                       T.C. Memo. 2001-164



                     UNITED STATES TAX COURT



     PATRICK S. ELLIOTT AND DONNA J. ELLIOTT, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent

     LARRY S. ELLIOTT AND JULIA F. ELLIOTT, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 19425-98, 19433-98.           Filed July 3, 2001.



     George W. Connelly, Jr., and Linda S. Paine, for

petitioners.

     David B. Mora, for respondent.
                                   - 2 -

               MEMORANDUM FINDINGS OF FACT AND OPINION

       GERBER, Judge:     Respondent determined deficiencies in income

tax, additions to tax, and penalties in these consolidated1 cases

as follows:

Patrick S. and Donna J. Elliott
Docket No. 19425-98

                                Addition to Tax         Penalty
Year         Deficiency         Sec. 6651(a)(1)       Sec. 6662(a)

1992          $8,787              $2,179               $1,757
1993          11,681                ---                 2,336
1994          32,325                ---                 6,465
1995           4,316                ---                   863

Larry S. and Julia F. Elliott
Docket No. 19433-98

                                Addition to Tax         Penalty
Year         Deficiency         Sec. 6651(a)(1)       Sec. 6662(a)

1992         $12,330               $2,583              $2,466
1993          16,433                4,052               3,289
1994          48,631               10,376               9,726
1995          10,616                  489               2,123

       Numerous issues have been settled by the parties, leaving

the following issue for our consideration:        whether the notices

of deficiency sufficiently informed petitioners that they were

not being allowed to offset deductions against compensation on

their Forms 2106, Employee Business Expenses.2


       1
       These cases have been consolidated for purposes of trial,
briefing, and opinion.
       2
       Petitioners do not attempt to substantiate the expenses in
question. Instead, they ask us to find they are allowable as
claimed on the basis of petitioners’ procedural argument.
                                                   (continued...)
                               - 3 -

                         FINDINGS OF FACT

     Each set of petitioners, Patrick and Donna Elliott and Larry

and Julia Elliott, respectively, was married and filed joint

Federal income tax returns for each of the years under

consideration.   All petitioners resided in the State of Texas at

the time their petitions were filed.    Patrick and Larry, at all

pertinent times, were employees, officers, and shareholders of

American Energy Services, Inc. (AES).   Patrick owned 30 percent

of the AES stock, and he served as its vice president.    Larry

owned 29 percent of the AES stock and he served as its president.

     Patrick and Larry received Forms W–2, Wage and Tax

Statement, showing wages from AES and reported the amounts as

gross income (from wages) on page 1, line 7, of their Federal

income tax returns.   Patrick and Larry also received Forms 1099-

MISC, Miscellaneous Income, reflecting additional amounts paid to

them by AES.   The Form 1099-MISC income was received from AES

under its employee reimbursement plan for Patrick and Larry.

AES’ reimbursements were made without review of the employee’s

expenditures and provided for reimbursement of amounts up to

$40,000 annually.   AES did not have an “accountable plan” for

reimbursement of travel and business expenses as that term is




     2
      (...continued)
Accordingly, if petitioners’ procedural attack is unsuccessful,
they will not be entitled to deductions.
                               - 4 -

used in the regulations under section 62.3   Patrick and Larry

included the Form 1099-MISC nonemployee compensation on their

respective Forms 2106 in conjunction with their claims for

employee expenses.   Accordingly, the nonemployee compensation

from AES was offset by Patrick’s and Larry’s employee business

expenses claimed on their respective Forms 2106.   In this manner,

the offset portion of the nonemployee compensation from AES was

not included in Patrick’s and Larry’s gross income reported on

page 1 of their returns for each tax year.

     In the process of offsetting the income and expenses on

their Forms 2106, Patrick and Larry generally treated the excess

amount of employee business expenses or nonemployee compensation

in a similar manner.   If their claimed expenses exceeded the

nonemployee compensation reflected on the Form 2106, the excess

expense amount was carried to Schedule A, Itemized Deductions,

and claimed as employee expenses deductible from adjusted gross

income.   If their nonemployee compensation exceeded their claimed

employee business expenses, then the excess compensation was

included in gross income on page 1 of their Forms 1040, U.S.

Individual Tax Return.   Patrick and Larry differed in their




     3
       Unless otherwise indicated, section references are the
Internal Revenue Code in effect for the period under
consideration, and Rule references are to the Tax Court’s Rules
of Practice and Procedure.
                                - 5 -

inclusion of the excess compensation in that one included the

excess as wage income and the other as “Other Income”.

