                             T.C. Memo. 1998-361



                           UNITED STATES TAX COURT



            J. MICHAEL JOLY AND BONNIE B. JOLY, JODY STEVEN JOLY,
                     AND DAVID ANDREW JOLY, Petitioners v.
                 COMMISSIONER OF INTERNAL REVENUE, Respondent



        Docket No. 5985-97.                Filed October 5, 1998.



        J. Michael Joly and Jody Steven Joly, pro se.

        Stephen J. Neubeck, for respondent.



                             MEMORANDUM OPINION


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

the provisions of section 7443A(b)(3) and Rules 180, 181, and

182.1

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

     Respondent determined deficiencies in petitioners' Federal

income taxes and accuracy-related penalties for the years as

follows:

Petitioners J. Michael Joly and Bonnie B. Joly

                                          Accuracy-Related
           Year      Deficiency               Penalty

           1992        $5,478                  $1,096
           1993         3,464                     693
           1994         1,951                     390

Petitioner Jody Steven Joly

           Year                             Deficiency

           1993                               $1,020
           1994                                1,583

Petitioner David Andrew Joly

           Year                             Deficiency

           1992                               $2,143

     After concessions, the issues remaining for decision are:

(1) Whether certain amounts paid to or on behalf of J. Michael

Joly and Jody Steven Joly by J. Michael Joly, Inc. constitute

employee wages; (2) the correct method of computing the amounts

of the losses and gains that J. Michael Joly, Jody Steven Joly,

and David Andrew Joly must recognize with respect to their

J. Michael Joly, Inc. stock; and (3) whether J. Michael Joly and

Bonnie B. Joly are liable for the section 6662(a) accuracy-

related penalties.

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

The stipulations of fact and attached exhibits are incorporated
                                - 3 -

herein by this reference.   J. Michael Joly (Michael), Bonnie B.

Joly (Bonnie), and David Andrew Joly (David) resided in

Centerville, Ohio, and Jody Steven Joly (Jody) resided in

Kettering, Ohio, on the date the petition was filed in this case.

     Michael and Bonnie were husband and wife during the taxable

years in issue.   They have four sons, James, Jody, David, and

Adam.

     Over the past 35 years, Michael has developed an excellent

reputation in the Dayton, Ohio, area for his development and

construction of custom homes.   He has been listed as one of the

top 10 builders by the Home Builders Association for over 15

years.   Because of his reputation, Michael does not need to

advertise for business but rather secures new customers by

referrals.

     In the latter part of 1982, Michael decided to incorporate

his then sole proprietorship as J. Michael Joly, Inc. (the

corporation) to take advantage of both the perceived tax benefits

and the limitation of his personal liability.   The corporation

elected to be treated as an S corporation for Federal income tax

purposes.

     The corporation developed and constructed single-family,

custom homes.   Michael served as the corporation's president

during its entire existence.    He was the primary reason for the

corporation's success in attracting customers before and during

the taxable years in issue.    He was responsible for negotiating
                                   - 4 -

all of the arrangements and devising the plans for the

development of new projects before and during the taxable years

in issue.

     Jody began working for the corporation at the beginning of

1993.   He served as its vice president and worked as its overall

manager of operations.    As part of his management responsibility,

he coordinated the hiring of independent contractors who were to

perform construction work at the project sites.        Jody also worked

as the lead carpenter on many of the homes built during 1993 and

1994.

     Prior to 1993, Jody had worked as a senior auditor for

Reliance Electric Company.       He studied accounting at Ohio State

University and business administration at Xavier University,

including some courses in taxation.

     David was a student during the taxable years in issue.         At

the time of trial, he was attending medical school.       He has never

worked for the corporation.

     Michael owned 100 percent of the corporation's stock when it

was incorporated in 1982.       In subsequent years, he caused the

corporation to issue 30 percent of the stock to be held by his

sons in varying amounts.       During the taxable years in issue,

Michael, Jody, and David held the corporation's stock as follows:

            Year     Michael         Jody      David

            1992         70%          ---       30%
            1993         70%          30%       ---
            1994         70%          30%       ---
                                   - 5 -

     The corporation did not maintain books and records by which

its shareholders' respective bases in their stock could be

determined, primarily as a result of Michael's failure to keep

such records.      Michael, Jody, and David have not proved their

bases in their corporate stock, other than zero, as of the

beginning of their taxable years in issue.

