                         T.C. Summary Opinion 2019-27



                         UNITED STATES TAX COURT



  BRADLEY M. MCGUIGAN AND SHIRLEY W. MCGUIGAN, Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 10617-17S.                         Filed September 30, 2019.


      Maris Baltins, for petitioners.

      Patsy A. Clarke, Lisa R. Jones, and Melissa D. Lang, for respondent.



                              SUMMARY OPINION


      VASQUEZ, 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




      1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect at all relevant times, and all Rule references are to the Tax
Court Rules of Practice and Procedure.
                                         -2-

Pursuant to section 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.

      Respondent determined deficiencies of $2,770 and $5,168 in petitioners’

Federal income tax for 2014 and 2015, respectively. Respondent also determined

a section 6662(a) accuracy-related penalty of $1,033.60 for 2015.

      The issues for decision are whether: (1) petitioner husband was an

independent contractor or a statutory employee entitled to report expenses on

Schedules C, Profit or Loss From Business, or a common law employee whose

expenses were reportable on Schedules A, Itemized Deductions, (2) petitioners are

entitled to deductions for legal and professional services, insurance (other than

health), and rent for vehicles, machinery, or equipment, and (3) petitioners are

liable for the section 6662(a) accuracy-related penalty for 2015.

                                    Background

      Some of the facts have been stipulated and are so found. The stipulation of

facts and the attached exhibits are incorporated herein by this reference.

Petitioners resided in Montana when they timely filed their petition.

      During the years at issue petitioner Bradley M. McGuigan worked as a

diesel technology specialist. Before then Mr. McGuigan had worked off and on

for John Knerr for approximately 20 years. In or around 2012 Mr. Knerr partnered
                                        -3-

with Chad Pardee to form Pardee Excavating, LLC, which later became Montana-

Dakota Services, Inc. (MDS).2 Mr. Knerr invited Mr. McGuigan to work for

MDS, and he accepted.

      Pursuant to an oral agreement with Mr. Knerr, Mr. McGuigan performed

gas recovery services for MDS at multiple oil well sites across Montana and North

Dakota. His duties included moving gas recovery equipment between oil well

sites, setting up and maintaining the equipment to recapture gas, and training oil

company employees to ensure continued plant operations. Much of the equipment

was leased directly to MDS, which entrusted it to Mr. McGuigan. Whenever Mr.

McGuigan needed assistance on a job, MDS sent additional workers to help him.

      Mr. McGuigan worked at the oil sites without direct supervision. He set his

own hours, which varied with the task at hand. Each day Mr. McGuigan filled out

reports entitled “Montana-Dakota Services, Inc. Daily Production Reporting”.

These reports offered proof that Mr. McGuigan was providing quality service.

      Additionally Mr. McGuigan submitted equipment logs to MDS secretaries,

who tracked the equipment from site to site. Because he performed gas recovery


      2
       In 2014 Pardee Excavating, LLC, brought in a new member and merged
with MDS. Mr. Knerr and Mr. Pardee were part owners of both entities, and Mr.
McGuigan kept the same employment agreement following this transition.
Accordingly, references to MDS are to both companies.
                                        -4-

services on site, he sometimes traveled hundreds of miles to do his job.

Accordingly, he worked away from home for approximately 300 days in 2014 and

270 days in 2015.

      Under his agreement with MDS, Mr. McGuigan was responsible for work-

related expenses including food, lodging, travel, and insurance. He was also

responsible for any expenses arising from damage to the equipment during

transport. MDS did not reimburse him for these expenses. Additionally, he drove

his own truck to the various worksites and took his tools with him.

      In 2014 Mr. McGuigan paid $2,000 to rent a forklift, which he used to move

certain equipment. MDS offered him a rollback truck to perform this task, but he

opted to use the forklift instead because it would make the job easier. MDS did

not reimburse him for the forklift expense.