     Respondent determined that petitioners should have reported

the nonemployee compensation as part of their gross income and

not in connection with Patrick’s and Larry’s Forms 2106.    In

addition to determining that nonemployee compensation was

includable in gross income, respondent also determined that the

excess employee expenses over nonemployee compensation that had

been claimed on the Schedules A were not allowable for failure to

show them to be ordinary and necessary and/or lack of

substantiation.     Petitioners have conceded that respondent did

not err in disallowing the excess portions of employee business

expenses claimed on petitioners’ Schedules A.

                               OPINION

     Petitioners, on Forms 2106, offset employee expenses against

employee reimbursement compensation received from their

company/employer.   Accordingly, no portion of the compensation

that had been offset was included in gross income reported on

page 1 of petitioners’ income tax returns.    Petitioners should

have included the compensation in gross income and deducted the

expenses, if adequately substantiated, on Schedules A (as

deductions from adjusted gross income).    Respondent’s

determination was to simply include the compensation, unreduced

by the offsetting expenses, in petitioners’ gross income.    In
                               - 6 -

effect, respondent’s determination did not allow the offsetting

expenses in calculating gross income.   Respondent explains that

it was not necessary to make a further adjustment regarding the

offsetting expenses, insofar as they did not exceed the

compensation.   That is so because petitioners did not claim them

on Schedules C, Profit or Loss From Business, or Schedules A of

their returns as deductions from the gross or adjusted gross

income that was used to compute petitioners’ respective taxable

income.   Accordingly, respondent did not expressly state that the

offsetting expenses, up to the amount of the compensation, were

disallowed as business deductions or as miscellaneous itemized

deductions.

     Petitioners argue that respondent’s failure to make an

express determination with respect to the employee expenses

claimed on Forms 2106 results in the employee expenses’ not being

placed in issue.   Petitioners further argue that if the expenses

are not in issue, then the Court lacks subject-matter

jurisdiction over the offsetting expenses.   Next, petitioners

contend that they did not raise the expenses in their petitions

and therefore the expenses are allowable as reflected on their

Forms 2106.

     Respondent counters that his determination corresponded to

petitioners’ reporting approach.   Respondent determined that the

nonemployee compensation is includable in gross income on page 1
                                - 7 -

of petitioners’ Forms 1040 without the offset of the expenses

claimed on the Forms 2106.   Because the expenses were not claimed

on the Schedules A as deductions from reported adjusted gross

income (AGI), there was no need for respondent to expressly

disallow the expenses.   By increasing gross income without a

reduction for the expenses, respondent contends that tacit

disallowance has been effected.   Under those circumstances,

respondent contends that it was up to petitioners to assert the

manner in which the employee expenses they had reflected on the

Forms 2106 would be deductible if not allowable in offset of the

compensation shown on the Forms 1099-MISC.

     The parties have each postured their arguments to facilitate

the result they seek.    From the Court’s perspective, however, the

question boils down to whether respondent’s determination

provided sufficient information to advise petitioners that they

were not receiving the benefit of the expense offset.   We agree

with petitioners that no express language was employed by

respondent to advise petitioners that no offset of expenses was

being allowed.   In that regard, respondent’s income-side

adjustments did carry with them the implication that the setoff

of the expenses was not being allowed.

     Petitioners’ methodology of offsetting expenses directly

from what would have otherwise been reported as gross income was

not permissible.   From an employee’s perspective, there are
                                 - 8 -

generally two types of deductible expenses--those used in

computing AGI and those that are deductible from AGI.     Deductions

used in arriving at AGI would be favored because such deductions

are not subject to certain limitations, including those provided

for in sections 67 and 68.   Congress, in defining AGI, provided

that certain reimbursed expenses of employees could be treated as

deductions in computing AGI.    Sec. 62(a)(2)(A).   Under the

section 62 regulations, a distinction is made between the so-

called accountable reimbursement plans and those which are

nonaccountable.   If an employer establishes an accountable plan,

the employees are not required to report the reimbursement in

gross income.   If the employer’s plan is nonaccountable, the

regulations provide that the employee’s expenses, if properly

substantiated, are allowable as deductions from AGI and subject

to various limitations, including those of section 67.     Sec.

1.62-2(c)(5), Income Tax Regs.    Likewise, if there is no

reimbursement arrangement, the employee deductions will be from

AGI and not allowable under section 62(a)(2).

