                        T.C. Memo. 2001-173



                      UNITED STATES TAX COURT



      RICHARD R. PELHAM AND PAULA A. PELHAM, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent

      RRP TRUST, RICHARD R. PELHAM, TRUSTEE, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 18687-99, 18688-99.            Filed July 12, 2001.




     W. McNab Miller III, for petitioners.

     W. Lance Stodghill, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     COHEN, Judge:   Respondent determined deficiencies in

petitioners’ Federal income taxes and accuracy-related penalties

under section 6662(a) as follows:
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Richard R. and Paula A. Pelham
Docket No. 18687-99

                                      Penalty
         Year     Deficiency       Sec. 6662(a)

         1996       $4,761                $952
         1997       11,050               2,210

RRP Trust, Richard R. Pelham, Trustee
Docket No. 18688-99

                                      Penalty
         Year     Deficiency       Sec. 6662(a)

         1996      $12,297           $2,459
         1997       36,558            7,312


     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.   After concessions by the parties, the issue remaining

for decision is whether petitioner RRP Trust (the trust) should

be disregarded for Federal income tax purposes and the income and

expense from the business operations of Lake Lock & Key

attributed to petitioners Richard R. Pelham and Paula A. Pelham

(the Pelhams).

                         FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

     Richard R. Pelham (Richard Pelham) and Paula A. Pelham

(Paula Pelham), husband and wife, resided in Humble, Texas, at
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the time they filed their petition.    The principal address of the

trust was Humble, Texas, at the time of filing its petition.

     Prior to the establishment of the trust, Richard Pelham

owned and operated Lake Lock & Key as a sole proprietorship.

Lake Lock & Key was engaged in the sale, repair, and maintenance

of locks and keys for homes and motor vehicles, including selling

locks and keys, installing and repairing locks for homes and

motor vehicles, opening and repairing broken locks and those with

missing keys, and making replacement keys.   As a sole

proprietorship, all of the equipment was owned or provided by

Richard Pelham individually.

     The trust was established upon the suggestion of the

Pelhams’ accountant.   The Pelhams then consulted with a tax

attorney, to whom they paid $2,495 to draft the trust document.

Edwina Hamilton (Hamilton), the adult daughter of the Pelhams,

was involved in the trust arrangement and, on October 1, 1996,

Hamilton, as donor, and Richard Pelham, as trustee, executed the

trust agreement.   The trust designated Richard Pelham as both the

trustee and beneficiary of the trust.   Paula Pelham was named as

the successor trustee.   Under the terms of the trust, the

beneficiary, while serving as trustee, had the power to appoint

cotrustees and successor trustees.

     The trust was initially funded with $1 from Hamilton and,

upon the request of Richard Pelham, Hamilton wrote a check for
                               - 4 -

$700 dated December 13, 1996, that was deposited into the trust

bank account.   The trust agreement provided that any other person

could add property acceptable to the trustee.

     Richard Pelham operated the lock and key business under the

assumed name “Lake Lock & Key” until November 14, 1996, when he

filed a Withdrawal Notice of Assumed Name certificate, stating

that the trust would be conducting business under the name “Lake

Lock & Key”.

     The operations of the lock and key business did not change

after the business was transferred to the trust.    As trustee,

Richard Pelham performed the same duties for Lake Lock & Key that

he performed before the creation of the trust.    Lake Lock & Key

used the same work order invoices.     Lake Lock & Key used the same

taxpayer identification number for the filing of sales tax

returns to the State of Texas and for the filing of State

unemployment tax returns both before and after Richard Pelham

began operating the business through the trust.

     Richard Pelham worked for Lake Lock & Key both before and

after the establishment of the trust.    After the establishment of

the trust, Richard Pelham, both individually and as trustee,

entered into a signed Employment Contract dated October 1, 1996.

In that contract, Richard Pelham agreed to provide his services

as a “chief residential and commercial lock and key service

technician” in exchange for a salary of $30,000 annually.
                                - 5 -

Richard Pelham received a Form W-2, Wage and Tax Statement, for

1996 from the trust in the amount of $7,500 and for 1997 from the

trust in the amount of $15,000.

     The ownership of the business bank account was transferred

from Richard Pelham, individually, to the trust in December 1996.

Richard Pelham paid personal expenses out of the trust bank

account.

     The Pelhams reported the income and expenses of Lake Lock &

Key from January 1 to October 19, 1996, on Schedule C, Profit or

Loss From Business, of their jointly filed Form 1040, U.S.