      When he was working on site at a refinery plant, the oil company trained

Mr. McGuigan to use its privately owned technology. Some of this information

was confidential. After speaking with an oil company representative about the

issue of privacy laws, Mr. McGuigan sought legal advice on avoiding trade secret

infringement disputes. Accordingly, he paid $1,500 and $2,500 for attorney’s fees

in 2014 and 2015, respectively. MDS did not reimburse him for these expenses.
                                         -5-

      Petitioners timely filed joint Forms 1040, U.S. Individual Income Tax

Return, for both tax years at issue. Mr. McGuigan reported on the Forms 1040

that MDS paid him wages of $93,360 and $96,615 in 2014 and 2015, respectively.

Likewise, MDS issued Mr. McGuigan Forms W-2, Wage and Tax Statement, and

withheld Federal income tax.3 Petitioners used a computer program to prepare

their returns and file them electronically. They did not hire a tax preparer or an

accountant.

      On the returns Mr. McGuigan declared himself a “mechanic” and petitioner

Shirley W. McGuigan declared herself “retired”. Mrs. McGuigan also listed

herself as a proprietor of “Jaws Northwest Corp.” on petitioners’ Schedules C for

2014 and 2015. Petitioners used these Schedules C to report the expenses related

to Mr. McGuigan’s employment with MDS under the premise that he was a

statutory employee.

      On February 17, 2017, respondent mailed petitioners a notice of deficiency

with respect to tax years 2014 and 2015, disallowing their Schedule C deductions

for legal and professional fees, insurance (other than health), and rent expenses.

Respondent also recharacterized petitioners’ remaining Schedule C deductions as

      3
        The record includes a copy of Mr. McGuigan’s 2015 Form W-2, which
does not indicate in box 13 that Mr. McGuigan was a “Statutory Employee”. The
record does not include a Form W-2 for tax year 2014.
                                          -6-

unreimbursed employee expenses and moved them to Schedule A for each year at

issue.4

          For 2015 respondent determined a penalty under section 6662(a) and (b)(2)

for an underpayment due to a substantial understatement of income tax. The

record includes Form 300, Civil Penalty Approval Form, signed by Revenue

Agent (RA) Kyle Crider’s group manager, who approved the RA’s initial

determination to impose the penalty for tax year 2015. The group manager’s

signature is dated January 6, 2017.

                                      Discussion

I.        Burden of Proof

          Generally, the Commissioner’s determination of a deficiency is presumed

correct, and the taxpayer has the burden of proving it incorrect. Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933). However, under section 7491(a),

the burden of proof may shift to the Commissioner as to any factual issue relevant

to a taxpayer’s liability for tax if the taxpayer meets certain preliminary

conditions. See Higbee v. Commissioner, 116 T.C. 438, 442-443 (2001).

Petitioners have not claimed or shown that they meet the requirements of section


          4
        Other adjustments made in the notice of deficiency are computational and
need not be addressed in this opinion.
                                         -7-

7491(a) to shift the burden of proof to respondent as to any relevant factual issue.

Accordingly, the burden of proof remains on petitioners.

II.   Employment Classification

      A.     General Rules

      An individual performing services as an employee may deduct expenses

incurred in the performance of services as an employee as miscellaneous itemized

deductions on Schedule A to the extent the expenses exceed 2% of the taxpayer’s

adjusted gross income. See secs. 62(a), 63(a), (d), 67(a) and (b), 162(a). Itemized

deductions may be limited under section 68 and may have alternative minimum

tax implications under section 56(b)(1)(A)(i).

      “An individual who performs services as an independent contractor is

entitled to deduct expenses incurred in the performance of services on Schedule C

and is not subject to limitations imposed on miscellaneous itemized deductions.”

Feaster v. Commissioner, T.C. Memo. 2010-157, slip op. at 5. A statutory

employee under section 3121(d)(3) is not an employee for purposes of section 62

and may deduct business expenses on Schedule C. See Rosemann v.

Commissioner, T.C. Memo. 2009-185, slip op. at 6-7 & n.3; see also Rev. Rul. 90-

93, 1990-2 C.B. 33.
                                        -8-

      Petitioners argue that Mr. McGuigan was an independent contractor or a

statutory employee during the years at issue and was thereby entitled to deduct

business expenses on Schedules C. Respondent contends that Mr. McGuigan was

a common law employee who could deduct his unreimbursed employee expenses

on Schedules A only, subject to the 2% of adjusted gross income limitation.

