                     T.C. Summary Opinion 2008-16



                       UNITED STATES TAX COURT



 ROBERT LOUIS RUSTEN AND SUZAN VERONICA RUSTEN, DECEASED, KELLY
        FARRIER, PERSONAL REPRESENTATIVE, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8792-06S.               Filed February 19, 2008.



     Robert Louis Rusten, pro se.

     Kelly Farrier (personal representative), for Suzan Veronica
     Rusten, Deceased.

     Blaine Holiday, for respondent.



     GOEKE, Judge:    This case was heard pursuant to the

provisions of section 7463 of the Internal Revenue Code in effect

at the time the petition was filed.1    Pursuant to section


     1
         Unless otherwise indicated, all section references are to
                                                     (continued...)
                               - 2 -

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

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

for any other case.

     This case arises from respondent’s notice of deficiency for

the taxable year 1998, in which respondent determined a $6,012

deficiency in self-employment tax and a $1,202 section 6662

penalty.

     This case involves income Mr. Rusten earned as a consultant

in the railroad business.   Mr. Rusten’s consulting activities

were primarily in Canada, and the difficulties in verifying the

expenses Mr. Rusten incurred on behalf of his clients made this

case factually complex.   The self-employment tax is the only tax

liability in question because respondent allowed a foreign tax

credit, which eliminated petitioners’2 basic income tax

liability.   On the record before us, we must decide:   (1) Whether

Mr. Rusten’s self-employment income for 1998 is taxable in the

United States; (2) whether petitioners’ cost of goods sold was

greater than the amount respondent allowed; and (3) whether

petitioners are liable for a penalty under section 6662.




     1
      (...continued)
the Internal Revenue Code (Code) in effect for the year in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
     2
      While Suzan Veronica Rusten is now deceased, references to
“petitioners” are to Robert Louis Rusten and Suzan Veronica
Rusten.
                                - 3 -

                             Background

     The trial of this case was held over 2 days during which Mr.

Rusten and his administrative assistant testified, and the

parties stipulated certain exhibits into the record.

     Mr. Rusten was a citizen and a resident of the United States

during 1998, but he worked in Canada as a consultant in the

railroad industry.    Mr. Rusten was an independent contractor

associated with a company called CLN Industries International

(CLN).    Mr. Rusten assisted railroad companies by purchasing

machinery such as locomotives, generators, and traction motors

for them and by training their employees to make repairs and

maintain the locomotives and cars.

     Despite the fact that Mr. Rusten considered himself an

independent contractor and was taxed as such in the United

States, in Canada Mr. Rusten was taxed as an employee of CLN.

CLN withheld the American equivalent of $21,011.53 of income

taxes from Mr. Rusten’s compensation and paid them to the Canada

Revenue Agency.    The income taxes withheld were reported on a

T4A-NR, Statement of Fees, Commissions, or Other Amounts Paid to

Non-Residents for Services Rendered in Canada.    The Canadian

Government retained these withheld income taxes.

     Petitioners timely filed their 1998 Federal income tax

return.    Petitioners’ return was audited for the taxable year

1998.    After the first audit, the parties reached an agreement
                                - 4 -

that resulted in an increase in petitioners’ taxable income by

$12,385 as a result of an adjustment decreasing cost of goods

sold by $15,182 and other adjustments that reduced taxable

income.

     After the second audit, respondent issued a notice of

deficiency that increased petitioners’ taxable self-employment

income by an additional $68,638, primarily because of adjustments

increasing by $70,572 the net profit reported on Schedule C,

Profit or Loss From Business.    Respondent based these adjustments

on a series of deposits into petitioners’ business checking

accounts totaling $146,362.    The second audit also resulted in

the allowance of a foreign tax credit of $19,030, which

eliminated petitioners’ regular income tax liability.

     Respondent also reduced the cost of goods sold for 1998 to

$5,818 after the first audit.    Exhibits and testimony at trial

establish that this cost of goods sold figure does not include

many of the expenses Mr. Rusten incurred buying equipment and

materials for the railroads for which he provided consulting

services.   There was a great deal of testimony offered about

other possible cost of goods sold items, but the records of

income and expense petitioners produced at trial were

disorganized and incomplete.

     In the notice of deficiency, respondent also determined that

petitioners were liable for a penalty under section 6662.
                                - 5 -

                              Discussion

     The first issue that we must decide is whether Mr. Rusten’s

self-employment income was properly subject to tax in the United

States.   Section 1401 imposes a tax on the self-employment income

of every individual, including the income earned by an American

citizen working in a foreign country.      See Duncan v.

Commissioner, 86 T.C. 971, 972 (1986).      While section 911

excludes foreign earned income from gross income under certain

circumstances, section 911 does not apply to self-employment

income.   Sec. 1402(a)(11).   However, section 1401(c) provides

that if there is an agreement in effect between the United States

and a foreign country pursuant to section 233 of the Social

Security Act, then self-employment income of an individual is

exempt from American self-employment taxes to the extent that

under the agreement the income is subject to tax under the Social

Security system of the foreign country.

