UNITED STATES TAX COURT

116 T.C. No. 8

UNITED STATES TAX COURT

U.R. NEELY, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 14936-98.

Filed February 13, 2001.

P contends that R is barred from assessing

additional employment taxes because the notice of

determination concerning worker classification was

issued after the expiration of the general 3-year

period of limitations under sec. 6501(a), I.R.C. R

contends that the period of limitations on assessment

is indefinitely extended pursuant to sec. 6501(c)(1),

I.R.C., by reason of P’s fraud in the filing of various

employment tax returns.

Held: The elements of fraud in the employment tax

context are the same as those in the income, estate,

and gift tax contexts.

Held, further, P did not commit fraud for purposes

of sec. 6501(c)(1), I.R.C. Accordingly, R is barred by

the statute of limitations from assessing additional

employment taxes for the taxable periods in issue.

- 2 Kirk A. McCarville, for petitioner.

John W. Duncan, for respondent.

VASQUEZ, Judge:

Respondent issued to petitioner a notice of

determination concerning worker classification.

Petitioner

contends that respondent is barred from assessing additional

employment taxes for the taxable periods in issue on the grounds

that the notice of determination was issued after the expiration

of the general 3-year period of limitations under section

6501(a).1

Respondent argues that the period of limitations on

assessment remains open pursuant to section 6501(c) by reason of

petitioner’s fraudulent conduct.

In a previous opinion, we addressed whether this Court

possesses jurisdiction to address issues pertaining to the period

of limitations on assessment in the context of a case brought

under section 7436.

We resolved that inquiry in the affirmative.

See Neely v. Commissioner, 115 T.C. 287 (2000).

Accordingly, we

now address whether the period of limitations on assessment

expired prior to the issuance of respondent’s notice of

determination.

1

All section references are to the Internal Revenue Code

as amended, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

- 3 FINDINGS OF FACT

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

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.

Petitioner resided in

Phoenix, Arizona, at the time he filed his petition in this case.

Petitioner’s Background

Petitioner graduated from high school in 1972 and

immediately thereafter began working in the air-conditioning

business by installing ductwork for his father.

In 1976, after

attending one semester of college, petitioner went to work for

Geottle’s Metal Products (Geottle).

Petitioner’s initial

responsibilities at Geottle included installing sheet metal and

air-conditioning units.

He later worked his way up into the

estimating department, where he bid jobs on behalf of his

employer.

In 1985, petitioner left Geottle and formed his own business

called the A/C Co. (the company).2

The company specialized in

the installation of air-conditioning equipment and associated

ductwork, and the company’s principal place of business was

located in Mesa, Arizona.

The activities of the company during

1992 constitute the focus of respondent’s determination.

2

The company was initially operated as a partnership

between petitioner and an associate, whom petitioner later bought

out. At all times during the 1992 tax year, the company was

operated by petitioner as a sole proprietorship.

- 4 Activities of the Company During 1992

The company experienced a busy year in 1992.

Petitioner had

approximately 100 jobs, with each job lasting anywhere from 6

weeks to 6 months.

While petitioner typically maintained a

workforce of approximately 20 to 25 people, during 1992 that

figure increased to 40.

field as installers.

Most of the employees served in the

Petitioner, a superintendent, an estimator,

and an office manager operated out of the business office.

At some point in 1992, Robert Cook approached petitioner

about working at one of his job sites.

Mr. Cook, however,

conditioned his services upon being paid in cash.

Due to his

need for labor, petitioner agreed, but only after informing Mr.

Cook that he would be issued a Form 1099 with respect to the cash

payments made to him.

William Baker and Dennis Page were hired by petitioner under

similar circumstances.

Petitioner did not meet with these

individuals; rather, he hired them on the recommendation of his

job foremen.

Mr. Baker and Mr. Page each insisted on being paid

in cash for their services, a condition to which petitioner again

agreed on the understanding that Forms 1099 would be issued with

regard to the payments.

Petitioner’s arrangements with Messrs. Cook, Baker, and Page

(collectively, the workers) constitute the only instance in which

petitioner paid a worker in cash for services rendered.

During

- 5 less busy times, petitioner rejected requests from individuals to

be paid in cash.

Petitioner’s Internal Accountant

Ann Gerber (formerly Ann Melcher) served as the company’s

office manager from 1986 until the company was sold in 1994.

Ms.

Gerber was responsible for all monetary aspects of the business.