     The parties have stipulated that AES did not have an

accountable plan, and so petitioners were not entitled to offset

or reduce the Form 1099-MISC compensation (nonaccountable

reimbursement) by their employee expenses without including the

compensation in gross income.    As outlined above, petitioners

were required to include the Form 1099-MISC compensation in gross
                               - 9 -

income and to claim their employee expenses, if properly

substantiated, on Schedule A as a deduction from AGI, subject to

certain limitations.   Accordingly, we must conclude that

respondent’s determinations that the nonemployee compensation

reflected on the Forms 1099-MISC is includable in gross income

were not in error.4

     Petitioners contend that they need not prove or justify

their employee expenses because of respondent’s failure to

expressly state that petitioners were not entitled to claim the

expenses.   Petitioners argue that the offsetting expenses

reflected on the Forms 2106 are not in issue and that we have no

jurisdiction over them.   If that were petitioners’ sole argument,

even if they were successful, it would have no effect on the

income tax deficiencies determined by respondent.5   That is so

because petitioners used the expenses to offset compensation that




     4
       In addition, petitioners do not question the correctness
of respondent’s determination that they failed to show that the
excess amounts of employee expenses that were claimed on the
Schedules A were ordinary and necessary or expended for the
purpose stated.
     5
       We must note that if respondent had merely disallowed the
offsetting expenses reflected by petitioners on their Forms 2106
and had not made any adjustment to the Form 1099-MISC
compensation, there would have been no resulting income tax
deficiency. That is so because petitioners did not first include
the compensation in the gross income that was used to compute
their adjusted gross income and, ultimately, their taxable
income.
                               - 10 -

had not been included in the gross income and/or used in the

computation of petitioners’ respective taxable income.

     In his determination, respondent increased petitioners’

gross income by the amount of the compensation that had been

reflected on the Forms 2106.   In an attempt to negate

respondent’s income-side determination, petitioners have argued

that, without an explicit expense determination by respondent,

petitioners’ reported positions would remain unchanged.

Petitioners make that argument in spite of the undisputed fact

that their employee expenses were not allowable in offset of

gross income.6   Petitioners have attempted an end run around the

error in their reporting position by arguing that they have

already included the Form 1099-MISC compensation in gross income

by reflecting it on the Forms 2106 and that respondent’s

determination is a duplication.    Petitioners’ duplication

argument is circuitous and obviously begs the question.    Because

petitioners used the expenses for direct offset, the compensation

was not included in the gross income petitioners used in

computing their tax liabilities.

     Section 6212 authorizes the Commissioner to determine a tax

deficiency.   Petitioners argue that any failure to make such a

determination results in a lack of our subject-matter



     6
       If allowable, the expenses would have been deductible from
AGI and subject to sec. 67 and other limitations.
                               - 11 -

jurisdiction over the issue of whether the expenses claimed on

the Forms 2106 are deductible.7   Respondent’s position, however,

is that subsumed within the inclusion of the Form 1099-MISC

nonemployee compensation in gross income is a disallowance of the

employee expenses that petitioners used to offset the income on

the Forms 2106.   Respondent also points out that petitioners did

not claim the offsetting expenses as deductions for or from AGI.

Following that reasoning, respondent contends that there was

nothing to disallow.

     Petitioners rely on section 7522(a), requiring that the

Commissioner, in notices of deficiency, “describe the basis for,

and identify the amounts (if any) of, the tax due”.      Section 7522

provides, however, that “An inadequate description * * * shall

not invalidate * * * [a] notice.”       In addition, as we pointed

out in Shea v. Commissioner, 112 T.C. 183, 195 (1999):      “Congress

enacted section 7522 with the expectation that the IRS would

‘make every effort to improve the clarity of all notices * * *

that are sent to taxpayers.’   H. Conf. Rept. 100-1104 (Vol. II),

at 219 (1988), 1988-3 C.B. 473, 709.”




     7
       In addition to their contention that respondent did not
make a determination, petitioners also point out that their
petitions did not include an assignment of error with respect to
the questioned expenses. Petitioners did, however, allege error
with respect to respondent’s determination that the Form 1099-
MISC compensation should be included in gross income on page 1 of
petitioners’ returns.
                               - 12 -

     Generally, respondent determined that petitioners should

have included the nonemployee income reflected on the Forms 1099-

MISC in gross income and not in an offset format on their Forms

2106.    In years where petitioners claimed the excess of employee

expenses over nonemployee compensation on the Schedules A,

respondent determined that said excess expenses had not been

substantiated or shown by petitioners to be ordinary and

necessary.8   Respondent employed the following explanatory

language, with certain minor variations for each group of

petitioners, in determining the relevant adjustments to

petitioners’ income:

            Nonemployee Compensation

     It is determined that you have nonemployee compensation
     from American Energy Services, Inc. in the amount of
     * * * rather than * * * as reported on your * * *
     income tax returns. Accordingly, your taxable income
     is increased * * *.

