162 (a) certain respective amounts relating to its

cattery activity that it (a) reimbursed to Debra K. Dursky (Ms.

Dursky) and her personal partner, Elizabeth Watkins (Ms.

2Agl section references are to the Internal Revenue Code in

effect for the years at issue

All Rule references are to the

Tax CouÊt Rules of Practice and Procedure.

3In addition to the issues remaining for decision that are

listed in the text, there are: other questions relating to certain

determiŠations in the respective notices of deficiency with

respect to those years that respondent issued to Ms . Dursky and

DKD whiòh are computational in that their resolution flows from

our resålution of certain of the issues that we address herein.

- 3 Watkins),

(b) paid to Ms. Watkins,

and licenses", and (d) paid to Ms. Dursky?

We hold that it is

not.

(2)

Is Ms. Dursky required to include in gross income as

constructive dividends the. certain respective amounts that we

have held with respect to issue (1) DKD is not entitled to

deduct?

(3).

We hold that she is .

In the light of our holdings with respect to issues

(1) and (2), is Ms. Dursky entitled to deduct under section

162(a) the certain respective amounts that we have held DKD is

not entitled to deduct?

(4)

We hold that she is not.

In the light of our holding with respect to issue (1) ,

is Ms . Dursky entitled to deduct in Schedule E, Supplemental

Income and Loss (Schedule E) , certain respective amounts of home

mortgage interest and real estate taxes that she paid?

We hold

that she is not.

(5)

Is DKD a' qualified personal service corporation, as

defined in section 448(d) (2), that is subject to the 35-percent

tax rate prescribed in section 11(b) (2)?

(6)

We hold that it is not.

Is DKD entitled to- deduct under section 162 (a) certain

amounts that it paid into a certain account that Fidelity

Investments maintained for it?

(7)

We hold that it is not.

Is Ms. Dursky.required to include in gross income as a

constructive dividends certain amounts that we have held with

- 4 respect to issue (6) DKD is not entitled to deduct?

We hold that

she is.

(8)

Is DKD entitled to deduct under section 162 (a) certain

amounts of premiums that it paid with respect to a health

insurance policy that Ms. Dursky purchased for herself? We rhold

that it is not.

(9)

Is Ms. Dursky entitled to exclude from gross income the

certain amounts, of premiums that that we have held with respect

to issue (8) DKD is not entitled to deduct?

We hold that she is

not.

FINDINGS OF FACT

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

At all relevant times, including throughout 2003 through

2005 (the years at issue) and at the times Ms. Dursky filed the

respective petitions in the cases at docket Nos. 24404-07 and

10819-08, Ms. Dursky resided in a house that she owned (Ms.

Dursky's residence) in West Des Moines, Iowa (West Des Moines) .

For an

ndisclosed period starting before the years at issue to

at least the time of the trial in these cases, Ms. Dursky's

persona

partner, Ms. Watkins, resided with Ms. Dursky in Ms.

Dursky's residence.

At all relevant times, including throughout the years at

issue a d at the times DKD filed the respective petitions in the

- 5 cases at docket Nos. 24403-07 and 10818-08, DKD maintained its

place of operation.at Ms. Dursky's residence.

At all relevant times, Ms. Dursky was the sole owner of Ms.

Dursky's residence, which had approximately 2,100 square feet of

space.

During each of the years at issue, the monthly fair

rental value of Ms. Dursky's residence was $1,600.

Dallas County, Iowa (Dallas County) , - the county in which Ms .

Dursky' s residence was located, assessed the following real

property tax on that residence for the real property tax year

indicated:

Real Property

Tax Assessed

Real Property Tax

Year Ended March 31

$3,976

3,966

3, 708

3,630

2003

2004

2005

2006

At all relevant times, Ms. Dursky's residence was subject to

a home mortgage loan on which Ms .' Dursky paid an undisclosed

amount of interest (home mortgage interest) during each of the

years at issue.

For an undisclosed pežiod starting before 1997 through at

least the years at issue, Ms. Dursky was an information

technology (IT) consultant.

On May 28, 1997, Ms. Dursky

incorporated DKD to provide IT consulting services.

- 6 At all relevant times, including throughout the years at

issue, DKD employed Ms. Dursky, who was the sole stockholder and

the sole officer of DKD, to perform IT consulting services for

it.4

At all relevant times, including throughout the years atissue,

Octagon

KD provided IT consulting services to a company known as

At those times, Octiagon, in turn, provided IT

consult ng services to other acompanies such as Wells Fargo.

Octagon paid DKD on an hourly basis for the IT consulting

services that DKD performed for it.

During the years at issue,

Ms . Dur ky was the only persön whom DKD employed to work on

matters relating to DKD's IT consulting business.

Dursky spent approximately 2, 000 hours during 2003 and

approxi ately 2,200 hours during each of the years 2004 and 2005

working for DKD in its IT consulting business .

Dursky

DKD paid Ms .

80, 400 annually as compensation for the IT consulting

work th t she performed for DKD during each of the years 2003,

2004, and 2005.5

For each of the years 2003 through 2005, DKD issued to Ms.

Dursky Form W-2, Wage and Tax Statement (Form W-2),

in which it

'At least during the years at issue, Ms. Dursky did not have

a written employment agreement with DKD.

3DKD also paid Ms. Dursky $80,400 annually as compensation

for the IT consulting work that she performed for DKD during each

of the

ears 2001 and 2002.

- 7 -

reported that it had paid her wages of $80,400.

In each of those

Forms W-2, DKD also reported certain respective amounts of

"Federal income tax withheld", "Social security wages", "Social

security tax withheld",

"Medicare.wages and tips",

"Medicare tax

withheld", "State wages, tips, etc.", and "State income tax".

DKD did not report any other amounts in.each of those.forms.

Throughout the years at issue, Ms. Dursky's personal assets

consisted primarily.of Ms. Dursky's residence, certain retirement

accounts, certain automobiles, certain stocks, including her 100-percent stock interest in -DKD, a joint checking account that Ms.

Dursky maintained with Ms. Watkins, and certain cats, kittens,

and equipment (e.g.,' cat trees, feeding bowls, .litter boxes)

relating to a cattery.

Cattery Activity of Ms. Dursky and Ms. Watkins

Since at least 1989 Ms. Watkins, and since at least 1994 Ms.

Dursky, each was engaged in the hobby of operating a cattery from

which each derived significant personal pleasure.

That cattery

operation included breeding, raising, and -offering for sale

certain cats and certain kittens, attending certain cat shows,

and entering in some of those-shows some of those cats and

kittens (cattery activity).

At a time not disclohed by the record before the years at

issue, Ms. Dursky and Ms. Watkins became engaged in the hobby of

jointly operating a cattery (cattery activity of Ms. Dursky and

- 8 -

Ms. Watkins) from which they continued to derive significant

personail. pleasure .

Ms . Dursky and Ms . Watkins had at least the

following two breeds of cats in the cattery activity of Ms.

Dursky ànd Ms . Watkins :

The Maine Coon breed (Maine Coons) and

the Nor egian Forest breed (Norwegian Forest cats) .'

The cattery activity of Ms . Dursky and Ms . Watkins took

place in Ms. Dursky's residence, except for attending cat shows

and visiting veterinarians.

The cattery activity= of Mss. Dursky

and Ms. Watkins required them to spend substantial time and

substantial money in operating that activity.

As part of the

catterydactivity of Ms. Dursky and Ms. Watkins, they traveled *

extensively to certain cat shows in the United States.

that Ms

The money

Dursky and Ms . Watkins spent in operating that activity

was for, inter alia, cat food, cat litter, veterinarians, cat '

show en rance fees, and transportation, meals, and lodging

relating to the attendance bys Ms. Dursky and/or Ms. Watkins at

certain cat .shows.

At a time not disclosed by the record before the years at

issue,

s. Dursky and Ms. Watkins created a Web site (cattery

activit

Web site) that they maintained for the cattery activity

'I 1989, a person or persons not identified by the record

operated a cattery for Maine Coons.

In 1994, Ms. Dursky was

operati g a cattery for Norwegian Forest cats.

In 1997, Ms.

Dursky nd Ms. Watkins were jointly operating a cattery for

Norwegi n Forest cats. At a time not disclosed by the record,

Ms. Dursky and Ms. Watkins were jointly operating a cattery for

Maine CC ons .

- 9 -

of Ms. Dursky and Ms. Watkins.

At the time of the trial in these

cases, the general public was able to access that Web site,

although it had not been updated since 2002.

The cattery activity Web site stated:

"We treat our cats as

members of our family", and "we have invested too much love in

our wonderful kittens to risk exposing them to an uncertain and

risky environment."

The cattery activity Web site also indicated

that kittens were.born in one of the bedrooms in Ms. Dursky's

residence, that the kittens stayed in the bedroom for five to

eight weeks after birth,- and that after the kittens were older

and well socialized "they are then allowed to run the house with

the other cats."

The cattery activity Web -site stated that "Our

goal * * * is to breed healthy, well-socialized Wegies

[Norwegian

Forest cats] who are at home--whether in the show ring or simply

as a beloved member of the family."

That Web site further stated

that."Our goal is to breed healthy, large, shaggy coated Maine

Coons with a gentle, loving personality."

As part of the cattery activity of Ms. Dursky and Ms.

Watkins, Ms. Dursky and Ms. Watkins participated in certain

competitions, clubs, and associations and attended cat shows over

much of the United States and developed relationships with cat

breeders around the world.

Web site stated:

In this regard, the cattery activity

- 10 We currently show exclusively in the Cat , Fancief-s

Ashociation (CFA) . We ave shown five of our cats to

Re ional? Wins and two of our female NFC' s [Norwegian ,

Fo est cats] have produded such outstanding offspring

th t they achieved the oveted title of CFA

Di tinguished Merit.

C rrently less than 10 Norwegian

Fo esta Cats throughout the world have been awarded the

ti le of Distinguished lvlerit--it is the highest award

th t CFA presents , to a þreeding pedigreed cat and we

ar very proud to [be] the owners of TWO NFC DM' s

[D stinguished Merits] ! We are: currently members of,

tw CFA clubs, the Hawkeye Cat Club and the Lucky

To cat Club.

In addition, we are also members of the

CFA Norwegian Forest Cat Breed Council and Deh [Ms .

Du sky] is a Breeder Me ber of, the Norwegian Forest *Cat

Fa ciers Association. By attending shows over much of

th United States we ha e developed friendshipsewith

breeders and exhibitors 3from around the world. Our

sußcess is built, on the trust of those breeders who

hage sold us our cats, ermitted us to use their studs

and to all those breeders who came beforetthem. * * *

The cattery activity Web site also indicated -that the Cat

Fanciers

Association (CFA) , the largests association - for" owner

of cats in the United States,7 had designated, the cattery

activity Áf Ms . Dursky and Ms . Watkins as a "CFA Approved Cattery

of Excellence" .

The cattery activity Web site adverti-sed for

sale a

at for $75, a cat for $150, a kitten for $200,3 and a

kitten

or $400.

CatterviActivity During the

ears at Issue

During each of the- years at issue, DKD had two activities:e

A consu ting activity. and a catteryractivity (DKD's cattery

'CF

imposed ethical standards and practices for catteries.

- 11 -

activity)."

Ms. Dursky and Ms. Watkins operated DKD's cattery

activity.

DKD's cattery activity was the cattery activity in

which Ms. Dursky and Ms. Watkins had engaged before the years at

issue.

While operating DKD's cattery activity during each of the

years at issue, Ms. Dursky and Ms. Watkins continued to breed,

raise, and offer for sale certain cats and certain kittens at Ms.

