UNITED STATES TAX COURT

ALS

T.C. Memo. 2013-10

UNITED STATES TAX COURT

THOUSAND OAKS RESIDENTIAL CARE HOME I, INC., ET AL.,' Petitioners

V.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 1448-10, 1480÷10,

1481-10.

Filed January 14, 2013.

R determined that a corporation's compensation packages for its

owner-employees were unreasonable and disallowed deductions for

compensation paid for the 2003 through 2005 tax years.

Held; The compensation packages paid to the corporation's

owner-employees were reasonable and deductible under I.R.C. sec.

162, for the 2003, 2004, and 2005 tax years to the extent determined

herein. The compensation paid to the owner-employees' daughter,

Grace-Ann Strick, was unreasonable.

1Cases of the following petitioners are consolidated herewith: Thousand

Oaks Residential Care Home I, Inc., docket No. 1480-10; and Robert A. Fletcher

and Pearl Fletcher, docket No. 1481-10. On December 15, 2011, we granted

motions to change the captions in docket Nos. 1448-10 and 1480-10.

SERVED Jan 14 2013

-2[*2]

Held, further, the corporation is liable for the I.R.C. sec. 4972

excise tax to the extent determined herein. It is not liable for the I.R.C.

sec. 6651(a)(1) and (2) additions to tax. Ps are liable for a portion of

the I.R.C. sec. 6662(a) penalties as redetermined in this opinion.

Matthew Taggart, Ryan Andrews, Michael B. Luftman, and Charles Kolstad,

for petitioners.

Kris H. An, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WHERRY, Judge: These cases are before the Court on petitions for

redetermination of income tax and excise tax deficiencies, additions to tax, and

penalties respondent determined for petitioners' 2002 through 2005 tax years.2

After concessions the issues remaining are:3

2Unless otherwise indicated, all section references are to the Internal Revenue

Code of 1986 (Code), as amended and in effect for the taxable years at issue. All

Rule references are to the Tax Court Rules of Practice and Procedure.

3Petitioners Robert A. Fletcher and Pearl Fletcher concede with respect to

their personal Federal income tax returns that they are not entitled to a deduction for

depreciation expenses of $5,800 reported on Schedules E, Supplemental Income and

Loss, for each of the 2003, 2004, and 2005 tax years. They also concede that they

are not entitled to deduct certain taxes of $1,670, $1,605, and $1,714 for the 2003,

2004, and 2005 tax years, respectively, reported on Schedule E, and respondent

(continued...)

-3[*3] (1) whether the compensation Thousand Oaks Residential Care Home I, Inc.

(TORCH), paid to Robert A. and Pearl Fletcher was reasonable under section 162

3(...continued)

concedes that they are entitled to deduct those expenses on Schedules A, Itemized

Deductions, for the applicable years. The Fletchers concede that they are also not

entitled to deduct other Schedule E taxes of $709, $668, and $1,916 for the 2003,

2004, and 2005, tax years, respectively, and respondent concedes that they are.

entitled to deduct those expenses oil Schedule A. The Fletchers concede that they

are not entitled to deduct Schedule E insurance expenses of $520, $500, and $505

for the 2003, 2004, and 2005 tax years, respectively. The parties agree that

Schedule E warehouse rental income should be decreased by $1,200 and $2,400 for

the 2003 and 2005 tax years, respectively. The Fletchers concede that they received

unreported rental income of $4,400, $6,000, and $5,800 for the 2003, 2004, and

2005 tax years, respectively. The Fletchers concede that they are liable for the sec.

6662 accuracy-related penalty with respect to the disallowed Schedule E expenses

and unreported 67 Erbes property rental income.

. Petitioner Thousand Oaks Residential Care Home I, Inc., concedes that it is

not entitled to deduct repairs and maintenance expenses of $2,954 for the 2003 tax

year. This petitioner concedes that it is not entitled to deduct rental expenses of

$2,800 and $7,100 for the 2003 and 2005 tax years, respectively. Respondent

concedes that this petitioner is entitled to deduct taxes and licenses expenses of

$19,198, $19,110, and $6,009 for the 2003, 2004, and 2005 tax years, respectively.

This petitioner concedes that it is iïot entitled to deduct expenses of $56 and $103

for the 2003 and 2005 tax years, respectively. It also concedes that it is not entitled

to other deductions of $26,464, $15,432, and $8,924 for the 2003, 2004, and 2005

tax years. This petitioner concedes that it is not entitled to deduct advertising

expenses of $45 or employee benefit programs expenses of $2,852 for the 2003 tax

year. Respondent concedes that this petitioner is entitled to deduct $20 for the

disallowed contribution for the 2003 tax year, and this petitioner concedes that it is

not entitled to deduct $150 of the same for the 2003 tax year. This petitioner

concedes that it is liable for the sec. 6662 accuracy-related penalty with respect to

all of its concessions listed in this paragraph.

[*4] for the 2003, 2004, and 2005 tax years, including the pension plan

contributions paid on behalf of Robert A. and Pearl Fletcher for the 2003 and 2004

tax years,

(2) whether the compensation TORCH paid to the Fletchers' daughter,

Grace-Ann Strick, was reasonable under section 162 for the 2003, 2004, and 2005

tax years,

(3) whether TORCH is liable for excise tax of $44,710.90 and $91,128.30

under section 4972 for the 2003 and 2004 tax years, respectively,

(4) whether TORCH is liable for section 6651(a)(1) failure file additions to

tax of $10,050.95 and $20,503.87 for the 2003 and 2004 tax years, respectively,

(5) whether TORCH is liable for section 6651(a)(2) failure to pay additions to

tax of $11,177.73 and $22,326.43 for the 2003 and 2004 tax years, respectively,

and

(6) whether petitioners Robert A. and Pearl Fletcher are liable for the section

6662(a) accuracy-related penalty for the 2003, 2004, and 2005 tax years and

whether TORCH is liable for the section 6662(a) accuracy-related penalty for the

2002, 2003, 2004, and 2005 tax years. The parties' stipulated facts and exhibits are

incorporated by this reference. The parties' stipulated facts and exhibits are

incorporated by this reference.

-5[*51

FINDINGS OF FACT

The parties' stipulation of facts and supplemental stipulation of facts, with

accompanying exhibits, and the stipulations of settled issues are incorporated herein

by this reference. At the time they filed their respective Tax Court petitions, the

individual petitioners resided in California and the corporate petitioner maintained

its principal place of business in California.