In addition to collecting receivables and paying expenses, Ms.

Gerber maintained the company’s books and processed the payroll.

As part of her payroll obligations, Ms. Gerber calculated the

proper amount of employment taxes3 to be withheld from each

employee’s paycheck.

Each time petitioner notified Ms. Gerber that a worker was

to be paid in cash, he instructed her that the worker was to be

issued a Form 1099 to reflect the payment.

Petitioner believed

that the issuance of a Form 1099 was sufficient to keep him in

compliance with relevant tax laws.

The workers submitted weekly timecards to Ms. Gerber, and

she would distribute the appropriate cash payments to them.

In

order to generate the cash necessary to pay the workers, Ms.

Gerber would write a check from the company’s account to

3

For convenience, we use the term “employment taxes” to

refer to taxes under the Federal Insurance Contributions Act

(FICA), secs. 3101-3128, the Federal Unemployment Tax Act (FUTA),

secs. 3301-3311, and income tax withholding, secs. 3401-3406.

See Henry Randolph Consulting v. Commissioner, 112 T.C. 1, 1 n.1

(1999).

- 6 petitioner.

The amount of the check included petitioner’s weekly

$500 draw, plus whatever amounts were owed to the workers.

After

depositing petitioner’s $500 draw to his individual account, Ms.

Gerber received the remainder of the check proceeds in cash.

She

in turn distributed the cash to the workers in the amounts they

were owed.

As a result of this practice, the amounts paid to the

workers were reflected on the company’s books as distributions to

petitioner.

Petitioner was not aware that the cash payments to

the workers were being accounted for in this manner.

Ms. Gerber withheld no employment taxes from the amounts

paid to the workers.

In addition, Ms. Gerber did not issue Forms

1099 to the workers, as such was the responsibility of

petitioner’s outside accountant.

Petitioner did not instruct nor

suggest to Ms. Gerber that the cash payments were not to be

reported to the Internal Revenue Service.

Petitioner’s External Accountant

Kenneth Messmer, a certified public accountant, served as

petitioner’s outside accountant starting in 1986.

Mr. Messmer

was responsible for preparing petitioner’s Form 1040, Individual

Income Tax Return (which included the activities of the company

on Schedule C, Profit or Loss From Business), and all of the

company’s required employment tax returns.

Additionally, Mr.

Messmer prepared the necessary Forms W-2, Wage and Tax Statement,

and Forms 1099 pertaining to the company.

- 7 Mr. Messmer’s contact with Mr. Neely was limited; he instead

dealt primarily with Ms. Gerber.

Ms. Gerber coded the checks

written on behalf of the company to various expense accounts, and

Mr. Messmer prepared the relevant tax returns based on such

information.

Petitioner’s Employment Tax Returns

Petitioner filed various employment tax returns relating to

the operations of the company during 1992.

Below is a summary of

the Forms 941, Employer’s Quarterly Federal Tax Return, filed on

behalf of the company:

Quarter

Ending

Date

Filed

Total Wages

Income Tax

Withholding1

FICA2

3/31/92

6/30/92

9/30/92

12/31/92

8/4/92

8/4/92

10/31/92

1/31/93

$70,188

70,188

113,345

113,380

$6,335

6,335

10,330

9,159

$10,739

10,739

17,342

17,347

1

2

Income Tax Withholding, secs. 3401-3406.

Federal Insurance Contributions Act, secs. 3101-3128.

With respect to the company’s 1992 tax liability under the

Federal Unemployment Tax Act, secs. 3301-3311, petitioner filed a

Form 940-EZ, Employer’s Annual Federal Unemployment (FUTA) Tax

Return, on March 1, 1993.

The form reflected total payments to

employees of $353,172, total taxable wages of $176,286, and a

FUTA tax liability of $1,410.

Petitioner was current in payment

of his employment tax obligations listed on the above-described

returns.

- 8 Over the course of 1992, petitioner’s company made cash

payments of $19,985 to Mr. Cook, $21,694 to Mr. Baker, and

$15,414 to Mr. Page.

The payments were not included in the

appropriate employment tax returns.

Petitioner, however, was not

aware in signing the returns that the payments to the workers had

been omitted.

Petitioner’s Individual Income Tax Return

During the review of his 1992 individual income tax return

with Mr. Messmer, petitioner informed Mr. Messmer that he had not

received all of the amounts which were reflected on the company

accounts as his personal draw.

After further investigation, Mr.

