UNITED STATES TAX COURT

T.C. Memo. 1999-192

UNITED STATES TAX COURT

FRANK AND VIRGINIA MUHICH, Petitioners v. COMMISSIONER OF

INTERNAL REVENUE, Respondent

MIDWEST PORTRAITS CORP., Petitioner v. COMMISSIONER OF INTERNAL

REVENUE, Respondent

Docket Nos. 21561-97, 21562-97.

Filed June 14, 1999.

Jennifer Prager Sodaro and Joe Alfred Izen, Jr., for

petitioners.

William T. Derick and Luanne S. DiMauro, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge:

These cases are before the Court consolidated

for purposes of trial, briefing, and opinion.

Frank and Virginia

Muhich (the Muhichs) and Midwest Portraits Corp. (Midwest)

separately petitioned the Court to redetermine respondent’s

- 2 determinations of the following deficiencies and accuracy-related

penalties under section 6662(a):

Frank and Virginia Muhich, docket No. 21561-97

Year

Deficiency

Penalty

Sec. 6662(a)

1994

1995

$18,164

21,885

$3,633

4,377

Midwest Portraits Corp., docket No. 21562-97

Year Ended

Deficiency

Penalty

Sec. 6662(a)

June 30, 1994

June 30, 1995

June 30, 1996

$15,075

26,090

40,137

$3,015

5,218

8,027

We must decide the following issues:

1.

Whether the trusts implemented and used by the Muhichs

during 1994 and 1995 should be disregarded for tax purposes

because the trusts lacked economic substance.

We hold they

should.1

2.

Whether the Muhichs' 1994 and 1995 gross income includes

compensation paid by Midwest in the amounts of $112,820 and

$130,193, respectively.

1

We hold it does.

Respondent also raises the alternative argument that

petitioners are taxable on trust income because the trusts were

"grantor trusts". Given our holding that the trusts are shams,

we need not and do not reach this issue.

- 3 3.

Whether section 162 allows Midwest to deduct payments to

a trust promoter in the amounts of $12,000 and $5,500 for 1994

and 1996, respectively.

4.

We hold it does not.

Whether section 162 allows Midwest to deduct payments to

the trusts in the amounts of $60,000, $103,238, and $132,766 for

1994, 1995, and 1996, respectively.

5.

We hold it does.

Whether the Muhichs are liable for accuracy-related

penalties under section 6662(a) and (b)(1) for 1994 and 1995.

We

hold they are.

6.

Whether Midwest is liable for accuracy-related penalties

under section 6662(a) and (b)(2) for 1994, 1995, and 1996.

We

hold it is to the extent discussed herein.

7.

Whether the Muhichs are liable for a penalty under

section 6673(a)(1).

We hold they are not.2

FINDINGS OF FACT

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

The stipulated facts and exhibits submitted therewith are

incorporated herein by this reference.

The Muhichs resided in

Mahomet, Illinois, when they petitioned the Court.

Midwest had

its principal place of business in Mahomet, Illinois, when it

petitioned the Court.

2

Rule references are to the Tax Court Rules of Practice and

Procedure. Unless otherwise indicated, section references are to

the Internal Revenue Code in effect for the years at issue.

- 4 Petitioner3 attended 3 years of college but did not obtain a

degree. From 1978 through the years in issue, petitioner owned,

operated, and was the president of Midwest.

Midwest was a

photography business, and it earned income by participating in

fund-raising programs of local community service organizations.

From 1985 forward, Midwest worked exclusively with fire,

rescue, and ambulance departments in the four-State region of

Illinois, Iowa, Wisconsin, and Indiana.

In addition to taking

the photographs, Midwest supplied the various departments with

professionals to assist in soliciting donations and handing out

complimentary certificates.

Under this arrangement, Midwest

received approximately 50 percent of the donations plus the

income from the sales of additional photographs.

Midwest

conducted its business in the four-State region by employing

"road people" to solicit donations, take the complimentary

photographs, and sell additional photographs.

Midwest employed

two people in its home office.

Before the subject years, petitioner drew a salary from

Midwest for the work he performed.

as officer compensation.

Midwest deducted his salary

Petitioner essentially compensated

himself on a commission basis, setting his salary upon Midwest's

3

References to petitioner are to Frank Muhich.

- 5 financial performance.

Petitioner had a wide variety of duties

including serving as Midwest's president and salesman.

Kim and Denise Martin (Martins) are certified public

accountants and have been petitioners' tax advisers since 1982.