Dursky's residence" and to attend certain cat shows in some of

which they entered some of those cats and kittens."

As was true

while they were operating the cattery activity of Ms. Dursky and

Ms. Watkins before dhe years at issue, Ms. Dursky and Ms. Watkins

continued to derive significant personal pleasure while operating

DKD's cattery activity during the years at issue.

During each of the years at issue, DKD used, without

purchasing, in DKD's cattery'activity the assets (e.g., cats,

kittens, cat trees, feeding bowls, litter boxes) that Ms. Dursky

9By referring to the cattery.activity of DKD as "DKD's

cattery activity", we are in no way implying or suggesting that

during any of the years at issue DKD's cattery activity

constituted a trade or business of DKD within the meaning of sec.

162(a).

"Of the approximately 2,100 square feet of space at Ms.

Dursky's residence, Ms. Dursky and Ms. Watkins used approximately

474 square feet in operating DKD's cattery activity during each

of the years at issue.

"During each of the years at issue, Ms. Dursky and Ms.

Watkins did not attend all of the cat shows in which they entered

certain cats and/or kittens while operating DKD's cattery

activity.

- 12 -

and Ms . Watkins had used before those years in the cattery

ac t ivity of Ms . Dursky and Ms . Watkins .

During each of the years at issue, Ms. Dursky spent

approximately 800 hours in ošerating DKD's cattery activity.

discussed above, during each of those years, DKD continued to pay

to Ms. Dursky the same amount of wages (i.e., $80,400) that it

had paid to her in 2001 and 2002.

The wages that DKD paid to Ms.

Dursky also remained unchanged in 2006, the year in which DKD-

discontinued DKD' s cattery activity.

During each of the years: at issue, Ms. 'Watkins spent more

hours than Ms. Dursky in operating DKD's cattery activity.

During each of those years, DKD made payments to Ms. Watkins

totalin

$7,700.

(We shall refer to any, -some, or all of those

payments as DKD' s payments to.- Ms . Watkins . )

For each of the

years at issue, DKD withheld Social Security tax and Medicare tax

f rom DKp' s 'payments to Ms . Watkins .

For each of the years at issue, DKD issued Form W-2 to Ms.

Watkins in which it reported that it had paid her wages of

$7,700.

For each of those years, Ms. Watkins filed a tax return

in whic

she included in gross income the $7, 700 that she had

received from DKD during each such year,

For each of the taxable years at issue, DKD filed Form 940,

Employer' s Annual Federal Unemployment (FUTA) Tax Return, and for

each quàrter during each of those years, DKD filed Form 941',

- 13 Employer's,Quarterly Federal Tax Return.

tIn each of those forms,

DKD reported DKD's payments to Ms. Watkins and paid any Federal

tax shown due in each such form.

During the years at issue, while operating DKD' s cattery

activity Ms . Dursky and Ms . Watkins desired to expand on the

national reputation of the cattery activity of Ms. Dursky and Ms.

Watkins that they had developed before those years.

In order to

do so, Ms . Dursky and Ms . Watkins- relied on their respective

years of cattery activity experience and their respective

reputations in the so-called cattery world.

While operating DKD's cattery activity during the years at

issue, Ms. Dursky and Ms. Watkins bred, raised

and offered for

sale Norwegian Forest cats and entered-certain of those cats in

certain cat shows.9

Starting at an undisclosed time in 2004,

they bred, raised,. and offered for sale -Abyssinian cats and

entered certain of those cats in certain cat shows.

While operating DKD's cattery "activity during 2003, Ms.

Dursky and Ms. Watkins produced approximately seven to nine

kittens from approximately five to seven litters.

While

operating DKD' s cattery activity during each of the years 2004

"The number of breeders that bred Norwegian Forest cats in

the Midwest region of the United States increased from

approximately three at the beginning of 2003 to approximately 10

to 15 by 2005.

14 -

and 200 5, Ms. Dursky and Ms. Watkins produced approximá.tely nine

kittens from approximately tliree litters.

Wh Lle operating DKD' s c ttery activity during the years at

issue,

s. Dursky and Ms. Wat kins entered at least 62 cats

49 cats

and 45. cats, respectively, in various cat shous that

were ty ically held on the east coast or the west coast of the

United åtates .

owner o

fee.

In order to enter a cat in any 'such "show, the

the cat, was require¶ to prepay a nonrefundable entrance

Me. Dursky, and Ms. Watkins did not attend all the cat shows

in which they entered cats.

During the years at issue,- Ms

Watkins typically attended.cat- shows without Ma.»Dursky, although

Ms. Dur ky attended some cat shows with Ms. Watkins.

yhile operating DKD' s cattery activity duning 2003, 2004,

and 2005 Ms. Watkins attended 30,cat shows; 31 cat ishows, and

28 cat

ho s, respectively, and Ms . Dursky attended a relativel

small n mber of those shows with Ms. Watkins.

When one or both

of them attended:a cat show, one or -both made .arrangements for

travel &nd" lodging.

cat sho

If Ms. Dursky and/or Ms. Watkins attended a

that was'not within driving di-stance of West - Des Moines

it took approximately 40 hours in order to travel to and from,

and par icipate in, the show.

If Ms. Dursky and/or Ms. Watkins

attended a cat show that was within driving distance of West Des

"The record does not establish how many cat shows during

each of the years at issue Ms . Watkins attended" with Ms . Dursky

and without Ms . Dur sky .

- 15 -

Moines, it took approximately -32 hours in order to travel to and

from,- and participate in, the show.

As was true of the cattery áctivity of Ms. Dursky and Ms.

Watkins before the years at issue, DKD's cattery activity was

designated by the CFA during -the years at issue as a "Cattery of

Excellence"

As was true of their beliefs while operating the cattery

activity of Ms. Dursky and Ms. Watkins before the years at issue,

while Ms. Dursky and Ms. Watkins were operating DKD's cattery

activity during the years at issue they believed that the price

of any cat or kitten offered for sale would increase if the cats

and kittens that they bred won national cat shows.

While

operating DKD's cattery activity during the years at issue, Ms.

Dursky and Ms. Watkins produced a total óf four cats that won

national championships."

During each of the years at issue, the monthly fair rental

value of Ms. Dursky's residence was $1,600. .During none of those

"National championship winners were- determined on the basis

of the total number of points earned by a cat during cat show

season. Cats earned points by winning cat shows; the number of

points earned depended on the number of cats competing in a show.

The number of cats competing in a cat show typically was not

determined until shortly before the show. Ms. Dursky and Ms.

Watkins often waited until the number of cats competing in a cat

show was determined before deciding whether to attend the show.

Because they waited until shortly before a cat show was scheduled

to take place to decide whether to attend it, Ms. Dursky and Ms.

Watkins paid a premium for any air transportation costs incurred

to attend the show.

- 16 -

years As there a written - rerital agreement between Ms . Dursky and

DKD with respect to Ms . Dursky' s residence .

Nonetheless , during

each of the years at issue, DKD paid Ms. Dursky $1, 000 monthly,

or $12, 000 annually (DKD' s purported rent) , for its claimed

partial use of Ms. Dursky's

esidence for DKD's cattery activity.

In arriying at that amount, neither Ms. Dursky nor DKD obtained

an appraisal to determine the fair rental value of (1) Ms.

Dursky'

residence or (2) the portion of that residence used in a

cattery activity during each of the- years at issue.

Instead, Ms.

Dursky, DKD, and Howard Musin (Mr. Musin) , the tax return

preparer of Ms . Dursky and DKD for at least each of the years

2003 an

2004,14 agreed that DKD should pay each month to Ms.

Dursky

1,000 for the use of¿Ms. Dursky's residence for a cattery

activity.

Ms. Dursky, DKD, a,nd Mr. Musin also agreed that DKD

should pay to Ms; Dursky 10 percent of certain expenses (e.g.,

utilities, repairs) relating sto Ms. Dursky's residence as

allocable to a cattery activity.15

4Mr . Mus in' s colleague , Jill Schwart z (Ms . Schwart z) , the

tax ret rn preparer of DKD fcr the year 2001, also advised Ms.

Dursky .nd DKD regarding the amount that DKD should pay Ms .

Dursky for the use of Ms. Dursky's residence for a cattery

activit .

isMs . Schwart z also advi ed Ms . Dursky and DKD regarding

DKD' s p ying Ms . Dursky 10 percent of certain expenses (e . g . ,

utiliti s, repairs) relating to Ms . Dursky' s residence as

allocable to a cattery activity.

The record does not establish whether DKD paid to Ms. Dursky

(continued. . . )

- 17 --

As was true while they were operating the cattery activity

of Ms. Dursky and Ms. Watkins before the years at issue, while

Ms . Dursky and Ms . Watkins were operating DKD' s cattery activity

during the years åt issue they continued to incur and pay

substantial expenses .

As discussed below, at least during each

of the years at issue, DKD reimbursed Ms . Dursky and Ms . Watkins

for those expenses" and also paid directly a very small amount

of expenses relating to the operation of DKD's cattery activity.

During each of the years at issue, Ms. Watkins used certain

computer software in order to record for each of those years the

substantial amounts expended and the insubstantial amounts

received while Ms. Dursky and Ms. Watkins were operating DKD's

cattery activity during each of those years.

During 2003, DKD reimbursed Ms. Dursky and Ms. Watkins

$60, 968 for the following amounts (2003 reimbursed cattery

expenses) that they had paid:

is ( , . . continued)

10 percent of any such expenses.

"During each of the years at issue, DKD reimbursed Ms.

Dursky and Ms. Watkins for certain amounts that they had expended

as shown on certain receipts by issuing checks drawn on DKD' s

bank account over which only Ms. Dursky had signature authority.

- 18 -

Type of Expense

Mileage to cat shows

Amount

$4,277

Motels

5, 669

Meals (50 p rcent)

Entry f ees

1,151

6 , 78 6

Airfares

13, 953 -

Pet sitters

Rental cars

2,566

2,107 -

Cattery cleaning

Veterinarian bills

Postage

1,761

13,576

150

Litter and food

Grooming products

Advertising

5,993

1,212

1 , 767

Total

Du ing 20 0 3 ,

60,968

in addition to DKD' s payments to Ms . Wat]iins of

$7,700 end DKD's purported rent of $12, 000 that DKD' paid to Ms .

Dursky, DKD paid directly $588 of unidentified "taxes and

licenses" .

Du ing 2004, DKD reimbursed Ms . Dursky and Ms . Watkins

$66, 734 for the following amounts (2004 reimbursed cattery

expenses) that they had paid:

- 19 -

Type of Expense

Mileage to cat shows

Motels

Meals (50 percent)

Amount

$4,643

8,385

1,814

Entry fees

Airfares

.6,338

7, 652

Pet sitters

Rental cars

Cattery cleaning

Veterinarian bills

Postage

Litter and food

2,095

1,994

5,080

14,759

167

7, 029

Photos

817

Grooming and misc.

supplies

3,004

Advertising

Long-distance

telephone

Misc. travel

Total

1,580

1,327

66,734

During 2004, in"addition to DKD's payments to Ms. Watkins of

$7,700 and DKD's purported rent of $12,000 that DKD paid to Ms.

Dursky, DKD paid directly $588 of unidentified "taxes and

licenses" .