Messmer became aware that the payments coded as petitioner’s

personal draw included the cash payments made to the workers.

Mr. Messmer therefore made an adjusting entry to petitioner’s

draw account by subtracting the cash payments to the workers and

adding those payments to the labor expense account under cost of

goods sold.

Petitioner's 1992 individual income tax return was

selected for examination in 1995.

In the course of the

examination, the revenue agent noticed that the cost of goods

sold reported by petitioner varied from the figure carried on the

company’s books by $57,000.

Petitioner initially did not know

the reason for the discrepancy, but he later informed the revenue

agent that the discrepancy was attributable to the cash payments

made to the workers.

- 9 Petitioner described the workers to the revenue agent as

independent contractors.

Petitioner further informed the revenue

agent that the workers had provided services to other people and

that they reported directly to the appropriate job sites.4

Petitioner cooperated with the revenue agent in every aspect

requested and provided her with all pertinent documents and

records.

Petitioner and respondent settled all matters relating to

the examination of petitioner’s individual income tax return.

As

part of the settlement agreement, petitioner stipulated various

aspects of the relationship which the workers maintained with the

company,5 and respondent allowed the payments to the workers to

be included in the labor component of cost of goods sold.

At

this point, petitioner provided respondent with Forms 1099-MISC,

Miscellaneous Income, concerning the payments to the workers.

Notice of Determination

On June 11, 1998, respondent mailed to petitioner a Notice

of Determination Concerning Worker Classification Under Section

7436 in which respondent determined that (1) the workers were

4

The revenue agent was equivocal in her recollection that

petitioner had described the workers as having submitted bids to

him for particular jobs.

5

Specifically, petitioner stipulated that (a) the workers

were required to comply with petitioner’s instructions about

when, where, and how their work was to be performed; (b)

petitioner had the right to discharge each of the workers; and

(c) the workers could have terminated their relationship with

petitioner at any time without incurring liability.

- 10 employees of the company for purposes of Federal employment taxes

under Subtitle C (Employment Taxes and Collection of Income Tax)

of the Internal Revenue Code, and (2) petitioner was not entitled

to “safe harbor” relief provided by section 530 of the Revenue

Act of 1978, Pub. L. 95-600, 92 Stat. 2763, 2885.

Respondent

attached to the notice of determination a schedule detailing the

proposed additional employment taxes.6

Respondent also asserted

a section 6663 fraud penalty with respect to such additional

taxes.

Petitioner filed with the Court a timely petition seeking

our review of the notice of determination pursuant to section

7436.

The notice was issued after the expiration of the general

3-year period of limitations on assessment as set forth in

section 6501(a).

No consents extending the period of limitations

have been executed.

6

In his petition, petitioner disputed the amounts of the

employment taxes and penalties that were set forth on the

schedule accompanying the notice of determination. We previously

granted respondent’s motion to dismiss in part for lack of

jurisdiction as to the amounts of employment taxes and related

penalties, in keeping with our decision in Henry Randolph

Consulting v. Commissioner, 112 T.C. 1 (1999). Subsequent to our

granting of respondent’s motion, Congress amended sec. 7436(a) to

provide the Tax Court with jurisdiction to determine the correct

amounts of employment taxes that relate to the Secretary’s

determination concerning worker classification. See Community

Renewal Tax Relief Act of 2000 (CRTRA), Pub. L. 106-554, sec.

314(f), 114 Stat. 2763. This amendment was made retroactive to

the effective date of sec. 7436(a). See id. sec. 314(g).

Accordingly, we have since vacated our prior order to dismiss in

part for lack of jurisdiction as to the amounts of employment

taxes relating to respondent’s determination concerning worker

classification.

- 11 OPINION

The sole matter for determination is whether the period of

limitations on assessment expired prior to the issuance of

respondent’s notice of determination.

Petitioner contends that

the assessment of any additional employment tax liability is

barred by the statute of limitations under section 6501, as the

notice of determination was issued after the general 3-year

period of limitations provided by section 6501(a).

Respondent,

on the other hand, contends that the general limitations period

under section 6501(a) does not apply in this case.

Respondent

claims that the employment tax returns at issue were false and

fraudulent with an intent to evade tax and that the period of

limitations thereby remains open pursuant to section 6501(c)(1).7

Accordingly, whether respondent’s notice of determination was

timely issued depends on whether petitioner committed fraud in

the filing of the employment tax returns.

