                  T.C. Summary Opinion 2011-58



                      UNITED STATES TAX COURT



         RICHARD J. AND JACQUELINE ROCCHIO, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 7719-10S.              Filed May 11, 2011.



     Richard J. Rocchio, pro se.

     William R. Brown, Jr., for respondent.



     ARMEN, Special Trial Judge:   This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in

effect when the petition was filed.1   Pursuant to section

7463(b), the decision to be entered is not reviewable by any


     1
        Unless otherwise indicated, all subsequent section
references are to the Internal Revenue Code in effect for the
year in issue, and all Rule references are to the Tax Court Rules
of Practice and Procedure.
                                 - 2 -

other court, and this opinion shall not be treated as precedent

for any other case.

     Respondent determined a deficiency in petitioners’ 2007

Federal income tax of $7,033 and an accuracy-related penalty

under section 6662(a) of $1,407.

     The issues for decision are:

     (1)    Whether petitioner-husband was a shareholder in an S

corporation during 2007 such that petitioner-husband is required

to report his pro rata share of the corporation’s income.      We

hold that he was; and

     (2)    whether petitioners are liable for the accuracy-related

penalty under section 6662(a).    We hold that they are not.

                              Background

     Some of the facts have been stipulated, and they are so

found.     We incorporate by reference the parties’ stipulation of

facts, supplemental stipulation of facts, and accompanying

exhibits.    All references to petitioner in the singular are to

petitioner Richard J. Rocchio.

     Petitioners resided in the State of Florida when the

petition was filed.

     Petitioner’s mother and father each owned 50-percent

interests in Leas-Co Leasing, Inc. (Leas-Co), a New York

corporation.    After the death of petitioner’s mother in 1993,

petitioner and each of his three siblings inherited 12.5-percent
                                - 3 -

interests in Leas-Co.   At all times, petitioner’s father owned

the remaining 50-percent interest in Leas-Co.     In the years

following petitioner’s mother’s death, petitioner’s father ran

Leas-Co, petitioner was on the board of directors, and

petitioner’s siblings were all officers.

     Sometime around 2000 petitioner’s father remarried.

Petitioner’s father’s new wife created family strife, and as a

result petitioner’s father became estranged from each of his

children.   Petitioner’s father and his new wife began “living

their life in luxury”, and petitioner and his siblings received

“little to nothing” from the company.

     On October 21, 2006, petitioner and his three siblings filed

for judicial dissolution of Leas-Co pursuant to N.Y. Bus. Corp.

Law section 1104-a (McKinney 2003).     On January 9, 2007,

petitioner’s father elected to purchase the shares held by

petitioner and his siblings pursuant to N.Y. Bus. Corp. Law

section 1118 (McKinney 2003).

     Petitioner and his siblings could not agree with their

father regarding the fair value of the corporation; thus,

litigation ensued that eventually resulted in a settlement.

Petitioner sold his shares in Leas-Co to his father on August 12,

2009.

     Leas-Co’s 2007 Form 1120S, U.S. Income Tax Return for an S

Corporation, reported $316,635 of ordinary business income.      A
                                - 4 -

2007 Schedule K-1, Shareholder’s Share of Income, Deductions,

Credits, etc., reported petitioner’s share of the ordinary

business income as $39,579, consistent with petitioner’s 12.5-

percent interest in Leas-Co.

      Petitioners did not include the $39,579 from the Schedule

K-1 on their 2007 Federal income tax return.

      In the notice of deficiency respondent determined that

petitioners must include the $39,579 reported on the Schedule K-1

in gross income and that petitioners are liable for the accuracy-

related penalty under section 6662(a) for a substantial

understatement of income tax.

                            Discussion

A.   Burden of Proof

      Generally, the Commissioner’s determinations are presumed

correct, and the taxpayer bears the burden of proving that those

determinations are erroneous.   Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933).

      Under section 7491(a)(1), the burden of proof may shift from

the taxpayer to the Commissioner if the taxpayer produces

credible evidence with respect to any factual issue relevant to

ascertaining the taxpayer’s liability.    Petitioners have not

alleged that section 7491 applies, nor did they introduce a

sufficiency of evidence to invoke that section; therefore, the

burden of proof remains on petitioners.
                               - 5 -

B.   S Corporation Pro Rata Distributive Share

      Generally, a shareholder of an S corporation must include in

gross income his or her pro rata share of the corporation’s

income, loss, deduction, or credit.    Sec. 1366(a), (c); see also

sec. 61(a).   Consequently, we must decide whether petitioner was

a shareholder of Leas-Co during 2007 such that he is required to

report his pro rata share of Leas-Co’s ordinary income.

      In the application of Federal tax law, State law controls in

determining the nature of the taxpayer’s legal interest in

property.   United States v. Natl. Bank of Commerce, 472 U.S. 713,

722 (1985); Aquilino v. United States, 363 U.S. 509, 513 (1960).

As a result we must look to New York State law to determine

petitioner’s interest in Leas-Co during 2007.