     In the statutory notice of deficiency, respondent determined

that Michael contributed $35,800, $68,413.75, and $43,696 with

respect to his stock in the corporation during 1992, 1993, and

1994, respectively, and has since conceded that Michael

contributed an additional $12,964 during 1992.      Jody and David

made no contributions with respect to their stock.       Petitioners

have not disproved respondent's determinations of their

contributions with respect to their stock.      The amounts

determined by respondent will, therefore, be used in the Rule 155

computation.

     Michael caused the corporation to regularly issue checks

from its bank account in payment of the family members' personal

expenses.    Relying on the corporation's bank statements,

respondent determined that the following amounts were paid to or

on behalf of the corporation's shareholders:

            Year        Michael       Jody       David

            1992      $83,526.53       ---     $25,784.81
            1993       98,515.43     $19,224      ---
            1994       65,082.10      23,415      ---
                                - 6 -

     These amounts differ slightly from the amounts determined in

the statutory notices of deficiency.    The amounts listed as paid

by the corporation to or on behalf of Michael include amounts

paid by it to or on behalf of Bonnie, James, and Adam and to or

on behalf of Jody and David for the taxable years during which

Jody and David were not shareholders.    We have considered and

reject petitioners' arguments that portions of these amounts

constitute loans from the corporation to the shareholders and/or

family members.    No loan documents or other records showing the

existence or amounts of the alleged loans were presented at

trial, and the corporation's Forms 1120S for 1992, 1993, and 1994

do not show any loans on the Schedules L (balance sheets).

Accordingly, the amounts listed above shall be used in the Rule

155 computation.

     Michael ceased to operate in the corporate form and resumed

designing and building homes as a sole proprietor shortly after

respondent's examination of petitioners' and the corporation's

tax returns for 1992, 1993, and 1994.

     The first issue for decision is whether any portions of the

amounts paid to or on behalf of Michael and Jody constitute

employee wages.    Respondent's determinations in the statutory

notices of deficiency are presumed to be correct, and petitioners

bear the burden of proving otherwise.    Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).
                                - 7 -

     On November 14, 1989, Michael entered into an agreement with

the corporation, acting on behalf of the corporation in his

capacity as its president.   The agreement stated that the sole

compensation for his services would be his share of the

corporation's profits.   Under the agreement, Michael was

permitted to withdraw monetary advances of anticipated profits.

The advances were to be treated as a loan on the corporation's

books to the extent they exceeded the corporation's profits.

     On December 2, 1991, Jody entered into a similar agreement

with the corporation with Michael acting on the corporation's

behalf as its president.   Michael stated at trial that the copy

of the agreement submitted to the Court was amended subsequent to

its execution but maintained that the substance of the document

was not changed by the added language.   On brief, Michael

admitted that Jody was "somewhat oblivious of the exacting

parameters" of the agreement.

     Respondent argues that the aforementioned agreements should

be disregarded and that portions of the amounts paid to or on

behalf of Michael and Jody should be treated as employee wages

earned with respect to their personal services rendered to the

corporation.   Respondent contends that Michael used these

agreements to avoid paying employment taxes under the Federal

Insurance Contributions Act (1954), ch. 736, 68A Stat. 415,

currently codified at 26 U.S.C. secs. 3101-3128 (1994) on the

amounts paid to or on behalf of himself and Jody.   See secs.
                                 - 8 -

3101, 3111.     Petitioners maintain that none of the amounts paid

to or on behalf of Michael and Jody constitute employee wages.

They argue that respondent's treatment of portions of such

amounts as employee wages is arbitrary.

     Section 3121(d) provides that the term "employee" means:

             (1) any officer of a corporation; or

          (2) any individual who, under usual common law
     rules applicable in determining the employer-employee
     relationship, has the status of an employee; * * *

     We first consider whether Michael and Jody provided services

to the corporation as employees under common-law rules.