Robert and Pearl Fletcher's Background--Lighting the Torch

Dr. Robert A. Fletcher began his career as an accountant for the Salvation

Army Grace Hospital in Windsor, Ontario. He received formal training by taking

charter accountant's courses offered by an accountant's association in Windsor,

Ontario. He then became the business manager of the office staff at Leamington

Memorial Hospital in Leamington, Ontario. Dr. Fletcher then moved to the United

States in 1962 and began working at Seaside Oil, which merged with Tidewater

Flying A Oil Co. that then merged with Getty Oil Co. He then became the chief

accountant for Getty Oil.

After leaving Getty Oil Dr. Fletcher decided to attend Cleveland Chiropractic

College in Los Angeles. After graduation Dr. Fletcher became a California licensed

chiropractor and began a chiropractic business in 1969.

-6[*6] Starting in 1974 Dr. Fletcher operated his chiropractic practice as an owneremployee of Robert A. Fletcher Chiropractic Corp., which was incorporated on

October 30, 1974. Dr. Fletcher spent approximately 30 hours per week at his

chiropractic practice until he retired from practicing chiropractic medicine in 1995.

Ms. Fletcher is a registered nurse. She went through three years of training at

the Grace Hospital in Toronto and received a nursing degree in 1959. After

receiving her nursing degree, Ms. Fletcher's first job was at Hotel Dieu Hospital in

Windsor, Canada, working in the operating room for about six months. After that,

she worked at Leamington Memorial Hospital in Ontario, where she ran the

recovery room. After the Fletchers moved to California Ms. Fletcher began working

at the St. Francis Hospital in Santa Barbara in the intensive care unit and in the labor

and delivery room.

After a few years Ms. Fletcher then went to work at the Granada Hills

Community Hospital, where she ran one of the shifts in the large extended care unit.

Her duties there included: overseeing the nurse's aides, dispensing medication,

writing all of the reports and recordings on patients' charts, overseeing lab results,

calling doctors, taking orders, and interacting with patients' families.

-7[*7] Thousand Oaks Residential Care I (Corporation)--Carrying the Torch

On June 30, 1973, the Fletchers purchased a struggling corporation called

Thousand Oaks Residential Care I from John and Edith Breen. Dr. Fletcher

explained that they paid $25,000 and assumed the debt obligations of the

corporation, which were several hundreds of thousands of dollars, including the real

property mortgage.4 The corporation owned and operated TORCH an assisted

living facility in Thousand Oaks, California.5

Dr. Fletcher was the corporation's sole shareholder. From 1973 to 2005 the

corporation's board of directors consisted of three members: Robert A. Fletcher,

Pearl Fletcher, and Lorne Muth, Pearl Fletcher's brother.

Dr. Fletcher oversaw TORCH's general operations, handled its finances, and

supervised its maintenance workers. He also performed substantial maintenance

work himself. After Dr. Fletcher retired from his chiropractic practice in 1995 he

4Although Dr. Fletcher's testimony was that they paid $25,000 and assumed

the debt obligations, the corporation's Federal Form 1120, U.S. Corporation Income

Tax Return, page 4 balance sheet för 2005 shows a common stock balance of

$24,000, and the record does not reveal any stock redemptions. We believe Dr.

Fletcher's testimony that they initially paid $25,000 for the corporation.

5An assisted living center, also known as a residential care home or

residential care facility, provides care and supervision to seniors above the age of 60

without skilled nursing services. A nursing home is a facility that provides

rehabilitation and skilled nursing services.

-8[*8] worked full time for TORCH. Ms. Fletcher worked on and managed the

assisted care personnel aspects of TORCH. She worked with residents, learned of

their diagnoses, handicaps and illnesses, handled family matters, communicated with

the nurses and nurses' aides, communicated with doctors and pharmacists, worked

with dietitians, and supervised the housekeeping staff. The Fletchers received Forms

W-2, Wage and Tax Statement, from TORCH reporting the following incomes:6

Year

Ms. Fletcher

Dr. Fletcher

1973-1983

-0-

-0-

1984

$6,000

-0-

1985

13,000

$12,923

1986

15,521

18,764

1987

26,769

29,077

1988

36,000

36,000

1989

36,000

36,000

1990

4,154

4,154

1991

-0-

-0-

1992

20,800

-0-

1993

20,800

-0-

6All amounts have been rounded to the nearest whole number. No Forms W2 were presented for any year where the amount paid was "-0-".

-9-

[*9] 1994

23,331

-0-

1995

25,885

-0-

26,500

-0-

26,500

-0-

26,500

-0-

26,112

3,112

25,072

19,669

2001

25,011

26,000

2002

} 129,030

130,000

512,985

315,699

1996

1

1997

1998

i

1999

2000

Total

J

The corporation did not begin to cover its expenses and was losing money

until the Fletchers had owned it for 18 months. The corporation paid all of its other

employees at the market rate for their services. The corporation reported the

following revenue information on it 541

Forms 1120 for the 1987 through 2005 tax

years:

Year

Gross

receipts

Taxable

income

Depreciation

expense

Taxable income

before deprecation

1987

$863,021

$35,863

$24,277

$60,140

1988

864,899

24,754

31,133

55,887

1989

826,847

(8,748)

25,907

17,159

1990

679,545

(28,066)

15,636

(12,430)

1991

840,221

3,075

19,586

22,661

-10[*10]

1992

894,853

(26,117)

25,441

(676)

1993

957,930

(8,463)

31,601

23,138

1994

982,305

34,585

32,410

66,995

1995

1,066,006

22,767

20,702

43,469

1996

1,127,454

16,063

33,092

49,155

1997

1,169,540

22,903

18,346

41,249

1998

1,238,596

44,632

30,033

74,665

1999

1,265,554

81,916

12,980

94,896

2000

1,250,983

29,479

10,380

39,859

2001

1,327,452

(27,516)

15,546

(11,970)

2002

1,001,110

297,798

13,949

311,747

20032

-0-

925,640

1,072

926,712

2004

-0-

(917,045)

-0-

(917,045)

2005

-0-

(3,943)

-0-

(3,943)

Total

16,356,316

519,577

362,091

881,668

1The Court has derived this column of information from the reported taxable

income and depreciation amounts on the Forms 1120.

2The facility was sold in 2002, and thereafter the corporation did not receive

any gross receipts.

In July 2002 the corporation hired the Fletchers' daughter, Grace-Ann Strick,

at $10 per hour. Beginning in October 2002 (after the sale of TORCH, see infra),

the corporation paid Ms. Strick $2,000 per month.