The Martins prepared all of petitioners' tax returns from 1982 to

date, and the Martins maintained petitioners' books and records

for each of the subject years.

Introduction to the Multitrust Scheme

In early March 1994, petitioner met with a financial

planner, James Myers (Myers).

Myers was a representative of

Heritage Assurance Group (Heritage), an entity that promoted

multitrust schemes as a means to avoid paying taxes.

Myers

introduced petitioner to Heritage's scheme, which worked

generally as follows.

An individual transfers his or her assets

and right to receive income to a newly created family trust in

exchange for a certificate of beneficial interest (CBI).

A CBI

gives the individual the right to receive any distributions that

the trustee, who is the same as the transferring individual,

decides to make.

The family trust pays and deducts all of the

trustee's personal expenses and distributes any excess corpus to

a charitable trust created under the scheme.

The individual

creates other trusts to circulate funds among and between.

Myers presented petitioner with promotional materials

containing flowcharts and explanations detailing the above

- 6 sequence of transactions.

These materials touted the tax

deductibility of all of the transferring individual's personal

expenses.

The materials generally claimed that the individual

would pay no tax on his or her income.

The materials made no

mention of any nontax benefit to be gained from the trust scheme.

After meeting with Myers, the Muhichs traveled over 100

miles to the offices of Heritage.

There they met with Edward

Bartoli (Bartoli), an attorney who was the

Heritage's scheme.

principal promoter of

Bartoli introduced petitioner to James Savino

(Savino), a certified public accountant associated with Heritage.

At or about the time of this meeting, the Muhichs submitted to

Heritage a form containing their financial information and

assets.

On this form, they stated that their number one

objective was "tax avoidance".

Creation of the Five Trusts

In May 1994, very soon after meeting with Bartoli, the

Muhichs, without consulting the Martins, implemented the multitrust scheme to avoid taxes.

Petitioner caused Midwest to pay

$12,000 to Heritage, and Heritage supplied petitioners with a

comprehensive packet of forms and documents that could be

customized to create and operate the trust scheme.

Petitioners used the promotional materials presented by Myers as

a model for their trust arrangement.

- 7 On May 4, 1994, the Muhichs created The Muhich Asset

Management Trust (Asset Trust).

Petitioner signed the trust

declaration as the "investor", Bartoli signed as creator and

trustee, and Ms. Muhich signed as trustee.

Within days, Ms.

Muhich transferred virtually all of her property to petitioner.

This property included an exhaustive list of housewares,

jewelry, electronics, china, and other personalty.

In turn,

petitioner transferred virtually all of his property (which now

included Ms. Muhich's transferred property) to the Asset Trust,

including the right to receive compensation for his services.4

In exchange, Ms. Muhich and petitioner each received a CBI

representing 50 and 40 units, respectively.

Within days, Bartoli

resigned as trustee, and petitioner was appointed trustee.

This

left the Muhichs as sole trustees and sole beneficiaries of the

Asset Trust.

On May 7, 1994, the Asset Trust established the Muhich

Charitable Trust (Charitable Trust).5

The Asset Trust funded the

corpus with a CBI from the Asset Trust representing 10 units of

ownership.

In exchange, the Asset Trust received a CBI

4

For reasons that are unclear, the Muhichs did not transfer

all of their significant property to the trust. As relevant

here, they retained title to their residence at 1106 West Dianne

and petitioner's stock in Midwest.

5

The Charitable Trust never sought nor received tax exempt

status under sec. 501(c).

- 8 representing 100 units of ownership in the Charitable Trust.

The Muhichs were the trustees.

On May 15, 1994, the Asset Trust created The Muhich Business

Trust (Business Trust).

The Asset Trust funded the corpus with

$10 in exchange for a CBI representing 100 units of ownership in

the Business Trust.

The Muhichs were the trustees.

On May 18, 1994, the Business Trust established The Muhich

Equity Trust (Equity Trust) and The Muhich Vehicle Trust (Vehicle

Trust).

The Business Trust funded the corpus of each trust with

$10 in exchange for a CBI from each trust representing 100 units

of ownership in each.

The Muhichs were the trustees.

The Muhichs listed their personal residence at 1106 West

Dianne as the address for the five trusts.

As sole trustees and

exclusive beneficiaries of all five trusts, the Muhichs had

exclusive control over the trust property.

They had the right to

receive distributions at their sole discretion and controlled all

the bank accounts.

Their ability to deal with and benefit from

all trust property was as free and unrestricted as before the

trusts were established.