Nationwide Mut. Ins. Co. v. Darden, 503 U.S. 318, 322-325 (1992).

Whether an individual is a common-law employee is a question of

fact.    Weber v. Commissioner, 103 T.C. 378, 386 (1994), affd. per

curiam 60 F.3d 1104 (4th Cir. 1995).

        Among the relevant factors to be considered in deciding the

nature of the employer-employee relationship are the following:

(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 hired party's role in hiring and paying

assistants; (4) the permanency of the relationship between the

parties to the relationship; (5) the extent of the hired party's

discretion over when and how long to work; (6) whether the work

performed is an integral part of the principal's business; (7)

the relationship the parties believe they are creating; and (8)

the provision of benefits typical of those provided to employees.
                                - 9 -

Nationwide Mut. Ins. Co. v. Darden, supra at 323-324; Weber v.

Commissioner, supra at 387; Simpson v. Commissioner, 64 T.C. 974,

984-985 (1975).   No one factor is determinative; rather, all the

incidents of the relationship must be assessed and weighed.

Nationwide Mut. Ins. Co. v. Darden, supra at 324; NLRB v. United

Ins. Co., 390 U.S. 254, 258 (1968); Azad v. United States, 388

F.2d 74, 76 (8th Cir. 1968); Weber v. Commissioner, supra at 387;

Simpson v. Commissioner, supra at 985.

     The record does not support petitioners' argument that the

services which Michael and Jody provided to the corporation were

insubstantial.    During 1992, Michael was solely responsible for

managing and operating the business.    During 1993 and 1994, while

Jody took over some daily responsibilities, Michael continued to

negotiate all of the arrangements and financing, developed the

plans for the custom homes, and reviewed the progress at the

construction sites.   Jody performed management functions and

worked for the corporation as the lead carpenter on many of its

projects.

     Moreover, Michael and Jody were employees of the corporation

by virtue of having been officers of the corporation (president

and vice president, respectively), and having provided more than

minor services to it.   Sec. 31.3121(d)-1(b), Employment Tax Regs.

On this record, we conclude that Michael and Jody rendered

substantial services to the corporation as employees.
                               - 10 -

     We must next decide what constitutes reasonable compensation

for the services performed by Michael and Jody as employees.

Petitioners, relying on the agreements described supra, maintain

that it is reasonable for Michael and Jody to have received no

salaries for their services as employees.    In the statutory

notices of deficiency, respondent determined that the following

amounts paid to or on behalf of Michael and Jody constitute

employee wages:

                  Year        Michael         Jody

                  1992       $46,000           ---
                  1993        86,000        $16,705
                  1994        61,000         23,415

     Initially, we reject petitioners' claim that the failure to

pay employee wages to Michael and Jody is reasonable.    We find

that the characterization in the aforementioned agreements of the

amounts paid to or on behalf of Michael and Jody do not reflect

the true character of such payments.    See Joseph Radtke, S.C. v.

United States, 712 F. Supp. 143 (E.D. Wis. 1989), affd. per

curiam 895 F.2d 1196 (7th Cir. 1990).

     The question left for us to decide is what constitutes

reasonable compensation for the personal services actually

rendered by Michael and Jody as employees.    Sec. 162(a)(1); Roob

v. Commissioner, 50 T.C. 891, 898 (1968); sec. 1.162-7, Income

Tax Regs.   Whether compensation is reasonable is a question to be

resolved on the basis of an examination of all the facts and

circumstances of the case.    Kennedy v. Commissioner, 671 F.2d
                                - 11 -

167, 173 (6th Cir. 1982), revg. 72 T.C. 793 (1979); Mayson

Manufacturing Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir.

1949), revg. a Memorandum Opinion of this Court.

