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United States Tax Court
T.C. Memo. 2022-16
BARRY A. HACKER AND CELESTE HACKER,
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket No. 3870-12.
Filed March 7, 2022.
—————
Steven P. Flowers and Nathalie M. Cornett, for petitioners.
William F. Castor and Vassiliki Economides Farrior, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARIS, Judge: By notice of deficiency dated November 14, 2011,
respondent determined deficiencies in federal income tax of $125,070,
$191,417, $146,712, $196,940, and $171,760 for petitioners’ tax years
2004, 2005, 2006, 2007, and 2008, respectively, and civil fraud penalties
under section 6663(a) 1 of $93,802.50, $126,201.75, $110,034,
$121,176.75, and $128,820 for petitioners’ tax years 2004, 2005, 2006,
2007, and 2008, respectively. In the alternative, respondent determined
accuracy-related penalties pursuant to section 6662(a) for the years at
issue. Respondent additionally determined that petitioners are liable for
an addition to tax pursuant to section 6651(a)(1) for 2004 of $12,507.40.
1 Unless otherwise indicated, all statutory references are to the Internal
Revenue Code, Title 26 U.S.C. (section), in effect at all relevant times, all regulation
references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all
relevant times, and all Rule references are to the Tax Court Rules of Practice and
Procedure.
Served 03/07/22
2
[*2]
After concessions, 2 the issues for decision are whether:
1.
petitioners received imputed wage income from Blossom
Day Care Centers, Inc. (Blossom), of $198,740, $209,200,
$220,210, $231,800, and $244,000 for 2004, 2005, 2006,
2007, and 2008, respectively, from distributions and
personal expenses Blossom paid for services petitioners
performed as employees;
2.
petitioners received constructive dividends from Blossom
of $594,170, $446,782, $375,246, $327,503, and $319,854
for 2004, 2005, 2006, 2007, and 2008, respectively, relating
to distributions and personal expenses Blossom paid to or
on behalf of petitioners as shareholders;
3.
petitioners received unreported gross income based upon
unexplained cash deposits into their personal bank
accounts of $20,221, $57,322, $69,088, $98,567, and
$24,895 for 2004, 2005, 2006, 2007, and 2008, respectively;
4.
petitioners’ net nonpassive income from Hacker
Corporation (Hacker Corp.), reported on Schedule E,
Supplemental Income and Loss, should be decreased by
$96,647 for 2004 and increased by $66,956, $13,694,
$99,902, and $156,653 for 2005, 2006, 2007, and 2008,
respectively;
5.
petitioners received distributions in excess of basis from
Hacker Corp. of $65,914 for 2008;
2 Petitioners have conceded that they received (1) distributions in excess of
basis from Hacker Corporation (Hacker Corp.) of $8,400 in 2004; (2) unreported
nonemployee compensation from the Oklahoma Child Care Association of $4,950 and
$1,600 in 2006 and 2008, respectively; (3) unreported interest income of $1,450.26 and
$79.49 in 2007 and 2008, respectively; (4) an unreported taxable State income tax
refund of $2,783 in 2008; and (5) unreported gambling winnings of $15,140 in 2008.
Petitioners have also conceded that Hacker Corp. was not entitled to deduct reported
advertising expenses of $300 in 2008, and that all income or loss from Hacker Corp.
reported as passive should be reclassified as nonpassive for 2004, 2005, and 2006.
Respondent has conceded adjustments to petitioners’ net income from Accurate
Electric reported on Schedule C, Profit or Loss From Business, of $11,638 and $20,750
for 2007 and 2008, respectively.
3
[*3]
6.
petitioners received unreported rental income of $1,180 for
2004;
7.
petitioners are entitled to deduct rental expenses reported
on Schedule E of $31,164 in excess of those amounts
respondent allowed for 2004;
8.
petitioners failed to report capital gain income of $21,031
on the sale of the property located at 1006 Cleveland
Avenue, Sand Springs, Oklahoma (Cleveland Ave.), for
2005;
9.
petitioners’ net Schedule E passive income from Hacker
Investment, LLC (Hacker Investment), should be
increased by $18,919, $29,149, $106, and $14,019 for 2005,
2006, 2007, and 2008, respectively;
10.
petitioners failed to report capital gain income of $138,612
on the sale of rental real estate by Hacker Investment for
2007;
11.
petitioners are liable for an addition to tax for failure to
timely file, pursuant to section 6651(a)(1), for 2004; and
12.
petitioners are liable for civil fraud penalties under section
6663(a) or, in the alternative, accuracy-related penalties
under section 6662(a) for 2004 through 2008. 3
FINDINGS OF FACT
I.
Related Cases and Entities
This case is before the Court in connection with respondent’s
examination of returns of petitioners and Blossom, an Oklahoma
corporation of which petitioners are the sole shareholders. Following
that examination, respondent issued to Blossom notices of deficiency
3 Respondent additionally reduced petitioners’ 2004 net capital loss
carryforward from $1,332 to $278, resulting in an increase in 2005 capital gain income
of $1,054, and disallowed $3,091 of petitioners’ claimed mortgage interest expense
deduction for 2007. Although petitioners challenged the adjustments in the petition,
they did not introduce any evidence at trial or raise any arguments on brief in support
of their positions. Accordingly, the Court deems petitioners to have conceded those
issues. Respondent’s remaining adjustments are computational; the Court does not
further address them.
4
[*4] and determination of worker classification, and to petitioners a
notice of deficiency that is the subject of this opinion. Petitioners and
Blossom petitioned this Court for redetermination of the deficiencies
and employment classification, and those cases were consolidated for
trial, briefing, and opinion. 4 The records for the consolidated cases
include the consolidated Stipulation of Facts, the First through Sixth
Supplemental Stipulations of Facts, evidence presented at trial, and the
consolidated Stipulation of Settled Issues. The Court determined that
petitioners were both employees of Blossom in Blossom Day Care
Centers, Inc. v. Commissioner (Blossom I), T.C. Memo. 2021-86, and that
Blossom was liable for deficiencies in Blossom Day Care Centers, Inc. v.
Commissioner (Blossom II), T.C. Memo. 2021-87. As discussed in greater
detail below, many of the Court’s holdings in those cases affect the
resolution of the issues herein. The Court takes judicial notice of all facts
and issues presented at trial in the three consolidated cases in
considering the issues relating to this case.
II.
Background of Petitioners
Barry A. Hacker and Celeste Hacker (Hackers or petitioners),
husband and wife, resided in Oklahoma at the time they filed the
Petition.
Beginning in 1986 and at all relevant times, petitioners were the
sole shareholders and corporate officers of Blossom, an Oklahoma
corporation that operated childcare centers in the Tulsa metropolitan
area. In addition to running the daycare centers, Mr. Hacker worked as
an electrician, doing business under the name Accurate Electric and
reporting income on Schedule C. The Hackers were also the sole owners
of the passthrough entities Hacker Corp., an S corporation, and Hacker
Investment, a limited liability company.
Petitioners have three children, sons Steven and Ashley, born in
1975 and 1979, respectively, and daughter Whitney, born in 1987
(collectively, Hacker children or their children).
4 By Order dated July 7, 2021, after trial and briefing were complete, the Court
severed the present case from the consolidated group.
5
[*5] III.
Blossom Day Care Centers
Blossom is discussed more fully in Blossom II, at *5–18. The
Court restates those findings relevant to the resolution of petitioners’
liability herein.
A.
Operation of Business
Mrs. Hacker opened Blossom as an unincorporated business
entity in 1982. Blossom was incorporated in 1986 and was a valid
corporation in the State of Oklahoma during all years at issue.
Petitioners were the sole shareholders of Blossom, with Mrs. Hacker
owning 51% and Mr. Hacker owning 49% of Blossom’s stock.
During the years at issue Blossom operated child daycare centers
in the Tulsa metropolitan area at the following locations:
1. 801 Long St., Sand Springs, Oklahoma (Long St.);
2. 4744 South Mingo Rd., Tulsa, Oklahoma (Mingo Rd.);
3. 800 North 81st West Ave., Tulsa, Oklahoma (81st West
Ave.);
4. 11505 East 76th St. North, Owasso, Oklahoma (76th St.
North); and
5. 9135 East 61st St., Tulsa, Oklahoma (East 61st St.).
Beginning in May 2005 and through the years at issue, Blossom also
operated a sixth location at 1020 South Elm Pl., Broken Arrow,
Oklahoma (Elm Pl.). Before the property transfers described infra,
petitioners owned the Long St. and Mingo Rd. properties, and Blossom
owned the 81st West Ave., 76th St. North, East 61st St., and Elm Pl.
properties.
B.
Role of the Hackers
Petitioners were Blossom’s only corporate officers from its
incorporation through the years at issue. Mrs. Hacker served as
Blossom’s president, as well as its director of curriculum and education.
Her duties included personally overseeing and supervising employees,
making hiring and firing decisions, and managing Blossom’s six daycare
directors. All of Blossom’s employees ultimately reported to her.