      An individual qualifies as a statutory employee under section 3121(d)(3)

only if the individual is not a common law employee pursuant to section

3121(d)(2). See Ewens & Miller, Inc. v. Commissioner, 117 T.C. 263, 269

(2001); Rosemann v. Commissioner, slip op. at 7. Section 3121(d)(2) provides

that an “employee” is “any individual who, under the usual common law rules

applicable in determining the employer-employee relationship, has the status of an

employee”. Because an individual qualifies as a statutory employee only if the

individual is not a common law employee, we will first decide whether petitioner

was a common law employee of MDS.

      B.    Common Law Employee

      The term “employee” is not defined for purposes of the income tax issue

before us; therefore, common law rules must be applied to determine whether an

individual is an employee. Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318,

322-323 (1992); Matthews v. Commissioner, 92 T.C. 351, 360 (1989), aff’d, 907
                                          -9-

F.2d 1173 (D.C. Cir. 1990); Simpson v. Commissioner, 64 T.C. 974, 984 (1975).

Whether an employer-employee relationship exists is a question of fact. Air

Terminal Cab, Inc. v. United States, 478 F.2d 575, 578 (8th Cir. 1973); Prof’l &

Exec. Leasing, Inc. v. Commissioner, 89 T.C. 225, 232 (1987), aff’d, 862 F.2d 751

(9th Cir. 1988). If an employer-employee relationship exists, its characterization

by the parties as some other relationship, such as principal-independent contractor,

is of no consequence. Sec. 31.3121(d)-1(a)(3), Employment Tax Regs.

      This Court has enumerated the following factors in determining whether an

employer-employee relationship exists: (1) the degree of control exercised by the

principal over the details of the work; (2) which party invests in the facilities used

in the work; (3) the opportunity of the taxpayer for profit or loss; (4) whether the

principal has the right to discharge the taxpayer; (5) whether the work is part of

the principal’s regular business; (6) the permanency of the relationship; and (7) the

relationship the parties believe they are creating. Weber v. Commissioner, 103

T.C. 378, 387 (1994), aff’d per curiam, 60 F.3d 1104 (4th Cir. 1995); Prof’l &

Exec. Leasing, Inc. v. Commissioner, 89 T.C. at 232; Simpson v. Commissioner,

64 T.C. at 984-985. No single factor is dispositive. Simpson v. Commissioner, 64

T.C. at 985. All of the facts and circumstances must be studied. Prof’l & Exec.

Leasing, Inc. v. Commissioner, 89 T.C. at 232.
                                        -10-

             1.    Degree of Control

      While all of the above factors are important, the “right-to-control” is the

“master test” in determining the nature of a working relationship. Matthews v.

Commissioner, 92 T.C. at 361. Both the control exercised by the alleged employer

and the degree to which the alleged employer may intervene to impose control

must be examined. Radio City Music Hall Corp. v. United States, 135 F.2d 715,

717 (2d Cir. 1943); DeTorres v. Commissioner, T.C. Memo. 1993-161. “[N]o

actual control need be exercised, as long as the employer has the right to control.”

Prof’l & Exec. Leasing, Inc. v. Commissioner, 862 F.2d at 753. In order for an

employer to retain the requisite control over the details of an employee’s work, the

employer need not direct each step taken by the employee. Prof’l & Exec.

Leasing, Inc. v. Commissioner, 89 T.C. at 234; Gierek v. Commissioner, T.C.

Memo. 1993-642.

      The record does not indicate that Mr. McGuigan worked for any entity other

than MDS or hired his own subcontractors to assist him when he serviced MDS’

customers, as an independent contractor might. Rather, he performed gas recovery

services only for oil companies that were under contract with MDS. Whenever he

needed assistance on a job, MDS sent additional workers to help him. MDS

asserted control over Mr. McGuigan by requiring him to monitor the location of
                                        -11-

the gas recovery equipment he used. In addition, Mr. McGuigan submitted daily

reports to the oil companies as proof that MDS was providing the service for

which it was under contract.