- 11 -

[*11] Passing the Torch

On October 1, 2002, the corporation sold its sole asset, the assisted living

facility, in an installment sale for $3,400,000 to Inga Jakobavich.7 The corporation

allocated the $3,400,000 sale proceeds as follows: (1) $83,000 to furniture,

equipment and machines, (2) $17,000 to a 1999 Windstar Van, (3) $200,000 to

goodwill, and (4) $3,100,000 to building and land. Ms. Jakobavich has owned and

operated an assisted living facility called Hillcrest Royale Retirement Community

(Hillcrest) since 1989. After the purchase Ms. Jakobavich changed the name from

TORCH to Thousand Oaks Royale Retirement Community. Since 2003 Ms.

Jakobavich has paid herself $240,000 a year as the owner-operator of Hillcrest.

When TORCH was sold it had about 85 residents and between 45 and 50

employees on staff. As part of the sale agreement, Dr. Fletcher entered into an

interim lease back and management Jagreement starting on October 1, 2002, and

ending on the earlier of April 30, 2003, or when Ms. Jakobovich obtained her own

7Ms. Jakobovich agreed to pay the following amounts: (i) $700,000 at 8%

interest with a monthly payment of $5,402.71 from November 1, 2002, to October

1, 2007; and (ii) $2,120,000 at 7% interest with a monthly payment of $14,983.72

from November 1, 2002, to April 1, 2003, when the entire principal balance together

with interest was due.

[*12] license. The Fletchers continued to work at TORCH for nine months

following its sale.

After the Sale of TORCH

The corporation created a defined benefit plan (pension plan), effective

January 1, 2003. The Fletchers and Ms. Strick were the only participants of the plan.

The corporation paid Dr. Fletcher Form W-2 wages of $200,000, $200,000,

and $30,000 in 2003, 2004, and 2005, respectively. It also contributed $191,433 and

$259,506 to the pension plan for the benefit of Dr. Fletcher in 2003 and 2004,

respectively, for a total compensation package of $880,939. The corporation paid

Ms. Fletcher Form W-2 wages of $200,000, $200,000, and $30,000 in 2003, 2004,

and 2005, respectively.8 It also contributed $191,433 and $198,915 to the pension

plan for the benefit of Ms. Fletcher in 2003 and 2004, respectively for a total

compensation package of $820,348.

The corporation's annual board minutes dated November 28, 2003, state:

"Compensation to Administrators was approved for payment of back salaries that

8The Schedules E for 2004 and 2005 appear to mistakenly leave off the

$200,000 and $30,000 of executive compensation for each of the Fletchers. The

Fletchers do not dispute receiving this income, and their accountant explained at

trial that the expense for the Fletchers' compensation was included in the cost of

labor elsewhere on the return.

- 13 [*13] were not paid in prior years due to insufficient cash flow." The corporation's

annual board minutes dated November 26, 2004, reiterated that the salaries approved

in the prior year would remain the same, and the annual board minutes dated

December 26, 2005, again state thatithe compensation paid to the Fletchers was

intended as catchup compensation for inadequate compensation from prior.years.

In 1987 the long-term debt ofithe corporation was $758,071. In 2002 the

long-term debt was $16,228, but the corporation owed $141,167 to its shareholders.

The corporation's 2005 Form 1120 page 4 shows that at the end of the year the

corporation had assets of $151,734 in cash on hand, $200 in current assets, and

$700,000 in mortgage and real estate loans. It also shows that the corporation had

liabilities of $149,262 in loans from shareholders, $515,987 in mortgages, notes,

bonds payable in a year or more, $24,000 in common stock, and $162,685 in

retained earnings.

Ragnar Storm-Larsen's accounting firm, Storm-Larsen & Co., Inc., has

prepared petitioners' returns and accounting records since the early 1990s. Mr.

Storm-Larsen is an enrolled agent and has an M.B.A. degree from the California

Lutheran University. It was Mr. Storm-Larsen's regular business practice to ask the

taxpayer to review and approve a return before it was filed.

[*14] Dr. Fletcher approached Mr. Storm-Larsen when he believed that the sale of

TORCH was imminent and that he and Ms. Fletcher would be paying a large amount

of tax. Mr. Storm-Larsen researched catchup compensation and explained to Dr.

Fletcher that if he had not been paid reasonable compensation in the past then he

could make an adjustment and pay himself more. Mr. Storm-Larsen also advised Dr.

Fletcher that a contribution to the pension plan was a benefit and that he could

include it as compensation not previously received. Mr. Storm-Larsen advised the

Fletchers that the compensation was reasonable.

Expert Report--Elizabeth Newlon, Ph.D.

Respondent commissioned Elizabeth Newlon, Ph.D., a senior consultant of

National Economic Research Associates, Inc., to assess the compensation Dr. and

Ms. Fletcher could reasonably expect for work performed at TORCH. Dr. Newlon

has a B.S. degree in economics from Ohio State University and an M.A. degree and

a Ph.D. in economics from Carnegie Mellon University. She is a published writer

and has worked on discrimination, wage-and-hour, and wrongful termination suits

and provided compensation estimates for medical directors.

In order to compare the Fletchers' compensation with the nationwide data

available, Dr. Newlon first determined that Ms. Fletcher's responsibilities were

those of a medical and health services manager and that Dr. Fletcher's

- 15 [*15] responsibilities were those of a general and operations manager, although she

questioned "that there was a need for a full-time manager of this type". Dr. Newlon

then compared the Fletchers' compensation with that of individuals doing similar

types of work at residential care facilities in California.

Dr. Newlon used labor rates from the Bureau of Labor Statistics'

Occupational Employment Statistics program. That data is available only for 20022010; therefore Dr. Newlon deflated the compensation back to 1973 using the

average decrease in compensation year to year, working backwards from 2010 to

2002. Dr. Newlon also adjusted the data to control for differences in the prevailing

wages in California. She increased the national figures using the ratio of the median

California medical and health services manager wages for Ms. Fletcher and the

median general and operations manager wages for Dr. Fletcher to the national

median wages for those positions (which worked out to be 118% for both). Dr.