6
[*6] Mr. Hacker, also since 1986 and through the years at issue,
served as Blossom’s corporate vice president, as well as its secretary and
treasurer. During the years at issue Mr. Hacker also served as Blossom’s
director and as its director of accounting and finance. He had authority
over all of Blossom’s bank accounts, and his daily responsibilities
included depositing parents’ payments for childcare into Blossom’s bank
accounts and personally writing all of the payroll checks to Blossom’s 90
employees.
Together petitioners actively participated in Blossom’s daily
operation, frequently working 50 to 60 hours per week, performing all
levels of tasks from maintenance and custodial duties to classroom
instruction and supervision of teachers to purchasing and delivering
food. They were also responsible for ensuring that the programs and
employees at Blossom complied with the standards of the Oklahoma
Department of Human Services.
During the years at issue petitioners did not receive a salary or
wages from Blossom. Rather, Blossom made payments in the form of
management fees to Hacker Corp., 5 which in turn paid wages to
petitioners and the Hacker children for services rendered to Blossom.
The Hacker children were not employees of Blossom during the years at
issue.
C.
Corporate Spending
During the years at issue Blossom maintained an American
Express (AMEX) credit card, account ending x4001, for which
petitioners were authorized users. Whitney was added as an authorized
user in 2005 and Ashley in 2006. Mr. Hacker also maintained an AMEX
credit card, account ending x1009, on which he, Mrs. Hacker, and Ashley
were authorized users. Beginning in 2007 Mr. Hacker also maintained
a Citi Cards (Citi) credit card account on which he was the sole
authorized user, and Mrs. Hacker maintained a Bank of America credit
card on which she was the sole authorized user.
Petitioners and their children used the credit cards to make
purchases necessary to operate the daycare centers, but they also
regularly used them to pay personal expenses. During 2004 through
2007 the Hackers and their children charged thousands of dollars in
personal expenses on Blossom’s credit card account, as well as their own
5 Hacker Corp. is described in greater detail infra Findings of Fact, section IV.
7
[*7] AMEX, Citi, and Bank of America credit cards, all of which Blossom
invariably paid. In addition to routine personal purchases, such as
restaurant meals, auto expenses, and personal medical expenses, the
Hackers either used the corporate credit card or had Blossom pay their
personal credit card charges for such expenses as college tuition,
vacations, jewelry, and other luxury items. The Hacker children
continued to make personal purchases with the credit cards even though
they were not employees of Blossom and during periods when they were
not employees of Hacker Corp.
In addition to paying for credit card purchases, Blossom provided
petitioners and their children with vehicles. During the years at issue,
Mr. Hacker drove a 2003 Hummer as his personal vehicle, while Mrs.
Hacker primarily used a 2000 Lexus as her personal vehicle. Both
vehicles were titled in petitioners’ names, but Blossom paid the notes on
the vehicles and claimed depreciation deductions for them on its tax
returns. In March 2004 Blossom traded in a Ford Expedition that it
owned for $24,919 toward the purchase of a 2004 BMW, which was titled
in Steven’s name. Steven was the borrower on the car loan and used the
BMW for commuting and other personal purposes. Similarly, beginning
in April 2004 Ashley began driving a 2004 Cadillac Escalade as his
personal vehicle. The Escalade was titled in Ashely’s name, and Ashley
was the borrower on the car loan. Blossom paid the notes on both
Steven’s and Ashley’s vehicles and claimed depreciation for those
vehicles on its tax returns. Neither petitioners nor their children
maintained any mileage logs or other records of the extent, if any, to
which they used the vehicles for Blossom’s business purposes.
D.
Bookkeeping and Return Preparation
1.
Bookkeeping
Blossom did not have an in-house bookkeeper before December
2007. Rather, Blossom engaged the services of Walters & Bailey, C.P.A.,
Inc. (Walters & Bailey), for bookkeeping and tax return preparation. Rob
Crowder, a certified public accountant performing independent contract
work for Walters & Bailey, prepared Blossom’s general ledgers and
financial statements, which would serve as the basis for its tax returns
for 2004, 2005, and 2006.
Mr. Crowder prepared Blossom’s general ledgers and financial
statements using information petitioners provided. They gave him bank
statements from Blossom’s operating, payroll, and loan accounts but
8
[*8] failed to provide any records relating to substantial undeposited
cash payments received from Blossom parents. The Hackers also
provided credit card statements but did not provide Mr. Crowder with
any guidance as to which expenditures were business expenses and
which were personal. Although the petitioners and their children used
the credit cards for both business purchases and personal expenditures,
they did not categorize their business expenses or notate the statements
to indicate which purchases were personal. Similarly, the checks
reflected on Blossom’s bank statements were not coded as to whether
they related to a business expense or a personal expense.
Despite the lack of guidance from petitioners, Mr. Crowder
determined that many of the expenses on the credit card statements
were personal and used a general ledger account entitled “A/R–Officer”
as a catchall for credit card charges that he determined were petitioners’
personal expenses. The “A/R–Officer” general ledger account increased
from $208,776.22 at the beginning of 2004 to $1,379,408.30 at the end
of 2006 primarily on account of charges to the credit cards.
In December 2007 Blossom hired Bonnie King to perform inhouse bookkeeping and accounting functions, including the preparation
of its general ledger and financial statements for 2007 and 2008. Ms.
King prepared the general ledger using Blossom’s bank statements from
its operating, payroll, and loan accounts, but, as with Mr. Crowder,
petitioners did not provide any information regarding the undeposited
cash or other payments. Ms. King prepared general ledgers that
included the posting of payments of charges on the two AMEX credit
card accounts, as well as the Bank of America credit card and the Citi
credit card. Petitioners did not notate which expenditures were personal
and which were business. Ms. King posted the majority of the credit card
expenditures to Blossom’s general ledger supplies account and the
remainder to food and activities. Like Mr. Crowder, Ms. King posted in
the “A/R–Officer” account those expenses that appeared to her to be
personal.
2.
Blossom’s Tax Returns
Blossom’s tax returns were prepared by Walters & Bailey, using
the general ledgers and financial statements prepared by Mr. Crowder
or Ms. King. The returns reported gross receipts of $2,473,118,
$2,864,239, $2,766,247, and $2,718,796 for 2004, 2005, 2006, and 2007,
9
[*9] respectively. 6 Blossom claimed deductions for the expenses as
posted in its general ledger. It included “Note Rec. Officer” among its
current assets on the Schedule L, Balance Sheets per Books, attached to
the returns, reporting the amounts believed to be personal expenditures.
On its returns for 2004 through 2007, Blossom reported the beginning
and ending balances of the “Note Rec. Officer” as follows:
Year
Beginning balance
Ending balance
2004
$236,189
$685,694
2006
2007
348,390
1,210,159
1,210,159
1,332,066
2005
685,694
348,390
Petitioners never made any repayment of the amounts designated as the
“Note Rec. Officer”, nor did Blossom pay them any wages or salary.
IV.
Hacker Corp.
A.
Management Fees
In 2002 petitioners incorporated Hacker Corp. as an Oklahoma
corporation. During all years relevant to this case Hacker Corp. elected
to be treated as an S corporation for federal income tax purposes.
Petitioners were the sole shareholders of Hacker Corp., each owning
50% of the company’s stock.
During 2004 through 2008 Blossom made payments in the form
of management fees to Hacker Corp., which in turn paid wages to
petitioners and their children for services they rendered to Blossom.
Hacker Corp. paid wages to petitioners as follows:
Year
Mr. Hacker
Mrs. Hacker
2004
$44,615
$44,618
2005
36,923
36,925
2006
19,999
20,001
2007
26,153
27,694
2008
29,230
29,232
6 Blossom’s 2008 tax return was not submitted into evidence or otherwise
included in the record.
10
[*10] Ashley was a paid employee of Hacker Corp. from 2005 through
2008. Steven was a paid employee of Hacker Corp. during 2004 and
2005. From January 2006 to August 2008 Steven operated a car stereo
modification business and was not employed by Hacker Corp. Whitney
was not a paid employee of Hacker Corp. during the years at issue. No
written contract or fee agreement was prepared in connection with
Blossom’s arrangement with Hacker Corp.
B.
Property Transfers
Before May 2005 Blossom or petitioners owned the real properties
on which Blossom’s daycare locations operated. In May 2005 title to each
property was transferred by quitclaim deed to Hacker Corp., and the
transfers were recorded in the Tulsa County land records. Following the
transfers, Blossom continued to operate its daycare centers at the same
locations, but Hacker Corp. assumed payment of the property taxes and
in June 2005 began making payments on the mortgages securing the
properties held by Security Bank. No formal lease agreement between
Blossom and Hacker Corp. was signed, but Blossom began making rent
payments either directly to Hacker Corp. or to Security Bank in
payment of the mortgages on behalf of Hacker Corp. Beginning on its
tax return for 2005, Hacker Corp. claimed deductions for depreciation
with respect to the buildings, for payment of property taxes, and for
interest paid in connection with the mortgages.
The management fees and rent payments from Blossom were
Hacker Corp.’s only income for 2004 through 2008.
V.
Rental Real Estate Activities
A.