Midwest continued to operate as a corporation and continued

to conduct business the same as before the trusts were created.

Petitioner's work and duties at Midwest remained the same, but he

no longer took a salary from Midwest.

Instead, he caused Midwest

to contract with the Asset Trust for the provision of his

- 9 services.

The Asset Trust was to receive $3,000 per month, plus

additional consideration based upon company performance.

Operation and Tax Reporting of the Five Trusts

Upon creation of the trusts, the Muhichs hired Aegis Co.

(Aegis) to help operate them.

Heritage.

Aegis was affiliated with

Regarding the Asset Trust, the Muhichs named

themselves as executive trustees and executive secretaries,

charging themselves with the duty to manage the trust.

In

return, the Asset Trust agreed to pay the Muhichs' housing,

transportation, health care, and education expenses.

The Asset Trust did not engage in the active conduct of any

trade or business at any time during the years at issue.

For

1994 and 1995, the Asset Trust had approximately $114,370 and

$202,242 in available funds deposited into its accounts over

which the Muhich's had signatory authority.

The funds included

$100,820 and $130,193 for 1994 and 1995, respectively, in

"consulting fees" received by the Asset trust for the services of

petitioner.

The balance of the funds for each year was composed

primarily of transfers from Midwest and other trusts

characterized by the Muhichs as loans, and a small amount of

interest income that was payable to petitioner.

From the available funds for 1994 and 1995, the Asset Trust

paid the Muhichs' housing, transportation, health care,

education, and miscellaneous expenses.

These payments included:

- 10 $70,000 in construction costs, interest costs, and closing costs

for their new residence at 404 North Shore Drive; all of the

education costs for the Muhichs' college-aged children; utilities

for the Muhichs' personal residence; personal automobile expenses

of the Muhichs'; mortgage payments on the Muhichs' personal

residence at 1106 West Dianne; and trustee fees to the Muhichs.

In each year, the Asset Trust paid to the Charitable Trust the

funds that remained after all these payments.

For 1994 and 1995, the Asset Trust filed tax returns with

respondent (Forms 1041) wherein its reported income included the

consulting fees paid by Midwest for petitioner's services and

petitioner's interest income.

After deducting therefrom the

above-described personal expenses of the Muhichs and the amounts

paid to the Charitable Trust, the Asset Trust reported zero

taxable income in each year.6

The other trusts did not engage in any business activity

during 1994 or 1995.

The Charitable Trust distributed some money

in each year to various charities.

With the balance, the

Charitable Trust participated in a series of circular

6

The Asset Trust did not deduct the $70,000 in construction

costs. Also, the Asset Trust elected to treat a large 1995

payment to the Charitable Trust as a charitable contribution

deduction on its 1994 return under sec. 642(c)(1).

- 11 transactions with the other trusts and Midwest.7

Throughout the

1995 year, petitioner moved funds among and between the Asset

Trust, the Charitable Trust, and the Equity Trust in a circular

fashion.

Petitioner labeled the movements of funds "loans" or

"loan repayments".

For tax purposes, the Charitable Trust filed 1994 and 1995

returns claiming it was a nonexempt charitable trust under

section 4947(a)(1), and it paid no tax for either year.

The Equity Trust, the Business Trust, and the Vehicle Trust

were dormant in 1994 and 1995, and each filed 1994 and 1995

income tax returns showing no taxable income.

All of the above-described trust tax returns for 1994 were

prepared by Savino.

The Martins were not aware of petitioners'

participation in the trust scheme until late 1994 when they

prepared Midwest's tax return for that fiscal year.

The Martins

discovered that Midwest purportedly paid no wages to petitioner,

7

One such series of transactions occurred on June 21, 1995,

when petitioner caused Midwest to pay the Asset Trust $14,247.

On that same day, all of the following occurred: (1) The Asset

trust paid $14,247 by check to the Charitable Trust; (2) the

Charitable Trust paid $14,247 by check to the Equity Trust; and

(3) the Equity Trust paid the $14,247 by check back to the Asset

Trust. Also on June 21, 1995, petitioner repeated three more

times this exact same series of movements of funds in a circular

fashion in the exact same amount, $14,247. Petitioner labeled

all of these advances "loans". Finally, petitioner caused the

Asset Trust to pay back the $14,247 to Midwest by check dated

June 21, 1995.

- 12 and they began inquiring.

Soon thereafter and at the request of

the Muhichs, Mr. Martin attended one of Heritage's seminars.

Mr. Martin left the seminar with concerns about the legitimacy of

the trust scheme, and he conveyed his concerns to petitioner.

