                T.C. Summary Opinion 2008-94



                     UNITED STATES TAX COURT



                REGINALD JARRETT, Petitioner v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent

      THOMAS JARRETT AND JUDA L. JARRETT, Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 4873-06S, 4874-06S.       Filed July 31, 2008.



     Reginald Jarrett and Thomas Jarrett, pro sese.

     Jeanne Gramling, for respondent.



     SWIFT, Judge:   These consolidated cases were heard

pursuant to the provisions of section 7463 of the Internal

Revenue Code in effect when the petitions were filed.   Pursuant

to section 7463(b), the decisions to be entered are not

reviewable by any other court, and this opinion shall not be

treated as precedent for any other case.   Respondent determined
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deficiencies in and additions to petitioners’ 1999 Federal

income taxes as follows:
                                     Addition to Tax     Penalty
         Petitioners   Deficiency    Sec. 6651(a)(1)   Sec. 6662(a)

   Reginald Jarrett     $1,251             $62             $250
   Thomas and Juda         914              --              182
   Jarrett


     Unless otherwise indicated, all subsequent section

references are to the Internal Revenue Code in effect for 1999,

and all Rule references are to the Tax Court Rules of Practice

and Procedure.

     In these consolidated cases the primary issue for decision

is whether petitioner Thomas Jarrett (Thomas) and petitioner

Reginald Jarrett (Reginald) underreported their respective 1999

self-employment tax liabilities.


                              Background

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

     At the time the petitions were filed petitioners resided

in Raleigh, North Carolina.

     Thomas and petitioner Juda Jarrett (Juda) were married,

and Reginald is their adult son.


Thomas

     Between 1975 and early 1998 Thomas operated a tax return

preparation business as a sole proprietorship under the name of

TJ’s Enterprises.
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        On March 3, 1998, a North Carolina corporation named

Trecom, Inc. (Trecom), was formed by Thomas as an

S corporation.     Thomas and Reginald were each 50-percent

shareholders in Trecom.1    Thomas and Juda served as Trecom’s

officers.     Nominally, Trecom was incorporated to provide a

corporate form for Thomas’s tax return preparation business.

        After the incorporation of Trecom in 1998 and during 1999,

however, Thomas did not make significant changes to the

operation of his tax return preparation business.       In payment

for tax return preparation services, clients continued to make

checks out to Thomas personally or to TJ’s Enterprises, not to

Trecom.     Thomas treated funds received for tax return

preparation services as his own.       Few, if any, of Thomas’s

clients apparently knew of Trecom’s existence.

        In 1999 Thomas maintained two bank accounts–-one in his

own name and one in the name of TJ’s Enterprises.       In 1999 no

bank account was maintained in the name of Trecom.

        In 1999 Thomas received certain payments from individual

clients of his tax preparation business totaling approximately

$7,000.

        Some of the payments Thomas received for tax return

preparation services were deposited in TJ’s Enterprises’ bank




    1
      The record indicates that Juda may have owned some of
the shares of stock in Trecom that we treat as owned by Thomas.
                               -4-
account.   Other payments were not deposited in a bank account

and were spent by Thomas for personal purposes.

     It does not appear that Thomas had an employment agreement

with Trecom, that Trecom exercised direction and control over

Thomas in his execution of the tax return preparation business,

or that in 1999 Trecom paid Thomas a salary.   The record does

not indicate that Trecom had any clients or business activity

whatsoever.

     The evidence does not establish that Trecom performed any

tax return preparation services or any other services of any

kind for Thomas, for Reginald, or for anyone else.

     Thomas prepared and timely filed with Juda a 1999 joint

Federal income tax return.   Thomas attached a Schedule C,

Profit or Loss From Business, for TJ’s Enterprises reflecting

$17,444 in total gross income (which included the $7,000 Thomas

received for tax return preparation services), $16,420 in

expenses (including $7,000 in expenses Thomas allegedly paid to

Trecom for professional services allegedly rendered by Trecom

to TJ’s Enterprises), and taxable income of $1,024, on which

Thomas calculated and reported a total 1999 self-employment tax

liability of just $145.

     Thomas also attached a Schedule E, Supplemental Income and

Loss, and reported as passthrough income from Trecom the $7,000
                                -5-
that Thomas had reported on his Schedule C as paid to Trecom

for professional services.


Reginald

     During 1999 Reginald operated a cabinet installation

business as a sole proprietorship.

     Reginald was not an employee of Trecom and performed no

services for Trecom, and Trecom did not pay Reginald a salary.