Hacker Investment, LLC
Petitioners formed Hacker Investment as an Oklahoma limited
liability company in August 2002. During 2005, 2006, 2007, and 2008
Mr. and Mrs. Hacker each held one-half of the outstanding membership
interests in Hacker Investment. Hacker Investment filed Form 1065,
U.S. Return of Partnership Income, for 2005, 2006, and 2008; although
Hacker Investment prepared a Form 1065 for 2007, respondent has no
record that the return was filed. 7
7 Petitioners’ 2007 tax return is consistent with the amounts reported on the
unfiled 2007 Form 1065.
11
[*11] B.
Rental Activities
During the years at issue petitioners owned, either directly or
through Hacker Investment, several rental properties. They maintained
a spreadsheet to track the rents received from each property. They
reported the income and expenses from their rental activities directly on
Schedule E attached to their individual return for 2004. For subsequent
years Hacker Investment reported the rental income and expenses on
Forms 1065, and those amounts flowed through to petitioners’
individual returns. 8
In June 2002 petitioners purchased the property located at 419
North Lincoln Avenue, Sand Springs, Oklahoma (Orleans Apartments),
for $355. They subsequently transferred that property to Hacker
Investment. They continued to make various improvements to the
property. In May 2007 Hacker Investment sold the Orleans Apartments
for $475,000.
Petitioners purchased the property located at 500 North
Washington Avenue, Sand Springs, Oklahoma (Washington Ave.), for
$39,000 in June 2004 and subsequently deeded it to Hacker Investment.
On August 21, 2007, Hacker Investment divided the property in half and
sold one portion for $16,000.
In June 2004 petitioners also acquired the Cleveland Ave.
property for $27,500. They made various improvements to the property
before selling it for $95,500 in November 2005. After settlement fees,
they received proceeds of $88,942. They did not report the sale on their
2005 tax return.
VI.
Return Preparation
Petitioners received extensions of time to file their return for each
of the years at issue and filed joint individual income tax returns for
2004, 2005, 2006, 2007, and 2008 on December 5, 2005, October 15,
2006, October 15, 2007, October 15, 2008, and October 15, 2009,
respectively. On their returns, they reported total tax of $50,775, $6,976,
$65,568, zero, and zero for 2004, 2005, 2006, 2007, and 2008,
8 Among the rents received listed in the spreadsheet were rents attributable to
the property located at 839 Katy Street. Although Hacker Investment reported those
rents on its returns, property records show that Blossom owned that property during
the years at issue. The Court has held that those rents are income to Blossom for 2005,
2006, and 2007. See Blossom II, at *31–32.
12
[*12] respectively. Their reported income for each year included the
wages received from Hacker Corp.; income or loss from Hacker Corp.,
reported on Schedule E; and income or loss from rental real estate
(which they reported directly on Schedule E for 2004 and as flowthrough
amounts from Hacker Investment in subsequent years). For 2006, 2007,
and 2008, they also reported income from Accurate Electric on
Schedule C. They did not report wages, salary, or dividends from
Blossom for any year 2004 through 2008.
VII.
Examination
Respondent examined petitioners’ tax returns for 2004, 2005,
2006, 2007, and 2008 in an examination that also covered the tax
returns of Hacker Corp. for 2004 through 2008, Hacker Investment for
2005 through 2008, and Blossom for 2004 through 2007, as well as
Blossom’s worker classifications of petitioners for 2005 through 2008.
Beginning in March 2008 petitioners executed, both for themselves and
on behalf of Blossom, a series of timely Forms 872, Consent to Extend
the Time to Assess Tax, for 2004, 2005, 2006, and 2007.
During the examination of petitioners’ returns, Revenue Agent
Floyd (RA Floyd) conducted a bank deposits analysis of petitioners’ bank
accounts, as well as the accounts of their business entities. RA Floyd
examined their bank account records, identified all of the deposits, and,
after subtracting out reported income and items identified as
nontaxable, concluded that petitioners had received unreported income.
RA Floyd additionally determined that the 2004 Note Rec. Officer
beginning balance was a personal loan forgiven by Blossom. Throughout
the examination, petitioners attempted to conceal their receipt of
personal benefits from Blossom. Mr. Hacker claimed that Steven’s
wedding was “a big celebration of Blossom” and that the various trips of
petitioners and their children to the Bahamas, Europe, Hawaii, Las
Vegas, and New Orleans, paid for by Blossom, were for business or so
that they would not be distracted while performing administrative
tasks. Following the examination, respondent issued the notice of
deficiency to petitioners, as well as notices of deficiency and
determination of worker classification to Blossom, determining that
petitioners were employees of Blossom and should have received wage
compensation during the years covered.
In the notice issued to petitioners, respondent determined
deficiencies of $125,070, $191,417, $146,712, $196,940, and $171,760 for
13
[*13] 2004, 2005, 2006, 2007, and 2008, respectively, on the basis of the
following adjustments:
a. Wages from Blossom
– Taxpayer Wife (TPW)
b. Wages from Blossom
– Taxpayer Husband
(TPH)
c. Rental
expenses/depr.
d. Sch. E1 – rents
received
e. Distributions from
Hacker Corp. in excess
of basis
f. Sch. E nonpassive
income/loss Hacker
Corp.
g. Sch. E passive
income/loss Hacker
Corp.
h. Unexplained
deposits
i. Qualified dividends
from Blossom
j. SE AGI adjustments
k. Itemized deductions
l. Standard deduction
m. Exemptions
n. Sch. E passive
income/loss Hacker
Investment
o. Capital gain or loss
p. 1099 Income –
Oklahoma Child Care
Association
q. Sch. C from Accurate
Electric loss
r. Interest income
s. State refunds, offsets
t. Gambling winnings
Total Adjustments
2004
2005
2006
2007
2008
$99,370
$104,600
$110,105
$115,900
$122,000
99,370
104,600
110,105
115,900
122,000
31,164
—
—
—
—
1,180
—
—
—
—
8,400
—
—
—
65,914
(96,647)
66,956
13,694
99,902
156,653
(86,803)
(10,762)
(107,102)
—
—
20,221
57,322
69,088
98,567
24,895
594,170 9
446,782
375,246
327,503
319,854
(1,429)
(4,050)
(4,036)
(5,462)
(3,213)
(9,700)
(10,000)
—
—
—
—
18,919
29,149
—
22,085
—
—
—
—
—
—
—
17,804
9,920
—
—
$687,020
27,558
9,600
—
—
$833,610
11,982
3,168
4,950
18,284
6,801
106
138,612
3,682
3,501
14,019
—
—
1,600
—
11,638
20,750
—
1,450
79
—
—
$616,349
—
—
$929,201
2,783
15,140
$869,657
9 This amount includes the $236,189 Note Rec. Officer beginning balance
determined to be a loan forgiven.
14
[*14] In addition respondent determined civil fraud penalties under
section 6663 of $93,802.50, $126,201.75, $110,034, $121,176.75, and
$128,820 for the years at issue. Respondent determined the $93,802.50
fraud penalty for 2004 on the basis of the following adjustments:
Adjustments to income to which fraud
penalty applies
Amount
Wages from Blossom–TPW
Wages from Blossom–TPH
Dividends
Unexplained deposits
$99,370
99,370
594,170
20,221
Respondent determined the $126,201.75 fraud penalty for 2005 on the
basis of the following adjustments:
Adjustments to income to which fraud
penalty applies
Amount
Wages from Blossom–TPW
Wages from Blossom–TPH
Dividends
Unexplained deposits
$104,600
104,600
446,782
57,322
Respondent determined the $110,034 fraud penalty for 2006 on the basis
of the following adjustments:
Adjustments to income to which fraud
penalty applies
Amount
Wages from Blossom–TPW
Wages from Blossom–TPH
Dividends
Unexplained deposits
$110,105
110,105
375,246
69,088
Respondent determined the $121,176.75 fraud penalty for 2007 on the
basis of the following adjustments:
Adjustments to income to which fraud
penalty applies
Amount
Wages from Blossom – TPW
Wages from Blossom – TPH
Dividends
Unexplained deposits
$115,900
115,900
327,503
98,567
Respondent determined that the fraud penalty applies to all of the
adjustments to petitioners’ 2008 income.
15
[*15] A Civil Penalty Approval Form was signed on November 10, 2009,
by the immediate supervisor of RA Floyd, who examined petitioners’
returns, approving the imposition of the fraud penalties and the
accuracy-related penalties for underpayments due to substantial
understatements of income tax. Respondent also determined that
petitioners were liable for an addition to tax pursuant to section
6651(a)(1) for 2004 of $12,507.40.
Respondent issued the notice of deficiency on November 14, 2011,
and petitioners timely petitioned this Court for redetermination.
OPINION
I.