Individual Income Tax Return.   Subsequent to October 19, 1996,

the trust reported the income and expenses of Lake Lock & Key on

Schedule C of its Form 1041, U.S. Income Tax Return for Estates

and Trusts.    The trust reported no taxable income in either 1996

or 1997 because its net income from the lock and key business

operations was deducted as an income distribution deduction and

reported as such on a Schedule K-1, Beneficiary’s Share of

Income, Deductions, Credits, etc., to Richard Pelham as the

beneficiary.   Richard Pelham reported the income distribution

from the trust on Schedule E, Supplemental Income and Loss,

Part III, Income or Loss From Estate and Trusts, of the Pelhams’

jointly filed Federal individual income tax return.

     Richard Pelham owned the equipment used in the lock and key

business.   Lease payments in the amount of $2,875 per year were
                               - 6 -

reported as income by the Pelhams on Schedule C of their jointly

filed 1997 Form 1040 and were claimed as an expense on the

trust’s Schedule C of its 1997 Form 1041.    No lease agreement was

executed.   No payments were made by the trust to Richard Pelham

for use of the equipment, but the trust did make the payments on

the truck owned by Richard Pelham.     The handling of the equipment

lease transaction and of reporting for tax purposes was done by

the Pelhams’ tax preparer.

                              OPINION

     Respondent’s position is that the trust lacks economic

substance and should be disregarded for Federal income tax

purposes.   Respondent maintains that Richard Pelham created a

mere paper entity, the trust, and transferred the business

operations of his sole proprietorship, Lake Lock & Key, to the

trust for the purpose of avoiding self-employment tax under

section 1402.

     Petitioners argue that the trust should be treated as a

separate entity because:   (1) The trust is a valid trust under

State law; (2) a business may lawfully change from one form of

entity to another, provided that the legal requirements are met;

and (3) the trustee of the trust may operate a sole

proprietorship business within the trust entity.    Petitioners

claim that the income and expenses of Lake Lock & Key were

properly reported for Federal income tax purposes, because the
                                - 7 -

net income from the trust was reported as an income distribution

on a Schedule K-1 to Richard Pelham and accordingly was reflected

on the Pelhams’ Schedule E of their jointly filed Federal

individual income tax return.

     Taxpayers are entitled to structure their transactions to

minimize their tax obligations.    Gregory v. Helvering, 293 U.S.

465, 469 (1935).   However, transactions that have no significant

purpose other than to avoid tax and that do not reflect economic

reality will not be recognized for Federal income tax purposes.

Zmuda v. Commissioner, 79 T.C. 714, 719 (1982), affd. 731 F.2d

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

1245 (1980); see also Furman v. Commissioner, 45 T.C. 360, 364-

366 (1966), affd. 381 F.2d 22 (5th Cir. 1967).    Where the form of

a transaction has not altered any cognizable economic

relationships, we look through the form of the transaction and

apply the tax law according to the transaction’s substance.

Markosian v. Commissioner, supra at 1241.    This principle applies

regardless of whether the transaction creates an entity with

separate existence under State law.     Zmuda v. Commissioner, supra

at 720; see also Furman v. Commissioner, supra at 364.

     In deciding whether a purported trust lacks economic

substance, we consider the following factors:    (1) Whether the

taxpayer’s relationship, as grantor, to property purportedly

transferred into trust differed materially before and after the
                                 - 8 -

trust’s formation; (2) whether the trust had a bona fide

independent trustee; (3) whether an economic interest in the

trust passed to trust beneficiaries other than the grantor; and

(4) whether the taxpayer honored restrictions imposed by the

trust or by the law of trusts.    See Markosian v. Commissioner,

supra at 1243-1245.

     Respondent argues that Richard Pelham was effectively the

grantor of the trust because he arranged and paid for the

establishment of the trust and effectively transferred his

locksmith business to the trust.    Respondent relies on Zmuda v.

Commissioner, supra at 720, and does not rely on the grantor

trust provisions under sections 671 to 678.    Petitioners assert

that Hamilton was the settlor of the trust because she is named

as the donor in the trust document and she funded the trust with

$701.   Richard Pelham claims that he did not transfer assets, not

even personal assets, to the trust, because he leased the

business equipment to the trust.    However, Richard Pelham

testified that he had not signed the purported lease, and no

payments were made by the trust to him for use of the equipment.

Rather, the trust made the payments on the truck owned by Richard

Pelham.

