                              T.C. Memo. 2013-139



                        UNITED STATES TAX COURT



           WILEY M. ELICK AND SHARON ELICK, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

               WILEY M. ELICK DDS, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 23767-10, 23768-10.             Filed June 3, 2013.



      Joseph J. Dadich, for petitioners.

      Steven Mitchell Roth, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      KROUPA, Judge: Respondent determined deficiencies in petitioner Wiley

M. Elick DDS, Inc.’s (petitioner) and petitioners Dr. and Mrs. Wiley M. Elick’s

(Elicks) Federal income tax. After concessions, we must decide four issues. The
                                         -2-

[*2] first issue is whether petitioner’s payments for purported management fees in

2005 and 2006 are deductible under section 162. We hold that they are not.

Second, we must decide whether business losses the Elicks claimed for 2004, 2005

and 2006 (years at issue) are subject to the passive loss limitation under section

469.1 We hold that they are. Third, we must decide whether petitioner and the

Elicks are each liable for accuracy-related penalties under section 6662(a). We

hold that they are. The fourth issue is whether the Elicks are liable for the late-

filing addition to tax for 2006. We hold that they are.

                               FINDINGS OF FACT

      The parties have stipulated some facts. We incorporate the stipulation of

facts and the accompanying exhibits by this reference. Petitioner’s principal place

of business was in Hanford, California when it filed the petition. The Elicks

resided in California when they filed the petition.

I. Dental Practice

      Petitioner is a dental practice specializing in pediatric dentistry. The Elicks

were petitioner’s sole shareholders and board members. The Elicks were also each

salaried employees for petitioner. Dr. Elick was a full-time dentist for petitioner.

      1
       All section references are to the Internal Revenue Code (Code) for the
years at issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure, unless otherwise indicated.
                                          -3-

[*3] Petitioner also employed Dalanda McGee as its bookkeeper and office

manager. Petitioner paid Ms. McGee a salary and issued her Forms W-2, Wage

and Tax Statement, for 2005 and 2006.

      Dr. Elick also owned and operated Surgitek Outpatient Center, Inc.

(Surgitek). Surgitek is a dental surgery facility adjacent to petitioner’s facility.

II. The Management Agreement

      Petitioner explored creating an employee benefit plan in 2002. A

professional advised Dr. Elick to establish a company to manage petitioner’s

operations. A stock ownership plan benefiting petitioner’s employees would

purchase the company stock from Dr. Elick. The fees generated by management

services would fund the employee benefit plan.

      Dr. Elick set up the proposed structure with the professional’s assistance.

Dr. Elick became the sole owner of an existing corporation, SD Management

Group, Inc. (SDG). SDG established an employee stock ownership plan (ESOP)

to benefit petitioner’s employees. The ESOP then purchased from Dr. Elick all of

the SDG stock. Dr. Elick served as SDG’s only officer and board member.

      SDG then entered into an agreement to manage petitioner’s operations

(management agreement). SDG agreed to, among other things, produce annual

capital, operating and cashflow budget plans; investigate and document in writing
                                        -4-

[*4] customer complaints; develop policies and procedures; recruit, supervise and

train petitioner’s employees; perform fiscal services; and ensure regulatory

compliance. Petitioner agreed in exchange to pay SDG management fees equal to

between 1% and 25% of petitioner’s monthly gross receipts. Petitioner was

obligated to pay SDG within 20 days of each month’s end. Dr. Elick executed the

management agreement for both parties. Dr. Elick caused Surgitek to enter into a

similar agreement with SDG.

      SDG did not have any paid employees during 2005 and 2006. Dr. Elick

entered into a written agreement to be a “co-employee” of petitioner and SDG

(employment agreement). Dr. Elick executed the employment agreement on

behalf of SDG and himself. It was SDG’s only written employment contract in

effect during 2005 and 2006.

III. Management of Petitioner’s Operations

      Dr. Elick practiced dentistry full time for petitioner during 2005 and 2006.

Ms. McGee continued to work full time for petitioner and performed many

functions that SDG was to provide. Third parties performed payroll services and

compliance training during 2005 and 2006.

      Petitioner paid SDG $430,000 for 2005 and $303,000 for 2006 (collectively,

management fees). These amounts equaled 9.76% of petitioner’s annual gross
                                         -5-

[*5] receipts for 2005 and 9.98% for 2006. SDG never issued to petitioner

monthly invoices. Dr. Elick determined the amount of management fees petitioner

paid. Petitioner paid SDG at the fiscal year’s end.