     The Court of Appeals for the Sixth Circuit, the court to

which an appeal in this case lies, has adopted a set of basic

factors to be considered by the Court in deciding the

reasonableness of compensation:    (1) The employee's

qualifications; (2) the nature, extent, and scope of the

employee's work; (3) the size and complexities of the employer's

business; (4) a comparison of salaries paid with the employer's

gross and net income; (5) the prevailing general economic

conditions; (6) a comparison of salaries paid with distributions

of retained earnings; (7) the prevailing rates of compensation

for comparable positions in comparable concerns; (8) the salary

policy of the employer as to all employees; and (9) in the case

of small corporations with a limited number of officers, the

amount of compensation paid to the particular employee in

previous years.     Kennedy v. Commissioner, supra at 173-174;

Mayson Manufacturing Co. v. Commissioner, supra.     The facts must

be considered as a whole with no single factor decisive.     Mayson

Manufacturing Co. v. Commissioner, supra.

     Petitioners urge the Court to find that respondent erred in

determining that any amounts of employee wages were paid to

Michael and Jody.    In other words, they do not argue that a

finding of lesser amounts of employee wages would be more
                               - 12 -

appropriate and, due primarily to their failure to introduce any

corporate books and records, have not presented any credible

evidence upon which lesser amounts of employee wages may be

determined.   Respondent's determinations were based on the only

records available, the corporation's bank statements, from which

respondent determined that regular payments were made to and on

behalf of Michael and Jody.

     The record firmly establishes the fact that Michael was the

driving force behind the corporation's business during the

taxable years in issue.   At trial, Michael acknowledged his

reputation as being highly regarded in the construction industry

and his role as the corporation's "rainmaker".   We are not

convinced that Michael's participation in the corporation's

activities was drastically reduced after 1992.   We believe that

he remained in complete control of the corporation even after

Jody began working for it.    Jody's role in the corporation, while

not as influential as his father's, certainly would have demanded

the modest salary that respondent determined he received.

     After carefully considering the factors listed above, we

find that respondent's determinations of the amounts of Michael's

and Jody's employee wages for the taxable years in issue

constitute reasonable compensation for the services which they

provided to the corporation as employees during such years.
                             - 13 -

     We hold that Michael and Jody received employee wages from

the corporation in the amounts determined by respondent.2

     The second issue we must decide is the correct method of

computing the amounts of losses and gains that Michael, Jody, and

David must recognize with respect to their stock in the

corporation.

     In general, section 1366(a)(1) provides that a shareholder

shall take into account his pro rata share of an S corporation's:

          (A) items of income * * *, loss, deduction, or
     credit the separate treatment of which could affect the
     liability for tax of any shareholder, and

          (B) nonseparately computed income or loss.

     Section 1366(d)(1) limits the aggregate amount of losses and

deductions that may be taken into account by a shareholder under

section 1366(a) for any taxable year to:

          (A) the adjusted basis of the shareholder's stock
     in the S corporation (determined with regard to
     paragraph (1) of section 1367(a) for the taxable year),
     and

          (B) the shareholder's adjusted basis of any
     indebtedness of the S corporation to the shareholder
      * * *.



     2
          As a result of the additional deductions allowed to the
corporation in the amounts which we have held are properly
treated as employee wages, the corporation sustained net losses
instead of the reported net income for the taxable years in
issue. We find that the amounts of the net losses, after taking
into account respondent's uncontested adjustments to the
corporation's costs of goods sold, are $34,122, $57,579, and
$36,888 for 1992, 1993, and 1994, respectively.
                                - 14 -

     Any losses or deductions disallowed for any taxable year by

section 1366(d)(1) are treated as incurred by the S corporation

in the succeeding taxable year with respect to that shareholder.

Sec. 1366(d)(2).   Accordingly, subject to the section 1366(d)(1)

limitation, Michael, Jody, and David are entitled to their pro

rata shares of the corporation's losses.3

     Section 1368 provides that, in the case of an S corporation

which has no accumulated earnings and profits, a distribution of

property made with respect to its stock is treated as gain from

the sale or exchange of property to the extent the amount of the

distribution exceeds the adjusted basis of the stock.    Sec.

1368(a) and (b).