      Although Mr. McGuigan set his own hours and worked without direct

supervision, the record indicates that MDS had the right to control Mr. McGuigan

by dictating his worksite, monitoring the quality of his performance, and tracking

the equipment he needed to do his job. On the basis of the facts presented, this

factor indicates that Mr. McGuigan was an employee.

             2.    Investment in Facilities

      The fact that a worker provides his or her own tools or goods generally

indicates independent contractor status. Ewens & Miller, Inc. v. Commissioner,

117 T.C. at 271. Conversely, the fact that a worker has no investment in the

facilities used in the work is indicative of an employer-employee relationship. See

id.

      During the tax years at issue Mr. McGuigan supplied his own tools and

transportation to accomplish his job at each oil well site. However, it is not clear

from the record how much he paid for these tools. In addition, Mr. McGuigan did

not invest financially in the transport, setup, or maintenance of the equipment he

used to provide gas recovery services. Rather, MDS and the oil companies paid
                                         -12-

for these essential expenses. Therefore, this factor indicates that Mr. McGuigan

was an employee.

             3.     Opportunity for Profit or Risk of Loss

      An opportunity for profit or the risk of loss on the basis of the worker’s own

efforts and skill indicates independent contractor status. See Simpson v.

Commissioner, 64 T.C. at 988; Rosato v. Commissioner, T.C. Memo. 2010-39,

slip op. at 13. In contrast, earning an hourly wage or fixed salary indicates an

employer-employee relationship. See Robinson v. Commissioner, T.C. Memo.

2011-99, slip op. at 17-18 (citing James v. Commissioner, 25 T.C. 1296, 1300

(1956)), aff’d, 487 F. App’x 751 (3d Cir. 2012). For example, in Juliard v.

Commissioner, T.C. Memo. 1991-230, this Court held that, because the taxpayer

earned a salary and was reimbursed for expenses, he was not in a position to

increase his profit by his own actions, and he was not at risk for loss.

      For tax years 2014 and 2015, respectively, MDS paid Mr. McGuigan annual

salaries of approximately $93,000 and $96,000. The record indicates that Mr.

McGuigan earned his salary regardless of how well, or poorly, he performed his

duties. Additionally, the record does not show that he received incentive

compensation based on whether MDS increased its profits.
                                          -13-

       On the other hand, Mr. McGuigan credibly testified that the requirement

that he pay for repairs on broken equipment could cause him significant losses.

Thus, Mr. McGuigan’s salary could be reduced by the amount he spent on work-

related expenses because MDS did not reimburse these costs. Overall, this factor

is neutral.

              4.    Right To Discharge

       “The principal’s retention of the right to discharge a worker is indicative of

a common law employer-employee relationship.” Rodriguez v. Commissioner,

T.C. Memo. 2012-286, slip op. at 20 (citing Weber v. Commissioner, 103 T.C. at

391); see also Ellison v. Commissioner, 55 T.C. 142, 152 (1970). The record is

silent on this factor. At most this factor is neutral.

              5.    Integral Part of Regular Business

       A type of work that is part of the principal’s regular business is indicative of

employee status. See Simpson v. Commissioner, 64 T.C. at 989; Rosemann v.

Commissioner, slip op. at 11. During the years at issue, MDS offered oil well

services to oil companies in North Dakota and Montana. MDS assigned Mr.

McGuigan to perform a specific service which the oil companies hired MDS to

provide. Accordingly, Mr. McGuigan provided a service that lies within the scope
                                       -14-

of MDS’ regular business. Therefore, this factor indicates that Mr. McGuigan was

an employee.

            6.     Permanency of Relationship

      A continuing relationship indicates an employment relationship, while a

transitory relationship may be indicative of independent contractor status. See

Ewens & Miller, Inc. v. Commissioner, 117 T.C. at 273; Rosemann v.

Commissioner, slip op. at 11.

      We believe that the relationship between Mr. McGuigan and MDS was not

transient because Mr. McGuigan worked for MDS from 2012 through the years at

issue. Furthermore, Mr. Knerr, who was a member of MDS, had employed Mr.