During 2005, DKD reimbursed Ms. Dursky and Ms. Watkins

$68,329 for the following amounts (2005 reimbursed cattery

expenses) that they had paid:

- 20 Type of Expense

Mileage to at shows

Motels

Meals (50 percent )

Entry fees

Amount

$6, 350

8 , 121

1, 659

2,848

Airfares

Rental cars

16, 885

2;618

Veterinarian bills

Postage

13, 8 60

Litter

1, 664

Cat f ood

8 , 613

Photos

Grooming and mis c .

supplies

4, 190

Advertising

Total

1 401

68 , 329

During 2005, in additiorè to DKD's payments 'to Ms. Watkins of

$7,700 ånd DKD's purported reht of $12,000 t-hat DKD paid to Ms.

Dursky, DKD paid directly $58ß of unidentified "taxes and licenses"

In addition to reimbursing Ms. Dursky and Ms. Watkins for

the amotnts described above that they paid during each of the

years a

issue, DKD reimburse

lodging and food that they ha

of Ms .

them (1) $297.84 in 2003 for

paid ir that year for the mother

atkins who had attend d a banquet honoring them «for

winning a national cat show,

(2)

$88 . 97 in 2003 for restaurant

food th t Ms . Watkins' mother had paid in that year, and (3) $412

in 5.004 for entry tickets to Walt Disney World that Ms. Dursky

and Ms.|Watkins had paid in that year.

(We shall refer to the

reimbursements described in (1) and (2) as DKD' s 2003 reimburse-

- 21 -

ments for lodging and food relating to Ms. Watkins' mother.

shall refer to the reimbursements edescribed in (3) as DKD's 2004

reimbursements for entry tickets for Ms. Dursky and Ms. Watkins

to Walt Disney World.)

During 2003, Ms. Dursky and Ms. Watkins did not sell any

cats or kittens while operating DKD's cattery activity.

During

2004,. Ms. Dursky and Ms. Watkins did not sell any cats or kittens

while operating DKD's cattery activity except for three cats

and/or kittens that they sold in December of that year for a

total of $250.

During 2005, Ms. Dursky and Ms.. Watkins did not

sell any cats or kittens while operating DKD's cattery activity

except for a total- of eight cats and/or kittens that they sold in

June, July, August, October, and November of that year for,a

total of $1,525.

In 2006, at an undisclosed time in or before August, Mr.

Musin and Ms. Schwartz informed petitioners that the Internal

Revenue Service (IRS) was investigating Mr. Musin and Ms.i

Schwartz and intended to commence an examination of petitioners'

respective tax returns for 2003 and 2004.

August 2006,

As a result; around

(1) Ms. Dursky and Ms. Watkins discontinued operat-

"During 2005, while operating DKD's cattery activity Ms.

Dursky and Ms. Watkins sold (1) a total of three cats and/or

kittens in June for a total of $200, (2) a total of two cats

and/or kittens in July for a total of $200, (3) one cat or kitten

in August for $100, (4) one kitten in October for $575, and

(5) one kitten in November for $450.

- 22

ing DKD s cat tery ac t ivity, " (2 ) "Ms . Dursky and Ms . - Watkins

continueå operating that cattery activity as thescatter

of Ms.

ursky and Ms. Watkins

activity

and (3) Ms. Dursky and i]KD re

tained James R. Monroe (Mr. MÞnroe) .

Certain Retirement "Accounts

Vanguard

In I ecember 1995,- Ms. Dursky executed a document entitled

"VANG

D PROFIT-SHARING PLAN SIMPLIFIED ADOPTION AGREEMENT

(006)"

Vanguard plan documen .), that by its terms was effective

on Januäry 1, 1995.

The Vanghard pl n document stated that Debra

K. Dursky was the employer and that the employer was a "Sole

Proprie or/Self-Employed Indi idual".

That document also stated

that .De ra K. Dursky was .the þlan administrator and. that Vanguard

Fiduciary Trust Company (Vanggard) was the plan trust~ee .

Vanguard plan document did noþ identify a beneficiary.

The

Vanguard plan document also stated:

the Employer [Debra K. Dþrsky] shall make contributions

to the Trust for each Plan Year in an amount determined

by the Employer in its sple discretion by resolution

du y adopted on or befor the last day foi filing its

Efederal income tax return, including extensions, for

"A1.though Ms. Dursky arid6Ms. Watkins did not discontinue

operati g DKD's cattery activity until around August :i006, as

discuss d below, DKD did not claim any deductidns relating to

DKD' s c ttery activity in the tax return that it filed for its

taxable year 2006.

"Mr. Monroe prepared petitioners'" respective tax returns

for 200$ and is the lead atto ney representing petitioners in

these cÊses.

- 23 -

the taxable year with or within which such Plan Year

ends.

Pursuant to the Vanguard plan document, on certain dates in

2003 and 2006 Ms. Dursky sent the following checks to Vanguard

that she intended to be contributions under that plan document.

On December 30, 2003, Ms. Dursky sent a $10,000 check to Vanguard

for her benefit that was drawn on DKD's bank account maintained

at Bankers Trust (DKD's bank account).

In the so-called memo

portion of that check, Ms. Dursky wrote, inter alia, "2003

Keogh".

On April 10, 2006, Ms. Dursky sent a $10,000 check to

Vanguard for her benefit that was drawn on DKD's bank account.

During none of the years 2003 through 2005 did Ms. Dursky

make any contributions under the Vanguard plan document for the

benefit of Ms. Watkins.

Fidelity

On December 28, 2001, Ms. Dursky executed on behalf of DKD a

document that was entitled "Profit Sharing Plan Application"

(Fidelity application document) in order to open an account for a

profit-sharing plan at Fidelity (DKD Fidelity profit-sharing

plan).

Ms. Dursky completed and signed that document on behalf

of DKD.

The Fidelity application document indicated that the

employer was DKD Enterprises, Inc.

Nonetheless, Ms. Dursky

checked the box in that document marked "Self-Employed" and did

not check the box marked "Incorporated".

In response to the

question in the Fidelity application document "Do you currently

- 24 have or have you ever maintained another qualified plan?" , Ms .

Dursky

tated:

"Vanguard - 15% Fidelity - 85%" .

On December 28, 2001, Ms. Dursky also executed on behalf of

DKD a d cument that was entitled "Profit Sharing Plan

Contrib tion Form"

(Fidelity contribution document) .

The

Fidelit r contribution document indicated that the only

participant under the DKD Fidelity profit-sharing plan was Ms.

Dursky.

On certain dates in 2004, 2005, and 2006 DKD sent the

following checks to Fidelity that were intended to be

contribùtions under the DKD Fidelity profit-sharing plan.

April 14, 2004, DKD sent a $10, 000 check to Fidelity for the

benefit of Ms. Dursky that was drawn on DKD's bank account.

the so-called memo portion of that check, Ms. Dursky wrote, inter

alia,

"Fidelity Profit Sharing Keogh * * * for 2003" .

December 27, 2004, DKD sent a $10,000 check to Fidelity for the

benefit of Ms. Dursky that was drawn on DKD's bank account.

the so-called memo portion of that check, Ms. Dursky wrote, inter

alia,

"Keogh * * * for 2004" .

On April 11, 2005, DKD sent a

$10,000 check to Fidelity for the benefit of Ms. Dursky that was

drawn on DKD' s bank account .

In the so-called memo portion of

that check, Ms. Dursky wrote, inter alia,

"2004 Keogh".

On April

10, 2006, DKD sent a $5, 000 check to Fidelity for the benefit of

Ms . Duráky that was drawn on DKD' s bank account .

In the so-

- 25 called memo portion of that check, Ms. Dursky wrote, inter alia,

"2005".

During none of the years 2003 through 2005-did DKD send any

checks to "Fidelity that were intended to be contributions under

the DKD Fidelity profit-sharing plan for the benefit of Ms.

Watkins.

Ms. Dursky's Health Insurance Policy

At a time not disclosed by the record, Ñs. Dursky purchased

a health insurance policy in her name (Ms. Dursky's health

insurance policy) that was in effect at least during each of the

years 2003 and 2004 and that required her- to pay certain

quarterly premiums to the company'(health insurance provider)

that issued that policy to her.

During 2003 and 2004, DKD paid

to Ms. Dursky's health insurance provider the following premiums

on the dates indicated for Ms. Dursky's health insurance policy:

2003

Date

Amount

Mar. 30

July 14

Sept. 14

Dec. 30

Total

$1,687.50

1,687.50

1,887.60

6,950.10

Apr. 5

June 16

Oct. 4

Dec. 27

Total

$1,887.60

1,887.60

1,988.70

7,651.50

2004

DKD ' s Tax Re turns

2001

DKD filed Form 1120, U.S. Corporation Income. Tax Return

(Form.1i20), for 2001 (DKD's 2001 return) that Ms. Schwartz

signed is return preparer and that Ms. Dursky signed as the sole

officer of DKD.

In Schedule K, Other Information (Schedule K) ,

of DKD'ä 2001 return, DKD indicated that it was on the cash

method Öf accounting.

In DKD' s 2001 return, DKD reported (1)

sales" of $2,770,20 (2)

(3)

"returns and allowances" of zero,

"Cost of goods sold" of zero,

$226, 923, " and (5)

"Gross receipts or

(4)

"Other income" of

"Total income" of $229, 693 .

In DKD' s 2001 return, DKD claimed, inter alia, the following

deducti ns:

(1)

"Compensation of officers" of $80,400,

(2)

"Salaries and wages" of zero,

(4)

"Taxes and licenses" of $6, 307," (5)

sharing

(3)

"Rents" of $19,150,

etc., plans" of $30,000, and (6)

program " of $8,852.

"Pension, profit"Employee benefit

In that return, DKD also claimed "Other

2oT1 e record does not establish the nature of the "Gross

receipt( or sales" that DKD reported in DKD' s 2001 return.

"DI ) included a schedulel with DKD' s 2001 return in which

DKD indicated that the "Other' income" of $226, 923 reported

consist d of (1) consulting revenue of $223, 796 and (2) an Iowa

State tax refund of $3,127.

"DKD included a statement with DKD' s 2001 return in which

it desc ibed the "Taxes and licenses" claimed as "payroll taxes".

- 27 -

deductions" of $55,210.

DKD included a schedule with DKD's 2001

return in which it indicated that the "Other deductions" claimed

consisted of the "following types and amounts of-deductions:

Claimed Deduction

Cattery expensesi

Show fees

Promotional labor

Accounting

Postage

Insurance

Insurance - workman's

compensation

Licenses and permits

Meals

Supplies

Telephóne

Amount

$19,391

4,076

1,850

1,100

541

1,966

Travel

12,680

213

1,772

9,034

,183

Utilities

354

Total

55,210

DKD's claimed deductions for "Cattery expenses", "Show

fees", and "Travel" were for amounts that Ms. Dursky and Ms.

Watkins paid during 2001 in operating the cattery activity of Ms.

Dursky and Ms.' Watkins.

DKD attached to DKD's 2001 return Schedule L, Balance Sheets

per Books (Schedule L), for 2001 (2001 Schedule L).

schedule, DKD showed the following assets:

In that

"Cash", "Trade notes

and accounts receivable", and "Buildings and other depreciable

assets".

DKD did not show any other assets in the 2001 Schedule

L, such as cats, kittens, cat trees, feeding bowls, litter boxes,

or other assets relating to a cattery activity.

- 28 20 2

filed Form 1120 for 2002 (DKD' s 2002 return)

that Mr

Musin s gned as return prepa er and t-hat Ms. Dursky signed as the

sole of icer of DKD.

In Schedule K of DKD' s 2002 return, DKD

indicat d that it was on the cash method of accounting.