      Surgitek paid SDG $20,000 in 2005. Surgitek did not compensate SDG in

2006. And no other entity paid SDG in 2005 or 2006.

IV. Petitioner’s Federal Income Tax Returns

      A return preparer prepared, and petitioner filed, Forms 1120, U.S.

Corporation Income Tax Return, for 2005 and 2006. Petitioner claimed business

expense deductions for the management fees. Dr. Elick told the return preparer

the amounts petitioner had paid SDG. The return preparer did not verify the

accuracy of those numbers or review any documents confirming those amounts.

V. The Elicks’ Losses From Other Entities

      The Elicks jointly filed Forms 1040, U.S. Individual Income Tax Return, for

each of the years at issue. The Elicks filed their 2006 joint return in February

2008, after the filing deadline.

      The Elicks reported ordinary business losses from St. Jon Aircraft LLC for

the years at issue and from Willow Creek Farms LLC and Charity Properties LLC

for 2005 and 2006 (collectively, claimed losses). The Elicks reported ordinary

income from Surgitek for the years at issue.
                                         -6-

[*6] VI. Deficiency Notices, Petitions and the Elicks’ Motion To Amend

      Respondent issued separate deficiency notices to petitioner and the Elicks.

Respondent disallowed the management fee deductions petitioner claimed for

2005 and 2006. Respondent also determined against petitioner accuracy-related

penalties under section 6662(a). Petitioner timely filed a petition with this Court.

      Respondent disallowed the Elicks’ claimed losses under section 469.

Respondent determined against the Elicks accuracy-related penalties under section

6662(a) and the late-filing addition to tax under section 6651(a)(1) for 2006.

      The Elicks timely filed a petition with this Court. The Elicks alleged that

the claimed losses were not subject to passive loss limitations because they met

the material participation requirements. The Elicks moved to amend their petition

shortly before trial to allege Surgitek was a passive activity. They sought to offset

the claimed losses against Surgitek’s income. The Court denied the motion

because it was untimely.

                                     OPINION

      We must decide whether petitioner demonstrated that the management fees

were ordinary and necessary business expenses. We then consider whether the

Elicks’ claimed losses are subject to passive loss limitations. We then must
                                         -7-

[*7] consider the accuracy-related penalties and addition to tax respondent

imposed. We begin with the burden of proof.

I. Burden of Proof

      Petitioner bears the burden of proving that respondent’s determination of

the deficiencies set forth in the deficiency notice is incorrect. See Rule 142(a)(1);

Welch v. Helvering, 290 U.S. 111, 115 (1933). Moreover, the Commissioner’s

determination is normally presumed correct, and the taxpayer bears the burden of

proving that the determination is incorrect. See Rule 142(a); Welch v. Helvering,

290 U.S. at 115.

      The burden of proof on factual issues may shift to the Commissioner,

however, where the taxpayer complies with all requirements of section 7491(a).

Neither petitioner nor the Elicks argue section 7491(a) shifts the burden of proof

to respondent. And we find that neither petitioner nor the Elicks met the

requirements for section 7491(a). Accordingly, petitioner and the Elicks each

carry the burden of proof.

II. Deduction for Management Fees

      We now consider whether petitioner was entitled to deduct the management

fees as a business expense under section 162.
                                        -8-

[*8] A. Ordinary and Necessary

      Tax deductions are a matter of legislative grace, and taxpayers must satisfy

the specific statutory requirements for the item claimed. Rule 142(a); INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering,

292 U.S. 435, 440 (1934). Generally, a taxpayer may deduct ordinary and

necessary business expenses paid or incurred during the taxable year in carrying

on a trade or business. Sec. 162(a). Whether an expense satisfies section 162 is

generally a question of fact. Commissioner v. Heininger, 320 U.S. 467, 475

(1943).

      An expense is ordinary if it is customary or usual within a particular trade,

business or industry or relates to a common or frequent transaction in the type of

business involved. Deputy v. du Pont, 308 U.S. 488, 495 (1940). A necessary

expense is appropriate and helpful to the operation of the taxpayer’s trade or

business. See Commissioner v. Tellier, 383 U.S. 687, 689 (1966); Carbine v.