Petitioner dismissed Mr. Martin's concerns and indicated he would

rely on the advice given by the trust promoters.

Notwithstanding

their concerns, the Martins prepared the trusts' 1995 returns.

After 1995, the Martins prepared the 1996 Charitable Trust return

but refused to prepare any other trust returns.

Petitioners' Tax Reporting and Respondent's Determination

Midwest

Midwest filed Federal income tax returns (Forms 1120) for

its fiscal years ended June 30, 1994, 1995, and 1996.

In its

1994 return, Midwest deducted the $12,000 it paid to Bartoli in

connection with setting up the multitrust system.

During the

1996 fiscal year, Midwest paid to Aegis and deducted $5,500 in

fees related to administration of the trusts.

During fiscal years 1994, 1995, and 1996, Midwest paid the

Asset Trust $60,000, $103,238, and $132,766, respectively,

pursuant to the consulting contract.

Midwest labeled the

payments "consulting fees" and deducted these amounts in its

income tax returns.

By notice of deficiency dated August 6, 1997, respondent

determined the above-described payments were not ordinary and

- 13 necessary business expenses under section 162 and that they were

nondeductible constructive dividends.

Respondent disallowed

these deductions in full.

The Muhichs

The Muhichs filed Federal income tax returns for 1994 and

1995.

On these returns, the Muhichs did not report any income

from Midwest in the form of compensation or dividends.

By notice of deficiency dated August 6, 1997, respondent

determined the trust scheme was an abusive trust arrangement

which should be ignored for tax purposes.

Respondent determined

that petitioner received constructive dividends from Midwest in

the amounts of $112,820 and $130,193 for 1994 and 1995,

respectively.

For 1994, the constructive dividend amount is

composed of the $12,000 paid by Midwest to Bartoli and the

$100,820 in fees paid by Midwest to the Asset Trust during the

year.

For 1995, the entire amount represents fees paid by

Midwest to the Asset Trust during the year.8

OPINION

Economic Reality of the Trusts

We first decide whether the trusts should be disregarded for

tax purposes.

According to respondent, they should because they

lack economic substance and are shams.

8

We agree.

Respondent also made smaller, miscellaneous upward and

downward adjustments to the Muhichs' income in both years which

flowed from his determination that the trusts should be ignored.

- 14 For all issues in this case except the penalty under section

6673, respondent's determination is presumed correct, and

petitioners bear the burden of proving it wrong.

See Rule

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

Where an

entity is created that has no real economic effect and which

affects no cognizable economic relationship, the substance of a

transaction involving the entity will control over its form.

See

Zmuda v. Commissioner, 79 T.C. 714, 720 (1982), affd. 731 F.2d

1417 (9th Cir. 1984); Markosian v. Commissioner, 73 T.C. 1235,

1241 (1980).

Regarding economic substance, we recently stated:

"The doctrine of economic substance becomes applicable, and a

judicial remedy is warranted, where a taxpayer seeks to claim tax

benefits, unintended by Congress, by means of transactions that

serve no economic purpose other than tax savings."

ACM

Partnership v. Commissioner, T.C. Memo. 1997-115, affd. in part,

revd. on other grounds in part, dismissed in part and remd. in

part 157 F.3d 231 (1998).

We find such lack of economic purpose

in this case.

More specifically, we have held a trust is not recognized

for tax purposes if it has no economic substance apart from tax

considerations.

1245.

See Markosian v. Commissioner, supra at 1244-

These principles apply even though an entity may have been

properly formed and may have had a separate existence under

applicable local law.

See Zmuda v. Commissioner, supra at 720.

- 15 When the settlor is a trustee and the beneficiaries are the

settlor and his family, the trusts must be closely scrutinized

for economic substance.

See Markosian v. Commissioner, supra at

1245; see also Helvering v. Clifford, 309 U.S. 331, 334 (1940).

We consider the following factors when deciding whether a

trust lacks economic substance for tax purposes:

(1) Whether the

taxpayer's relationship as grantor to the property differed

materially before and after the trust's formation; (2) whether

the trust had an independent trustee; (3) whether an economic

interest passed to other beneficiaries of the trust; and (4)

whether the taxpayer felt bound by any restrictions imposed by

the trust itself or by the law of trusts.

See Markosian v.

Commissioner, supra at 1243-1245; see also Buckmaster v.

Commissioner, T.C. Memo. 1997-236.

As to the first Markosian factor, the Muhichs' relationship

to their property did not differ materially before and after the

formation of the trusts.