Burden of Proof
In general the Commissioner’s determinations set forth in a
notice of deficiency are presumed correct, and the taxpayer bears the
burden of showing the determinations are in error. Rule 142(a); Welch
v. Helvering, 290 U.S. 111, 115 (1933). When, as here, a case involves
unreported income, however, the U.S. Court of Appeals for the Tenth
Circuit, to which this case would be appealable absent a stipulation to
the contrary, see § 7482(b); Golsen v. Commissioner, 54 T.C. 742, 757
(1970), aff’d, 445 F.2d 985 (10th Cir. 1971), has held that the
Commissioner’s determination of unreported income is entitled to a
presumption of correctness only once some substantive evidence is
introduced demonstrating that the taxpayer received unreported
income, United States v. McMullin, 948 F.2d 1188, 1192 (10th Cir. 1991).
Once the Commissioner introduces some substantive evidence linking
the taxpayer to the income, the presumption of correctness applies, and
the burden shifts to the taxpayer to produce substantial evidence
overcoming it. 10 Id.
II.
Income from Blossom
A.
Background
During the years at issue, petitioners were the sole corporate
officers of Blossom and performed substantial services for Blossom in
that capacity. They were also its sole shareholders. They did not receive
10 Petitioners have not raised the issue of section 7491(a), which shifts the
burden of proof to the Commissioner in certain situations. The Court concludes that
section 7491(a) does not apply here because petitioners have not produced any evidence
that they have satisfied the preconditions for its application.
16
[*16] a salary or wages from Blossom during the years at issue.
Nevertheless, during that time, they received, either directly to
themselves or indirectly to their children or other businesses,
substantial economic benefit from Blossom in the form of money,
property, and other remuneration. Respondent contends that such
benefits constitute wages and dividends.
B.
Wages
Respondent determined that petitioners received wage income
from Blossom as follows:
Year
Mr. Hacker
Mrs. Hacker
Total
2004
2005
2006
2007
2008
$99,370
104,600
110,105
115,900
122,000
$99,370
104,600
110,105
115,900
122,000
$198,740
209,200
220,210
231,800
244,000
Respondent’s wage determinations were considered in connection
with the notice of determination of worker classification that was the
subject of Blossom I and the notice of deficiency that was the subject of
Blossom II. In those reports the Court sustained respondent’s
determinations that petitioners were employees of Blossom and that
remuneration provided directly or indirectly to them for their work as
such constituted wages. Petitioners provided substantial services to
Blossom and received compensation in the form of money, property, and
other direct and indirect benefits. Such compensation constitutes gross
income to them. See Treas. Reg. § 1.61-2(a)(1) (“Wages . . . are income to
the recipients unless excluded by law.”). Petitioners offer no argument
or evidence to show that the wages respondent determined are
erroneous or unreasonable or should be excluded from gross income.
Consistent with our holdings in Blossom I and Blossom II, the wage
adjustments here are sustained.
C.
Constructive Dividends
Respondent determined that petitioners, as shareholders,
received constructive dividends from Blossom of $594,169.87,
$446,782.26, $375,246.30, $327,503.57, and $319,854 for 2004, 2005,
2006, 2007, and 2008, respectively.
Section 61(a)(7) includes dividends in a taxpayer’s gross income.
When a corporation distributes property to a shareholder as a dividend,
17
[*17] whether formally or informally, the shareholder must include the
distribution in gross income to the extent of the corporation’s earnings
and profits. See §§ 301(a), (c)(1), 316; see also Welle v. Commissioner, 140
T.C. 420, 422 (2013). A constructive dividend arises when a corporation
confers an economic benefit upon a shareholder without expectation of
repayment and the corporation on the date of the deemed distribution
had current or accumulated earnings and profits. See Welle, 140 T.C.
at 422. The shareholder need not receive the dividend directly and must
include in gross income payments the corporation made on the
shareholder’s behalf. See Epstein v. Commissioner, 53 T.C. 459, 474–75
(1969); Vlach v. Commissioner, T.C. Memo. 2013-116, at *32–33. In
determining whether a shareholder received a constructive dividend,
the Court considers whether the payment benefited the shareholder
personally rather than furthering the interest of the corporation.
Hagaman v. Commissioner, 958 F.2d 684, 690–91 (6th Cir. 1992), aff’g
in part and remanding on other grounds T.C. Memo. 1987-549; Vlach,
T.C. Memo. 2013-116, at *33. Where a corporation constructively
distributes property to a shareholder, the constructive dividend received
by the shareholder is ordinarily measured by the fair market value of
the benefit conferred. Welle, 140 T.C. at 423.
Respondent based his determination of dividends on distributions
of cash and property and payments of personal expenses by Blossom as
follows:
Checks
Credit card charges
for personal
expenses
Payments on
personal vehicle
loans
Personal auto,
insurance, and
interest expenses
Undeposited
payments from
parents
Distribution
of vehicles
2004 A/R – officer
beginning balance
recharacterized as
dividend
2004
2005
2006
2007
2008
$36,779.02
$14,862.33
$14,077.99
$26,830.00
$74,803.13
312,031.44
389,056.95
342,411.60
271,867.00
—
93,715.34
105,439.25
84,984.88
73,462.74
57,423.50
41,827.76
48,286.54
40,417.96
31,865.00
71,798.00
47,448.31
54,839.21
86,228.74
88,767.78
99,798.00
24,919.00
—
236,189.00
—
14,000.00
—
—
—
—
—
18
[*18] Repairs
—
9,535.95
—
—
—
Net value of
distributed real
property
—
33,962.00
—
—
—
Real property tax
payments
—
—
3,835.13
—
2,866.00
Loan payments on
petitioners’
personal residence
—
—
—
29,811.05
39,522.84
Transfers
—
—
—
9,000.00
—
Payments to
Accurate Electric
—
—
9,500.00
27,700.00
41,631.00
Other payments of
personal expenses
—
—
—
—
176,011.23
Reduction for wage
adjustment
(198,740.00) (209,200.00) (220,210.00) (231,800.00) (244,000.00)
Total
$594,169.87 $446,782.23 $375,246.30 $327,503.57 $319,853.70
Petitioners do not present any arguments or evidence to dispute
respondent’s determination of dividends, except insofar as they disagree
with the adjustments to Blossom’s income and deductions. In
Blossom II, at *32–46, the Court considered those arguments and found
that certain expenditures paid by credit card and determined by
respondent to be personal were in fact business expenses. The Court
concluded that Blossom was entitled to additional business expense
deductions totaling $95,452.59, $83,671.47, and $23,023.57 for 2004,
2005, and 2007, respectively. Id. Accordingly, the Court concludes those
expenditures were business expenses and not personal expenses of
petitioners, and those amounts do not constitute dividends to them. The
credit card amounts shown above should be reduced by those same
amounts for 2004, 2005, and 2007, respectively.
At all relevant times prior to the transfer to Hacker Corp.,
petitioners owned the Long St. and Mingo Rd. properties. Therefore,
Blossom did not own two of the properties that petitioners caused to be
transferred to Hacker Corp. in 2005. Id. at *26–31. Blossom did not
distribute those properties, and the net value of those properties thus
does not constitute dividends to petitioners. The 2005 dividend amount
should be reduced by the net value of the Long St. and Mingo Rd.
properties.
The remaining amounts constitute economic benefits to
petitioners, either directly or indirectly, as shareholders of Blossom. The
19
[*19] Court holds that those amounts are dividends to petitioners
subject to the above adjustments:
Year
Dividend
per respondent
Adjustment
per opinion
Dividend
after adjustment
2004
2005
2006
2007
2008
$594,169.87
446,782.23
375,246.30
327,503.57
319,853.70
$95,452.59
*
—
23,023.57
—
$498,717.28
*
375,246.30
304,480.00
319,853.70
The Court holds that the 2005 dividend amount should be reduced
by $83,671, which relates to reasonable business expenses of Blossom,
and further reduced by the net value of the Long St. and Mingo Rd.
properties, which were not distributions to petitioners. The 2005
dividend after adjustment shall reflect these reductions to respondent’s
dividend determination.
III.
Unexplained Deposits
As previously discussed, gross income means all income from
whatever source derived. § 61(a). Gross income is construed broadly to
include all “accessions to wealth, clearly realized, and over which the
taxpayers have complete dominion.” Commissioner v. Glenshaw Glass
Co., 348 U.S. 426, 431 (1955). Every person subject to income tax is
required to maintain books and records to establish the amount of gross
income and deductions shown by that person on his or her income tax
return. See § 6001; Treas. Reg. § 1.6001-1(a).
Bank deposits are prima facie evidence of income. Tokarski v.
Commissioner, 87 T.C. 74, 77 (1986); Bolles v. Commissioner, T.C.
Memo. 2019-42, at *14. The bank deposits method of proof presumes
that all deposits into a taxpayer’s bank account during a given period
constitute taxable income unless the taxpayer can show that the
deposits were nontaxable. Clayton v. Commissioner, 102 T.C. 632, 645
(1994). The Government must take into account any nontaxable source
or deductible expense of which it has knowledge. DiLeo v. Commissioner,
96 T.C. 858, 868 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
During the examination of petitioners’ returns, RA Floyd
conducted a bank deposits analysis of their accounts and concluded that
they received unreported income of $20,221, $57,322, $69,088, $98,567,
and $24,895 for 2004, 2005, 2006, 2007, and 2008, respectively.