     Thomas timely prepared Reginald’s 1999 Federal income tax

return, and on May 12, 2000, Reginald filed his 1999 Federal

income tax return late.    The attached Schedule C for Reginald’s

cabinet installation business reported $20,149 in total gross

income, $19,363 in expenses, and $786 in taxable income, on

which Reginald calculated and reported a total self-employment

tax liability of just $111.   Included among the $19,363 in

claimed business expense deductions of Reginald’s cabinet

installation business was $7,200 in expenses allegedly paid by

Reginald to Trecom for professional services Trecom allegedly

provided to Reginald.    Reginald also attached a Schedule E, and

reported as passthrough income from Trecom the $7,200 that

Reginald had reported on his Schedule C as paid to Trecom for

professional services.
                               -6-
Trecom

     Thomas also prepared and filed Trecom’s 1999 Form 1120S,

U.S. Income Tax Return for an S Corporation, on which Trecom

reported $14,200 of income (consisting solely of the above

$7,000 and $7,200 Thomas and Reginald allegedly paid to

Trecom).   Attached to Trecom’s 1999 Form 1120S were two

Schedules K-1, Shareholder’s Share of Income, Credits,

Deductions, etc., reflecting the $14,200 purportedly earned by

Trecom and passed through to Thomas and to Reginald as

shareholders of Trecom ($7,000 to Thomas and $7,200 to

Reginald).

     For 1999 Trecom did not file a Form 940, Employer’s Annual

Federal Unemployment (FUTA) Tax Return, or any Forms 941,

Employer’s Quarterly Federal Tax Return.

     In summary, through the above Federal income tax reporting

for 1999, Thomas and Reginald claimed deductions from their

gross income ($7,000 and $7,200 respectively) that eliminated

the identical earned income amounts and then reported the same

amounts as unearned passthrough income from Trecom.   Obviously,

such reporting did not affect taxable income or Thomas’s and

Reginald’s reported 1999 Federal income tax liability, but it

did convert reported earned income (on which self-employment

taxes would be due) into reported unearned income (on which no

self-employment taxes would be due).
                                -7-
IRS Audits

     On audit of Thomas’s return for 1999, respondent

disallowed the $7,000 in Schedule C expenses claimed for

payments allegedly made to Trecom, and respondent removed from

Thomas’s income the $7,000 Thomas reported as passthrough

income from Trecom.   On the basis of respondent’s adjustments,

respondent then increased Thomas’s self-employment tax

liability from $145 to $1,134 and allowed Thomas a deduction

for one-half of the recalculated self-employment tax.

     On audit of Reginald’s return for 1999, respondent allowed

$11,285 and disallowed $8,078 of the total $19,363 in expenses

Reginald claimed on his 1999 tax return.   The disallowed

expenses included the entire $7,200 that Reginald claimed he

had paid to Trecom as well as $611 of car and truck expenses

and $500 of storage expenses.   Respondent removed from

Reginald’s income the $7,200 that Reginald reported as

passthrough income from Trecom.   Respondent then increased

Reginald’s 1999 self-employment tax liability from $111 to

$1,252, and respondent allowed Reginald a deduction for one-

half of the recalculated self-employment tax.
                                -8-
                           Discussion

Self-Employment Tax

     Under section 1401 self-employment income of individuals

is subject to self-employment tax.    Self-employment income

consists of earnings derived from the self-employment of

an individual less allowable business expense deductions.

Sec. 1402(a) and (b).   Income received in a trade or business

operated as a sole proprietorship generally constitutes self-

employment income and is subject to self-employment taxes.

Sec. 1.1402(c)-1, Income Tax Regs.

      Income received in a trade or business conducted as an

S corporation and passed through to its shareholders, however,

generally is not considered to be self-employment income and is

not subject to self-employment taxes.    Ding v. Commissioner,

T.C. Memo. 1997-435, affd. 200 F.3d 587 (9th Cir. 1999); Rev.

Rul. 59-221, 1959-1 C.B. 225.

     Respondent has treated income that Thomas and Reginald

received in their respective sole proprietorships as their

individual income and imposed thereon self-employment taxes.

Respondent disallowed expense deductions for the alleged

$14,200 in payments to Trecom and disregarded the $14,200 in

reported passthrough income from Trecom.

     The limited record before us establishes that in 1999

Thomas and Reginald operated their businesses as sole
                               -9-
proprietors.   The income in question is to be treated as earned

not by Trecom but by Thomas and Reginald individually and is

subject to self-employment taxes.

     The record establishes that the alleged $14,200 in

payments on the one hand between Thomas and Reginald to Trecom

and on the other hand from Trecom to Thomas and Reginald lacked

economic substance and should be disregarded.

     Transactions that lack economic substance (other than tax

benefits) are not recognized for Federal tax purposes.     Nicole

Rose Corp. v. Commissioner, 117 T.C. 328, 336 (2001), affd. 52

Fed. Appx. 545 (2d Cir. 2002), published at 320 F.3d 282 (2d

Cir. 2003); Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C.