The Muhichs' personal residence was the

address for all the trusts, and their personal use of their

property was never restricted.

As sole trustees and sole owners

of the CBI's, the Muhichs could manipulate, distribute, or

otherwise use trust property at their whim.

In fact, the trust

instruments gave them sole discretion to deal in trust property

and make distributions.

- 16 Petitioners argue that their residence at 1106 W. Dianne

and then at 404 North Shore Drive was the Asset Trust

"headquarters", and, therefore, they could deduct all operational

expenses connected thereto.

We disagree. Petitioners' attempt to

legitimize payment of their personal expenses is unavailing.

In

addition to the fact the trusts were not conducting a trade or

business, the expenses were personal in nature which preclude

their deductibility.

The first factor weighs against

petitioners.

As to the second Markosian factor, the trusts lacked an

independent trustee.

But for Bartoli's 6-day stint as trustee of

the Asset Trust, the Muhichs were at all times sole trustees of

all trusts.

The fact that Bartoli served as trustee for a

limited time is meaningless; it was a paper appointment solely

for the purpose of facilitating the creation of the trust scheme.

The second factor weighs against petitioners.

As to the third Markosian factor, no economic interest in

the trusts ever passed to any beneficiary other than the Muhichs.

The only beneficiaries were the Muhichs or other trusts they

created and controlled under the trust scheme.

The third factor

weighs against petitioners.

As to the final Markosian factor, the Muhichs were not bound

by any restriction imposed by the trusts or the law of trusts as

to the use of trust property.

The record demonstrates

- 17 petitioners dealt freely with trust funds and property, and they

manipulated funds between the trusts in a circular and

nonsensical manner.

This factor weighs against petitioners.

In addition to our analysis of the Markosian factors, all of

which favor respondent, other facts herein make clear that the

tangled web woven by petitioners did little more than conceal the

ownership of assets and disguise the true earner of income for

the purpose of avoiding taxes.

First, petitioners created an

elaborate scheme of documents and paperwork with an eye towards

creating an aura of legitimacy for the trusts.

These canned

documents were part of the mass-produced trust package marketed

by Heritage and paid for with the $12,000 fee.

Notwithstanding

the Muhichs spent time filling in the blanks, these documents do

not lend economic reality to the transactions they purport to

memorialize, and we place no weight on them.

Second, petitioner lacked a basic understanding of the

scheme's operation.

He was generally unfamiliar with the

intricacies and interworkings of the trust scheme, and he was

unfamiliar with basic terms such as "grantor", "beneficiary", and

"trust declarations".

Instead of directly responding to

questions asked at trial, petitioner often referred the Court to

the reams of paperwork submitted into the record with the

suggestion that the answers could be found somewhere in those

- 18 documents.9

Petitioner's inability to discuss basic trust

concepts is inconsistent with his contention that the trust

scheme was a legitimate business arrangement.10

In sum, petitioners established the trusts with an aim to

avoid, improperly, Federal income tax.

None of the trusts ever

reported taxable income, and none of them conducted a legitimate

business activity.

Petitioners' purpose for the trust scheme was

to take untaxed money out of Midwest and circulate it around the

trusts to pay the Muhichs' personal expenses.

admitted as much at trial.

The Muhichs

Although the Muhichs attempted to

identify other nontax reasons for the trusts, we find these

9

The following colloquy between petitioner and respondent's

counsel on cross-examination exemplifies petitioner's elusiveness

and lack of knowledge as to the operation of the trust scheme:

Q Edward Bartoli helped set up the initial

trust for you. Is that right?

A Right.

Q And that would include the declarations

for each of the trusts?

A I'm not that familiar with terms. It's

all written down. You have the trust

documents, so whatever's in the documents is

what we did.

10

We were similarly unimpressed with Ms. Muhich. She

admitted she was only "kind of" familiar with two of the trusts

and stated that she knew more about the entire scheme after

sitting through the trial than she did before.

- 19 reasons incredible.11

Because the trusts lacked economic

reality, the Court will ignore them for tax purposes.12

Gross Income/Deductions by Midwest

We turn to the question of whether the Muhichs' gross income

includes the "consulting fees" paid by Midwest to the Asset Trust

and the $12,000 paid by Midwest to the trust promoters (issue 2).

Related thereto is the question of whether section 162 allows

Midwest to deduct these payments and the $5,500 paid to the trust

promoters in 1996 (issues 3 and 4).

As to the "consulting fees", respondent determined that

these "fees" were nondeductible constructive dividends paid to

petitioner by Midwest, and, as such, were includable in his gross

income.