20
[*20] Petitioners acknowledge that the funds were deposited in their
accounts but do not offer any satisfactory explanation as to the source of
the funds or whether the funds were nontaxable or otherwise reported
on their returns. At trial Mr. Hacker speculated that the funds may have
been gambling winnings or rental payments but provided no additional
evidence or explanation to corroborate this testimony. He was emphatic,
however, that the unexplained deposits were “absolutely not” the
undeposited payments from Blossom parents. Respondent’s
determination of gross income based on unexplained deposits is
sustained.
IV.
Income from Hacker Corp.
A.
Schedule E Nonpassive Income
1.
Adjustments
An S corporation is not subject to federal income tax at the entity
level. § 1363(a). The corporation’s income, losses, deductions, and credits
are passed through to the shareholders at their pro rata shares.
§ 1366(a). Where a notice of deficiency includes adjustments for
S corporation items with other items unrelated to the S corporation, the
Court has jurisdiction to determine the correctness of all adjustments.
See Winter v. Commissioner, 135 T.C. 238 (2010); Berry v.
Commissioner, T.C. Memo. 2018-143, at *6. The substantiation
requirements of section 162 also apply to business expense deductions
for S corporations. Tabe v. Commissioner, T.C. Memo. 2019-149, at *21;
see also § 1363(b).
On its returns, Hacker Corp. reported income of $173,606,
$21,525, and $114,204 for 2004, 2005, and 2006, respectively, and losses
of $47,560 and $114,609 for 2007 and 2008, respectively, which
petitioners reported on Schedules E of their returns for the respective
years. 11 Respondent determined adjustments to the tax returns of
Hacker Corp. as follows:
11 For each year, 2004 through 2006, petitioners reported 50% of the income
from Hacker Corp. as passive income and 50% of the income as nonpassive. The parties
have stipulated that all income or loss from Hacker Corp. should have been classified
as nonpassive. In addition, because of a clerical error, petitioners erroneously reported
2006 income from Hacker Corp. of $214,204, rather than $114,204.
21
[*21]
2004
Gross receipts
Interest expense
Depreciation
Advertising
expense 12
Total
adjustments
($183,450)
—
—
—
($183,450)
2005
2006
2007
2008
($38,187)
59,066
35,315
($6,499)
—
13,091
$86,811
—
13,091
$142,917
345
13,091
—
—
—
$56,194
$6,592
$99,902
300
$156,653
The Court addresses respondent’s adjustments below.
2.
Gross Receipts
Gross income means all income from whatever source derived,
including income derived from business. See § 61(a)(2). Hacker Corp.
received payments from Blossom for services the Hackers and their
children rendered and, beginning in May 2005, for the use of the
buildings. On its returns, Hacker Corp. reported gross receipts of
$309,300, $342,650, $377,125, $228,100, and $204,514 for 2004, 2005,
2006, 2007, and 2008, respectively. During the examination of Hacker
Corp.’s returns, RA Floyd performed a bank deposits analysis of Hacker
Corp.’s bank accounts, as well as the books and records of Blossom, and
determined that Hacker Corp. received payments from Blossom totaling
$125,850, $304,463, $370,626, $314,911, and $347,431 for 2004, 2005,
2006, 2007, and 2008, respectively.
Petitioners disagree with respondent’s adjustments of Hacker
Corp.’s gross receipts but do not identify any errors in respondent’s
analysis. Indeed, on brief, they appear to accept that adjustments for
2004, 2005, and 2006 are appropriate when arguing for an increase in
Blossom’s deductions for management fees. See Blossom II, at *41–42.
Consistent with the Court’s findings in Blossom II, the Court finds that
Hacker Corp. received gross receipts of $125,850, $304,463, and
$358,026 for 2004, 2005, and 2006, respectively. The evidence supports
respondent’s adjustments to gross receipts for 2007 and 2008, and those
adjustments are sustained.
12 Petitioners concede that respondent properly disallowed the claimed $300
advertising expense deduction.
22
[*22]
3.
Interest Expense
Respondent determined adjustments to Hacker Corp.’s claimed
interest expense deductions for 2005 and 2008. For 2005 Hacker Corp.
deducted interest expenses of $118,132 paid on the note on the daycare
center properties it acquired from Blossom and petitioners in May of
that year. Respondent disallowed $59,066, or one-half of the claimed
amount, on the grounds that that amount was paid by the properties’
respective prior owners and not by Hacker Corp. 13 Respondent
additionally disallowed $345 of a claimed interest expense deduction for
2008 on account of lack of substantiation.
Hacker Corp. acquired the daycare center properties in May 2005
and did not begin making the note payments until June 2005. See also
Blossom II, at *9. Accordingly, it is not entitled to deductions for interest
paid before that time. With respect to the 2008 interest, petitioners have
not offered any evidence or argument to support Hacker Corp.’s
entitlement to the disallowed deduction. Respondent’s adjustments are
sustained.
4.
Depreciation
On its 2005, 2006, 2007, and 2008 returns, Hacker Corp. claimed
a depreciation deduction of $72,747 with respect to the daycare center
properties for each year. Hacker Corp. calculated its depreciation by
carrying over the same cost basis in the properties that Blossom had
used to calculate the depreciation on its 2004 return. Respondent
recalculated a depreciation amount using the fair market value of the
buildings at the time of transfer and, in turn, increased Hacker Corp.’s
cost basis in the property acquired from Blossom.
Section 301(d) provides that the basis of property received in a
distribution made by a corporation to a shareholder shall be the fair
market value of the property. Section 362(a)(1) provides that, in the case
of a transaction to which section 351 (relating to transfer of property to
a corporation controlled by the transferor) applies, the transferee
corporation’s basis in the transferred property shall be the same as it
would be in the hands of the transferor. In May 2005 Blossom
transferred to Hacker Corp. the properties at 81st West Ave., 76th St.
North, East 61st St., and Elm Pl. in a transaction deemed to be a
13 Respondent allowed (and the Court sustained) a corresponding increase in
Blossom’s interest expense deduction for 2005 to account for the other half of the
interest paid that year. See Blossom II, at *42–43.
23
[*23] distribution to petitioners pursuant to section 301(a). See also
Blossom II, at *26. Accordingly, respondent correctly determined that
the depreciable bases in those properties should have been the fair
market value at the time of distribution.
With respect to the Long St. and Mingo Rd. properties, however,
Blossom did not own the properties or distribute them to petitioners.
Petitioners owned the properties, and upon their transfer of those
properties to Hacker Corp., Hacker Corp.’s basis in such properties is
the same as it was in the hands of petitioners. See § 362(a)(1). The Court
thus finds that Hacker Corp. properly calculated its depreciation from
the basis carried over from the 2004 return. The amounts Hacker Corp.
claimed with respect to those properties were correct. 14
B.
Distributions in Excess of Basis
Sections 1366 through 1368 govern the tax treatment of
S corporation shareholders with respect to their investments in such
entities. Section 1366(a)(1) provides that a shareholder shall take into
account his or her pro rata share of the S corporation’s items of income,
loss, deduction, or credit for the S corporation’s taxable year ending with
or in the shareholder’s taxable year.
With respect to basis, section 1012 sets forth the foundational
principle that the basis of property for tax purposes shall be the cost of
the property. Cost, in turn, is defined by regulation as the amount paid
for the property in cash or other property. Treas. Reg. § 1.1012-1(a).
Section 1367 then specifies adjustments to basis applicable to
investments in S corporations. Basis in S corporation stock is increased
by income passed through to the shareholder under section 1366(a)(1)
and decreased by, inter alia, distributions not includable in the
shareholder’s income pursuant to section 1368; items of loss and
deduction passed through to the shareholder under section 1366(a)(1);
and certain nondeductible, noncapital expenses. § 1367(a); see also
Gleason v. Commissioner, T.C. Memo. 2006-191, 2006 WL 2601835,
at *5.
Section 1368 addresses treatment of distributions. The typical
rule for entities without accumulated earnings and profits is that
distributions are not included in a shareholder’s gross income to the
14 Respondent does not dispute Hacker Corp.’s reported depreciation method
or recovery period. The Court will accept them as correct.
24
[*24] extent that they do not exceed the adjusted basis of his or her stock
(but are applied to reduce basis), while any distribution amount in
excess of basis is treated as gain from the sale or exchange of property.
§ 1368(b); see also Gleason v. Commissioner, 2006 WL 2601835, at *6.
Petitioners’ basis in Hacker Corp. at the end of 2004 was zero,
because of distributions in excess of basis in 2004. 15 Following the
adjustments to Hacker Corp.’s income for 2005 through 2008,
respondent computed petitioners’ basis for each year and determined
that they received distributions from Hacker Corp. in excess of basis in
2008 of $65,914. Respondent determined this amount by using a 2008
beginning basis of $240,857, adding postexamination ordinary income of
$156,653 and capital contributions of $9,168, then subtracting
distributions of $340,764, to arrive at an adjustment for distributions in
excess of basis of $65,914. 16
The Court has determined that in 2005 the Hackers contributed
daycare center properties to Hacker Corp. Respondent’s calculation of
basis fails to take into account their 2005 contributions of the daycare
center properties, which increase petitioners’ basis in Hacker Corp. by
their bases in those properties. See § 358(a). The parties have stipulated
that petitioners’ basis in Hacker Corp. at the end of 2004 was zero.