Newlon then decreased Dr. Fletcher's estimated compensation to reflect the amount

she believed he was working, i.e. to 25% of the estimated amount for the years his

tax statements stated that he worked 25% of his time at TORCH, 100% for the years

after his retirement, and 25% for the years after the Fletchers sold TORCH. The

following table shows Dr. Newlon's conclusions as to reasonable compensation for

the Fletchers:

[*16] Year

2003

Ms. Fletcher

$61,622

% Mr. Fletcher Worked

Mr. Fletcher

25%

$6,952

Nov. - Dec. 25

2,614

Jan. - Oct. 100

52,286

2002

57,437

2001

55,111

100

56,526

2000

53,169

100

54,223

1999

51,296

100

52,014

1998

49,489

100

49,895

1997

47,746

100

47,862

1996

46,064

100

45,912

1995

44,441

100

44,042

1994

42,876

25

10,562

1993

41,365

25

10,132

1992

39,908

25

9,179

1991

38,502

25

9,323

1990

37,146

25

8,943

1989

35,837

25

8,579

1988

34,575

25

8,229

1987

33,357

25

7,894

1986

32,182

25

7,572

1985

31,048

25

7,264

1984

29,955

25

6,968

1983

28,899

25

6,684

1982

27,881

25

6,412

- 17 [*17] 1981

26,899

25

6,151

1980

25,952

25

5,900

1979

25,037

25

5,660

1978

24,155

25

5,429

1977

23,304

25

5,208

1976

22,484

25

4,996

1975

21,691

25

4,792

1974

20,927

25

4,597

1973

20,190

25

2,205

Total

1,130,545

565,005

Procedural Background

Respondent issued notices of deficiency on: October 21, 2009, for Dr. and

Ms. Fletcher's 2003, 2004, and 2005 tax years; October 21, 2006, for Thousand

Oaks Residential Home, Inc., for its tax years ended December 31, 2002, 2003,

2004, and 2005; and October 21, 2009, for Thousand Oaks Residential Care Home,

for its tax years ended December 31, 2003 and 2004, showing income tax

deficiencies and penalties of:9

9All values have been rounded to the nearest whole number.

- 18 [*18]

Petitioner

Robert A. & Pearl

Fletcher, docket

No. 1481-10

Year

Deficiency

Accuracy-related

penalty

Sec. 6662(a)

2003

$29,750

$5,950

2004

31,191

6,238

2005

16,729

3,346

Petitioner

TYE Dec. 31

Deficiency

Accuracy-related

penalty

Sec. 6662(a)

TORCH, docket No.

1480-10

2002

$99,391

$19,878

2003

526,695

105,399

2004

701

104

2005

18,916

3,783

Petitioner

TYE Dec. 31

Deficiency

Additions to tax

Sec. 6651(a)(1) and (2)

TORCH, docket No.

1448-10

2003

$44,711

$10,060

$11,178

2004

91,128

20,504

22,326

OPINION

I.

Burden of Proof

The Commissioner's determination of a taxpayer's liability for an income tax

deficiency is generally presumed correct, and the taxpayer bears the burden of

proving that the determination is improper. See Rule 142(a); Welch v. Helvering,

- 19 [*19] 290 U.S: 111, 115 (1933). However, pursuant to section 7491(a)(1), the

burden of proof on factual issues that affect the taxpayer's tax liability may be shifted

to the Commissioner where the "taxpayer introduces credible evidence with respect

to * * * such issue." The burden will shift only if the taxpayer has, inter alia,

complied with substantiation requirements pursuant to the Code and "maintained all

records required under this title and:has cooperated with reasonable requests by the

Secretary for witnesses, information, documents, meetings, and interviews". Sec.

7491(a)(2). Because we decide these cases on the preponderance of the evidence,

we need not address who bears the burden of proof.

IL

Reasonable Compensation

Respondent contends that the compensation packages paid to the Fletchers

were not reasonable under section 162 for the 2003, 2004, and 2005 tax years and

disallowed deductions for all of the compensation.1° Petitioners contend that

compensation paid in those years was reasonable and included catchup payments

1°0n brief respondent raises the issue of whether the fact that the corporation

made only two payments to the defined benefit plan included in the Fletchers'

compensation package makes the plan a temporary rather than a permanent one

under sec. 1.401-1(b)(2) Income Tax Regs. Respondent never challenged the plan

previously, and we decline to address this argument here, noting only that as

petitioners correctly point out: "[t]he permanency requirement referred to in the

regulations does not contemplate perpetual contributions". Estate of Benjamin v.

Commissioner, 54 T.C. 953, 967 (1970), aff'd, 465 F.2d 982 (7th Cir. 1972).

- 20 [*20] for prior years in which they were undercompensated. In determining the

reasonableness of compensation, we look at the compensation package as a whole,

which includes salary and pension plan contributions. Bianchi v. Commissioner, 66

T.C. 324, 330 (1976), aff'd, 553 F.2d 93 (2d Cir. 1977).

A.

Overview of Section 162(a)(1)

Section 162(a)(1) provides a deduction for ordinary and necessary business

expenses, including "a reasonable allowance for salaries or other compensation for

personal services actually rendered". The deductibility of compensation is

determined through a two-prong test: the amount of compensation must be

reasonable, and the payment must be purely for services rendered. Nor-Cal

Adjusters v. Commissioner, 503 F.2d 359, 362 (9th Cir. 1974), af_g T.C. Memo.

1971-200; sec. 1.162-7, Income Tax Regs. We consider the reasonableness of the

combined salary payments and the contributions to the defined benefit plan." See

Rutter v. Commissioner, 853 F.2d 1267, 1274 (5th Cir. 1988), aff_g T.C. Memo.

1986-407; Bianchi v. Commissioner, 66 T.C. at 333-334.

"Contributions to defined benefit plans are not generally deductible under

sec. 162 unless they meet the requirements of sec. 404(a). Sec. 404(a) incorporates

the reasonable compensation standard of sec. 162. See LaMastro v. Commissioner,

72 T.C. 377, 381-382 (1979).

- 21 [*21] B.

Catchup Compensation & Services Actually Rendered

Compensation for prior years' services is deductible in the current year as long

as the employee was actually under compensated in prior years and the current

payments are intended as compensation for past services. R.J. Nicoll Co. v.

Commissioner, 59 T.C. 37, 50-51 (1972). When the compensation was actually for

prior years of service, it need not be reasonable in the year it was paid. Devine

Bros., Inc., v. Commissioner, T.C. Memo. 2003-15. Therefore, we shall evaluate the

Fletchers' compensation in its entirnty. In order for an employer to deduct

compensation under section 162(a)(1) the compensation packages need to be both

reasonable and for services actually provided. Nor-Cal Adjusters v. Commissioner,

503 F.2d at 362; sec. 1.162-7, Income Tax Regs.

The corporation's annual board minutes dated November 28, 2003, explicitly

state: "Compensation to Administrators was approved for payment of back salaries

that were not paid in prior years due to insufficient cash flow." The corporation's

annual board minutes dated November 26, 2004, reiterated that the salaries

approved in the prior year would remain the same, and we infer that this means

that the board also intended those cómpensation packages as payment of back

salaries for prior years. The corporation's annual board minutes dated December

- 22 [*22] 26, 2005, again state that the compensation paid to the Fletchers was for

inadequate compensation from prior years.