            Itemized Deductions * * * [year]

     It is determined that you have miscellaneous expenses,
     subject to the two percent of adjusted gross income


     8
       In years where there was an excess of expenses over the
amount of nonemployee compensation on the Forms 2106, petitioners
claimed the excess on the Schedules A as itemized deductions. In
those years, respondent determined that the nonemployee
compensation was includable in gross income and disallowed the
excess expenses claimed on the Schedules A. In years where the
nonemployee compensation exceeded the expenses claimed on the
Forms 2106 and petitioners reported the excess on page 1 as gross
income, respondent determined that the amounts that had been
offset on the Forms 2106 were also includable on page 1 as gross
income. In either event, respondent did not explicitly disallow
the expenses claimed on the Forms 2106.
                               - 13 -

     limitation, in the amount of * * * rather than * * * as
     claimed on your * * * income tax return, since it has
     not been established that any amount in excess of that
     allowed constitutes an ordinary and necessary business
     expense, was expended, or was expended for the
     designated purpose. Accordingly, you are not allowed a
     deduction in the amount of * * * as claimed on your
     * * * income tax return.

     There is no explanatory language in the notices expressly

disallowing the offset of expenses that petitioners had claimed

on the Forms 2106.   It is clear, however, from the above

explanatory language that respondent determined that petitioners’

income should be increased by the amount of the Form 1099-MISC

nonemployee compensation that petitioners had reflected and

offset on Forms 2106.    It also follows that respondent’s

determinations increasing gross income were not first being

reduced by the employee expenses claimed by petitioners on the

respective Forms 2106.

     Petitioners contend that respondent’s determination would

have passed muster if it had been expressed by means of the

following three paragraphs petitioners propose:

     It is determined that you did not receive nonemployee
     compensation in the respective amounts of * * *. As a
     result, the amounts reported as nonemployee
     compensation on your Forms 2106 are reduced * * * [in
     the following amounts].

     It is determined that you received income from American
     Energy Services, Inc. in the respective amounts of
     * * * which should have been reported as compensation
     for services. Accordingly, your gross income is
     increased * * * [in the following amounts].
                              - 14 -

     It is determined that the expenses claimed on your
     Forms 2106 in the amounts of * * *, including those
     claimed as miscellaneous itemized deductions, are
     disallowed because * * * [reason for disallowance].

     Petitioners argue that the above-quoted paragraphs would

have made it clear that the expenses claimed on the Forms 2106

were being disallowed.   We note that petitioners’ suggested

explanation treats reporting the compensation on the Forms 2106

as the equivalent of including it in gross income.    We do not

agree with petitioners’ approach.   It is petitioners’ contention

that without the third paragraph the issue of the deductibility

of the expenses claimed on the Forms 2106 has not been subjected

to our jurisdiction.

     We must note that petitioners’ first recommended paragraph

addressing the reduction of income by the compensation reflected

on the Form 2106 is incorrect and/or unnecessary.    The

compensation referred to in petitioners’ first paragraph had no

effect on petitioners’ taxable income because of the offset.      The

language used by respondent to increase gross income by the Form

1099-MISC compensation identified the source of the increase and

the variance from the method petitioners used to reflect the

income.   Certainly, respondent’s determination would have been

more explicit and thorough if it had contained some reference to

the expenses that petitioners had offset on their Forms 2106.

For example, the following language would have been helpful:
                               - 15 -

     To the extent that you wish to claim the expenses shown
     on Form 2106, they must be claimed on Schedule A, but
     they are allowable only to the extent that you show
     them to be ordinary and necessary business expenses
     and/or to have been expended for the designated
     purposes.

If respondent had made an explanation regarding the offsetting

expenses, it would have been merely advisory and precatory.      It

would not explain a disallowance that resulted in an income tax

deficiency.   In the circumstances of these cases, respondent’s

failure to expressly disallow the offsetting expenses was not

tantamount to approving them as petitioners have contended.

     The Commissioner is required to inform taxpayers of

deficiency determinations.    There is no particular form to be

used or specific requirement as to the content of a notice of

deficiency.   Jarvis v. Commissioner, 78 T.C. 646, 655-656 (1982).

The notice must “fairly advise [petitioners] that deficiencies in

income taxes and additions to the tax had been determined and the

years and amounts thereof.”    Id.   In addition, section 7522

requires that the notices describe the basis for, and identify

the amounts (if any) of, the tax due.