In DKD' s 2002 return, D D reported (1)

sales" of

of good

(5)

800,

(2)

"Gross receipts or

"returns and allowances" of zero,

sold" of zero,

(4 )

(3)

"Cost

' Other income" of $198 , 608 , 24 and

"To al income" of $199, 408 .

In DKD' s 2002 return, DIe claimed, inter alia

deducti ns

(1)

"Compensation of officers" of $80, 400,

(2)

"Sa aries and wages" of $7,350,

(4)

"Ta es and licenses" of $7,354,2s (5)

sharing

the following

(3)

"Rents" Of $19,800,

etc., plans" of $10,000, and (6)

program " of $6, 931.

"Pension, profit"Employee,benefit

In that return, DKD also claimed "Other

deductions" of $58,424.

DKD included a schedule with DKD's 2002

return in which it ,indicated that the "Other deductions" claimed

consist d of the following t

es and amounts of deductions:

T e rècord does not est ablish the nature of the "Gross

receipts or sales" that DKD repórted in DKD' s 2002 return.

4DKD included a schedule with DKD's 2002 eturn in which

DKD ind cated that the "Other income" of $198, 608 reported

consist d of (1) consulting devenue of $197, 466 and (2) an Iowa

State t x refund of $1,142.

2sDRD included a statemer t with DKD' s 2002 return in which

it described the "Taxes and licenses" claimed as "payroll taxes"

- 29 -

Claimed Deduction

Cattery expensesi

Show feest

Labor

Amount

$26,784

4,485

1,245

Accounting

Automobile

Postage

Licenses and permits

550

5,170

261

Office

Supplies

557

1,550

Telephone

Travel and entertainmenti

Utilities

2,805

14,571,

401

Total

58,424

DKD's claimed deductions for "Cattery expenses", "Show

fees", and "Travel and entertainment" were for amounts that Ms.

Dursky and Ms. Watkins paid during 2002 in operating the cattery

activity of Ms. Dursky and Ms. Watkins.

DKD attached to DKD's 2002 return Schedule L for 2002.

that schedule, DKD. did not show any assets.

2003

DKD filed late Form 1120 for 2003- (DED's 2003 return), the

first year at issue in these cases, that Mr. Musin signed as

return preparer and that Ms. Dursky signed as the sole officer of

DKD.

In Schedule K of DKD's 2003 return, DKD indicated that it

was on a "MODIFIED ACCRUAL" method of accounting but did not

indicate what that meant.

In DKD's 2003 return, DKD reported (1)

sales" of $197,582.

activity.

"Gross receipts or

None of that amount was from DKD's cattery

In DKD's 2003 return, DKD also reported (1)

and allowances" of zero,

(2)

"returns

"Cost of goods sold" of zero,

- 30 (3)

"Other income" consisting of an "IOWA TAX REFUND" of $675,

and (4)

"Total income" of $198,257.

In DKD's 2003 return, DKD claimed, inter alia, the following

deductions:

(1)' "Compensation of officers" of $80,400,

(2)

"Salaries and wages" of $7,700,

(4)

"Takes and licenses" of $6,861," (5) "Pension, profit-

sharing

(3)

"Rents" of $19,400,

etc., plans" of $20,000, and (6)

programa" of $10,274.

deductions" of $75, OOO.

"Employee benefit

In that return, DKD also cl-aimed "Other

DKD included a schedule with DKD's 2003

return in which it indicated that the "Other deductions" claimed

consisted of the following types and amounts sof deductions:

Claimed Deduction

Amount

Cattery expensesi

$69, 515

Accounting

2, 025

Dues and subscriptions

286

Insurance

1, 687

Insurance - workman' s

compensation

363

Office

Travel and entertainment

1, 098

75,000

Total

DKD' s claimed deduction for "Cattery expenses" of $69, 515

included the 2003 reimbursed cattery expenses of $60,968. A

portion of the claimed deduction for, "Cattery expenses" (i.e.,

$386.81) was for DKD's 2003 reimbursements for lodging and food

relatinŠ to Ms. Watkins' mother.

DKI attached to DKD's 2003 return Schedule L for 2003 (2003

Schedul

L) . . In that schedule, DKD showed the following assets:

"DKD included a statement with DKD's 2003 return in which

it desc ibed the "Taxes and licenses" claimed as "payroll taxes"

- 31 "Cash",

"Trade notes and accounts receivable", and "Buildings and

other depreciable assets" .

DKD did not show any other: assets in

the 2003 Schedule L, such-as cats, kittens, cat trees, feeding

bowls, litter boxes, or other assets relating to~a cattery

activity.

2004

DKD filed late Form 1120 for 2004 (DKD' s 2004 return) .27

Schedule K of DKD's 2004 return, DKD indicated that it was on a

"MODIFIED ACCRUAL" method of accounting but did not indicate what

that meant .

In DKD's 2004 return, DKD reported (l)

sales" of $233,556,23 (2)

(3)

"Gross receipts or

"returns and allowances" of zero,

"Cost of goods sold" of zero,

of an "IOWA TAX REFUND" of $1, 000,

(4)

"Other ,income" consisting

and (5)

"Total income" of

$234,556.

In DKD's 2004 return, DKD claimed, inter alia, the following

deductions:

(2)

(1)

"Compensation of officers" of $80,400,

"Salaries and wages" of $7, 700, ' (3)

"Rents" of $24, 700,

27The copy of DKD' s 2004 return that is in the record is not

signed by a return preparer or by an officer of DKD.

2eThe record does not establish whether the $250 that we

have found DKD received in 2004 for the sale of certain cats

and/or kittens in December of that year was included in the

"Gross receipts or sales" of $233,556 that'DKD reported in DKD's

2004 return.

- 32 (4)

"Ta es, and licenses" of $6,861," (5)

sharing

etc., plans" of zero, and (6)

programa" of $5,763.

"Pension, profit-

"Employee benefit

In that return, DKD also claimed "Other

deductions" of $105,414.

DKD included a schedule with DKD's 2004

return in which it indicated athat the "Other deductions" claimed

consist d of the following types and amounts of deductions:

Claimed Dedúction

Cattery expensesi

Accounting

Bank charges

Convent ions and meet ings

Disability insu ance

Dues and subscriptions

Amount

$75, O91

1, 750

143

1, 50 0

1,145

20,000

Insurance

Office

Meals

3,373

189

1, 367

Telephone

697

Travel

Total

159

105, 414

DK 's claimed deduction for "Cattery expenses" of $75;091 e

included the 2004 reimbursed cattery expenses of $66,734. A portion|of the claimed deduction for "Cattery expenses" (i.e.,

$412) was for DKD's 2004 reimbursements for entry tickets for Ms.

Dursky Ånd Ms. Watkins to Walt Disney World.

DKID attached to DKD's 2004 return Schedule L for 2004 (2004.

Scheduld L) .

In that schedule, DKD showed the following assets:

"Cash",

"Trade notes and accounts receivable", and "Buildings and

other depreciable assets" .

the 200

DED did not show any other assets in

Schedule L, such as bats, kittens, cat trees, feeding

29DKD included a statement with DKD' s 2004 return ein which

it desc ibed the "Taxes and licenses" claimed as "payroll taxes"s

- 33- -

bowls, litter boxes, or other assets relating to a cattery

activity.

2005

DKD filed Form.1120 for 2005- (DKD's 2005 return)

that Mr.

Monroe," whom, as discussed above, DKD retained around-August

2006, signed as return preparer and that Ms. Dursky signed as the

sole officer of DKD.

In Schedule K of DKD's 2005 return, DKD

indicated that it was on a "MOD ACC" method of accounting but did

not indicate what that meant.

In DKD's return, DKD reported (1)

of $212,970," (2)

"Gross receipts or sales"

"returns & allowances" of zero,

goods sold" of zero,

(4)

(3)

"Cost of

"Other income" consisting of "State tax

refunds" of $1,000, and (5)

"Total income" of $213,970.

In DKD's 2005 return, DKD claimed, inter alia, the following

deductions:

(1)

"Compensation of officers" of $80,400,

(2)

"Salaries and wages" of $7,700,

(3)

"Rents" of $22,800,

(4)

"Taxes and licenses" of $6,740," (5)

"Pension, profit-

sharing, etc., plans" of zero,

(6)

"Employee benefit programs" of

"See supra note 19.

"The record does not establish whether the $1,525 that we

have found DKD received in 2005 for.the sale of certain cats

and/or kittens, see supra note 17, was included in the "Gross

receipts or sales" of $212,970 reported in DKD's 2005 return.

"Unlike'DKD's -2001 return, 2002 return, 2003 return, and

2004 return, DKD did not include a statement with DKD's 2005

return or otherwise provide a description of the nature of the

"Taxes and licenses" of $6,740 claimed in DKD's 2005 return.

- 34 zero, apd (7)

"Advertising" c f $1, 240 . P.

In that return, DKD

also claimed "Other deductior s" of $62, 942.

DKD included a

schedule with DKD's 2005 return, in which it indicated that the

"Other ieductions" claimed cánsisted of the following types and

amounts of deductions:44

"W have found that during 2005 DKD reimbursed Ms. Dursky

and Ms. Watkins $1,401 for adrertising.

34Múst of the "Other deductions" were for the 2005

reimbur ed, cattery expenses c f $68 , 329 . However, DKD did -not

claim a deduction for the $8,9121 for, which we have found DKD

reimbur ed Ms. Dursky and Ms.d Watkins -in 2005 for motels

s 35 -

Claimed Deductioni ' '

Automobiles

Bank charges

Legal and professional

Meals and entertainment

Miscellaneous

Office

Postage

Telephone

Amount

$6,350

1,175

21,878

35,188

441

710

Travel

515,730

Utilities

Annual report

377

Entry fees

'5,363

Rental car

Veterinarian

71,214

"13,986

Litter

Cat food

Photos

91,923

1°8,014

"53

Stud 'service

Total

800

62, 942

The deductions for automobiles, meals, miscellaneous, postage, travel, entry fees, rental cars, veterinarian, litter, cat

food, photos, and stud service related to DKD's cattery activity.

We shall refer to those deductions as "cattery expenses" .

2We have found that during 2005 DKD reimbursed Ms. Dursky

and Ms. Watkins $1,659 for meals.

3We have found that during 2005 DKD reimbursed Ms. Dursky

and Ms. Watkins $4,190 for grooming and miscellaneous supplies.

4We have found that during 2005 DKD reimbursed Ms. Dursky

and Ms. Watkins $42 for postage.

sWe have found that during 2005 DKD reimbursed Ms. Dursky

and Ms . Watkins $16 , 885 for airf ares .

'We have found that during 2005" DKD reimbursed Ms. Dursky

and Ms. Watkins $2,848 for entry fees.

?We have found that during 2005 DKD reimbursed Ms. Dursky

and Ms. Watkins $2,618 for rental cars.

"We have found that during 2005 DKD reimbursed Ms. Dursky

and Ms . Watkins $13 , 8 60 f or veterinarian bills .

We have found that during 2005 DKD reimbursed Ms. Dursky

and Ms. Watkins $1,664 for litter.

°We have found that during 2005 DKD reimbursed Ms. Dursky

and Ms. Watkins $8,613 for cat food.

"We have found that during 2005 DKD reimbursed Ms. Dursky

and Ms . Watkins $78 for photos .

- 36 -DKD attached to DKD's 2 05 return Schedule L for 2005.

that schedule, DKD did not si ow any assets.

20 6

DKD filed Form 1120 for 2006, the year during which DKD

discontinued DKD's cattery activity, that Mr. Monroe signed as

return preparer and that Ms. Dursky signed as the sole officer of

DKD.