Commissioner, 83 T.C. 356, 363 (1984), aff’d, 777 F.2d 662 (11th Cir. 1985).

      We have found management fees to be an ordinary and necessary expense in

some circumstances. See, e.g., Wy’East Color, Inc. v. Commissioner, T.C. Memo.

1996-136. Other times, we have not. See, e.g., Fuhrman v. Commissioner, T.C.

Memo. 2011-236. A taxpayer must demonstrate that management services were
                                        -9-

[*9] actually rendered. See sec. 1.162-7, Income Tax Regs.; see also ASAT, Inc.

v. Commissioner, 108 T.C. 147, 174-175 (1997); Am. Sav. Bank v.

Commissioner, 56 T.C. 828, 842-843 (1971); Weekend Warrior Trailers, Inc. v.

Commissioner, T.C. Memo. 2011-105; Wy’East Color, Inc. v. Commissioner, T.C.

Memo. 1996-136. A necessary expense need not be absolutely essential. United

States v. Haskel Eng’g & Supply Co., 380 F.2d 786, 788-789 (9th Cir. 1967). It

must be reasonable, however, in amount. Id. The reasonableness concept has

particular significance in dealings between related parties. Fuhrman v.

Commissioner, T.C. Memo. 2011-236.

      B.    Whether Management Fees Were Necessary

      Respondent contends that the management fees were unnecessary because

SDG did not provide any management services. Petitioner argues that it

demonstrated the management fees were necessary. We agree with respondent.

      Petitioner failed to show that SDG rendered any services. In fact, petitioner

offered no documentation reflecting that SDG performed any services for

petitioner. SDG agreed to provide various services that petitioner never

demonstrated it received, e.g., annual budget, operating and marketing plans.

Further, petitioner acknowledged that third parties provided services SDG was to
                                          -10-

[*10] provide. In addition, petitioner never provided contemporaneous records

corroborating it received any services.

      Petitioner contends that the management agreement shows the services SDG

purportedly provided. The management agreement, however, only indicates the

services SDG agreed to perform. The management agreement does not

demonstrate SDG performed any services benefiting petitioner. Petitioner never

received monthly invoices the management agreement required. Nor did

petitioner pay SDG monthly. The record reflects that petitioner and SDG

disregarded most terms of the management agreement.

      Petitioner contends Dr. Elick’s and Ms. McGee’s testimonies demonstrated

each provided service on SDG’s behalf. We disagree. Dr. Elick testified he was

acting as a SDG employee when he directed Ms. McGee to manage all aspects of

petitioner’s operations. We need not accept a taxpayer’s self-serving testimony

when corroborative evidence is absent. Beam v. Commissioner, T.C. Memo.

1990-304 (citing Tokarski v. Commissioner, 87 T.C. 74, 77 (1986)), aff’d without

published opinion, 956 F.2d 1166 (9th Cir. 1992). And the characterization that

Dr. Elick was a “co-employee” is inconsistent with his full-time employment as

petitioner’s dentist. SDG never compensated Dr. Elick, and there is no record of

his duties or the hours he performed management services. Moreover, he did not
                                         -11-

[*11] testify that he performed any other management service. Petitioner never

corroborated that Dr. Elick performed services as a SDG employee.

      Likewise, petitioner failed to establish Ms. McGee performed services as a

SDG employee. Ms. McGee performed the same duties and functions before and

during 2005 and 2006. There are again no records showing Ms. McGee performed

any services as a SDG employee. Ms. McGee was paid only by petitioner during

2005 and 2006. We find that neither Dr. Elick nor Ms. McGee provided petitioner

any services on behalf of SDG.

      Petitioner contends that the management fees were reasonable because

respondent stipulated (in its view) that Surgitek’s fees paid to SDG were

reasonable. Indeed, a stipulation may be treated as a conclusive admission. Rule

91(e). Petitioner argues that it is inconsistent to find some fees for similar service

unreasonable while others reasonable. See Achiro v. Commissioner, 77 T.C. 881,

903 (1981). Respondent stipulated the amounts Surgitek paid SDG, not that they

were reasonable. Even if respondent had conceded that those fees were

reasonable, it does not relieve petitioner from demonstrating it received services.

See id. at 903-904.

      In sum, petitioner has not demonstrated that SDG provided any services.