      On October 21, 2006, petitioner and his siblings filed for

judicial dissolution of Leas-Co pursuant to N.Y. Bus. Corp. Law

section 1104-a.   That statute permits holders of shares

representing 20 percent or more of the votes of all outstanding

shares of an S corporation to file a petition for dissolution if

those in control of the corporation (1) have been guilty of

illegal, fraudulent, or oppressive actions toward the complaining

shareholders, or (2) are wasting the corporation’s assets.    Id.

      On January 9, 2007, petitioner’s father, as the remaining

shareholder, elected to purchase petitioner’s and his siblings’

outstanding shares pursuant to N.Y. Bus. Corp. Law section 1118.
                              - 6 -

That statute provides for an irrevocable election and requires

valuation of the shares by the court if the shareholders cannot

agree on the fair value of such shares; further, the statute

provides that the valuation date is the date prior to the date on

which the petition for dissolution was filed.   Id.

     Petitioner contends that because he and his siblings filed

for judicial dissolution and his father elected to purchase his

shares, he was not liable for the Federal income tax on his pro

rata share of Leas-Co’s income in 2007.   In support of his

position petitioner relies on a decision and order issued in In

re Gillman (Audio Den, Ltd.), N.Y.L.J., Nov. 25, 1988, at 27

(Sup. Ct. 1988), which states in part:

          To permit the selling shareholder to participate
     in post-election management would serve no purpose, for
     his interest is frozen statutorily as of the day
     preceding his application for the corporation’s
     dissolution. What happens in the business thereafter
     is of no moment vis a vis the value of his shares.
     Indeed the last clause of [N.Y. Bus. Corp. Law] Section
     1118 specifically excludes from the valuation process
     “any element of value arising from * * * [the] filing
     [for dissolution]”.

     Petitioner contends that because his interest in Leas-Co was

frozen statutorily and he was no longer entitled to participate

in the management of Leas-Co, he is not liable for the Federal

income tax on his pro rata share of Leas-Co’s income for 2007.

Petitioner further contends that he is not liable for the Federal

income tax because he “never got the money for * * * [the

Schedule] K-1” in 2007.
                               - 7 -

     Respondent contends that petitioner remained a shareholder

of Leas-Co until his shares were sold in August 2009; therefore,

petitioner is liable for the Federal income tax on his pro rata

share of Leas-Co’s income for 2007.

     Petitioner’s reliance upon In re Gillman (Audio Den, Ltd.),

supra, is misplaced.   The court in that case acknowledged that

section 1118 of N.Y. Bus. Corp. Law, and the remainder of Article

11 of N.Y. Bus. Corp. Law, do not provide guidance regarding the

selling of a shareholder’s rights to profits and dividends during

“the hiatus which separates the filing of the dissolution

petition and payment for his shares.”   Id.

     In Commissioner v. Estate of Bosch, 387 U.S. 456, 465

(1967), the Supreme Court addressed the means for determining

State law in the context of a Federal tax case, stating:

     the State’s highest court is the best authority on its
     own law. If there be no decision by that court then
     federal authorities must apply what they find to be the
     state law after giving “proper regard” to relevant
     rulings of other courts of the State. In this respect,
     it may be said to be, in effect, sitting as a state
     court. Bernhardt v. Polygraphic Co., 350 U.S. 198
     (1956).

     The parties have not cited any case from New York State’s

highest court deciding the narrow legal question presented

herein, and we are not aware of any such case.2   Under the



     2
        In most states the State supreme court is the highest
court; however, in New York the supreme court is a trial court.
The New York Court of Appeals is the State’s highest court.
                               - 8 -

circumstances, we must do our best “to discern what such State’s

highest court would decide.”   Estate of Young v. Commissioner,

110 T.C. 297, 302 (1998).

     The New York Court of Appeals has held that even when a

corporation has been “dissolved, the shareholder’s interest does

not abruptly end.”   Indep. Investor Protective League v. Time,

Inc., 406 N.E.2d 486, 488 (N.Y. 1980).    Further, the New York

Supreme Court, Appellate Division, explained that a shareholder

in a corporation remains such “until payment is made for the fair

value of his shares”.   In re Davis, 571 N.Y.S.2d 234, 236 (App.

Div. 1991).

     In Stern v. Bambu Sales, Inc. (In re Spielfogel), 237 Bankr.

555, 559 (E.D.N.Y. 1999), the U.S. District Court for the Eastern

District of New York examined the issue of whether a shareholder

is entitled to a dividend after filing for dissolution (pursuant

to N.Y. Bus. Corp. Law section 1104-a) and a subsequent election

(pursuant to N.Y. Bus. Corp. Law section 1118) by the corporation

but before the purchase was complete.    As in the instant case,

several years separated the filing for dissolution and the actual

purchase of the shareholder’s shares.    Id. at 558.   The court

held that despite the filing for judicial dissolution and the

election by the corporation to purchase the shares, the

shareholder’s interest “was not put to an ‘abrupt[] end,’ * * *

by virtue of the election, * * * [and he remained] entitled to
                               - 9 -

the post-election dividend” before the sale of the shares was

accomplished.   Id. at 560.