In Schedule K of DKD's Form 1120 for 2006

return)

(DKD's 2006

DKD indicated that it was on a "MOD ACC" method of

account ng but did not indicate what that meant.

In DKD's 2006 return, DKD reported (1)

sales"

(3)

f $177, 519, 35 (2)

"Gross receipts or

"returns & allowances" of zero,

"Co t of goods sold" of zero, and (4)

"Total income" of

$177 , 519 .

In DKD''s 2006 return, DKD álaimed, inter alia, tlie followi c

deducti pns:

(2)

(1)

"Com'pensatioh of officers" of $80,400,

"Sa aries and wages" of zþro,

and lic nses" of $6,740," (5)

plans" of $15, 000, and (6)

(3), "Rents" of zero

(4)

"Taxes

"P~ension, profit-sharing, etc.

"E ployee benefit programs" of

$13, 458 .

In that return, DKD also claimed "Other deductions" of

$1,'7/59

DKD included a sched le with DKD's 2006 return in-whi 1

asThe record doesi not establish the nature . of the "Gross

receiptŠ or sales" reported iN DKD' s 2006 return.

"U like DKD' s 2001 retu n, 2002 return, 2003 return, and

2004 re urn, DKD did not incl de a statement with DKD's 2006

return < r otherwise provide a description of the nature of the

"Taxes nd licenses" of $6,74 claimed in DKD's 2006 return.

- 37 -

it indicated that the "Other deductions" claimed consisted of the

following types and amounts of deductions:

Claimed Deduction

Dues and subscriptions

Legal and professional

Miscellaneous

Annual report

Amount

$35

1,550

124

Total

1,759

DKD did not claim any deductions in DKD's 2006 return with

respect to DKD's cattery activity.37

DKD attached to DKD's 2006 return Schedule L for 2006.

that schedule, DKD did not show any assets.

Summary of DKD's Returns for 2001 Through 2006

The following chart summarizes DKD' s tax return treatment of

all income and certain deductions claimed for each of the years

2001 through 2006:

37We have found that Ms . Dursky and Ms . Watkins operated

DKD's cattery activity until around August 2006.

- 38 Income

2001

2002

2003

2004

2005

2006

$2,770

$800

$197,582

$233,556

$212,970

$177¿519

226,923

198, 608

675

1,O00

1,000

"Cattery expenses"

55, 210

58, 424

69, 515

75, O91

60 , 540

"Salaries and wages"

7,350

7,700

588

12,000

80,400

30, 000

10, 000

20, 000

15, 000

programs"

8 , 852

6 , 931

10 , 274

5 , 763

13 , 458

Income (loss)

42,643

23,715

(2,220)

53,014

52,742

68,661

sales"

"Other income"

Deductions Claimed

Deductions claimed

relating to DKD' s

cattery activity

"Taxes and licenses"

"Rent"

"a5iiipeiisation of

officers"

"Pension, profitsharing, etc . , plans"

"Employee benefit

~ 39 -

Ms. Dursky's Returns

2003

Ms. Dursky filed Form 1040, U.S. Individual Income Tax

Return (Form 1040), for 2003

(Ms. Dursky's 2003 return) that Mr.

Musin signed as return preparer and that she- signed.

In that

return, Ms. Dursky reported "Wages, salaries, tips, etc." of

$80,400 that she received during 2003 from DKD as compensation

for the IT consulting work that she performed for DKD during that

year.

In Schedule A--Itemized Deductions (Schedule A) attached to

Ms. Dursky's 2003 return, Ms. Dursky deducted "Real estate taxes"

of $3,458 and "Home mortgage interest and points" of- $5,204.

Ms. Dursky included with Ms. Dursky's 2003 return Schedule E

for 2003

(2003 Schedule E) .

In the 2003 Schedule E, Ms. Dursky

described the "rental real estate property" to which that schedule.pertained as "OFFICE SPACE WEST DES MOINE

[sic)

IA".

In that

schedule, Ms . Dursky responded in the negative to the following

question:

For each rental real estate property listed on line 1,

did you or your family use it during the tax year for

personal purposes for more than the greater of:

• 14 days or

• 10% of the total days rented at fair rental value?

- 40 --

In the 2003 Schedule E, Ms. Dursky reported "Rents received"

of $19, i0 0 " and claimed deduc tions for "Mortgage interest paid

to bank , etc." of $1,555'and for "Taxes" tof $610.

20 4

Dursky filed Form 1040 for-2004 (Ms. Dursky's 2004

return) that Mr . Musin signed as return preparer and that ,she

signed. «In ethat return, Ms. Dursky reported, "Wages, salaries

tips, ete." of $80,400 that she, received during 2004 from DKD as

compensation for the IT consulting work that she performed for

DKD during that year.

In Schedule A attached to Ms. Dursky's 2004 return, Ms.

Dursky ~ educted "Real estate taxes" of ,$3, 098 and "Home mortgage

interest and points" of $4, 302.

Ms'

Dursky included with Ms . Dursky' s 2004 return Schedule E

for 2004 (2004 Schedule E) .

In the 2004 Schedule E, Ms. Dursky 4

described the "rental real estate property" to which that sched

ule per ained as "OFFICE SPACE WEST DES MOINE

[sic]

IA" .

In that

schedule, Ms . Dursky responded in the negative to the following

questioia:

each rental real estate property listed on l ne 1

you or your family use it during the tax year for

personal purposes for more than the greater of :

"AÑ discussed above, in DKD' s 2003 return, DKD claimed a

deduction for "Rents" of $19, 00.

- 41 • 14 days or

• 10%- of the total days rented at fair rental value?

In the 2004 Schedule E, Ms. Dursky reported "Rents -received"

of $24, 700" and claimed deductions for "Mortgage interest paid

to banks, etc." of $1;555 and for "Taxes" of $610.

2005.

Ms. Dursky filed Form 1040 for 2005

(Ms. Dursky's 2005

return) that Mr. Monroe, whom, as discussed above, DKD retained

around August 2006, signed as return preparer and that she

signed.

In that return, Ms. Dursky reported "Wages, salaries,

tips, etc." of $80,400 that she received during 2005 from DKD as

compensation for the IT consulting work that she performed for

DKD during that year.

In Schedule A attached to Ms. Dursky's 2006 return, Ms.

Dursky deducted "Real estate taxes" of $2,287 and "Home mtg

interest and points" of $4,084.

Ms. Dursky included with Ms. Dursky's 2005 return Schedule .E

for 2005

(2005 Schedule E) .

In the 2005 Schedule E, Ms. Dursky

described the "rental real estate property" to which that schedule pertained as "OFFICE SPACE WEST DES MOINES, IA" .

In that

schedule, Ms. Dursky responded in the negative to the following

question:

"As discussed above, DKD claimed a deduction in DKD' s 2004

return for "Rents" of $24,700.

42 -

For each rental real est ate property listed on l'ine 1

di you or your family tise it during the tax year for

personal purposes for móre than the greater of :

• L4 days, or

•

0% of the total days rented at fair rental value?

the 2005 Schedule E, Ms. Dursky "reported "Rents received"

of $12,0004° and claimed deduåtions for "Mortgage interest paid

to banks, etc . " of $2, 398 an

for "Taxes" of $1, 343 .

Notices of Deficiency

DKD

On September 26, 2007,

espondent issued to,DKD a notice of

deficiency (notice) for its taxable year 2003 (DKD's 2003 notice) . - On.March.12, 2008, r(spondent issued to DKD a notice for

its tax ble years 2004 and 2005 (DKD's 2004.and 2005 notice)

IN DKD' s 2003 notice, respondent determined, inter alia,

that DKD is not, entitled toothe following deductions claimed for

2003:

"Other expenses" of $69,515,

(2)

"Salaries & wages" of

$7,700,

(3)

"Taxes and licenses" of $588,

and (5)

"Employee benèfit programs" of $10,274.

(4)

"Rents" of $19,400

In-that notice,

respond nt also determined that DKD is not entitled to a .$20, 000

deductio

claimed for 2003 for "Pension, profit sharing, plahš"

because

Th corporation paid the shareholder' s expenses for the

operation of the cat breeding business. The disallowed

°A discussed above, DKD claimed a deduction in DKD

return or "Rents" of $22,80d.

2005

- 43 -

business expenses are not ordinary and necessary for

the operation of the corporation's business. The

business that the shareholder operated was determined

to be a hobby and not operated for profit. The corporation's income increased, by the above amount

[$20,000] for the tax year ending December 31, 2003

[sic].

In DKD's 2004 and 2005 notice, respondent determined, inter

alia, that DKD is not entitled to the following deductions

claimed for 2004:

(1) Cattery expenses of $75, 091,

& Wages" of $7, 700,

(3)

(4)

"Salaries

"Taxes & Licenses" of $588, and

"Rents" of $24,700, and (5)

$1,145.

(2)

"Employee Benefit Programs" of

In that notice, respondent also determined, inter alia,

that DKD is not entitled to the following deductions claimed for

2005:

(1)

"Meals & Entertainment" of $1,878,

Expense" of $710,

(3)

Expense" of $6,350,

(6)

(10)

(8)

(5)

(9)

"Veterinarian Bills" of $13,986,

(7)

"Rental Cars" of $1,214,

(11)

"Litter Expense" of

(12)

"Cat Food Expense" of $8,014,

of $53,

(14)

"Stud Service Expense" of $800,

(17)

"Auto & Truck

"Utility Expenses" of

$1,923,

(16)

(4)

"Travel Expenses" of $15,730,

"Entry Fees" of $5,363,

Wages" of $7,700,

"Telephone

"Advertising" of $1,240,

"Miscellaneous Expenses" of $5,188,

$377,

(2)

(13)

"Photo Expenses"

(15) "Salaries &

"Taxes & Licenses" of $588, and

"Rents" of $22,800.

In addition, respondent determined in

DKD' s 2004 and 2005 notice that DKD was a qualified personal

service corporation, as defined in section 448(d) (2), for each of

the years 2004 and 2005.

In that notice, respondent also deter-

: - 44 -

mined that DKD is not entitled to the $20, 000 deduction claimed

for 200

for "Pension & Profit Sharing"" because

It is determined that-pension and profit sharing expense is $0.00, rather than $20,000.00 for the taxable

yegr ended December 31, 2004 because it has not been

es ablished that more than $0.00 was for an ordinary

and necessary business expense, and expended for the

pu pose designated. Accordingly, taxable income is

in reased $20, 000 .00 for the taxable year ended December 31, 2004.

In DKD's 2004 and 2005 niotice, respondent also determined

that DKD is liable for its taxable years 2004 and 2005 for

accuracy-related penalties under section 6662 (a) in the respective amounts of $9,548 and $8,475.

Dursky

On September 26, 2007, March 12, 2008, and March 12, 2008,

respectively, respondent issued to Ms. Dursky separate notices

for her taxable year 2003

year 2004

(Ms. Dursky's 2003 notice), her taxable

(.Ms. Dursky's 2004 notice), and her taxable year 2005

(Ms . Dursky' s 200 5 notice) .

In Ms. Dursky's 2003 notice, respondent determined that Ms

Dursky is required to include in gross income as constructive

dividends the following deductions that DKD claimed in DKD' s

003

"As discussed above, DKD did not claim in DKD' s 2004 return

a deducEion of $20,000 for "Pension, profit-sharing, etc.,

plans". DKD claimed in DKD's 2004 return a $20,000 deduction for

"Dues ar d subscriptions" . The record does not explain how

respondent determined that the $20, 000 that DKD claimed as a

deducti ri for "Dues and subscriptions" in DKD' s 2004 return was a

$20,000 deduction for "Pension & Profit Sharing".