McGuigan intermittently for approximately 20 years. On the basis of the facts

presented, this factor indicates that Mr. McGuigan was an employee.

            7.     Relationship the Parties Thought They Created

      The withholding of taxes is consistent with a finding that an individual is a

common law employee. See Packard v. Commissioner, 63 T.C. 621, 632 (1975);

Rosato v. Commissioner, slip op. at 14. MDS provided Mr. McGuigan with

Forms W-2 for the years at issue. In both 2014 and 2015 MDS withheld Federal

income tax from Mr. McGuigan’s income and remitted those amounts to

respondent. MDS did not indicate on Mr. McGuigan’s 2015 Form W-2 that he
                                        -15-

was a statutory employee. On the basis of these facts, this factor indicates that Mr.

McGuigan was an employee.

             8.    Conclusion

       Several of the above factors indicate that Mr. McGuigan was a common law

employee whereas other factors are neutral. After weighing these factors, the

Court concludes that Mr. McGuigan was a common law employee of MDS for the

2014 and 2015 taxable years. Therefore, he is precluded from claiming Schedule

C deductions as a statutory employee under section 3121(d) and the underlying

regulations. See Ewens & Miller, Inc. v. Commissioner, 117 T.C. at 269; Colvin

v. Commissioner, T.C. Memo. 2007-157, slip op. at 28, aff’d, 285 F. App’x 157

(5th Cir. 2008); see also sec. 31.3121(d)-1, Employment Tax Regs.

III.   Petitioners’ Schedule A Deductions

       We next determine whether petitioners are entitled to deductions for

unreimbursed employee business expenses that respondent disallowed for lack of

substantiation.

       A.    General Rules

       Deductions are a matter of legislative grace, and the taxpayer generally

bears the burden of proving entitlement to any deduction claimed. See Rule

142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial
                                          -16-

Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). A taxpayer claiming a deduction

on a Federal income tax return must demonstrate that the deduction is allowable

pursuant to a statutory provision and must further substantiate that the expense to

which the deduction relates has been paid or incurred. See sec. 6001; Hradesky v.

Commissioner, 65 T.C. 87, 89-90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir.

1976).

      Section 162 allows a taxpayer to deduct all ordinary and necessary expenses

paid or incurred by the taxpayer in carrying on a trade or business; but personal,

living, or family expenses are not deductible. Secs. 162(a), 262(a). A trade or

business expense is ordinary if it is normal or customary within a particular trade,

business, or industry, and it is necessary if it is appropriate and helpful for the

development of the business. Commissioner v. Heininger, 320 U.S. 467, 471

(1943); Welch v. Helvering, 290 U.S. at 113-114.

      A “trade or business” includes the “trade or business” of being an employee.

O’Malley v. Commissioner, 91 T.C. 352, 363-364 (1988); Primuth v.

Commissioner, 54 T.C. 374, 377-378 (1970). The taxpayer bears the burden of

establishing that his employer would not have reimbursed him for such expenses.

See Podems v. Commissioner, 24 T.C. 21, 22-23 (1955); Benson v.

Commissioner, T.C. Memo. 2007-113, slip op. at 9; Putnam v. Commissioner,
                                         -17-

T.C. Memo. 1998-285, slip op. at 8. He can do so by showing that he was

required or expected to bear these costs. See Fountain v. Commissioner, 59 T.C.

696, 708 (1973); see also Dunkelberger v. Commissioner, T.C. Memo. 1992-723

(finding that management team expected taxpayer to bear expense of business

lunches with vendors).

      If the taxpayer is able to establish that he paid or incurred a deductible

expense but is unable to substantiate the precise amount, the Court generally may

approximate the deductible amount, but only if the taxpayer presents sufficient

evidence to establish a rational basis for making the estimate (Cohan rule). See

Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); see also Vanicek v.

Commissioner, 85 T.C. 731, 742-743 (1985). For certain kinds of business

expenses, including automobile expenses, section 274(d) overrides the Cohan rule.