We found the Fletchers' testimony that the compensation was intended as

catchup compensation for prior years credible and, when viewed along with the

corporation's annual board minutes, we find that the compensation was intended as

compensation for each of the three years at issue, respectively, and as catchup

compensation for prior services actually rendered. Now we must determine whether

the catchup compensation was reasonable.

C.

Reasonableness of Payments

The reasonableness of the payments is considered with reference to five broad

factors set forth in Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983),

rev'a T.C. Memo. 1980-282. No single factor is dispositive. Id. at 1245. The

relevant factors are: (1) the employee's role in the company; (2) a comparison of the

employee's salary with salaries paid by similar companies for similar services; (3)

the character and condition of the company; (4) potential conflicts of interest; and (5)

internal consistency. Id. at 1245-1247.

The Court of Appeals for the Ninth Circuit, to which an appeal in these cases

would lie absent stipulation to the contrary, adds an additional factor: whether an

independent investor would be willing to compensate the employee as he was so

- 23 [*23] compensated. Metro Leasing & Dev. Corp. v. Commissioner, 376 F.3d 1015,

1019 (9th Cir. 2004), a_ff£g 119 T.C. 8 (2002). The Court of Appeals notes that "the

perspective of an independent investor is but one of many factors that are to be

considered when assessing the reasonableness of an executive officer's

compensation." Id. at 1021. The reasonableness of compensation is a question of

fact to be determined on the basis of all the facts and circumstances. Pac. Grains,

Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968), af£g T.C. Memo. 1967-7.

1.

Employee's Rolé in the Company

This factor looks to the overall significance of the employee to the company.

Elliotts, Inc. v. Commissioner, 716 F.2d at 1245. "Relevant considerations include

the position held by the employee, hours worked, and duties performed, Am.

Foundry v. Commissioner, 536 F.2dl 289, 291-292 (9th Cir. 1976), as well as the

general importance of the employee to the success of the company". Id.

The Fletchers were hands-on owner-operators of TORCH. Although

TORCH was only moderately profitable, the Fletchers explained that they bought

the facility for very little cash (i.e., $25,000) plus assumed liabilities, when the

revenues from the facility could not even cover its bills and that within 18 months

they had turned it around. Dr. Fletcher was the president and overall manager of

- 24 [*24] TORCH, and Ms. Fletcher was the head nurse and was in charge of personnel

and resident relations. We find this factor weighs in favor of petitioners.

2.

Comparison With Salaries Paid by Similar Companies

The next relevant factor is a comparison of the employee's salary with salaries

paid by similar companies providing similar services. Elliotts, Inc. v. Commissioner,

716 F.2d at 1246; Hoffman Radio Corp. v. Commissioner, 177 F.2d 264, 266 (9th

Cir. 1949).

Petitioners did not provide the Court with any evidence of employees of other

companies providing similar services with the exception of Ms. Jakobavich, who

testified that she has paid herself $240,000 a year as the owner-operator of Hillcrest

since 2003. However, we know nothing of Ms. Jakobavich's job description, duties,

hours, or the profitability of Hillcrest. Respondent presented an expert witness to

compare the Fletchers' compensation with nationwide data.12

12We note that we evaluate expert opinions in the light of each expert's

demonstrated qualifications and all other evidence in the record. See Parker v.

Commissioner, 86 T.C. 547, 561 (1986). We are not bound by an expert's opinion

and may accept or reject an expert opinion in full or in part in the exercise of sound

judgment. See Helvering v. Nat'l Grocery Co., 304 U.S. 282, 295 (1938); Parker v.

Commissioner, 86 T.C. at 561-562. We may also reach a determination of value

based on our own examination of the evidence in the record. Silverman v.

Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), aff'a T.C. Memo. 1974-285.

- 25 [*25] Combining two of the tables .s_upra, we can summarize respondent's expert's

findings as to the adequacy of Dr. F1 tcher's and Ms. Fletcher's compensation:

Ms.

Fletcher

actual

Amount

under-paid

Year

Ms.

Fletcher

(estimate)

Dr.

Fletcher

(estimate)

Dr.

Fletcher

actual

Amount

underpaid

2002

$57,437

$129,030

($71,593)

$54,900

$130,000

($75,100)

2001

55,111

25,011

30,100

56,526

26,000

30,526

2000

53,169

25,072

28,097

54,223

19,669

34,554

1999

51,296

26,112

25,184

52,014

3,112

48,902

1998

49,489

26,500

22,989

49,895

-0-

49,895

1997

47,746

26,500

21,246

47,862

-0-

47,862

1996

46,064

26,500

19,564

45,912

-0-

45,912

1995

44,441

25,885

18,556

44,042

-0-

44,042

1994

42,876

23,331

19,545

10,562

-0-

10,562

1993

41,365

20,800

20,565

10,132

-0-

10,132

1992

39,908

20,800

19,108

9,179

-0-

9,179

1991

38,502

-0-

38,502

9,323

.-0-

9,323

1990

37,146

4,154

32,992

8,943

4,154

4,789

1989

35,837

36,000

(163)

8,579

36,000

(27,421)

1988

34,575

36,000

(1,425)

8,229

36,000

(27,771)

1987

33,357

26,769

6,588

7,894

29,077

(21,183)

1986

32,182

15,521

16,661

7,572

18,764

(11,192)

1985

31,048

13,000

18,048

7,264

12,923

(5,659)

1984

29,955

6,000

! 23,955

6,968

-0-

6,968

-26[*26]

1983

28,899

-0-

28,899

6,684

-0-

6,684

1982

27,881

-0-

27,881

6,412

-0-

6,412

1981

26,899

-0-

26,899

6,151

-0-

6,151

1980

25,952

-0-

25,952

5,900

-0-

5,900

1979

25,037

-0-

25,037

5,660

-0-

5,660

1978

24,155

-0-

24,155

5,429

-0-

5,429

1977

23,304

-0-

23,304

5,208

-0-

5,208

1976

22,484

-0-

22,484

4,996

-0-

4,996

1975

21,691

-0-

21,691

4,792

-0-

4,792

1974

20,927

-0-

20,927

4,597

-0-

4,597

1973

20,190

-0-

20,190

2,205

-0-

2,205

Total

1,068,923

512,985

555,938

558,053

315,699

242,354

For the years for which a "-0-" appears in the above table, petitioners did not

supply a Form W-2. The Fletchers credibly testified that for the years for which they

did not have a Form W-2 from the corporation, the corporation did not have

sufficient funds to pay them a salary, making a Form W-2 unnecessary. Respondent

did not establish that the Fletchers received a salary in any of those years and failed

to produce any further Forms W-2.