- 45 return and that respondent disallowed in DKD's 2003 notice!

(1)

"Cattery expenses" of $69,515,

$7,700,

(3)

(2)

"Salaries and wages" of

"Taxes and licenses" of $588,

(4)

"Rents" of $19,400,

(5)

"Pension, profit-sharing, etc.,. plans".of $20,000, and

(6)

"Employee benefit programs" of $9,695.

In Ms. Dursky's 2003

notice, respondent also- determined to (1) exclude from Ms.

Dursky's 2003 Schedule E the rental income of $19,400 that she

reported and (2) disallow the deductions of (a)

penses" of $1,555,

(c)

(b)

"Mortgage Ex-

"Other Expenses" of $2,870, and

"Depreciation Expense" of $641 that she claimed in the 2003

Schedule E with respect to Ms. Dursky's residence.

In Ms. Dursky's 2004 notice, respondent determined that Ms.

Dursky is required to include in gross income as constructive

dividends the following deductions that DKD claimed in DKD's 2004

return and that respondent disallowed in DKD's-2004 and 2005

notice:

'(1)

"Cattery expenses" of $75,091,

wages" of $7,700,

of $24,700,

(5)

(3)

(2)

"Taxes and licenses" of $588,

"Pension" of'$20,000," and (6)

programs" of $1,145.

"Salaries and

(4)

"Rents"

"Employee benefit

In Ms. Dursky's 2004 notice, respondent

also determined to (1) èxclude from Ms. Dursky's 2004 Schedule E

the rental income of $24,700 that she reported and (2) disallow

the deductions for (a)

of $610,

(c)

"Mortgage Interest" of $1,555,

"Other Expenses" of $730, and (d)

"See supra note 41.

(b)

"Taxes"

"Depreciation" of

$641 th t .she claimed in the 2004 Schedule E;with respect to Ms

Dursky'

residence .

Int that notice, respondent aalso,determined

that Ms

Dursky -is liable for her taxable year 2004 for an

accuracy-related spenalty under sections 6662 (a) of $3, 280 . 60

In Ms

Durský

Dursky's 2005 notice, respondent determined that Ms.

s required to include in gross income as constructive

dividends the following deductions that DKD claimed in DKD's 2005

return and that respondent disallowed in DKD's 2004 and 2005

notice:

(1)

"Meals and entertainment" -of $1,878

$710

(3)

"Advertising" of $1, 240

$6,350,

(5)

"Travel" of $15,730,

(7)

Uti]ities" of $37.7; -(8)

(6)

"Automobiles" of

"Miscellaneous" of $5,188,

"Cat food" of.$8,014, *(9)

fees", of $5,-363,

(10)

of $13 , 986,

"Litter" of $1, 923,

(12)

(4)

"Rental car" of $1;214,

(15)

(2) ,"Telephone"

(13)

(11)

"Entry

"Veterinarian"

"Stud Service" Sof $800

(14)

"P otos" sof $53,

"Salaries and wages" of $7/700,

(16)

"Taxes and licenses" of $588; and (17)

In Ms. IDursky' s 2005 notice,

"Rents" of -$22, 800 .

espondent also determined to

(1) exclude from Ms. Dursky's 2005 Schedule E the rental income

(a)

d (2) disallow the deductions for

"Mo tgage Interest" of,$2 398,

(b)

"Taxes" of $1,343, and

E with iresþect to Ms. Dursky's residence.respond

In thatsnotice,

t also determined tb t Ms. Dursky is liable for her

- 47 taxable year 2005 for an accuracy-related penalty under section

6662 (a) of $2, 520 . 80 .

OPINION

DKD and Ms . Dursky bear the burden of proof with respect to

the determinations which remain at issue in the respective

notices that respondent - issuedato them.-

See Rule 142 (a) ; Welch

v. Helvering, 290 U;S. 111, 115 (1933) .

Moreover, deductions are

strictly a matter of legislative grace, .and DKD and Ms. Dursky

bear the burden of proving entitlement to any respective deductions that:they claim.

U.S. 79, 84

(1992) .

See INDOPCO, Inc. v. Commissioner, 503

Respondent bears the burden of proof with

respect to any new matter.

sioner, 77 T.C. 881,

890

See Rule 142(a); Achiro v. Commis--

(1981) .

Before turning to the issues presented, we shall comment on

the respective testimonies of Ms. Dursky and Ms. Watkins, who

were the only witnesses at the "trial in these cases.

We found

those testimonies to be in certain material respects questionable, implausible, unpersuasive, uncorroborated, vague, and/or

conclusory.

We also found (1) the testimony of Ms. Dursky to be

in certain material respects self -serving and (2) the testimony

of Ms . Watkins to be in certain material respects serving the

interests of Ms . Dursky, her personal partner,

corporation that Ms. Dursky wholly owned.

and DKD, the

We shall not rely on

the respective testimonies of Ms. Dursky and Ms. Watkins to

48 -

establi h the respective positions of DKD and Ms. Dursky with

respect to the issues to which those testimonies pertained.

e.g., T karski v. Commissioner,

87 T.C.

74,

See,

(1986).

Cattery Activity

DKD--Claimed Deductions

It is the position of DKD that for the years at issue it is

entitled to deduct under section 162(a) the following amounts

relating to DKD's cattery activity:

(1) Respective reimbursed

cattery expenses of $59,817, $64,920, $66,628;

salary of $7,700 paid- to Ms. Watkins;

(2) purported

(3) certain unidentified

"taxes and licenses" of $588; and (4) purported rent of $4,333

paid to Ms. Dursky."

Se tion 162(a) provides in pertinent part:

SE ,

162.

TRADE OR BUSINESS EXPENSES.

(a) In General.--There shall be allowed as a

deduction all the ordinary and necessary expenses paid

or incurred during the taxable year in carrying on any

trade or business * * *

In order to be entitled for each of the years at issue to

the ded ctions that it is claiming with respect to DKD's cattery

activity, DKD must show that for each of those years that cattery

activity constituted a trade or business of DKD within the

meaning of section 162(a).

In order to establish that for each

"D D conceded certain additional amounts that it claimed as

deducti ns relating to DKD's cattery activity in its respective

returns for the years at issue.

- 49 -

of the years at issue DKD's cattery activity.constituted a trade

or business of DKD within the meaning of section 162(a), DKD must

show that during each of those years it had"the intent or motive

to make a profit from that activity.

Commissioner, 28 T.C: 1100

(9th Cir. 1958).

See Am. Props., Inc. v.

(1957), affd. per curiam 262 F.2d 150

As we explained in Am. Props., Inc., supra at

1111,

The determination of whether the activities of a taxpayer constitute the carrying on of a trade or business

requires an examination of facts in each case. Hiqqins

v. Commissioner, 312 U.S. 212

[(1941)].

It has been

held thát whether an enterprise is conducted as la

business for profit is a matter of intention and good

faith, and all the facts in a particular case are to be

considered. * * *

Thus, the issues in the final analysis turn upon

the question of whether during the years in questiong

the petitioner and the corporation had the requisite

intent or motive of making a profit.

Intention is a

question of fact to be determined not only from the

direct testimony as to intent, but a consideration of

all the evidence, including the conduct of the parties.

The statement of an interested party of his intention

and purpose is not necessarily conclusive. * * *

DKD contends that for each of the years at issue DKD's

cattery activity constituted a trade or business within the

meaning of section 162(a) because it conducted that activity

during each of those years "In order to produce more income and a

profit".

On the record before us, we reject DKD's contention.

Since at least 1989 Ms. Watkins; and since at least 1994 Ms.

Dursky, each was engaged in the hobby of operating a cattery from

which each derived significant personal pleasure.

At a time not

- 50 -

disclos d.by the record before the years at issue, Ms. Dursky and

Ms. Wat ins became engaged in the hobby of jointly operating a

cattery from which they continued to derive significant personal

pleasure.

The cattery activity of Ms. Dursky and Ms. Watkins

took place in Ms. Dursky's residence, except for attending cat

shows and visiting veterinarians.

That cattery activity required

them to spend substantial time and substantial money, including

substantial time and substantial money spent by one or both of

them in participating in certain competitions, clubs, and associations and traveling extensively to attend certain CFA44 cat

shows over much of the United States.

At least five of the cats

of Ms. Dursky and Ms. Watkins won awards during certain competitions, at least two of their Norwegian Forest cats produced such

outstanding offspring that they-achieved the coveted title of CFA

Disting ished Merit, 45 and the CFA designated the cattery activity of Ms . Dursky and Ms . Watkins as a "CFA Approved Cattery of

Excellence . "

At a time not disclosed by the record before the years at

issue, Ms. Dursky and Ms. Watkins created a Web site that they

"The CFA is the largest association for owners of cats in

the UniÃed States.

4sThe title of CFA Distinguished Merit was the highest award

that th CFA presented to a breeding pedigreed cat . At the time

the CFA awarded the title of CFA Distinguished Merit to each of

the two Norwegian Forest cats of Ms. Dursky and Ms. Watkins,

fewer than ten Norwegian Forest cats throughout the world had

been awŠrded that title.

-1

- 51 maintained for their cattery activity.

At the time of the trial

in these cases, the general public was able to access that Web

site, although it had not been updated since 2002.

activity Web site stated:

The cattery

"We treat our cats as members of our

family" and "we have invested too much love in our wonderful

kittens to risk exposing them to an uncertain and risky environment."

The cattery activity Web site advertised for sale two

cats for $75 and $150, respectively, and two kittens for $200 and

$400, respectively.

During the years at-issue', DKD had a cattery activity, which

was the cattery activity in which Ms. Dursky and Ms. Watkins had

engaged before those years.

While operating DKD's cattery

activity during the years at issue, Ms. Dursky and Ms. Watkins

continued to engage in the same kinds of activities in which they

had engaged before those years while operating the cattery

activity of Ms. Dursky and Ms. Watkins."

As was true while they

were operating the cattery activity of Ms. Dursky and Ms. Watkins

before the years at issue, Ms. Dursky and Ms. Watkins each

continued to derive significant personal pleasure while operating

DKD's cattery activity during the years at issue.

"During each of the years at issue, DKD used, without

purchasing, the assets (e.g., cats, kittens, cat trees, feeding

bowls, litter boxes) that Ms. Dursky and Ms. Watkins had used

before those years in the cattery activity of Ms. Dursky and Ms.

Watkins.

Starting sometime in 2004, while Ms. Dursky and Ms.

Watkins were -operating DKD's cattery-activity they began breeding, raising, offering for sale, and showing Abyssinian cats in

addition to Norwegian Forest cats.

52 -

During the years at issue, while operating DKD' s cattery

activity-Ms. Dursky and Ms. Watkins desired to expand on the

national reputation that they had developed before those years

while operating the cattery activity of Ms. Dursky and Ms.

Watkins

In order to do so, they- relied on their respective

years of cattery activity experience and their respective reputa

tions in the so-called cattery world.

As I was true of the cattery activity of Ms . Dursky and Ms .

Watkins before the years at issue, DKD' s cattery activity was

designated by the CFA during the years at issue as a "Cattery of

Excellence" .

As was true of their beliefs while operating the cattery

activity of Ms. Dursky and Ms. Watkins before the years at issue,

while M . Dursky and Ms . Watk.ins were operating DKD' s cattery

activit

during the years at issue they believed that the price

of any

at or kitten offered for sale would increase if the cats

and kit ens that they bred won national cat shows.

While operat-

ing DKD s activity during the years at issue, Ms . Dursky and Ms .