See secs. 274(d), 280F(d)(4)(A)(i); Sanford v. Commissioner, 50 T.C. 823, 827-

828 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969).

      B.     Legal and Professional Services

      For 2014 and 2015, respectively, petitioners claimed deductions of $1,500

and $2,500 for legal and professional services. Respondent disallowed these

deductions in full for lack of substantiation.
                                        -18-

      It is well established that legal fees stemming from a taxpayer’s employee

status are deductible on Schedule A. Test v. Commissioner, T.C. Memo. 2000-

362, slip op. at 14, aff’d, 49 F. App’x 96 (9th Cir. 2002). The deductibility

depends on the “origin and character” of the claim for which the legal fees were

incurred and whether the claim bears a sufficient nexus to the taxpayer’s business

or income-producing activities. See United States v. Gilmore, 372 U.S. 39, 49

(1963); Test v. Commissioner, slip op. at 11.

      Mr. McGuigan’s testimony, which the Court found credible and forthright,

establishes that he sought legal advice on avoiding trade secret infringement after

an oil company representative advised him to do so. More specifically, the oil

company was MDS’ client, and MDS expected Mr. McGuigan to bear the cost of

his employment-related expenses. As a result, Mr. McGuigan paid $1,500 and

$2,500 in 2014 and 2015, respectively, to protect his employment as an oil

mechanic. Taking into account the record as a whole, the Court concludes that

these expenses originated in Mr. McGuigan’s conduct as an employee of MDS.

Therefore, petitioners are entitled to Schedule A deductions of $1,500 and $2,500,

respectively, for tax years 2014 and 2015.
                                          -19-

      C.     Rent of Vehicles, Machinery, or Equipment

      For 2014 and 2015, respectively, petitioners claimed deductions of $9,856

and $3,600 for rent of vehicles, machinery, or equipment. Respondent disallowed

these expenses in full for lack of substantiation.

      A portion of this reported expense for 2014 arises from Mr. McGuigan’s

renting a forklift. Mr. McGuigan testified at trial that “[he] had a choice to use a

rollback truck that * * * [MDS] would have paid for”, but he opted instead to rent

a forklift for $2,000 “to make * * * [his] job a hundred percent easier and

quicker.” Respondent argues that petitioners are precluded from deducting the

forklift rental expense because MDS offered other equipment for Mr. McGuigan

to use in the course of his employment.

      As discussed above Mr. McGuigan must establish that MDS either required

or expected him to pay for the expense of renting vehicles, machinery, or

equipment. See Fountain v. Commissioner, 59 T.C. at 708; see also Dunkelberger

v. Commissioner, T.C. Memo. 1992-723, 1992 Tax Ct. Memo LEXIS 763, at *5.

The record, however, shows that MDS neither required nor expected Mr.
                                        -20-

McGuigan to rent the forklift. Accordingly, petitioners are not entitled to deduct

the forklift rental expense.5

      Other than the forklift rental expense, the record contains no evidence of

petitioners’ reported rent expenses. We therefore sustain respondent’s

disallowance of these deductions.

      D.     Insurance (other than health)

      We next address respondent’s disallowance of petitioners’ deductions for

insurance (other than health).

             1.     2014

      On their 2014 return petitioners deducted $987 for insurance. Respondent

argues that petitioners are precluded from deducting this expense for lack of

substantiation. The record is devoid of evidence of this reported expense.

Consequently, respondent’s determination on this issue is sustained.

             2.     2015

      On their 2015 return petitioners deducted $3,654 for insurance. Respondent

contends that this reported expense was for automobile insurance, and petitioners

have not argued otherwise. Petitioners were allowed a Schedule A deduction for


      5
       While we do not doubt that the use of the forklift improved his job
performance, Mr. McGuigan’s job performance is not the issue before us.
                                         -21-

car and truck expenses using the standard mileage rate. See sec. 1.274-5(j)(2),

Income Tax Regs.

      A taxpayer may deduct vehicle expenses using either actual costs or the

standard mileage rate. See id. Because petitioners cannot claim deductions for

both actual expenses and those calculated using the standard mileage rate, we

sustain respondent’s disallowance. See Tesar v. Commissioner, T.C. Memo.