     The notices that respondent issued to petitioners met those

basic standards.   Respondent did provide a paragraph explaining

each adjustment that accounted for the total amounts of the

deficiencies determined.   Respondent increased gross income by

the Form 1099-MISC compensation, unreduced by the amounts of

expenses that petitioners had used as setoffs on the Forms 2106.
                             - 16 -

Respondent also increased income by the amounts of the excess

expenses claimed on the Schedules A, which respondent disallowed

for lack of a showing that the expenses were ordinary and

necessary or that they were expended for the stated purpose.     If

respondent had specifically and expressly “disallowed” the

offsetting expenses as petitioners suggest, the disallowance

would not have resulted in any increase or decrease in the

amounts of the deficiencies determined.   Finally, because

respondent included the unreduced amounts of the Form 1099-MISC

compensation in income, petitioners would be able to comprehend

that respondent was giving no effect to the expense setoffs.9

     In a recent case, we considered whether the Commissioner’s

position was new matter in the context of section 7522.      Shea v.



     9
       Petitioners’ arguments herein make it obvious that they
were aware that the expenses that they had offset against the
income on the Forms 2106 were not being given any effect because
of the resultant income tax deficiency. If petitioners had
chosen to give them effect, they would have had to assert and
prove their entitlement to the expenses. If petitioners had been
successful in showing their entitlement to the expenses, they
would not have been entitled to deduct them from or offset them
against gross income, as they attempted to do on the Forms 2106.
The expenses would have been deductible on Schedule A and subject
to various limitations that would result in reduced amounts’
being allowable. We also note that petitioners deducted the
excess by which the expenses exceeded the Forms 1099-MISC
compensation on their Schedules A. Petitioners, however, did
not follow that route and instead chose to wage a collateral
attack on respondent’s determination. In that regard,
petitioners did not question respondent’s determination that they
had not shown that such expenses claimed on the Schedules A were
not ordinary and necessary and/or that they were expended for the
stated purpose.
                                - 17 -

Commissioner, 112 T.C. 183 (1999).       In that case, the

Commissioner’s adjustment and explanation in the notice of

deficiency related to the total amount of business gross receipts

based on a bank deposit analysis.     Subsequently, the taxpayer

contended that the reconstructed receipts were community income

and that only half of the amount determined was includable.      The

Commissioner countered that section 66(b) authorized the

disallowance of community property benefits in certain

circumstances.     The language of the notice had no reference to

community property interests or section 66(b).      In Shea, we held:

     that where a notice of deficiency fails to describe the
     basis on which the Commissioner relies to support a
     deficiency determination and that basis requires the
     presentation of evidence that is different than that
     which would be necessary to resolve the determinations
     that were described in the notice of deficiency, the
     Commissioner will bear the burden of proof regarding
     the new basis. * * * [Emphasis added.]

Id. at 197.    That holding was predicated on our understanding

that the purpose of section 7522 is to give taxpayers notice of

the basis for a deficiency determination.       Id. at 196.

     In these cases, respondent did provide petitioners with

explanations for all of the adjustments that made up the

deficiency.     Unlike the taxpayer in Shea, petitioners are not

seeking to place the burden of proof on respondent.      Instead,

petitioners contend that the expenses are not in issue, and,

therefore, they have no burden to show their entitlement to the

expenses.     However, as already explained, respondent’s
                                - 18 -

determination that the Form 1099-MISC compensation is includable

as page 1 gross income makes it incumbent on petitioners rather

than respondent to show their entitlement to the deduction items.

Petitioners’ approach to reporting the compensation and expenses

was wrong as a matter of law.    Respondent’s determination

adequately described the basis for the income tax deficiencies

for purposes of section 7522.

     It would have been helpful for respondent to expressly state

that the expenses were not allowed in the manner petitioners had

claimed them.   Such a statement, however, would have no effect on

the amount of the income tax deficiencies that respondent

determined.   Section 7522 does not require the Commissioner to

make suggestions, recommendations, or comments in a notice of

deficiency concerning taxpayers’ reporting positions that have no

effect on the deficiency that the Commissioner has determined.

Accordingly, we find that respondent was not required to

explicitly disallow the expenses.    We also find that it is

irrelevant that the Form 2106 expenses were not placed in issue

in these cases.   In effect, it is petitioners’ failure to

substantiate the expenses that results in their not being allowed

as deductions from AGI.
                             - 19 -

     In accord with the foregoing and to reflect the agreements

of the parties,

                                   Decisions will be entered

                              under Rule 155.