Looking at the above table, even respondent's own expert, whom the Court

found knowledgeable, agrees that the Fletchers were underpaid in comparison with

- 27 [*27] data from a national survey." Using the data from this chart, respondent's

expert shows that before the years at issue Ms. Fletcher was underpaid by $555,938

and Dr. Fletcher was underpaid by $242,354.

In the years at issue, as we determined above, Dr. Fletcher received a total

compensation package of $880,939 and Ms. Fletcher received a total compensation

package of $820,348 for services rendered. After subtracting the amounts by which

the Fletchers were underpaid in prior years as determined by respondent's expert,

Dr. Fletcher's combined compensation for the years at issue was $638,585 and Ms.

Fletcher's combined compensation for the years at issue was $264,410.

Respondent's expert, Dr. Newlon, used labor rates from the Bureau of Labor

Statistics' Occupational Employment Statistics program to determine the figures

represented in the table above. That data for 2003 through 2005 shows that a

combined compensation inflated for California wages and assuming full- time

employment, would be $187,537.40 for Dr. Fletcher and $195,785.60 for Ms.

Fletcher.14 Because of the large difference between the actual compensation and

"We note that Dr. Newlon did not account for the time value of money.

Because the Fletchers were required to wait for compensation for prior years, their

catchup compensation should also have been inflated for the time value of money.

14These figures were taken from a table included in Dr. Newlon's expert

report that reported data from the Bureau of Labor Statistics' Occupational

(continued...)

[*28] respondent's expert's opinion, this factor weighs in favor of finding that the

Fletchers' compensation was unreasonable.

3.

Character and Condition of the Company

Under this factor we analyze the character and condition of the company,

focusing on the company's size, complexity, net income, and general economic

condition. Elliotts, Inc. v. Commissioner, 716 F.2d at 1246.

First, we note that one of the reasons the Fletchers determined to pay

themselves catchup compensation is that in multiple years the corporation had

insufficient cashflow and profit to pay them adequate compensation. However, the

corporation's profitability is not the only indication of the character and condition

of the company.

In 1987 the long-term debt of the corporation was $758,071. By 2002 the

long-term debt had been reduced to $16,228, and the corporation owed $141,167

in loans from shareholders.15 Had the Fletchers chosen to pay themselves higher

salaries in years they chose to aggressively pay down the loans, the outstanding

"(...continued)

Employment Statistics program. Dr. Newlon did not reach any conclusions for

these numbers; however, she did not believe that the Fletchers were each fully

employed by the corporation for each of years at issue.

isWith stated capital of only $25,000 the corporation was thinly capitalized

and some of the loans from shareholders might arguably in substance have been

capital. Respondent has never raised this issue; consequently, we shall treat the

"loans" as loans.

1

- 29 -

[*29] debt would have been higher when TORCH was sold and the Fletchers would

have made less on the sale. Also, as we noted above, TORCH was only moderately

profitable, but the Fletchers bought the facility when the revenues it generated could

not even cover its bills and within 18 months had turned it around. Although the

corporation was not profitable enough to pay the Fletchers in some years, the

Fletchers paid down long-term debt, and upon purchasing TORCH, managed to

make it profitable enough to pay its bwn bills and to command a substantial price

when it was sold. Therefore we find this factor slightly favors petitioners.

4.

Potential Conflicts of Interest

This factor focuses on any indicia that there may be a conflict of interest. Id.

Primarily we are concerned whether a relationship exists between the employee and

the company that may permit the disguise of nondeductible corporate distributions as

salary expenditures. Id.

The Fletchers, as owner-operators who never received a dividend and who

used all of the profits of TORCH's sale to pay themselves income, undoubtedly had

a conflict of interest. Petitioners' opening brief agrees that "a conflict of interest

clearly existed". With petitioners' concession we find that this factor weighs

- 30 [*30] against finding that the compensation the Fletchers received was reasonable

and deductible under section 162.

5.

Internal Consistency

"[E]vidence of an internal inconsistency in a company's treatment of payments

to employees may indicate that the payments go beyond reasonable compensation."

Elliotts, Inc. v. Commissioner, 716 F.2d at 1247. In most of the years before the

years at issue, the Fletchers' compensation was indeed inconsistent with the

payments to other employees, but the Fletchers discriminated against themselves. In

years when the corporation experienced cashflow problems or was not profitable

they took no, or very little, salary. Respondent correctly points out that during the

years at issue the Fletchers had large salaries; however, as discussed above, we

found that the.Fletchers were paying themselves previously earned compensation for

years in which they were under compensated. We find that this factor weights in

favor of finding that the compensation the Fletchers received was reasonable and

deductible under section 162.

6.

Additional Factor: The Independent Investor

While we found supra that the Fletchers did intend the compensation as

catchup compensation for prior services rendered, paying out compensation

packages that deplete the rest of the corporation's assets denies the corporation's

- 31 [*31] equity owners a fair return on!their capital investment. In Elliotts, Inc. v.

Commissioner, 716 F.2d at 1247, the Court of Appeals for the Ninth Circuit noted

that

If the bulk of the corporation'is earnings are being paid out in the form

of compensation, so that the corporate profits, after payment of the

compensation, do not represent a reasonable return on the shareholder's

equity in the corporation, then an independent shareholder would

probably not approve of the compensation arrangement. If, however,

that is not the case and the company's earnings on equity remain at a

level that would satisfy an independent investor, there is a strong

indication that management is providing compensable services and that

profits are not being siphoned out of the company disguised as salary.

[Fn. ref. omitted.]

The Fletchers purchased TORCH for $25,000 in 1973, and the record does

not indicate if they paid in any additional amounts.16 A reasonable investor would

expect to receive a return on this initial investment and would not approve of a

16The reCOrd does not reveal whether the Fletchers were personally liable for

the loans assumed upon the purchase of TORCH, which would warrant an increased

return on the investment. And the record does not indicate whether the Fletchers

contributed additional amounts to TORCH during the periods it could not cover its

bills. Because the record is so sparse as to additional paid-in capital, we will

assume that TORCH took loans from the shareholders and then repaid them when

there was money.

Also, as discussed supra not 4, Dr. Fletcher testified that the Fletchers paid

$25,000 and assumed the debt obligations when they purchased the corporation;

however, the corporation's Form 1120, page 4 balance sheet for 2005 shows a

common stock balance of $24,000, and the record does not reveal any stock

redemptions. We f'md Dr. Fletcher's testimony credible that they initially paid

$25,000 for the corporation.

- 32 [*32] salary package that entirely depletes the corporation's assets. Id. (20% return

on equity "would satisfy independent investor"); L & B Pipe & Supply Co. v.