This is the first instance in which this Court has been

called upon to determine whether a taxpayer committed fraud in

the employment tax context.

Nonetheless, the determination of

fraud for purposes of the period of limitations on assessment

7

Respondent also alleged in his answer that the failure of

petitioner to reflect the cash payments to the workers on the

appropriate employment tax returns constituted a willful attempt

by petitioner to defeat or evade employment taxes, justifying an

indefinite extension of the period of limitations pursuant to

sec. 6501(c)(2). However, respondent neither argued this point

at trial nor raised it in the course of the posttrial briefing.

Accordingly, we treat this argument as having been withdrawn.

- 12 under section 6501(c)(1) is the same as the determination of

fraud for purposes of the penalty under section 6663, see RhonePoulenc Surfactants & Specialties v. Commissioner, 114 T.C. 533,

548 (2000), and an extensive body of law exists addressing the

fraud penalty in the income, estate, and gift tax contexts.

We

shall rely on such case law in our analysis below.

Fraud is defined as an intentional wrongdoing designed to

evade tax believed to be owing.

See Edelson v. Commissioner, 829

F.2d 828, 833 (9th Cir. 1987), affg. T.C. Memo. 1986-223; McGee

v. Commissioner, 61 T.C. 249, 256 (1973), affd. 519 F.2d 1121

(5th Cir. 1975).

The Commissioner bears the burden of proving

fraud and must establish it by clear and convincing evidence.

See sec. 7454(a); Rule 142(b).

To satisfy the burden of proof,

the Commissioner must show that (1) an underpayment in tax

exists, and (2) the taxpayer intended to conceal, mislead, or

otherwise prevent the collection of taxes.

See Parks v.

Commissioner, 94 T.C. 654, 660-661 (1990).

Petitioner concedes that his failure to include the cash

payments made to the workers on the appropriate employment tax

returns resulted in an understatement in tax.

Accordingly, we

focus on whether the understatement was a product of fraudulent

intent.

As described below, the record in this case does not

support a finding that petitioner acted with an intent to

conceal, mislead, or otherwise prevent the collection of taxes.

Petitioner testified that he believed the employment tax

- 13 returns to be accurate at the time he signed them.

He was not

aware that the payments to the workers should have been included

in the employment tax returns, and, in any event, he was not

specifically aware that the payments were not so included.

Furthermore, petitioner did not know that the payments to the

workers had been coded for accounting purposes as distributions

to himself.

Petitioner’s testimony in this regard was highly

credible, and we note that it was corroborated by the testimony

of his former office manager and his outside accountant.

Ms. Gerber stated that she had no problems with Mr. Neely in

terms of his honesty with her and that he never asked her to do

anything that made her uncomfortable in terms of her job

responsibilities and duties.

Similarly, Mr. Messmer testified

that he at no time had reservations as to petitioner’s

forthrightness and honesty in terms of producing the documents

and information necessary for him to prepare full and accurate

tax returns.

Even the revenue agent who conducted the

examination of petitioner’s income tax return conceded that

petitioner cooperated with her in every aspect requested and

provided her with all pertinent records and documents.

These

witnesses do not paint petitioner as one out to deprive the

Commissioner of his rightful tax revenue.

The only potential “badge of fraud” in this case is

petitioner’s agreement to pay the workers in cash.

The cash

arrangement, however, was not part of a scheme on the part of

- 14 petitioner to underreport employment taxes.

In each case, the

request to be paid in cash was initiated by the worker.

Petitioner agreed to the workers’ requests because he needed

additional labor to satisfy his exceptionally high volume of

contracts.

Furthermore, petitioner conditioned the arrangement

on the understanding that the company would issue a Form 1099

reflecting the cash payments.

Petitioner instructed Ms. Gerber

to see that Forms 1099 were in fact issued to the workers.

It

was thus petitioner’s intent that the Commissioner be aware of

the cash payments as opposed to the contrary.

Respondent has not established, let alone on a clear and

convincing basis, that petitioner intended to conceal, mislead,

or otherwise prevent the collection of taxes.

As a result,

section 6501(c)(1) does not operate to extend the period of

limitations on assessment beyond the 3-year period set out in

section 6501(a).

Accordingly, as the period of limitations

expired prior to the issuance of respondent’s notice of

determination, the assessment of any additional employment tax

liability for the taxable periods in issue is barred.

To reflect the foregoing,

Decision will be entered for

petitioner.