Petitioners’ basis for 2005 should include the adjustments for the
contribution of the properties. Even if the Court accepts respondent’s
starting 2008 basis of $240,857, adjusts for income and capital
contributions as determined by respondent, then subtracts distributions
of $340,764, respondent has misread the results. The remaining $65,914
represents petitioners’ remaining basis and not distributions in excess
of basis. Further, the Court has redetermined Hacker Corp.’s income to
reflect substantial adjustments, as discussed supra. In the Rule 155
computation, the parties shall take these adjustments into account and
recalculate the amount, if any, by which petitioners’ 2008 distributions
from Hacker Corp. exceeded their basis therein.
Respondent determined, and petitioners agree, that they received
distributions from Hacker Corp. in excess of basis of $8,400 in 2004.
15
16 The parties are in agreement that Hacker Corp. did not have accumulated
earnings and profits at the time of the distributions at issue.
25
[*25] V.
A.
Rental Real Estate Activities
The Hackers
1.
2004 Rental Income and Expenses
On Schedule E, attached to their 2004 return, petitioners
reported rental income of $77,862 and expenses totaling $102,289.
Respondent determined that they failed to report $1,180 in rental
income, on the basis of a review of petitioners’ records. Respondent
additionally disallowed claimed deductions for insurance expenses of
$783, interest payments totaling $28,487, and depreciation of $1,894, on
account of lack of substantiation. Petitioners dispute the adjustments,
but did not present any evidence at trial or offer any argument on brief
in support of their position. Respondent’s determinations are sustained.
2.
2005 Capital Gains Income
Respondent determined that petitioners failed to report capital
gains income of $21,031 on the sale of the Cleveland Ave. property in
2005.
Gross income includes gains from dealings in property. § 61(a)(3).
A taxpayer must recognize gain on the sale of property in an amount
equal to the difference between the amount realized and basis. §§ 1001,
1012; see also O’Boyle v. Commissioner, T.C. Memo. 2010-149, 2010 WL
2766818, at *3, aff’d per curiam, 464 F. App’x 4 (D.C. Cir. 2012).
Petitioners bear the burden of establishing basis in their property. See
Rule 142(a); O’Boyle v. Commissioner, 2010 WL 2766818, at *3.
Petitioners purchased the Cleveland Ave. property in June 2004
for $27,500 and sold it in November 2005 for $95,500. After settlement
fees, petitioners received net proceeds of $88,942. On the basis of
invoices and verified payments petitioners submitted, respondent
allowed additional basis of $40,411 for improvements to the property.
Respondent therefore determined a gain of $21,031.
On review of the evidence, including petitioners’ bank statements
and claimed improvements, the Court finds that petitioners are entitled
to additional basis of $1,294 paid on November 15, 2004, for
miscellaneous improvements provided on check No. 6094. Petitioners
did not introduce any additional evidence or arguments to otherwise
rebut respondent’s determination. Accordingly, the Court finds that
26
[*26] petitioners’ adjusted basis in the Cleveland Ave. property was
$69,205, and that their gain on the sale was $19,737.
B.
Hacker Investment
1.
Overview
As a general rule partnerships are not subject to Federal income
tax, and items of partnership income, loss, deduction, and credit are
reflected on the partners’ individual income tax returns. See § 701;
Keeter v. Commissioner, T.C. Memo. 2018-191, at *9. On its returns
Hacker Investment reported losses of $5,616, $30,295, and $14,019 for
2005, 2006, and 2008, respectively. Hacker Investment prepared a
return for 2007, showing income of $4,536, but respondent has no record
that the return was filed. Petitioners reported those amounts as passive
income or loss on Schedules E of their returns for the respective years.
Respondent determined adjustments to the income and expenses
of Hacker Investment as follows: 17
Rental income
Depreciation
Interest
Repairs
Depreciation—
windows/doors
Other rental expenses
Total
2005
2006
2007
2008
$12,002
$9,752
$51,715
—
4,690
(4,072)
(16,751)
(295)
—
2,227
—
—
2,138
21,626
(4,673)
$4,346
—
—
3,341
—
—
—
(25,649)
—
$18,919
$29,149
$4,642
$7,687
17 Respondent’s adjustments to Hacker Investment’s income and expenses, set
forth on the Form 4605–A, Examination Changes–Partnerships, Fiduciaries,
S Corporations, Etc., issued after respondent’s examination of Hacker Investment, are
based on a 2007 reported income of zero.
27
[*27] On the basis of these adjustments, respondent determined an
increase in Schedule E income of $18,919, $29,149, $106, 18 and
$14,019 19 for 2005, 2006, 2007, and 2008, respectively. 20
2.
Rental Income
Hacker Investment reported gross rents of $78,963, $79,536, and
$55,014 for 2005, 2006, and 2007, respectively. Hacker Investment
maintained records that showed it received gross rents of $90,965,
$89,288, and $51,715 for 2005, 2006, and 2007, respectively, 21 and
respondent determined that these amounts constituted the correct rents
received by Hacker Investment. Petitioners have not offered any
argument or evidence to dispute respondent’s adjustment. Respondent’s
adjustment is sustained.
3.
Repairs Expense
Section 162(a) allows as a deduction all ordinary and necessary
business expenses paid or incurred in carrying on any activity that
constitutes a trade or business. No current deduction is allowed for
capital expenditures, however. See § 263(a). Capital expenditures
include amounts paid out for new buildings or for permanent
improvements or betterments made to increase the value of any
property or estate. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 83
(1992); see also § 263(a)(1). The capitalization rules of section 263(a) and
the regulations thereunder do not treat an expense to repair property as
18 Petitioners’ 2007 tax return reflected income from Hacker Investment of
$4,536 as calculated on the prepared 2007 partnership return. The $106 adjustment
in the notice of deficiency is the difference between respondent’s adjustment in the
Form 4605-A and the amount petitioners reported.
19 Although respondent determined a $7,687 adjustment to the 2008
partnership return, respondent disallowed the entirety of petitioners’ claimed loss of
$14,019, as the loss was claimed as passive on petitioners’ Schedule E. See § 469.
20 The unified audit and litigation procedures of the Tax Equity and Fiscal
Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, §§ 401–406, 96 Stat. 324, 648–
71, do not apply to Hacker Investment. Hacker Investment qualifies as a small
partnership under section 6231(a)(1)(B)(i) and did not elect, pursuant to section
6231(a)(1)(B)(ii), to have TEFRA apply. See Cvancara v. Commissioner, T.C. Memo.
2013-20, at *3 n.4; Wadsworth v. Commissioner, T.C. Memo. 2007-46, 2007 WL 610069,
at *6 (“The small partnership exception permits this Court to review in a deficiency
suit items that otherwise would be subject to partnership-level proceedings.”).
21 These amounts exclude amounts attributable to the property located at 839
Katy Street, which was owned by Blossom during the years at issue.
28
[*28] a capital expenditure. See Gibson & Assocs., Inc. v. Commissioner,
136 T.C. 195, 232 (2011). Such an expense is not a capital expenditure
because it does not increase the value or prolong the useful life of the
property (or adapt the property to a different or new use). Id. at 232–33.
Whether an expense is for a repair is a factual determination that turns
on a finding that the work did or did not prolong the useful life of the
property, increase its value, or make it adaptable to a different use. Id.
at 233. As a general, though not absolute, rule, an important factor in
determining whether the appropriate tax treatment is an immediate
deduction or capitalization is the taxpayer’s realization of benefits
beyond the year in which the expenditure is incurred. INDOPCO, Inc. v.
Commissioner, 503 U.S. at 87; Tsakopoulos v. Commissioner, T.C.
Memo. 2002-8, 2002 WL 23952, at *7–8.
On its 2006 return Hacker Investment claimed a deduction for
rental repair expenses of $34,994. Respondent disallowed $21,626 of
that amount, comprising $11,309.31 for a new roof on the Orleans
Apartments and $10,316.96 to replace windows and doors, on the
grounds that such costs should have been capitalized, rather than
deducted. Petitioners introduced into evidence invoices from Metro
Construction, Inc., showing work performed on various properties, but
not showing that the replacement roof, doors, or windows were of such
a nature as to constitute only minor repairs. The Court concludes that
those expenses should have been capitalized. 22 In turn the basis of the
Orleans Apartments should also be adjusted to reflect the capital
improvements of the new roof, windows, and doors.
4.
Depreciation
Hacker Investment claimed depreciation deductions of $16,980,
$16,980, $8,892, and $12,841 for 2005, 2006, 2007, and 2008,
respectively. These amounts included depreciation with respect to
Hacker Investment’s rental properties for each year, as well as the 839
Katy Street property and a warehouse.