     Taking into account the total amounts paid to or on behalf

of Michael, Jody, and David during the taxable years in issue,

supra p. 5, and the portions of such amounts which we have held

to be employee wages, supra p. 10, we find that the amounts

distributed to them with respect to their stock are as follows:

          Year       Michael       Jody       David

          1992     $37,526.53       ---     $25,784.81
          1993      12,515.43     $2,519       ---
          1994       4,082.10       ---        ---

     3
          In addition, we find that Michael, Jody, and David are
entitled to deductions for their pro rata shares of the
corporation's separately stated charitable contributions in the
amounts of $3,788, $3,270, and $2,370, for 1992, 1993, and 1994,
respectively. Secs. 1363(b)(1), 1366(a)(1); see sec. 702(a)(4).
Michael, Jody, and David concede that they must include in their
gross income their pro rata shares of the corporation's
separately stated interest income, as determined by respondent.
                                  - 15 -

       After reviewing the statutory notices of deficiency and

subsequent computations referred to supra, we find that

respondent has not adjusted Michael's, Jody's, and David's

adjusted bases in their stock in accordance with the applicable

law.       For the taxable years in issue, a shareholder's adjusted

basis in the stock of an S corporation is:       (1) Increased by the

shareholder's pro rata share of the corporation's income; (2)

decreased by the shareholder's pro rata share of the

corporation's losses and deductions; and (3) decreased by the

amount of the shareholder's section 1368 distributions.       Sec.

1367; sec. 1.1367-1(e), Income Tax Regs.       Respondent erroneously

flip-flopped steps (2) and (3) by decreasing the adjusted bases

by the amounts of the shareholders' distributions before

decreasing the adjusted bases by the amounts of the shareholders'

pro rata shares of losses and deductions.4

       We hold that the amounts of Michael's, Jody's, and David's

recognized losses and gains with respect to their stock in the

corporation must be computed in a manner consistent with the law

in effect during the taxable years in issue, as explained supra.

       4
         For taxable years beginning after Dec. 31, 1996, the
Small Business Job Protection Act of 1996, Pub. L. 104-188, sec.
1309(a)(1), 110 Stat. 1755, 1783, amended the parenthetical
language in sec. 1366(d)(1)(A) to read "(determined with regard
to paragraphs (1) and (2)(A) of section 1367(a) for the taxable
year)". The effect of this amendment was to change the order of
the basis adjustments to that used by respondent in the statutory
notices of deficiency. See H. Rept. 104-586, at 89 (1996), 1996-
3 C.B. 331, 427. This amendment, however, is not applicable to
the taxable years in issue.
                               - 16 -

     The third issue for decision is whether Michael and Bonnie

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

negligence for 1992, 1993, and 1994.    Respondent's determinations

of negligence are presumed to be correct, and petitioners bear

the burden of proving that the penalties do not apply.   Rule

142(a); Welch v. Helvering, 290 U.S. at 115; Bixby v.

Commissioner, 58 T.C. 757, 791-792 (1972).

     Section 6662(a) imposes a 20-percent penalty on the portion

of an underpayment attributable to any one of various factors,

one of which is negligence or disregard of rules or regulations.

Sec. 6662(b)(1).   Respondent determined that Michael and Bonnie

are liable for the accuracy-related penalty imposed by section

6662(a) for their underpayments of taxes in 1992, 1993, 1994, and

that such underpayments were due to negligence or disregard of

rules or regulations.   "Negligence" includes a failure to make a

reasonable attempt to comply with the provisions of the Internal

Revenue laws or to exercise ordinary and reasonable care in the

preparation of a tax return.   Sec. 6662(c); sec. 1.6662-3(b)(1),

Income Tax Regs.   "Disregard" includes any careless, reckless, or

intentional disregard of rules or regulations.   Sec. 6662(c);

sec. 1.6662-3(b)(2), Income Tax Regs.

     Section 6664(c)(1), however, provides that the penalty under

section 6662(a) shall not apply to any portion of an

underpayment, if it is shown that there was reasonable cause for

the taxpayer's position with respect to that portion of the
                              - 17 -

underpayment and that the taxpayer acted in good faith with

respect to that 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 proper tax liability for the year.   Id.

     Based on the record, we find that Michael and Bonnie have

not proved that their underpayments were due to reasonable cause

or that they acted in good faith.   We hold that Michael and

Bonnie are liable for the section 6662(a) accuracy-related

penalty for 1992, 1993, and 1994.

     To reflect the foregoing,

                                         Decision will be entered

                                    under Rule 155.