The record reflects that certain services were performed by petitioner’s employees
                                         -12-

[*12] or third parties, not SDG. And petitioner did not show it received any other

services that the management agreement obligated SDG to provide. Petitioner has

not demonstrated that the management fees were necessary or reasonable.

Petitioner demonstrated no correlation between the $733,000 in management fees,

or nearly 10% of its gross annual revenue, and the services purportedly performed.

Accordingly, we find that petitioner has not established that any management fees

were necessary or reasonable. We sustain respondent’s determination.

III. Whether Claimed Losses Are Subject to Passive Loss Limitations

      We now consider respondent’s determination that the Elicks’ claimed losses

were subject to the passive loss limitations. The deduction of passive activity

losses is generally suspended. Sec. 469(a). A passive activity loss is the excess of

the aggregate losses from all passive activities over the aggregate income from all

passive activities for the taxable year. Sec. 469(d)(1). A passive activity includes

the conduct of any trade or business in which the taxpayer does not materially

participate. Sec. 469(c)(1).

      Respondent determined that the claimed losses were subject to section 469’s

limitations. The Elicks alleged in the petition that they met the material

participation requirements for the claimed losses. The Elicks now acknowledge

that they did not actively participate in those activities. Rather, they contend that
                                        -13-

[*13] they should have been permitted to offset the claimed losses against the

Surgitek income. We disagree.

      The Elicks reported income from Surgitek for the years at issue. The Elicks

moved to amend the petition shortly before trial to allege that Surgitek was

incorrectly characterized as an active activity and that the claimed losses should be

offset against that income. Respondent argued that the proposed amendment was

untimely and would be prejudicial. See Rule 41(a). We agreed with respondent.

Accordingly, the Elicks are precluded from offsetting the claimed losses against

the Surgitek income.

      Consequently, the Elicks have not demonstrated they are entitled to the

business losses under section 469. We therefore sustain respondent’s

determination.

IV. Penalties and Addition to Tax

      Respondent imposed accuracy-related penalties under section 6662(a)

against petitioner and the Elicks. Respondent also imposed an addition to tax

against the Elicks for late filing the return for 2006. We address each in turn.

      A. Accuracy-Related Penalties

      We now consider the accuracy-related penalties under section 6662(a) that

respondent determined against petitioner for 2005 and 2006 and against the Elicks
                                         -14-

[*14] for the years at issue. A taxpayer is liable for an accuracy-related penalty on

any part of an underpayment attributable to, among other things, negligence or a

substantial understatement of income tax. Sec. 6662(b)(1) and (2). The

Commissioner has the burden of production and must come forward with

sufficient evidence that it is appropriate to impose a penalty with respect to the

liability of any individual.2 Sec. 7491(c); see Higbee v. Commissioner, 116 T.C.

438, 446-447 (2001). The taxpayer bears the burden of proof as to any defense to

the accuracy-related penalty. Sec. 7491(c); Rule 142(a); Higbee v. Commissioner,

116 T.C. at 446.

      Negligence is defined as any failure to make a reasonable attempt to comply

with the provisions of the Code 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.

A taxpayer fails to make a reasonable attempt to ascertain the correctness of a

deduction, credit or exclusion on a return that would seem to a reasonable and

prudent person to be “too good to be true” under the circumstances. Sec.

1.6662-3(b)(1)(ii), Income Tax Regs.




      2
        We note that sec. 7491(c) does not apply to corporate taxpayers. See NT,
Inc. v. Commissioner, 126 T.C. 191, 195 (2006).
                                        -15-

[*15] A taxpayer is not liable for an accuracy-related penalty, however, if the

taxpayer acted with reasonable cause and in good faith with respect to any portion

of the underpayment. Sec. 6664(c)(1); sec. 1.6664-4(a), Income Tax Regs. The

determination of whether a taxpayer acted with reasonable cause and in good faith

depends on the pertinent facts and circumstances, including the taxpayer’s efforts

to assess his or her proper tax liability, the knowledge, experience and education

of the taxpayer, and the reliance on the advice of a professional. Sec.

1.6664-4(b)(1), Income Tax Regs.

             1. Petitioner

      Respondent argues petitioner did not make a reasonable attempt to comply

with the Code. We agree. Petitioner did not provide any credible evidence that it

received services yet claimed $733,000 in expenses for management fees. Nor did

petitioner show that it respected the terms of the management agreement.