Relying on real property records and petitioners’ cost bases,
respondent calculated the depreciable basis, excluding land value, for
each of the properties. In addition, respondent disallowed the claimed
depreciation deduction for the property at 839 Katy Street, which
22 On the basis of the invoices introduced at trial, respondent concedes that
Hacker Investment is entitled to additional deductions for repair expenses of $9,535
for 2005 and $17,280.23 for 2006.
29
[*29] Blossomed owned, and the warehouse, which petitioners
maintained for personal use. Respondent concluded that Hacker
Investment was entitled to depreciation of $14,753, $14,842, $4,673, and
$8,495 for 2005, 2006, 2007, and 2008, respectively.
Petitioners have not introduced any evidence or advanced any
argument in support of their assertion that respondent’s determinations
of allowable depreciation are incorrect, and the Court sustains
respondent’s determinations. 23
5.
Interest and Other Rental Expenses
Petitioners do not raise any arguments or identify evidence in
support of their position with respect to the disallowed deductions for
interest or other rental expenses. Those adjustments are sustained.
6.
2007 Capital Gains Income
On Form 4797, Sales of Business Property, attached to their 2007
return, petitioners reported gain of $27,200. The reported gain
pertained to Hacker Investment’s sale of the Orleans Apartments and
was based on a sale price of $335,000 and an adjusted basis of $307,800.
Respondent determined that petitioners underreported their gain by
$138,612 by understating Hacker Investment’s gain from the sale of the
Orleans Apartments and omitting the sale of the Washington Ave.
property. Respondent determined that Hacker Investment realized total
gain of $165,812 on its sales, calculated as follows:
Property
Orleans
Apartments
Washington
Ave.
Amount realized
Cost
Capital
improvements
Depreciation
Gain
$475,000
$355,000
$21,331
($51,143)
$149,812
16,000
—
—
—
16,000
Petitioners contend that respondent did not properly calculate the
gain on either property. With respect to the Orleans Apartments, they
23 The Court holds infra that respondent failed to include Hacker Investment’s
basis in the subdivided portion of the Washington Ave. property sold in 2007 and
instructs the parties to calculate the correct basis and include in the computations
pursuant to their Rule 155 submission in determining petitioners’ capital gain income
for that year. Although the basis calculation may result in a reduction in the allowable
depreciation for 2007 and 2008, the Court will treat any reduction as a concession on
the part of respondent.
30
[*30] identify no error in respondent’s calculation, and the calculation
is supported by the evidence. The Court sustains respondent’s
determination regarding the Orleans Apartments.
In the case of the Washington Ave. property, however, respondent
has treated the gross amount received as income without taking into
consideration the basis in the property or any adjustments thereto.
Petitioners acquired the Washington Ave. property in June 2004 for
$39,000 and subsequently deeded the property to Hacker Investment.
Respondent determined that the correct depreciation on the Washington
Ave. property in 2004 was $469, and that the correct depreciation in
each of 2005, 2006, and 2007 was $865. In 2007 Hacker Investment
divided the property in half and sold one portion for $16,000. Hacker
Investment’s correct basis in the sold portion of the Washington Ave.
property, therefore, should have been one-half of the $39,000 purchase
price, adjusted downward for allowable depreciation through the date of
sale. The parties shall submit computations pursuant to the Court’s
determination of the issues in accordance with their Rule 155
computations.
VI.
Additions to Tax and Penalties
A.
Section 6651(a)(1) Addition to Tax
Section 6651(a)(1) imposes an addition to tax for failure to timely
file a Federal income tax return unless it is shown that the failure is due
to reasonable cause and not due to willful neglect. See also Higbee v.
Commissioner, 116 T.C. 438, 447 (2001). The addition to tax is equal to
5% of the amount required to be shown as tax on the delinquent return
for each month or fraction thereof during which the return remains
delinquent, up to a maximum addition of 25% for returns more than four
months delinquent. § 6651(a)(1). Under section 7491(c) the
Commissioner bears the burden of producing evidence with respect to
the liability of the taxpayer for any addition to tax. See Higbee, 116 T.C.
at 446–47. The burden of proving reasonable cause and lack of willful
neglect falls on the taxpayer. See § 6651(a); Higbee, 116 T.C. at 446–47.
For 2004 petitioners filed their income tax return on December 5,
2005, which was after the due date of October 15, 2005. See § 6081(a).
Respondent has thus met his burden of production. Petitioners have not
established that their failure to timely file was due to reasonable cause.
Accordingly, the section 6651(a)(1) addition to tax is sustained for 2004.
31
[*31] B.
Penalties
1.
Compliance with Section 6751(b)
Respondent determined that petitioners are liable for section
6663(a) fraud penalties or, in the alternative, section 6662(a) accuracyrelated penalties on the basis of underpayments due to negligence or
substantial understatements of income tax for the years at issue. The
Commissioner bears the burden of production with respect to an
individual taxpayer’s liability for any penalty, requiring the
Commissioner to come forward with sufficient evidence indicating that
the imposition of the penalty is appropriate. See § 7491(c); Higbee, 116
T.C. at 446–47. As part of that burden, the Commissioner must produce
evidence that he complied with the procedural requirements of section
6751(b)(1). See Graev v. Commissioner, 149 T.C. 485, 492–93 (2017),
supplementing and overruling in part 147 T.C. 460 (2016). Section
6751(b)(1) requires the initial determination of certain penalties to be
“personally approved (in writing) by the immediate supervisor of the
individual making such determination.” See Graev, 149 T.C. at 492–93;
see also Clay v. Commissioner, 152 T.C. 223, 248 (2019) (quoting section
6751(b)(1)), aff’d, 990 F.3d 1296 (11th Cir. 2021).
Where the taxpayer has challenged the Commissioner’s penalty
determination, the Commissioner must come forward with evidence of
proper penalty approval as part of his initial burden of production under
section 7491(c). Frost v. Commissioner, 154 T.C. 23, 34 (2020). Once the
Commissioner makes that showing, the taxpayer must come forward
with contrary evidence. Id. The supervisory approval must be secured
no later than (1) the date on which the IRS issues the notice of deficiency
or (2) the date, if earlier, on which the IRS formally communicates to the
taxpayer the Examination Division’s determination to assert a penalty.
Belair Woods, LLC v. Commissioner, 154 T.C. 1, 15 (2020).
Respondent produced a copy of the Civil Penalty Approval Form
signed on November 10, 2009, by the immediate supervisor of RA Floyd,
who examined petitioners’ returns, and approving the imposition of the
fraud penalties and the accuracy-related penalties for underpayments
due to substantial understatements of income tax. Respondent formally
communicated his determination to assert the fraud penalties and the
accuracy-related penalties against petitioners in the examination
report, which respondent issued to petitioners on November 12, 2009.
The notice of deficiency in this case was issued on November 14, 2011.
Petitioners do not claim, and the record does not support a conclusion,
32
[*32] that respondent communicated his initial determination to
petitioners before the date the examining agent’s manager signed the
Civil Penalty Approval Form. Accordingly, respondent has satisfied his
burden with respect to section 6751(b). 24
2.
Section 6663(a) Fraud Penalties
Section 6663(a) imposes a penalty equal to 75% of the taxpayer’s
underpayment of Federal income tax that is due to fraud. Fraud is an
intentional wrongdoing on the part of the taxpayer with the specific
purpose of evading a tax believed to be owing. Petzoldt v. Commissioner,
92 T.C. 661, 698 (1989); Minchem Int’l, Inc. v. Commissioner, T.C.
Memo. 2015-56, at *43, aff’d sub nom. Sun v. Commissioner, 880 F.3d
173 (5th Cir. 2018). If any portion of the underpayment is attributable
to fraud, the entire underpayment will be treated as attributable to
fraud unless the taxpayer establishes by a preponderance of the
evidence that part of the underpayment is not due to fraud. § 6663(b);
see also Minchem Int’l, Inc., T.C. Memo. 2015-56, at *43–44.
Respondent has the burden of proving fraud by clear and
convincing evidence. See § 7454(a); Rule 142(b). To carry that burden of
proof, respondent must show, for each year, that (1) an underpayment
of tax exists and (2) some portion is attributable to the Hackers’ fraud.
See Hebrank v. Commissioner, 81 T.C. 640, 642 (1983); Benavides & Co.,
P.C. v. Commissioner, T.C. Memo. 2019-115, at *31. Fraud is a question
of fact to be resolved upon consideration of the entire record. DiLeo, 96
T.C. at 874. Fraud is never presumed and must be established by
independent evidence. Minchem Int’l, Inc., T.C. Memo. 2015-56, at *45.
Respondent has clearly and convincingly demonstrated for each
year at issue that petitioners failed to report income from various
sources. The first element of the fraud penalty has been established.
The Court now turns to the second element of the fraud penalty
and must determine whether petitioners had the requisite fraudulent
intent. Because direct evidence of fraudulent intent is seldom available,
fraud may be proven by circumstantial evidence and reasonable
inferences drawn from the facts. Niedringhaus v. Commissioner, 99 T.C.
202, 210 (1992); Benavides & Co., P.C., T.C. Memo. 2019-115, at *34.