Midwest contends that these "fees" are deductible by

11

Petitioner, for example, testified he adopted the trust

scheme to protect Midwest and his assets. If such was the case,

then why did the Muhichs not transfer their most significant

assets to the trusts immediately upon creation (i.e., their

various real estate holdings and the stock in Midwest)?

Moreover, Midwest was already a corporation; thus, Midwest

enjoyed the benefits of limited liability attendant to doing

business in the corporate form.

12

Respondent does not contest petitioners' assertion that

the amounts the Charitable Trust paid to sec. 501(c)(3)

organizations are deductible by the Muhichs. The parties shall

take these deductions into account in the Rule 155 computation.

- 20 Midwest as compensation for petitioner's services.13

We agree

with Midwest that the "consulting fees" are deductible

compensation for petitioner's service.

We agree with respondent

that these "fees" are includable in petitioner's gross income,

but as compensation rather than dividends.

A payment to a shareholder/employee is compensation if:

(a)

The corporation intends the payment to be solely for services

rendered by the shareholder/employee, and (b) the amount paid is

reasonable as to the services rendered.

See Electric & Neon,

Inc. v. Commissioner, 56 T.C. 1324 (1971), affd. without

published opinion 496 F.2d 876 (5th Cir. 1974); sec. 1.162-7,

Income Tax Regs.

A corporation's intent to compensate for

services is a condition precedent to the underlying payment's

deductibility, see Electric & Neon, Inc. v. Commissioner, supra,

and such an intent is determined when the payment is made, see

Paula Constr. Co. v. Commissioner, 58 T.C. 1055 (1972), affd.

without published opinion 474 F.2d 1345 (5th Cir. 1973).

An

intent to compensate is a question of fact, which in the case of

a corporation turns on the actions of the officers.

See King's

Court Mobile Home Park, Inc. v. Commissioner, 98 T.C. 511, 514

(1992).

13

We employ close scrutiny when a shareholder/employee

Petitioner fails to acknowledge that if the amounts are

compensation, he must include them in income.

- 21 controls the corporation's affairs.

See Paula Constr. Co. v.

Commissioner, supra at 1058.

While we held the trusts were shams and should be ignored

for tax purposes, we find the consulting contract helpful for the

limited purpose of determining the intent of the parties.

The

contract provides that "[Midwest] desires to contract the skills

and services of one Frank W. Muhich in the performance of

services on behalf of [Midwest]," and we find that petitioner

performed these services for Midwest during the subject years.

Before the subject years, petitioner worked as a principal

officer of Midwest, establishing its name recognition, overseeing

its business, and playing a key role in its success.

His work-

related duties did not change after the trusts were formed; he

continued to own and operate Midwest exactly as before, and

Midwest continued to pay compensation for his services.

We

conclude Midwest paid the "consulting fees" intending to

compensate petitioner for his services.

In disregarding the

Asset Trust's existence for tax purposes, we view these payments

received directly by petitioner, the true earner of the income.

As to reasonableness, each year petitioner based his salary

upon the financial performance of Midwest.

We view this as a

reasonable way for an owner of a closely held business to

compensate himself or herself.

The contract in this case

specifically provides for compensation of $3,000 per month, plus

- 22 additional amounts based upon Midwest's financial performance.

This compensation package is very similar to the commission type

arrangement used before the trust scheme.

On the primary basis

of the amount of compensation that Midwest paid petitioner before

the subject years, the type and content of the services he

performed during the subject years, and the gross receipts those

services produced for Midwest, we conclude petitioner's

compensation during the subject years was reasonable.

We hold

Midwest may deduct the "consulting fees" under section 162, and

petitioner must include these fees in income in the amounts of

$100,820 and $130,193 for 1994 and 1995, respectively.

We now turn to the $12,000 and $5,500 payments made by

Midwest to the trust promoters in 1994 and 1996, respectively.

Respondent determined these amounts were not deductible by

Midwest and that the $12,000 was a constructive dividend to

petitioner.14

Petitioners contend that both amounts were

deductible under section 162(a), and that the $12,000 is not

includable in petitioner's income.

We disagree.

A taxpayer may deduct "all ordinary and necessary expenses

paid or incurred during the taxable year in carrying on any trade

or business."

14

Sec. 162.

The taxpayer must show that the

The issue of whether the $5,500 payment was includable in

petitioner's gross income as a constructive dividend is not

before the Court.

- 23 expenses were both ordinary and necessary.