     “In determining the settlors of a trust, we look beyond the

named grantors to the economic realities to determine the true

grantor.”   Id.   Hamilton was a straw man who acted only in form
                                - 9 -

as the grantor of the trust.    Hamilton’s involvement was a mere

formality; she signed the trust document and funded the trust

with a nominal amount.    Considering the economic realities, the

true grantor of the trust was Richard Pelham.    Richard Pelham,

upon the advice of his tax preparer, consulted with an attorney

who drafted the trust documents, and Richard Pelham paid $2,495

for the trust package and asked his daughter to write a check for

$700 to the trust.    Richard Pelham also transferred intangible

assets to the trust, such as the business name and the ongoing

business operations of Lake Lock & Key.

     The business was operated in substantially the same manner

both before and after the trust was created.    The business and

its activities continued under the same name, used the same work

order invoices, used the same taxpayer identification number for

filing its State unemployment tax return and sales tax return

with the State of Texas, and used the same business equipment.

After the establishment of the trust, Richard Pelham continued to

manage and work for the business.

     The trust did not have an independent trustee.    Richard

Pelham had control over the trust activities and trust assets.

Richard Pelham was named as the sole trustee of the trust, and he

had exclusive control over the trust and the business operations.

Richard Pelham paid the personal expenses of the Pelhams from the

trust bank account.    Additionally, Paula Pelham was named as
                                - 10 -

successor trustee.   Under the terms of the trust, the trustee had

the power to appoint successor trustees and cotrustees.

     Petitioners assert that the personal expenses that were paid

from the trust bank account were accounted for as a distribution

and that only the legitimate business expenses were deducted.

Even so, Richard Pelham had the ability to control fully the

trust’s activities and trust assets for his own benefit because

no independent trustee had any meaningful control over the

management of the trust.

     No one other than Richard Pelham held any meaningful

economic interest in the trust because, under the terms of the

trust agreement, Richard Pelham was the named beneficiary of the

income and principal of the trust.

     Petitioners argue that Richard Pelham achieved benefits from

operating the sole proprietorship within a trust and not forming

a corporation because:   (1) The trust could avoid the State

franchise tax imposed on the profits of a corporation, which

would have been approximately $2,040; (2) the trust would not

have to pay the State incorporation filing fee of $300; and

(3) the trust did not have to maintain corporate formalities,

such as shareholder minutes.

     Petitioners’ argument that a trust had advantages over a

corporation misses the point.    The incorporation alternative is

not an issue here.   Petitioners chose the form of a trust and are
                             - 11 -

responsible for the consequences of their decision.   Those

consequences are not the same as corporate form.   The U.S.

Supreme Court has observed repeatedly:   “while a taxpayer is free

to organize his affairs as he chooses, nevertheless, once having

done so, he must accept the tax consequences of his choice,

whether contemplated or not, * * * and may not enjoy the benefit

of some other route he might have chosen to follow but did not.”

Commissioner v. Natl. Alfalfa Dehydrating & Milling Co., 417 U.S.

134, 149 (1974) (citations omitted).

     Richard Pelham testified at trial about his decision to use

a trust entity to operate his sole proprietorship:

          Q    And how was it decided that you wanted to
     start operating Lake Lock & Key through the trust?

          A    Just for the retirement reason.

          Q    Which retirement reason are we talking about?

          A    About saving that money for ten years, and
     letting it build up. And the life insurance policy.
     Otherwise, I’m–-maybe tax reasons, I guess. Because I
     was–-I just turned–-I went on Social Security, and I
     was allowed to make like $8,000 a month.

               That’s what I understood. That I wouldn’t
     have to pay, like–-I’d have to pay taxes on income from
     the business, but not Social Security after $8,000.

               *    *    *    *    *     *    *

          Q    Mr. Pelham, if everything stayed the same,
     what was the purpose of forming the trust?

          A    My retirement money that I had to invest
     every month. And to my knowledge, not–-just being a
     layman on the tax part, only paying tax on the income,
     and not Social Security.
                             - 12 -

               Like for instance, if I made, let’s say
     40,000 in a year, I only had to pay Social Security on
     that 8,000 that I paid myself. But let’s say the other
     balance of the 32,000, I had to pay income tax on, but
     not Social Security tax. That was my understanding.

               I guess what you’d say is for tax reasons.

     Based on Richard Pelham’s testimony and the totality of the

evidence, we conclude that the primary purpose of establishing

the trust was to avoid employment tax.   The trust lacked

independent economic substance.   Richard Pelham was, in

substance, the grantor of the trust.   Thus, the income and

expenses from the operations of Lake Lock & Key during the years

in issue are attributable to the Pelhams and not to the trust.

The Pelhams are liable for self-employment taxes on the net

income of Lake Lock & Key for the years in issue.

     To reflect the foregoing and concessions of the parties,

                                         Decisions will be entered

                                    under Rule 155.