     Because petitioner’s interest in Leas-Co did not “abruptly

end” upon the filing for judicial dissolution and subsequent

election by petitioner’s father to purchase shares, petitioner

remained a shareholder in Leas-Co until the sale of his shares

was complete in August 2009.   See id. at 559; Indep. Investor

Protective League v. Time, Inc., supra at 488; In re Davis, supra

at 236.

     Petitioner maintains that even if he were a shareholder in

2007, he is not liable for the Federal income tax on the income

of Leas-Co for 2007 because he “never got the money for

* * * [the Schedule] K-1” in 2007.

     Contrary to petitioner’s contention, section 1.1366-1(a)(1),

Income Tax Regs., provides that “An S corporation must report,

and a shareholder is required to take into account in the

shareholder’s return, the shareholder’s pro rata share, whether

or not distributed, of the S corporation’s items of income”.

(Emphasis added.)   Because petitioner was a shareholder in Leas-

Co until August 2009 and regardless of whether the income from

Leas-Co was distributed in 2007, petitioner must report his pro

rata share of Leas-Co’s income on his Federal income tax return.

See sec. 1366(a), (c); sec. 1.1366-1(a)(1), Income Tax Regs.
                                - 10 -

      Accordingly, we hold that petitioner is required to report

his pro rata share of Leas-Co’s 2007 income on his joint Federal

income tax return for that year.

C.   Section 6662(a) Substantial Understatement of Tax

      Respondent determined in the notice of deficiency that

petitioners are liable for the accuracy-related penalty under

section 6662(a) for a substantial understatement of income tax

for 2007.

      Section 6662(a) and (b)(2) imposes a penalty equal to 20

percent of any underpayment of tax that is due to a substantial

understatement of income tax.    See sec. 6662(a), (b)(2).   An

individual substantially understates his or her income tax when

the reported tax is understated by the greater of 10 percent of

the tax required to be shown on the return or $5,000.    Sec.

6662(d)(1)(A).

      The accuracy-related penalty does not apply to any portion

of an underpayment, however, if it is shown that there was

reasonable cause for the taxpayer’s position and that the

taxpayer acted in good faith with respect to that portion.      Sec.

6664(c)(1); sec. 1.6664-4(a), Income Tax Regs.    The determination

of whether a taxpayer acted with reasonable cause and in good

faith is made on a case-by-case basis, taking into account all

the pertinent facts and circumstances.    Sec. 1.6664-4(b)(1),

Income Tax Regs.   The most important factor is the extent of the
                                   - 11 -

taxpayer’s effort to assess his proper tax liability for such

year.     Id.    Circumstances that may indicate reasonable cause and

good faith include an honest misunderstanding of fact or law that

is reasonable in light of the experience, knowledge, and

education of the taxpayer.       Sec. 1.6664-4(b), Income Tax Regs.;

see Higbee v. Commissioner, 116 T.C. 438, 449 (2001) (citing Remy

v. Commissioner, T.C. Memo. 1997-72).         The determination of

whether a taxpayer acted with reasonable cause and in good faith

with respect to an underpayment that is related to an item

reflected on the return of a passthrough entity is made on the

basis of all pertinent facts and circumstances, including the

taxpayer’s own actions, as well as the actions of the passthrough

entity.     Sec. 1.6664-4(e), Income Tax Regs.

        Section 7491(c) places on the Commissioner the burden of

production with respect to a taxpayer’s liability for any

penalty.        Respondent satisfied his burden of production because

the record shows that petitioners substantially understated their

income tax for 2007 by $7,033, which amount exceeds the greater

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

$5,000.     See sec. 6662(d)(1)(A); Higbee v. Commissioner, supra at

446.     Accordingly, petitioners bear the burden of proving that

the accuracy-related penalty should not be imposed with respect

to any portion of the underpayment for which they acted with

reasonable cause and in good faith.         See sec. 6664(c)(1); Higbee
                             - 12 -

v. Commissioner, supra at 446.   The mere fact that we held

against petitioners with respect to petitioner’s status as a

shareholder of Leas-Co does not, in and of itself, require

holding for respondent on the accuracy-related penalty.   See

Hitchins v. Commissioner, 103 T.C. 711, 719 (1994).

     In view of the complexities surrounding the taxation of S

corporations and their shareholders, as well as the challenges of

devining New York State law, we find that petitioner did have

reasonable cause to believe that he was not a shareholder of

Leas-Co in 2007 and did act in good faith with respect to the

underpayment.

     Accordingly, we hold that petitioners are not liable for the

accuracy-related penalty under section 6662(a).

                           Conclusion

     We have considered all of the arguments made by the parties,

and, to the extent that we have not specifically addressed them,

we conclude that they do not support a result contrary to that

reached herein.
                             - 13 -

     Finally, we observe, without commenting on the validity of

such, that petitioner may have a remedy pursuant to New York

State law with respect to the undistributed earnings of Leas-Co

reported on the Schedule K-1 for 2007.

     To reflect the foregoing,


                                         Decision will be entered

                                   for respondent as to the

                                   deficiency in tax and for

                                   petitioners as to the

                                   accuracy-related penalty.