Commissioner, T.C. Memo. 1994-187 (investor would have been happy with either

6% dividend return plus 10% growth in retained earnings or 20% growth in

shareholders' equity).

As the cases above show, the Court has found a return on investment of

between 10% and 20% tends to indicate compensation was reasonable." A 10%

return on $25,000 compounded annually for 31.5 years (1973-2005) is roughly

$503,300, and a 20% return is $7,800,982.18 Because TORCH was a small highly

leveraged business purchased with a large amount of debt, a hypothetical investor in

TORCH might be satisfied with a 10% return on this investment. Therefore the

corporation should have had $503,300 left for distribution after payment of the

17We note that in June 1973 the prime interest rate was between 7.5% and

7.75% and that a 10-year Treasury note had a 6.46% interest rate. Because of the

nature of TORCH an investor would have expected to earn a higher rate of return

than the Treasury note.

18Although as explained in Miller & Sons Drywall, Inc. v. Commissioner,

T.C. Memo. 2005-114, "this Court has generally calculated a corporation's ROE

[return on equity] by dividing its net income after tax for a specific year by its

shareholders equity" instead of using compound growth rates, we find that under the

specific facts of these cases using compound growth rates paints a more accurate

picture. As the table supra page 9 shows, the corporation had minimal income in

most of the years it was in business and in both 2004 and 2005 had negative

mcome.

- 33 [*33] compensation packages. Beca se the compensation packages did not leave

enough of the corporation's assets to be paid back to the hypothetical investor as a

return on investment, we find that this factor,weighs against a fmding of reasonable

compensation.

7.

Conclusion

After reviewing each factor discussed above, we fmd that the compensation

packages the Fletchers received as ebmpensation for the 2003, 2004, and 2005 tax

years were unreasonable. Taking into account the rate of return a reasonable

investor would have expected, we find that the Fletchers were overpaid by a total of

$282,615.19 A reasonable investor would require at least this amount remain in

19We have found that the cor oration should have had on hand $503,300 to

pay the hypothetical investor, and the corporation had $162,685 in retained earnings

at the end of the 2005 tax year. W disallowed Ms. Strick's compensation of

$59,000 infra (that in substance ampunted to a dividend or distribution to

shareholders and a gift by them to their daughter), which increased the amount the

corporation hád left on hand. Ther¼fore, the Fletchers were overpaid by a total of

$282,615 (i.e. $503,300 - $161,68 - $59,000 = $282,615).

The Fletchers' combined tot I compensation for the years at issue was

$1,701,287. Dr. Fletcher's combined compensation accounted for 51.8% of that

amount, and Ms. Fletcher's accounted for 48.2%. Therefore we attribute $146,395

of the overpayment to Dr. Fletcher and $136,220 to Ms. Fletcher. Of Dr. Fletcher's

combined compensation his salary accounted for 48.8% and the pension plan

contribution accounted for 51.2%. Therefore we find that Dr. Fletcher was overpaid

in salary by $71,441 (which is not eductible) and had a nondeductible pension plan

(continued...)

- 34 [*34] the corporation to be paid out to the investor as a return on the investment.

We again note that the reasonableness of compensation is a question of fact to be

determined on the basis of all the facts and circumstances. Pacific Grains, Inc. v.

Commissioner, 399 F.2d at 606.

III.

Compensation Paid to Grace-Ann Strick

Respondent contends that the compensation paid to Ms. Strick was not

reasonable under section 162 for the 2003, 2004, and 2005 tax years. As discussed

supra, section 162(a)(1) provides a deduction for ordinary and necessary business

expenses, including reasonable compensation for services rendered. Under the twoprong test the amount of compensation must be reasonable, and the payment must be

purely for services rendered. Nor-Cal Adjusters v. Commissioner, 503 F.2d at 362;

sec. 1.162-7, Income Tax Regs.

In July 2002 the corporation hired Ms. Strick at $10 per hour. The

corporation was sold on October 1, 2002, and beginning in October 2002, the

corporation paid Ms. Strick $2,000 per month.

19(...continued)

contribution of $74,954. Of Ms. Fletcher's combined compensation her salary

accounted for 52.4% and the pension plan contribution accounted for 47.6%.

Therefore we find that Ms. Fletcher was overpaid in salary by $71,380 (which is not

deductible) and had a nondeductible pension plan contribution of $64,840.

- 35 [*35] Petitioners contend that Ms. trick was hired to handle third-party vendors

and worker's compensation claims filed by former employees against the

corporation. Petitioners provided dócuments related to worker's compensation

claims filed by Paula Muriel and A paro Villasenor to substantiate Ms.. Strick's

employment. Ms. Muriel's acciden occurred on or about February 11, 2002, and

was settled on or about March 21, 2002. As this was before Ms. Strick began

working for TORCH, we do not fin this evidehce substantiates Ms. Strick's

employment.

Petitioners also provided documents related to the claim filed by Amparo

Villasenor. Mr. Villasenor was injured on or about May 13, 2000. Although the

file is much more extensive than that of Ms. Muriel and it appears that petitioners

hired and paid attorneys through 20 3 to handle the appeal of the worker's

compensation claim, Ms. Strick's name does not appear on any of the documents,

and she did not testify at trial to ex lain what services she provided. On the basis of

the preponderance of the evidence we find that all.of the compensation paid to

Grace-Ann Stick was not reasonabl under section 162 for the 2003, 2004, and 2005

tax years and the corporation is not entitled to deduct it.

- 36 -

[*36] IV.

Section 4972 Excise Tax

Because TORCH did not file Form 5330, Return of Excise Taxes Related to

Employee Benefit Plans, respondent contends that the corporation is liable for excise

tax of $44,710.90 and $91,128.30 under section 4972 for the 2003 and 2004 tax

years, respectively. Section 4972 imposes a 10% tax on any nondeductible

contributions to qualified employer plans. See Citrus Valley Estates, Inc. v.

Commissioner, 99 T.C. 379 (1992), aff'd in part, remanded in part, 49 F.3d 1410

(9th Cir. 1995). Because we found supra that a portion of TORCH's contributions to

the pension plan was unreasonable compensation and therefore not deductible under

section 162 (and thereby section 404), the 10% section 4972 excise tax applies to

that extent.

V.

Section 6651(a)(1) and (2) Additions to Tax

Respondent contends that the corporation is liable for section 6651(a)(1)

failure to file additions to tax of $10,050.95 and $20,503.87 for the 2003 and 2004

tax years, respectively. As a general rule, "any person made liable for any tax

* * * shall make a return or statement according to the forms and regulations

prescribed by the Secretary." Sec. 6011(a); see also Citrus Valley Estates, Inc. v.