     In order to minimize the risk of subjecting workers to both

American and Canadian employment taxes, the United States and

Canada signed a totalization agreement to allocate Social

Security and other taxes (employment taxes) paid by workers who

would otherwise be subject to both tax regimes.     Agreement With

Respect to Social Security, U.S.-Can., Mar. 11, 1981, 35 U.S.T.

3403.   The totalization agreement was made pursuant to section

233 of the Social Security Act, and it governs self-employment
                               - 6 -

taxes.   Therefore, under section 1401(c), the United States may

not tax self-employment income to the extent that Canada has the

right to tax such income under the totalization agreement.     See

id. art. II(1)(a)(ii).

     Under article V of the totalization agreement, an employed

person working in either the United States or Canada is subject

to the employment taxes of only the country in which the person

works.   By contrast, if a person is self-employed and would

otherwise be subject to self-employment taxes in both countries,

the person is subject to the self-employment taxes of only the

United States unless the person is a resident of Canada.   If a

person would be subject to employment taxes of both countries

because he is considered by the United States to be self-employed

and by Canada to be an employee, the tie-breaker rule is that the

person will be treated as self-employed.

     Mr. Rusten falls within this tie-breaker rule.   The Internal

Revenue Service has the exclusive right to tax him as a self-

employed person residing in the United States, but without the

tie-breaker rule the Canada Revenue Agency would have the right

to tax him as an employee working in Canada.   Unfortunately, the

Canada Revenue Agency did not apply the tie-breaker rule, and any

attempts that Mr. Rusten made to recover the Canadian taxes that

CLN withheld from him were unsuccessful.   Section 1401(c) offers

no protection to Mr. Rusten because since Canada did not have the
                               - 7 -

right to tax the income he earned from work with CLN, that income

was properly subject to self-employment tax in the United States.

     While petitioners have unused foreign tax credits because of

the income taxes that Mr. Rusten paid in Canada, those credits

cannot be used to offset petitioners’ self-employment tax

liability.   Under section 901(a), foreign tax credits are only

allowed against the regular tax liability imposed by chapter 1 of

subtitle A of the Code.   See secs. 26(b), 27(a).   However,

petitioners’ tax liability arises from self-employment taxes

imposed by chapter 2 of subtitle A of the Code, and therefore may

not be offset by foreign tax credits.   See sec. 1401.

     The second issue that we must decide is whether in

determining petitioners’ gross income respondent should have

allowed a cost of goods sold greater than$5,518.    Section 61

defines gross income as all income from whatever source derived.

However, in determining gross income taxpayers may offset gross

receipts by the cost of goods sold.    Sec. 1.61-3(a), Income Tax

Regs.   Section 6001 and the regulations thereunder require

taxpayers to maintain adequate books and records of their income

and expenses.   When taxpayers fail to meet their record-keeping

obligations, the Commissioner is forced to reconstruct the

taxpayers’ income and expenses through indirect methods.

Indirect methods of income reconstruction have long been

accepted, so long as any method employed is reasonably reliable.
                                 - 8 -

Giddio v. Commissioner, 54 T.C. 1530 (1970).      Having failed to

establish the applicability of section 7491(a), petitioners have

the burden of establishing additional amounts of cost of goods

sold over the amount respondent has determined in the notice of

deficiency.   See Rule 142(a).

     Respondent reduced petitioners’ cost of goods sold for 1998

to $5,818 after the first audit.    Exhibits and testimony at trial

establish that this cost of goods sold figure is understated and

that petitioners have substantiated additional costs of goods

sold of $17,680, consisting of expenses that Mr. Rusten incurred

buying equipment and materials for the railroads for which he

provided consulting services.    Petitioners argue that there were

additional cost of goods sold items, but the documentation in the

record simply does not sustain any additional amounts.

     Under section 6662(a) and (b)(1) and (2), taxpayers are

liable for a penalty equal to 20 percent of the portion of the

underpayment of tax attributable to negligence or to a

substantial understatement of income tax.      A substantial

understatement of tax exists if the amount of the understatement

exceeds the greater of (1) 10 percent of the tax required to be

shown on the return, or (2) $5,000.      Sec. 6662(d)(1)(A).

     Respondent has satisfied his burden of production under

section 7491(c) because petitioners understated their income tax

by more than 10 percent and by more than $5,000.
                                 - 9 -

     Under section 6662(d)(2)(B)(i), the amount of a tax

understatement may be reduced by the portion thereof that is

attributable to the tax treatment of an item for which there was

substantial authority.   We find that given the unusual

circumstances of this case, petitioners’ underreporting of Mr.

Rusten’s self-employment tax was due to reasonable cause.

Therefore, the penalty under section 6662 is not applicable.

     To reflect the foregoing,



                                              Decision will be entered

                                         under Rule 155.