See Northwestern Ind.

Tel. Co. v. Commissioner, 127 F.3d 643, 646 (7th Cir. 1997),

affg. T.C. Memo. 1996-168.

legislative grace.

Deductions are a matter of

See INDOPCO, Inc. v. Commissioner, 503 U.S.

79, 84 (1992).

In the context of section 162, an expense is necessary if it

is appropriate or helpful for the development of the taxpayer's

business.

See Welch v. Helvering, 290 U.S. at 114.

An expense

is ordinary if it relates to a transaction commonly or frequently

occurring in the taxpayer's business community.

See

INDOPCO,

Inc. v. Commissioner, supra at 85 (discussing the requirements of

section 162).

It follows from our holding that the trusts were shams and

should be ignored for tax purposes that the payments in pursuance

of the scheme were not ordinary and necessary business expenses

under section 162.

The expenses were not appropriate or helpful

for the development of Midwest's photography business, nor was

there any evidence they were a usual expense within Midwest's

business community.

We hold the payments to the trust promoters

(Bartoli and Aegis) are not deductible under section 162.

Turning to constructive dividends, taxpayers must include

dividends in gross income.

See sec. 61(a)(7).

When a

corporation distributes property to a shareholder as a dividend,

the shareholder must include in gross income the distribution to

- 24 the extent of the corporation's earnings and profits.

301(a), (c)(1), and 316.

See secs.

The shareholder must do so even though

the corporation has not formally declared a dividend.

See

United States v. Mews, 923 F.2d 67, 68 (7th Cir. 1991); Crosby v.

United States, 496 F.2d 1384, 1388 (5th Cir. 1974).

The

shareholder need not receive the distribution directly.

Payments

on behalf of a shareholder are treated as if paid directly to the

shareholder.

See Epstein v. Commissioner, 53 T.C. 459, 474-475

(1969).

In determining whether a shareholder has received a

constructive dividend, we look to whether the payment by the

corporation benefited the shareholder personally rather than

furthered the interest of the corporation.

See Hagaman v.

Commissioner, 958 F.2d 684, 690-691 (6th Cir. 1992), affg. and

remanding on other grounds T.C. Memo. 1987-549; Ireland v. United

States, 621 F.2d 731, 735 (5th Cir. 1980).

Given our holding

the trusts were shams and were created by the Muhichs to

avoid taxes, we hold the $12,000 payment to the trust promoters

was solely to benefit petitioner and his family personally.

We

hold petitioner must include the payment in his income as a

constructive dividend.15

15

Petitioners neither argued nor proved that Midwest did

not have sufficient earnings and profits for us to categorize the

payment as a dividend under sec. 316.

- 25 Section 6662(a)

The Muhichs

Respondent determined the Muhichs are liable for the

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

both years in issue.

This section imposes a penalty equal to 20

percent of the portion of an underpayment that is attributable

to, among other things, negligence.

Petitioners will avoid this

penalty if the record shows that they were not negligent; i.e.,

they made a reasonable attempt to comply with the provisions of

the Internal Revenue Code, and they were not careless, reckless,

or in intentional disregard of rules or regulations.

See sec.

6662(c); Accardo v. Commissioner, 942 F.2d 444, 452 (7th Cir.

1991), affg. 94 T.C. 96 (1990); Drum v. Commissioner, T.C. Memo.

1994-433, affd. without published opinion 61 F.3d 910 (9th Cir.

1995).

Negligence connotes a lack of due care or a failure to do

what a reasonable and prudent person would do under the

circumstances.

See Allen v. Commissioner, 92 T.C. 1 (1989),

affd. 925 F.2d 348 (9th Cir. 1991); Neely v. Commissioner, 85

T.C. 934, 947 (1985).

The accuracy-related penalty of section

6662 is not applicable to any portion of an underpayment to the

extent that an individual has reasonable cause for that portion

and acts in good faith with respect thereto.

6664(c)(1).

See sec.

Such a determination is made by taking into account

all facts and circumstances, including the experience and

knowledge of the taxpayer and his or her reliance on a

- 26 professional tax adviser.

See sec. 1.6664-4(b)(1), Income Tax

Regs.

The Muhichs seek relief from the penalty by arguing they

relied in good faith on advice from the Martins and Bartoli.

Good faith reliance on the advice of counsel or a qualified

accountant can, in certain circumstances, be a defense to the

accuracy-related penalty for negligence.

See, e.g., Ewing v.