Petitioner did not therefore act with ordinary and reasonable care.

      Petitioner argues that the reasonable cause exception applies. It suggests

that it relied on a qualified adviser when Dr. Elick established SDG and petitioner

entered into the management agreement. Petitioner emphasizes that adviser’s

credentials. Respondent asserts that the adviser is irrelevant because he only

arranged the ESOP and did not review petitioner’s tax returns for 2005 and 2006.
                                        -16-

[*16] Respondent further argues that petitioner’s return preparer never advised the

management fees were necessary or reasonable. Thus, petitioner cannot rely on

guidance from the return preparer. We agree with respondent.

      Petitioner was advised in 2002 regarding SDG and the management

agreement. Respondent challenged the management fee deductions claimed for

2005 and 2006. Petitioner did not demonstrate that a professional advised it that

the management fees were necessary or reasonable. Rather, the record

demonstrates that Dr. Elick determined the annual management fee. He then

provided that amount to his return preparer. There is no indication that Dr. Elick

provided his return preparer all necessary information to determine whether the

management fees satisfied the requirements of section 162. Nor is there any

indication that any tax professional audited those amounts or determined that the

management fees were necessary or reasonable. See Neonatology Assocs., P.A. v.

Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

      We find that petitioner did not act under the relevant facts and

circumstances with reasonable cause and in good faith with respect to 2005 and

2006. We therefore hold petitioner liable for the accuracy-related penalties under

section 6662(a).
                                           -17-

[*17]         2. The Elicks

        The Elicks do not challenge that they failed to materially participate in the

passive activities. And the record does not reflect that the Elicks made a

reasonable attempt to comply with the Code. Respondent has therefore met his

burden of production. The Elicks have not argued or shown that they acted with

reasonable cause or in good faith. We find therefore that the Elicks did not act

under the relevant facts and circumstances with reasonable cause and in good faith

with respect to the years at issue. We accordingly hold that the Elicks are liable

for the accuracy-related penalties under section 6662(a).

        B.    Addition to Tax for Late Filing

        We next turn to whether the Elicks are liable for the late-filing addition to

tax under section 6651(a)(1) for 2006. The late-filing addition to tax is imposed

for failure to file a tax return on or before the specified filing date unless it is

shown that such failure is due to reasonable cause and not due to willful neglect.

Sec. 6651(a)(1); United States v. Boyle, 469 U.S. 241, 245 (1985). The

Commissioner has the burden of production with respect to an addition to tax.

Sec. 7491(c); Higbee v. Commissioner, 116 T.C. at 446. To meet this burden, the

Commissioner must produce sufficient evidence establishing that it is appropriate

to impose the addition to tax. See Higbee v. Commissioner, 116 T.C. at 446-447.
                                         -18-

[*18] If the Commissioner meets his burden, then the taxpayer bears the burden of

proving that the late filing was due to reasonable cause and not willful neglect. Id.

at 446.

      Respondent determined that the Elicks are liable for the late-filing addition

to tax regarding the return for 2006. The Elicks acknowledge that they filed the

2006 return late. Respondent has accordingly met his burden.

      The Elicks argue nevertheless that they acted with reasonable cause and

without willful neglect because they were waiting for a third party to issue a

Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., of a Form

1065. Respondent argues that the Elicks failed to show reasonable cause. We

agree with respondent.

      A taxpayer is responsible for timely filing returns and may not passively

wait for a third party to provide documentation. Feldman v. Commissioner, T.C.

Memo. 1993-17, aff’d, 20 F.3d 1128 (11th Cir. 1994); see also LFAM Corp. v.

United States, 42 Fed. Cl. 698, 703 (1999) (late-filing addition to tax imposed

against taxpayer that passively waited for third party to issue Schedule K-1). The

Elicks failed to establish that they actively sought the information or that they

were unable to reasonably estimate their tax. Petitioners did not corroborate
                                        -19-

[*19] testimony that they requested the information. We will therefore sustain the

late-filing addition to tax.

      We have considered all remaining arguments the parties made and, to the

extent not addressed, we find them to be irrelevant, moot or meritless.

      To reflect the foregoing,


                                                     Decision will be entered under

                                               Rule 155 in docket No. 23767-10.

                                                     Decision will be entered for

                                               respondent in docket No. 23768-10.