24 Because petitioners’ substantial understatement of income tax for each year
is sufficient to sustain the accuracy-related penalty (to the extent that petitioners’
conduct was not fraudulent), the Court does not address the accuracy-related penalties
for negligence.
33
[*33] The taxpayer’s entire course of conduct may be indicative of
fraudulent intent. Niedringhaus, 99 T.C. at 210.
Circumstances that may indicate fraudulent intent, commonly
referred to as “badges of fraud,” include but are not limited to
(1) understating income; (2) maintaining inadequate records; (3) giving
implausible or inconsistent explanations; (4) concealing income or
assets; (5) failing to cooperate with authorities; (6) engaging in illegal
activities; (7) providing incomplete or misleading information to one’s
tax return preparer; (8) lack of credibility of the taxpayer’s testimony;
(9) filing false documents, including false income tax returns; (10) failing
to file tax returns; and (11) dealing in cash. Minchem Int’l, Inc., T.C.
Memo. 2015-56 at *46. No single factor is dispositive; however, the
existence of several factors “is persuasive circumstantial evidence of
fraud.” Vanover v. Commissioner, T.C. Memo. 2012-79, 2012 WL 952871,
at *4.
Respondent argues that petitioners’ fraudulent intent is
demonstrated by a number of the badges of fraud, including their failure
to maintain records with respect to personal expenses and cash receipts,
the extravagant uses of Blossom’s funds on personal expenses, and Mr.
Hacker’s vague, misleading, or uncorroborated statements to RA Floyd.
The Court agrees. Blossom consistently reported gross receipts
over $2,000,000 while during the same period petitioners received no
wages from Blossom. Even though Blossom paid a management fee to
Hacker Corp., the Hackers were paid only relatively low wages. Mr.
Hacker received wages of only $44,615, $36,923, $19,999, $26,153, and
$29,230 while Mrs. Hacker received wages of $44,618, $36,925, $20,001,
$27,694, and $29,232 for 2004, 2005, 2006, 2007, and 2008, respectively.
Despite these low wages, petitioners and their children financed a lavish
lifestyle through Blossom. Blossom provided petitioners and their
children with the use of personal vehicles; paid for vacations for
petitioners and their children to the Bahamas, Europe, Hawaii, Las
Vegas, and New Orleans; purchased jewelry and other luxury items; and
paid numerous routine personal expenses, including restaurant meals,
auto expenses, personal medical expenses, mortgage payments, and
college tuition. Petitioners did not report on their personal returns the
receipt of these benefits, providing incomplete information to their
bookkeepers and return preparers. During the examination of their
returns, petitioners attempted to conceal them from respondent through
the examination, such as by providing vague, misleading, or outright
false statements to RA Floyd.
34
[*34] If any portion of an underpayment is attributable to fraud, the
entire underpayment will be treated as attributable to fraud unless the
taxpayer establishes by a preponderance of the evidence that part of the
underpayment is not due to fraud. § 6663(b); see also Minchem Int’l, Inc.,
T.C. Memo. 2015-56, at *43–44. In the notice of deficiency, respondent
laid out the adjustments on which the fraud determination was based.
The Court examines those amounts in greater detail below.
In the notice of deficiency, respondent determined the fraud
penalty for 2004 on the basis of the following adjustments to income:
Adjustments to income to which fraud
penalty applies
Wages from Blossom–TPW
Wages from Blossom–TPH
Dividends
Unexplained deposits
Amount
$99,370
99,370
594,170
20,221
The Court held supra that $95,452 of the 2004 dividend amount
respondent determined related to reasonable business expenses of
Blossom and was not a dividend to petitioners. With respect to the
remaining adjustments to petitioners’ wages from Blossom, dividends,
and unexplained deposits, the Court sustains the application of the
fraud penalty. However, the evidence shows and the Court finds that
the adjustments to petitioners’ income other than wages from Blossom,
dividends, or unexplained deposits were not due to fraud and therefore
not subject to the fraud penalty.
In the notice of deficiency, respondent determined the fraud
penalty for 2005 on the basis of the following adjustments to income:
Adjustments to income to which fraud
penalty applies
Amount
Wages from Blossom–TPW
Wages from Blossom–TPH
Dividends
Unexplained deposits
$104,600
104,600
446,782
57,322
The Court held supra that the 2005 dividend amount should be reduced
by $83,671, which related to reasonable business expenses of Blossom,
and further reduced by the net value of the Long St. and Mingo Rd.
properties, which were not distributions to petitioners. With respect to
the remaining adjustments to petitioners’ wages from Blossom,
dividends, and unexplained deposits, the Court sustains the application
35
[*35] of the fraud penalty. However, the evidence shows and the Court
finds that the adjustments to petitioners’ income other than wages from
Blossom, dividends, or unexplained deposits were not due to fraud and
therefore not subject to the fraud penalty.
In the notice of deficiency, respondent determined the fraud
penalty for 2006 on the basis of the following adjustments to income:
Adjustments to income to which fraud
penalty applies
Amount
Wages from Blossom–TPW
Wages from Blossom–TPH
Dividends
Unexplained deposits
$110,105
110,105
375,246
69,088
The Court sustained respondent’s 2006 adjustments to petitioners’
wages, dividends, and unexplained deposits. The fraud penalty, as
applied to those adjustments, is sustained. However, the evidence shows
and the Court finds that any adjustment to petitioners’ income other
than wages from Blossom, dividends, or unexplained deposits were not
due to fraud and therefore not subject to the fraud penalty.
In the notice of deficiency respondent determined the fraud
penalty for 2007 applies to the following adjustments to income:
Adjustments to income to which fraud
penalty applies
Amount
Wages from Blossom–TPW
Wages from Blossom–TPH
Dividends
Unexplained deposits
$115,900
115,900
327,503
98,567
The Court held supra that $23,023.75 of the 2007 dividend amount
respondent determined related to reasonable business expenses of
Blossom and was not a dividend to petitioners. With respect to the
remaining adjustments to petitioners’ wages from Blossom, dividends,
and unexplained deposits, the Court sustains the application of the
fraud penalty. However, the Court finds that the adjustments to
petitioners’ income other than wages from Blossom, dividends, or
unexplained deposits were not due to fraud and therefore not subject to
the fraud penalty.
In the notice of deficiency respondent determined that the fraud
penalty for 2008 applies to all of the adjustments to petitioners’ income.
36
[*36] The Court held supra that respondent erred in calculating
petitioners’ distributions in excess of basis from Hacker Corp. In
addition, respondent has conceded the $20,750 adjustment to
petitioners’ net income from Accurate Electric. The Court sustains the
application of the fraud penalty to the adjustments to petitioners’ wages
from Blossom, dividends, unexplained deposits, and unreported
gambling winnings. However, the evidence shows and the Court finds
that the adjustments to petitioners’ income other than wages from
Blossom, dividends, unexplained deposits, or gambling winnings were
not due to fraud and therefore not subject to the fraud penalty.
Petitioners have not raised any additional arguments or shown
that any other amounts should be excluded from the fraud penalty.
Accordingly, the Court holds that they are liable for fraud penalties for
the years at issue to the extent discussed herein. To the extent that the
Court’s redetermination of petitioners’ income affects those items to
which respondent determined fraud penalties, however, a
commensurate adjustment to the fraud penalties is required.
3.
Section 6662(a) Accuracy-Related Penalties
Respondent determined, in the alternative, that petitioners are
liable for accuracy-related penalties pursuant to section 6662(a) for the
years at issue. Section 6662(a) and (b)(2) imposes an accuracy-related
penalty equal to 20% of the portion of an underpayment of tax required
to be shown on a tax return that is attributable to a “substantial
understatement of income tax.” An understatement of income tax is a
“substantial understatement” if it exceeds the greater of 10% of the tax
required to be shown on the return or $5,000. § 6662(d)(1)(A). Taxpayers
may avoid a section 6662(a) penalty if they can show that they had
reasonable cause and acted in good faith. § 6664(c). The accuracy-related
penalty does not apply to any portion of an underpayment on which a
fraud penalty is imposed under section 6663. § 6662(b) (flush language).
Petitioners reported income tax of $50,775, $6,976, $65,568, zero,
and zero for 2004, 2005, 2006, 2007, and 2008, respectively. Even
allowing for the adjustments the Court has made to respondent’s
determinations, petitioners’ understatements of income tax were
substantial for all years at issue. Petitioners do not argue that they had
reasonable cause for their understatements. Petitioners are therefore
liable for the accuracy-related penalty on those portions of the
underpayment not subject to the fraud penalty for each year at issue.
37
[*37] VII.
Conclusion
Petitioners are liable for deficiencies for 2004, 2005, 2006, 2007,
and 2008 to the extent discussed herein. Respondent’s determinations
of fraud penalties for all years are sustained in part, and respondent’s
determinations of accuracy-related penalties for all years and an
addition to tax for 2004 are sustained as set forth above.
The Court has considered all of the arguments made by the
parties, and to the extent they are not addressed herein they are
considered unnecessary, moot, irrelevant, or otherwise without merit.
To reflect the foregoing,
Decision will be entered under Rule 155.
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