Watkins produced a total of four cats that won national championships .

As was true while they were operating the cattery activity

of Ms. Dursky and Ms. Watkins- before the years at issue, while

Ms . Dursky and Ms . Watkins we{re operat.ing DKD' s cattery activity

during

he years at issue they continued to incur and pay sub-

- 53 stantial expenses.

During the years at issue, DKD reimbursed Ms.

Dursky and Ms. Watkins for those substantial expenses and claimed

deductions for those reimbursed expenses and for certain other

claimed expenses in its respective tax returns for those years."

While operating DKD's cattery activity during 2003, Ms.

Dursky and Ms. Watkins produced approximately seven to nine

kittens from approximately five to seven litters.

While operat-

ing DKD's activities during each of the years 2004 and 2005, Ms.

Dursky and Ms. Watkins produced approximately nine kittens-from

approximately three litters.

During 2003, Ms. Dursky and Ms. Watkins did not sell any

cats or kittens while operating DKD's cattery activity.

During

2004, Ms. Dursky and Ms.- Watkins did not sell any cats or kittens

while operating DKD's cattery activity except for three cats

and/or kittens that,they sold in December of that year ifor a

total of $250.

During 2005, Ms. Dursky and Ms. Watk.ins did not

sell any cats or kittens while operating DKD's cattery activity

except for a total of eight cats and/or kittens that they sold in

"In DKD's 2003. return, DKD claimed deductions for cattery

expenses of $69,515 and for purported salary of $7,700, "Taxes

and licenses" of $588, and purported rent of $12,000 relating to

DKD's cattery activity. In DKD's 2004 return, DKD claimed

deductions.for cattery expenses of $75,091 and for purported

salary of $7,700, "Taxes and licenses" of $588, and purported

rent of $12,000 relating to DKD's cattery activity. In DKD's

2005 return, DKD claimed deductions for cattery expenses of

$60,540 and for purported salary of $7,700, "Taxes and licenses"

of $588, and purported rent of $12,000 relating to DKD's cattery

activity. See supra note 43.

- 54 -

June, J ly, August, October, and November of that year for a

total o

$1, 525 .

In 2006, at an undisclosed stime" in or before August; Mr.

Musin and Ms . Schwartz, the tiax return preparers for DKD and/or

Ms. Dursky," informed them that the IRS was investigating Mr.

Musin and Ms. Schwartz and intended to commence an examination of

petitioners' respective tax returns for 2003 and 2004.

result, around August 2006,

As a

(1) Ms. Dursky and Ms. Watkins

discontinued operating DKD' s cattery activity, 49 (2) Ms . Dursky

and Ms . Watkins continued operating that cattery activity as the

cattery activity of Ms. Dursky and Ms. Watkins, and (3) Ms.

Dursky and DKD retained Mr. Monroe.5°

Ex ept for the respective testimonies of Ms. Dursky and Msg

Watkins

on which we are unwilling to rely, there is no reliable

evidence in -the record to support our finding . that during each of

"See supra note 14 .

49Although Ms . Dursky and Ms . Watkins did not discontinue

operatiÅg DKD's cattery activity until around August 2006, DKD

did not claim any deductions relating to DKD' s -cattery activity

in the tax return that it filed for its taxable year 2006.

soSee supra note 19 .

-.55 -

the years at issue DKD intended to make a profit from DKD's

cattery activity.

Based upon our examination of the entire record before us,.

we find that DKD has failed to carry its burden of establishing

that during each of the years at issue it intended to make a

profit from DKD's cattery activity.

On that record, we find that

during each of the years at issue DKD expended substantial

amounts in DKD's cattery activity for the personal pleasure of

Ms. Dursky, its sole stockholder, and with the -expectation that

it would be able to deduct those substantial amounts for each of

those years.

On the record before us, we further find that

during each of the years at issue DKD's cattery activity was

incident to the personal hobby of Ms. Dursky,- DKD's- sole stockholder, who before, during, rand after those years derived signif-

i-cant personal pleasure from the cattery activity in which she

was involved.

Based upon our-examination of the -entire record before us,

we find that DKD has failed to carry its ,burden of.establishing

that for each of the years at issue DKD's cattery activity

constituted a trade or business of DKD within the meaning of

"For example, the record does not contain reliable evidence

of a business plan for DKD that described specifically what steps

Ms. Dursky, DKD's sole stockholder and sole officer, intended to

take during the years at issue in an attempt to increase significantly revenues and/or to reduce significantly expenses in order

to generate a profit for DKD from DKD's cattery activity.

- 56 -

section 162(a).

On that record, we further find that DKD has

failed to carry its burden of establishing that for each of the

years a

issue it is entitled under section 162(a) to deduct with

respect to DKD's cattery:

and Ms. Watkins,

salary,

(T)-Amounts reimbursed to Ms. Dursky

(2) amounts paid to Ms. Watkins as purported

(3) amounts paid for certain "taxes and licenses", and

(4) amounts'paid to Ms. Durs y as purported rent.

Dursky--Claimed Constructive Dividends

We have found that during each of the years at issue DKD

expende

substantial amounts in DKD's cattery activity for the

personal pleasure of Ms. Dursky, its sole stockholder, and that,

during each of those years that activity was incident to the

personal hobby of Ms. Dursky.

On the record before us; we.find

that for each of the years at issue Ms. Dursky is required to

include in gross income as constructive dividends the amounts of

deductions relating to DKD's cattery activity that DKD claimed for eac

of those years and that we havez disallowed."

Dursky--Claimed Cattery Activity Deductions

Itfis the alternative position of Ms. Dursky.-that -

If this Court finds; that the cattery operation was

opárated by Debra Dursky and not DKD Enterprises, which

is contrary to the stipulation between the parties,

th n Debra Dursky should be allowed to deduct the

"P titioners do not dispute that for each of the years- at

issue D D had earnings and profits that were at least equal to

the amoùnt of constructive dividends that we have found Ms.

Dursky has for each of those years.

- 57 -

cattery expenses under I.R.C. §162, since the cattery

was operated for a profit.

In holding that DKD is not entitled for each of the years at

issue to deduct under section 162(a) the various deductions that

it is claiming with respect to DKD's cattery activity, we did not

find that "the cattery operation was operated by Debra Dursky and

not DKD Enterprises".

Instead, we found that DKD failed to carry

its burden of establishing (1) that during each of the years at

issue DKD intended to make a profit from DKD's cattery activity

and (2) that for each of those years DKD's cattery activity

constituted a trade or business of DKD within the meaning of

section 162(a).

Thus, the premise on which Ms. Dursky advances

her alternative position is not valid."

On the record before us, we find that for each of the years

at issue Ms. Dursky is not entitled to deduct under section

162(a) the deductions relating to DKD's cattery activity that DKD

is claiming for each of those years and that we have disallowed.

Ms. Dursky--Claimed Schedule E Deductions

It is the position of Ms. Dursky that she is entitled for

each of the years at issue to deduct in Schedule E the respective

"Even if the premise on which Ms. Dursky advances her

alternative position were validi on the record before us, we

would nonetheless reject that position.

If that premise were

valid, on the record before us, we would find under sec. 183 and

the regulations thereunder that for each of the years at issue

Ms. Dursky is not entitled to deduct the amounts that DKD is

claiming as deductions for each of those years with respect to

DKD's cattery activity and that we have disallowed.

- 58 -

portions of the mortgage interest and real estate tax that she

paid wi h respect to Ms. Dursky's residence that are allocable to

DKD' s piùrported rental of a portion of that residence for DKD' s

cattery activity.

We have found that DKD failed to carry its burden of establishing i (1) that for each of the years at issue DKD' s cattery

activitë constituted a trade or business of DKD within the

meaning of section 162 (a) and (2) that for each of those years

DKD is gntitled to deduct under that section any amounts that it

claimed as rent for the portion of Ms. Dursky's residence where

Ms . Dursky and Ms . Watkins operated DKD' s cattery activity . 54

On the record before us, we find that Ms. Dursky has failed

to carry her burden of establishing that for each of the years at

issue sl e is entitled to deduct in Schedule E the respective

portions of mortgage interest and real estate tax that she paid

with respect to Ms. Dursky's kesidence that are allocable to

DKD's purported rental of that residence for DKD's cattery

activit .55

34Although respondent determined that Ms . Dursky does not

have reÅtal income for each of the years at issue attributable to

the pur orted rent that DKD is claiming as a deduction for each

of thosé years and that we have disallowed, we have held that for

each of the years at issue Ms. Dursky is required to include in

gross income as constructive dividends that disallowed purported

rent .

ssRe pondent determined that for each of the years at issue

Ms. Dur ky is entitled to deduct in Schedule A the respective

(continued. . . )'

- 59 -

Qualified Personal Service Corporation

It is the position of DKD that it is not a qualified personal service corporation, as defined in section 448 (d) (2) , for

each of the years 2004 ande2005 that .is subject to the 35-percent

tax .rate prescribed in section 11(b) (2) ."

Section 448 (d) (2) defines the term "qualified personal

service corporation" to mean:

SEC. 448 (d) . Def initions and Special Rules . - -For

purposes of this section--

(2) Qualified personal service corporation.-The term "qualified personal service corporation"

means any corporation-(A) substantially all of the activities

of which involve the performance of services

in the fields of health, law, engineering,

architecture, accounting, actuarial science,

performing arts, or consulting, and

(B) substantially all of the stock of

which (by value) is held directly (or indirectly through 1 or more partnerships, S

corporations, or qualified personal service

ss (. . . continued)

amounts of mortgage interest and real estate tax that she paid

and that she claimed in Schedule E for each of those years and

that we have disallowed.

s'Respondent determined in DKD' s 2004 and 2005 notice that

DKD is a qualified personal service corporation for each of the

years 2004 and 2005. Respondent did not make any such determination in DKD's 2003 notice. Respondent argues on brief that DKD

also is a qualified personal service corporation for 2003.

Therefore, respondent has the burden of establishing that DKD is

a qualified personal service corporation for 2003.

- 60 -

corporations dot described in paragraph (2)

or (3) of subsection (a) ) by--

(i) employees performing services

for such |corporatiorr in connection with,

the activlities involving a field

referred to in subparagraph (A) ,

Se tion 1 . 448 -1T (e ) (3 )

Temporary Income - Tax Regs . ,

52 Fed.

Reg. 22 68 (June 16, 1987) , provides in pertinent part:

(3) Meaning of qualified personal service

coÝporation.

For purposes of this section, the term

"qUalified personal serv!ice corporation" means any

cogporation that meets-(i), The function telst of paragraph (e) (4) of this

seation, and

(ii) The ownership test of paragraph - (e)-(5) of

th s section.

Se tion 1. 448 -1T (e) (4 ) , Temporary Income Tax Regs . , supra,

provide

in pertinent part thht the function test is met "if 95

percent or more of the time sþent by employees of the

corpora ion, serving in their capacity as such, is devoted. to the

performance of services" in, inter alia, consulting.

Section

1. 448 -1T (e) (5) (i) (A) , Temporaiy Income Tax Regs , , 52 Fed. Reg .

22770 (June 16,

1987) , providgs in pertinent part that a

corpora ion "meets the ownership, test, if at all times during the

taxable year, " substantially all the corporation' s stock, by

value, is held, directly or indirectly, by" employees who perform

services for the scorporation

n connecti'on with activities

involving the performance of åervices in, inter ali

consulting.