254, 278 (1999), affd. 254 F.3d 1313 (11th Cir. 2001).     The

Commissioner may ignore the parties’ characterization of

transactions that lack economic substance, and the Commissioner

may instead tax the transactions according to their true

nature.   Rice’s Toyota World, Inc. v. Commissioner, 752 F.2d

89, 95 (4th Cir. 1985), affg. in part and revg. in part on

other grounds 81 T.C. 184 (1983).

     Clearly, the alleged offsetting $14,200 in payments

between Thomas and Reginald and Trecom had no business purpose

and produced only reported self-employment tax avoidance for

Thomas and Reginald.   As respondent determined, Thomas and

Reginald may not deduct the claimed $7,000 and $7,200 payments
                               -10-
allegedly made to Trecom as business expenses, and the $7,000

and the $7,200 in alleged passthrough income from Trecom to

Thomas and to Reginald is not includable in petitioners’ income

as S corporation passthrough income.    The $7,000 and $7,200 are

includable in Thomas’s and Reginald’s respective gross business

income and are subject to self-employment taxes.2


Reginald’s Other Expenses

       With regard to deductions disallowed by the Commissioner

in a notice of deficiency, generally taxpayers bear the burden

to prove that the deductions are allowable.    Rule 142(a)(1);

Turner v. Commissioner, 126 T.C. 299, 310 (2006).    Petitioners

have not argued that the burden of proof has shifted to

respondent.    See sec. 7491(a).

       No information was provided regarding the disallowed

storage expenses.    A reconstructed mileage log Thomas provided

for Reginald at trial does not support the $611 car and truck

expense deduction respondent disallowed.    See secs. 162,

274(d).



   2
     For a case involving a fact pattern similar to that
involved herein and holding that income allegedly passed
through from an S corporation was to be treated as wage income
and subject to employment taxes, see Arnold v. Commissioner,
T.C. Memo. 2007-168. See also Spicer Accounting, Inc. v.
United States, 918 F.2d 90, 92-93 (9th Cir. 1990);
Joly v. Commissioner, T.C. Memo. 1998-361, affd. without
published opinion 211 F.3d 1269 (6th Cir. 2000).
                               -11-
     Petitioners have not met their burden of proof relating to

storage and car and truck expenses.   We sustain respondent’s

disallowance of these items.


Section 6662(a) Penalty

     Under section 6662(a) a 20-percent penalty is imposed on

the amounts of taxes shown due on Federal income tax returns

attributable to negligence or disregard of Federal income tax

rules or to substantial understatements of income taxes.    Sec.

6662(a) and (b)(1) and (2).

     For purposes of section 6662(a) negligence includes

failure to make a reasonable attempt to comply with the tax

laws.   Sec. 6662(c); Nicole Rose Corp. v. Commissioner, supra

at 341.

     Under section 6664(c)(1) a taxpayer who had reasonable

cause for and in good faith took a position that created an

underpayment may be excepted from imposition of a section

6662(a) penalty.   Gee v. Commissioner, 127 T.C. 1, 5-6 (2006).

     Respondent has met his burden of production under section

7491(c) relating to imposition of the section 6662(a)

penalties, and petitioners bear the burden to show why they

should be excepted from the penalties.   See Higbee v.

Commissioner, 116 T.C. 438, 446-447 (2001).   Petitioners have

not met their burden.
                               -12-
     We sustain respondent’s section 6662(a) penalties as to

petitioners.


Section 6651(a)(1) Additions to Tax

     Under section 6651(a)(1) an addition to tax is imposed on

the amount of tax shown due on late-filed Federal income tax

returns in the amount of 5 percent for each month or part of a

month that the return is late with a maximum addition to tax of

25 percent of the amount of tax shown due.   The addition to tax

under section 6651(a)(1) will not be imposed, however, if the

taxpayer demonstrates that the late filing was for reasonable

cause and not due to the taxpayer’s willful neglect.     Sec.

6651(a)(1); McGowan v. Commissioner, T.C. Memo. 2008-125.

     Reginald admits that his 1999 Federal income tax return

was filed late.    Reginald does not argue that he had reasonable

cause to file his return late or that his late filing was not

due to willful neglect.   Reginald only argues that because a de

minimis amount of tax was shown due on his 1999 Federal income

tax return, he should not have to pay the section 6651(a)(1)

addition to tax.   There is no de minimis statutory or

regulatory exception from the imposition of the section

6651(a)(1) penalty, and Reginald is liable therefor.
                        -13-
To reflect the foregoing,


                                Decisions will be entered

                            for respondent.