Commissioner, 99 T.C. at 462 (holding section 6651(a) is applicable to the failure to

file a Form 5330). Section 6651(a)(1), in the case of a failure to file a return on

- 37 [*37] time, imposes an addition to tax of 5% of the tax required to be shown on the

return for each month or fraction thereof for which there is a failure to file, not to

exceed 25% in the aggregate.20 The addition to tax will not apply if it is shown that

such failure is due to reasonable cause and not due to willful neglect. Sec.

6651(a)(1).

Respondent also contends that the corporation is liable for section 6651(a)(2)

failure to pay additions to tax of $11,177.73 and $22,326.43 for the 2003 and 2004

tax years, respectively, because the corporation did not pay the excise tax due to be

shown on Form 5330. Section 6651(a)(2) provides for an addition to tax of 0.5% per

month up to 25% for failure to pay the amount shown on a return unless it is shown

that the failure is due to reasonable cause and not due to willful neglect.

Petitioners contend that they reasonably relied on the advice of Mr. StormLarsen that the compensation package was reasonable and therefore deductible, thus

TORCH need not file Form 5330. They argue that the failure to file and failure to

pay were due to reasonable cause and not willful neglect. When Dr. Fletcher

understood that after the sale of TORCH they would be paying a large amount

of tax, he sought Mr. Storm-Larsenr's advice. Mr. Storm-Larsen researched

20The sec. 6651(a)(1) addition to tax is reduced by the amount of the sec.

6651(a)(2) addition to tax for any month (or fraction thereof) to which an addition to

tax applies under both sec. 6651(a)(1) and (2). See sec. 6651(c)(1).

- 38 [*38] catchup compensation and explained to Dr. Fletcher that if he had not been

paid reasonable compensation in the past then he could make an adjustment and pay

himself more. Mr. Storm-Larsen also told Dr. Fletcher that a contribution to the

pension plan was a benefit and that he could pay himself for compensation not

previously received. Mr. Storm-Larsen advised the Fletchers that the compensation

was reasonable, which would therefore not require a Form 5330 filing.

The Supreme Court of the United States has explained that "Courts have

frequently held that "reasonable cause" is established when a taxpayer shows that he

reasonably relied on the advice of an accountant or attorney that it was unnecessary

to file a return, even when such advice turned out to have been mistaken." United

States v. Boyle, 469 U.S. 241, 250 (1985). We agree with petitioners that they

reasonably relied on the advice of their accountant and TORCH is not liable for the

section 6651(a)(1) and (2) additions to tax.

VI.

Section 6662(a) Accuracy-Related Penalty

Respondent also contends that petitioners Robert A. and Pearl Fletcher are

liable for the section 6662(a) accuracy-related penalty for the 2003, 2004, and 2005

tax years and petitioner TORCH is liable for the section 6662(a) accuracy-related

penalty for the 2002, 2003, 2004, and 2005 tax years.

- 39 [*39] Subsection (a) of section 6662 imposes an accuracy-related penalty of 20% of

any underpayment that is attributa le to causes specified in subsection (b).

Respondent asserts that one or botli of two causes justify the imposition of the

penalty for each year: a substantial understatement of income tax and negligence.

Sec. 6662(b)(1) and (2).

There is a "substantial understatement" of income tax for any tax year where,

in the case of an individual, the amount of the understatement exceeds the greater of .

(1) 10% of the tax required to be sl¼own on the return for the tax year or (2) $5,000.

Sec. 6662(d)(1)(A). In the case of corporations (other than S corporations or

personal holding companies) the adiount of the understatement exceeds the greater of

(1) 10% of the tax required to be sl own on the return for the tax year or (2)

$10,000,000. Sec. 6662(d)(1)(B).

.

.

Section 6662(a) also impose a penalty for negligence or disregard of the

rules or regulations. Under this see ion "'negligence' includes any·failure to make

a reasonable attempt to comply with the provisions of this title". Sec. 6662(c).

Under caselaw, "'Negligence is a láck of due care or the failure to. do what a

reasonable and ordinarily prudent p rson would do under the circumstances.'"

Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quoting Marcello v.

Commissioner, 380 F.2d-499, 506 (5th Cir. 1967), aff'a on this issue 43 T.C. 168

- 40 [*40] (1964) and T.C. Memo. 1964-299), aff'd, 904 F.2d 1011 (5th Cir. 1990),

aff'd, 501 U.S. 868 (1991).

There is an exception to the section 6662(a) penalty when a taxpayer can

demonstrate (1) reasonable cause for the underpayment and (2) that the taxpayer

acted in good faith with respect to the underpayment. Sec. 6664(c)(1). Regulations

promulgated under section 6664(c) further provide that the determination of

reasonable cause and good faith "is made on a case-by-case basis, taking into

account all pertinent facts and circumstances." Sec. 1.6664-4(b)(1), Income Tax

Regs.

Reliance on the advice of a tax professional may, but does not necessarily,

establish reasonable cause and good faith for the purpose of avoiding a section

6662(a) penalty. See Boyle, 469 U.S. at 251 ("Reliance by a lay person on a

lawyer [or accountant] is of course common; but that reliance cannot function as a

substitute for compliance with an unambiguous statute.").

The caselaw sets forth the following three requirements in order for a

taxpayer to use reliance on a tax professional to avoid liability for a section 6662(a)

penalty: "(1) The adviser was a competent professional who 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

- 41 [*41] adviser's judgment." See Neonatology Asscos., P.A. v. Commissioner,.115

T.C. 43, 99 (2000), aff'd, 299 F.3d 221 (3d Cir. 2002); see also Charlotte's Office

Boutique, Inc. v. Commissioner, 425 F.3d 1203, 1212 n.8 (9th Cir. 2005) (quoting

and with approval the above three rong test), a_ff£g 121 T.C. 89 (2003).

With respect to the employn ent plan contributions, we find that petitioners

actually relied on the advice of their accountant, who was a competent professional,

and that they provided him with the necessary and accurate information. Therefore,

petitioners are not liable for the section 6662(a) accuracy-related penalty related to

the contributions.

However, as discussed supra, we found that the compensation paid to Ms.

Strick was not for services actually rendered and therefore not reasonable

compensation. We do not find tha Dr. and Ms. Fletcher actually relied on the

advice of their accountant with respect to those payments, and TORCH is therefore

liable for the section 6662(a) accuracy-related penalty related to those amounts.

The Court has considered all of the parties' contentions, arguments, requests,

and statements. To the extent not discussed herein, the Court concludes that they are

meritless, moot, or irrelevant.

- 42 [*42] To reflect the foregoing,

Decisions will be entered

under Rule 155.