Commissioner, 91 T.C. 396, 423-424 (1988), affd. without

published opinion 940 F.2d 1534 (9th Cir. 1991); Jackson v.

Commissioner, 86 T.C. 492, 539-540 (1986), affd. 864 F.2d 1521

(10th Cir. 1989); Pessin v. Commissioner, 59 T.C. 473, 489

(1972); Conlorez Corp. v. Commissioner, 51 T.C. 467, 475 (1968).

In those cases, the taxpayer must establish:

(1) The adviser had

sufficient expertise to justify reliance, (2) the taxpayer

provided necessary and accurate information to the adviser, and

(3) the taxpayer actually relied in good faith on the adviser’s

judgment.

See Ellwest Stereo Theatres of Memphis, Inc. v.

Commissioner, T.C. Memo. 1995-610.

The record in this case demonstrates the Muhichs did not act

reasonably with respect to reporting their income for 1994 and

1995.

The Muhichs' claim that they relied in good faith on the

Martins for advice as to the tax treatment of the trust scheme is

unsupported by the evidence.

The Muhichs failed to disclose to

the Martins they had purportedly divested themselves of most of

- 27 their assets and adopted the trust scheme.

The Martins never

advised the Muhichs about the scheme before the Muhichs entered

into it.

The Muhichs had all the trusts' returns for the year of

inception (1994) prepared by Savino in an attempt to keep the

existence of the trusts from the Martins.

Although the Martins

did prepare the 1995 returns for the trusts, they did so

reluctantly and only after informing petitioner of their concern

as to the trusts' legitimacy.

Nor are we persuaded that the Muhichs reasonably relied upon

a qualified expert in the form of Bartoli.

Bartoli's bias was

obvious, and his ability to benefit financially by luring

individuals into the scheme should have sent up a red flag.

Petitioner is an experienced businessman who should have been

suspicious of Bartoli's claims.

Further, the record contains no

evidence as to Bartoli's qualifications or expertise; he was

noticeably absent from the trial, and petitioner was unable to

locate him.

The only information the Muhichs provided Bartoli

was a list of assets and a questionnaire wherein they documented

their desire to avoid taxes.

We hold the Muhichs are liable for

the accuracy-related penalties for negligence as determined by

respondent.

Midwest

Respondent determined that Midwest is liable for the

accuracy-related penalty under section 6662(a) and (b)(2) for all

- 28 years in issue.

This section imposes a penalty equal to 20

percent of the portion of an underpayment that is attributable

to, among other things, a substantial understatement of income

tax.

An understatement is substantial if it exceeds the greater

of 10 percent of the tax required to be shown on the return or

$10,000 (for corporations).

See sec. 6662(d)(1).

The

understatement is reduced if it is based on substantial authority

or is adequately disclosed on the return or in a statement

attached to the return.

See sec. 6662(d)(2).

The reasonable

cause exception under section 6664(c)(1) may also be used to

avoid the penalty if proven by the taxpayer.

Midwest made no relevant disclosures on its returns.

Furthermore, the record does not disclose Midwest had substantial

authority for deducting the payments to the trust promoters.

Accordingly, for each year that the Rule 155 computation reflects

a substantial understatement within the meaning of section

6662(d)(1), Midwest will be liable for this penalty.

Section 6673

Respondent moved the Court at the end of trial to impose a

penalty under section 6673(a)(1).

Respondent asserts the

Muhichs' position is frivolous and groundless, and that they

instituted this lawsuit primarily for delay.

As relevant,

section 6673(a)(1)(A) and (B) provides that the Court may impose

a penalty of up to $25,000 wherever proceedings before us have

- 29 been instituted or maintained by the taxpayer primarily for

delay, or wherever the taxpayer's position in a proceeding is

frivolous or groundless.

We decline to impose a penalty under section 6673.

Although

the Muhichs' position that the trusts had economic substance was

frivolous, we have rejected respondent's position the "consulting

fees" were dividends, holding instead the "fees" were

compensation.

The Muhichs' position in this proceeding was

somewhat meritorious to the extent they were defending against

respondent's determination of constructive dividends.

We

admonish the Muhichs that we shall not be inclined to exercise

our discretion under section 6673 so favorably in the future if

presented with similar arguments by them, and we may impose a

penalty.

In reaching all our holdings herein, we have considered each

argument made by the parties, and, to the extent not discussed

above, find those arguments to be irrelevant or without merit.

To reflect the foregoing,

An appropriate order will be

issued denying respondent’s motion

to impose a penalty under section

6673(a)(1), and decisions will be

entered under Rule 155.

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