-.61 -

We have found- that Ms. Dursky, the only stockholder of DKD

and the only employee of DKD who.performed consulting services

for it, spent approximately 2-,000 hours during the year-2003 and

approximately 2,200 hours during each of the years 2004 and 2005

working.for DKD in its IT consulting business. : We have also

found that during each of the years 2003, 2004; and 2005 Ms.

Dursky spent approximately 800 hours operating DKD's cattery

activity."

On the record before us, we find that.during each of the years 2003, 2004, and 2005 Ms. Dursky did not spend 95 percent or

more of her time while working for DKD performing consulting

services for it.

On that record, we further find that for each

of the years at issue DKD is not a qualified personal service

corporation, as defined in.section 448(d) (2), that is subject to

the 35-percent tax-rate prescribed in section 11(b) (2).

DKD Fidelity Profit-Sharing Plan

DKD--Claimed Deductions

It is the position of DKD that it is entitled to deduct

(1) for 2003 a $10,000 contribution under the 'DKD Fidelity

profit-sharing plan that it made on April 14, 2004, by sending a

"We have found that during each of the years at issue Ms.

Watkins spent more hours than Ms. Dursky operating DKD's cattery

activity. We have not found the precise number of hours that Ms.

Watkins spent during each of those years operating that-~activity

because we are unwilling to rely on her testimony in that respect.

- 62 -

$10, 000 check to Fidelity;

(2) for 2004 a total of $20, 000 of

contrib tions that it made under that profit-sharing plan by

sending a .$10, 000 check to Fidelity on December 27, 2004, and a

$10, 000 check to Fidelity on April 11, 2005; and (3) for 2005 a

$5, 000 contribution that it made under that profit-sharing plan

by sending a $5,000 check to Fidelity on April 10, 2006.5"

It is the position of respondent that for each of the yeaes

at issu

DKD is not entitled to the deduction that DKD is claim-

ing for DKD's contributions under the DKD Fidelity profit-sharing

plan.

n support of respondent's position, respondent asserts in

pertinent part:

If [Ms.] Watkins is determined to have been an

employee of the cattery, then the failure to include

[Ma.] Watkins in DKD's pension plan is a fatal flaw. A

quÅlified pension plan cannot discriminate in favor of

hic hly compensated employees .

I . R . C. § 401 (a) (4 ) .

"H ghly compensated employee" is defined in I.R.C. §

41 (q) as a [sic] employee who was a 5 percent owner at

saIn DKD' s 2003 return, D.KD claimed a deduction for the

$10 , O O O contribut ion under the DKD Fidelity prof it - sharing plan

that it is claiming here.

In: DKD's 2004 return, DKD did not

claim a deduction of $20, 000 for contributions under that plan.

It did, however, claim in that return a $20, 000 deduction for

"Dues aüd subscriptions" . Respondent determined that the $20, 000

that DKÒ claimed in DKD' s 2004 return for "Dues and subscriptions" was a $20,000 deduction claimed for contributions under

the DKD Fidelity profit-sharing plan. The record does not

explain how respondent made that determination, see supra note

41, but DKD does not dispute it.

In DKD's 2005 return, DKD did

not "claim a deduction for a $5, 000 contribution under the DKD

Fidelit profit-sharing plan. DKD claims for the first, time here

a deductiion for 2005 for a $5, 000 contribution that it made under

the DKD Fidelity profit-sharing plan by sending a $5, 000 check to

Fidelity on Apr. 10, 2006. Thus, DKD has the burden of proof

with reåpect to that claimed deduction for 2005.

- 63 -

-any time during the year or preceding year or was in

the top-paid group of employees. As the sole shareholder of DKD, [Ms.] Dursky qualifies as a "highly

compensated employee." [Ms.] Dursky and [Ms.] Watkins

were both employees. DKD did not offer, or pay, [Ms.]

Watkins any pension benefits. The purported pension

plan is not, therefore, a qualified pension plan and no

pension contributions should be allowed.

DKD counters that the reason stated in DKD's 2003 notice and

in DKD's 2004 and 2005 notice for respondent's determinations

that DKD is not entitled for the years 2003 and 2004 to the

deductions that it claimed in its respective tax returns for

those years for contributions under the DKD Fidelity profitsharing plan was that those contributions are not "ordinary and

necessary" expenses.

As a result, DKD argues that respondent has

the burden of proving that the DKD Fidelity profit-sharing plan

did not include Ms. Watkins as a participant.

According to DKD,

"Respondent presented no evidence, at trial or otherwise, regarding who were the participants in the [DKD] Fidelity pension [sic]

plan."

We reject DKD's contention about what the record establishes

"regarding who were the participants in the [DKD] Fidelity pension [sic] plan."

The Fidelity contribution document that Ms.

Dursky executed on behalf of DKD on December 28, 2001, indicated

that the only participant under the DKD Fidelity profit-sharing

plan was Ms. Dursky.

Moreover, petitioners have taken the posi-

- 64 -

tion at trial and on brief that Ms . Dursky was an employee of DKD

during each of the years at issue.59

On the record before us, we find that for each of the years

at issue the DKD Fidelity profit-sharing plan discriminated in

favor of Ms. Dursky, DKD's sole stockholder, who was a "highly

compensated employee" as defined in section 414 (q) .

On that

record, we further find that for each of the years at issue the

DKD Fid lity profit-sharing plan did not constitute a qualified

profit-sharing plan under section 401(a) .

On the record before

us, we find that for each of the years at issue DKD is not entitied to a deduction for any contributions made under the DKD

Fidelit

profit-sharing plan.4°

Dursky--Claimed Constructive Dividends

We have found that for each of the years at issue DKD is not

entitled to deduct any contributions made under the DKD Fidelity

profit-sharing plan.

On the record before us, we find that any

respective contributions that DKD made under that plan and

ssFor each of the years at issue, DKD issued Form W-2 to Ms.

Watkins, in which it reported that it paid her wages of $7, 700 .

For eac of those years, Ms. Watkins filed Form 1040, in which she inc uded in gross income the $7, 700 that she had received

from DKD during each such year.

'°In the light of our holding, we need not address respondent's lternative argument that if the DKD Fidelity profitsharing plan were to constitute a qualified profit-sharing plan

under s c. 401(a) , DKD would be entitled to deduct for each year

at issu only the contributions that it made under that plan

during each such year.

- 65 -

claimed as deductions in its respective tax returns for the years

at issue and that we have disallowed are required to be included

in Ms. Dursky's income as constructive dividends for her respective taxable years at issue in which DKD made those contributions ."

Ms . Dursky' s Health Insurance Policy

DKD--Claimed Deductions

It is DKD's position that for each of the years at issue it

is entitled to deduct certain premiums that it paid on a health

insurance policy issued in Ms. Dursky's name that she had purchased."

In support of DKD' s position, DKD asserts:

An employer is entitled to deduct, as ordinary and

necessary trade or business expense, medical insurance

premiums it paid for its employees. . I.R.C. §-162(a) .

Since DKD Enterprises paid medical insurance premiums on a medical insurance policy for its employee,

Debra Dursky, DKD Enterprises is entitled to deduct the

"See supra notes 52 and 58.

"In petitioners' opening brief; petitioners state that DKD

paid in 2003 and 2004, respectively, and is entitled to deduct

for those years the respective premiums of $6, 950 and $7, 651 on

Ms. Dursky's health insurance policy. In petitioners' reply

brief, petitioners claim that, in addition to those claimed

respective deductions for 2003 and 2004, it is entitled to deduct

for 2005 $7, 651 of health insurance premiums that it paid in that

year on Ms. Dursky's health insurance policy. We have found that

during 2003 and 2004 DKD paid premiums on Ms. Dursky's health

insurance policy totaling $6,950.10 and $7,651.50, respectively.

We have not found that DKD paid any premiums on that policy

during 2005.

- 66 me ical insurance premiums as ordinary and necessary

business expenses under I.R.C. § 162(a) .

It is respondent' s posit ion that DKD is not entitled t of the

deductions that it is claiming for the premiums that it paid on

Ms. Dursky's health insurance policy."

In support of

respond nt's position, respondent asserts in respondent's reply

brief:

th medical insurance premiums paid by DKD [on Ms .

Dursky' s health insurance policy] were not made pursuanj to an accident or he lth plan as required by I.R.C.

§ 106 (a) . DKD never had an accident or health irisurang plan. DKD simply rote checks to a health insurer, allegedly>on behalf of [Ms.] Dursky.

Also, I.R.C. § 105 states that amounts received by

an employee through accident or health insurance for

pe sonal injuries or sicknéss shall be included in

gr ss income to the extent such amounts (1) are attributåd -to contributions by the employer which were anot

inŠludible in the gross income of the employee or

(2 are paid by the employer . [Ms . ] Dursky did not

include the health insurance premiums as compensat on.

Se tion 162 (a) permità a taxpayer - to deduct all the ordinary

and necessary expenses paid or incurred during the taxable year

in carrying on any trade or business, including -a reasonable

In,petitioners' reply brief, petitioners argue that responden conceded in respondent ' s opening brief that DKD is

entitled to deduct for the years at, issue any respective premiums

that it paid on Ms. Dursky's gealth insurance policy.- We disagree. Although respondent did not offer any reason in respondent's épening brief in support of respondent!s position;that DKD

is not ntitled to deduct those premiums, we conclude that i

respond nt did not concede that issue - in that brief . Respondent

explained in respondent' s repily brief , which we quote ein perti

nent pa t in the text, why re|spondenta believes that DKD is not

entitled ,to deduct for each df the years at issue any premiums

that it paid on Ms . Dursky' s health insurance policy .

- 67 -

allowance for salaries or other' compensation for personal services actually rendered.

Sec. 162(a) (1).

Section 1.162-10,

Income Tax Regs., provides in pertinent part with respect to

"Certain-employee benefits" as follows:

Amounts paid or accrued within the taxable year for

* * * a sickness, accident, hospitalization, medical

expense, * * * or similar benefit plan, are deductible

under section 162(a) if they are ordinary and necessary

expenses of the trade or business. a * *

In Waterfall Farms, Inc. v. Commissioner, T.C. Memo. 2003327, we held:

When payments for medical care are properly

excludable from an employee's income [under section 105

and/or 106] because they are made under a "plan for

employees," they are deductible by the employer as

ordinary and necessary business expenses under section

162(a). * * *

Based upon our examination of the entire record before us,

we find that DKD has failed to carry its burden of establishing

that it had in effect during-any of the years at issue a sickness, hospitalization, medical expense, or similar benefit plan

for employees.

On that record, we find that DKD has failed to

carry its burden of establishing that for each of the years at

issue it is entitled to deduct any premiums that it paid on Ms.

Dursky's health insurance policy.

Ms. Dursky--Claimed Exclusion from Income

It is the position of Ms. Dursky that she is entitled to

exclude under section 105 or 106 the premiums that she claims DKD

paid during each of the years at issue on Ms. Dursky's health

s - .68 -

insuran e policy:"

We have found that DKD has failed"to carry

DKD' s b rden of establishing that during each of thé years at

issue- i

had in effect a sickness, hospitalization, medical

expense

or similar plan for employees.

On the-record before us,

we find that Ms. Dursky is not entitled for any of the years at

issue t

exclude from gross

ncome under section- 105 or 106 the

amount éf any premiums that DKD paid o

Ms . Dursky' s health

insuran e poliòy.

We have considered all c(f the contentions and argüments of

the par ies "that are not discussed herein, and weefind them to be

without merit, irrelevant, ant1/or moot.

To reflect the foregoing(, the concessions of respondent, and

the conc essions of petitioners

Decisions will be entered

under Rule 155

"See supra note 62.

This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.