1997-207, slip op. at 17 (“Automobile expense may be computed using actual

costs, such as depreciation, or using the standard mileage method; thus, petitioners

cannot deduct depreciation expense and use the standard mileage rate.”).

IV.   Section 6662(a) Accuracy-Related Penalty

      We next determine whether petitioners are liable for a section 6662(a)

accuracy-related penalty for tax year 2015.6 Section 6662(a) imposes a penalty

equal to 20% of any underpayment that arises from a substantial understatement of

income tax. See sec. 6662(b)(2). An understatement is substantial if it exceeds

the greater of 10% of the correct tax or $5,000. Sec. 6662(d)(1)(A).

      Under section 7491(c) respondent has the burden of production with respect

to the section 6662(a) penalty. To meet this burden, respondent must produce


      6
         While petitioners did not address their liability for the accuracy-related
penalty in their petition, we find that it was tried by consent. See Rule 41(b).
                                        -22-

sufficient evidence indicating that it is appropriate to impose the penalty against

petitioners. See Higbee v. Commissioner, 116 T.C. at 446. Respondent’s burden

of production under section 7491(c) includes establishing compliance with the

supervisory-approval requirement of section 6751(b). See Graev v.

Commissioner, 149 T.C. 485, 493 (2017), supplementing and overruling in part

147 T.C. 460 (2016).

      Section 6751(b)(1) provides that, subject to certain exceptions in section

6751(b)(2), no penalty shall be assessed unless the initial determination of the

assessment is personally approved in writing by the immediate supervisor of the

individual making the determination or such higher level official as the

Commissioner may designate. Written approval of the initial penalty

determination under section 6751(b)(1) must be obtained before the proposed

penalty is first formally communicated to the taxpayer in a writing that also

advises the taxpayer of his rights to appeal the penalty with the Internal Revenue

Service Office of Appeals. Clay v. Commissioner, 152 T.C. __, __ (slip op. at 44)

(Apr. 24, 2019).

      A reasonable-cause exception to the section 6662(a) penalty is found in

section 6664(c)(1), which provides that no penalty is imposed under section 6662
                                         -23-

“with respect to any portion of an underpayment if it is shown that there was a

reasonable cause for such portion and that the taxpayer acted in good faith with

respect to such portion.” 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 taxpayer’s effort to

assess his or her proper tax liability. Id. Similarly, reasonable cause and good

faith is not necessarily indicated by reliance on facts that, unknown to the

taxpayer, are incorrect. Id.

      Respondent has complied with the requirements of section 6751(b)7 and

contends that petitioners are liable for a section 6662(a) and (b)(2) penalty for

2015 to the extent that there is a substantial understatement of income tax. Thus,

if the Rule 155 computation indicates that petitioners’ understatement exceeds the

greater of $5,000 or 10% of the amount of tax required to be shown on the return,

respondent has satisfied his burden of production.




      7
        The RA in this case recommended the assertion of a substantial
understatement penalty under sec. 6662(b)(2). That recommendation was
approved in writing by his immediate supervisor on January 6, 2017, as evidenced
by a Civil Penalty Approval Form included in the record.
                                        -24-

      Since respondent has met his burden, petitioners must come forward with

persuasive evidence that the penalty is inappropriate. Petitioners may meet their

burden by proving that they acted with reasonable cause and in good faith with

respect to the underpayment. See sec. 6664(c)(1); see also Higbee v.

Commissioner, 116 T.C. at 447; sec. 1.6664-4(b)(1), Income Tax Regs.

Petitioners, however, have not argued or even suggested that they acted with

reasonable cause, arguing only that their returns were correctly based on their

determination that Mr. McGuigan was a statutory employee. As explained supra,

petitioners’ determination was incorrect.

      We therefore hold that petitioners are liable for the section 6662(a) and

(b)(2) accuracy-related penalty to the extent the Rule 155 computations show there

is an underpayment attributable to a substantial understatement of income tax.

      To reflect the foregoing,


                                                    Decision will be entered under

                                               Rule 155.
