                              T.C. Memo. 2013-10



                        UNITED STATES TAX COURT



THOUSAND OAKS RESIDENTIAL CARE HOME I, INC., ET AL.,1 Petitioners
                           v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 1448-10, 1480-10,             Filed January 14, 2013.
                  1481-10.



           R determined that a corporation’s compensation packages for its
      owner-employees were unreasonable and disallowed deductions for
      compensation paid for the 2003 through 2005 tax years.

             Held: The compensation packages paid to the corporation’s
      owner-employees were reasonable and deductible under I.R.C. sec.
      162, for the 2003, 2004, and 2005 tax years to the extent determined
      herein. The compensation paid to the owner-employees’ daughter,
      Grace-Ann Strick, was unreasonable.


      1
      Cases of the following petitioners are consolidated herewith: Thousand
Oaks Residential Care Home I, Inc., docket No. 1480-10; and Robert A. Fletcher
and Pearl Fletcher, docket No. 1481-10. On December 15, 2011, we granted
motions to change the captions in docket Nos. 1448-10 and 1480-10.
                                          -2-

[*2]          Held, further, the corporation is liable for the I.R.C. sec. 4972
       excise tax to the extent determined herein. It is not liable for the I.R.C.
       sec. 6651(a)(1) and (2) additions to tax. Ps are liable for a portion of
       the I.R.C. sec. 6662(a) penalties as redetermined in this opinion.



       Matthew Taggart, Ryan Andrews, Michael B. Luftman, and Charles Kolstad,

for petitioners.

       Kris H. An, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


       WHERRY, Judge: These cases are before the Court on petitions for

redetermination of income tax and excise tax deficiencies, additions to tax, and

penalties respondent determined for petitioners’ 2002 through 2005 tax years.2

       After concessions the issues remaining are:3

       2
       Unless otherwise indicated, all section references are to the Internal Revenue
Code of 1986 (Code), as amended and in effect for the taxable years at issue. All
Rule references are to the Tax Court Rules of Practice and Procedure.
       3
        Petitioners Robert A. Fletcher and Pearl Fletcher concede with respect to
their personal Federal income tax returns that they are not entitled to a deduction for
depreciation expenses of $5,800 reported on Schedules E, Supplemental Income and
Loss, for each of the 2003, 2004, and 2005 tax years. They also concede that they
are not entitled to deduct certain taxes of $1,670, $1,605, and $1,714 for the 2003,
2004, and 2005 tax years, respectively, reported on Schedule E, and respondent
                                                                          (continued...)
                                         -3-

[*3] (1) whether the compensation Thousand Oaks Residential Care Home I, Inc.

(TORCH), paid to Robert A. and Pearl Fletcher was reasonable under section 162



      3
        (...continued)
concedes that they are entitled to deduct those expenses on Schedules A, Itemized
Deductions, for the applicable years. The Fletchers concede that they are also not
entitled to deduct other Schedule E taxes of $709, $668, and $1,916 for the 2003,
2004, and 2005, tax years, respectively, and respondent concedes that they are
entitled to deduct those expenses on Schedule A. The Fletchers concede that they
are not entitled to deduct Schedule E insurance expenses of $520, $500, and $505
for the 2003, 2004, and 2005 tax years, respectively. The parties agree that
Schedule E warehouse rental income should be decreased by $1,200 and $2,400 for
the 2003 and 2005 tax years, respectively. The Fletchers concede that they received
unreported rental income of $4,400, $6,000, and $5,800 for the 2003, 2004, and
2005 tax years, respectively. The Fletchers concede that they are liable for the sec.
6662 accuracy-related penalty with respect to the disallowed Schedule E expenses
and unreported 67 Erbes property rental income.

        Petitioner Thousand Oaks Residential Care Home I, Inc., concedes that it is
not entitled to deduct repairs and maintenance expenses of $2,954 for the 2003 tax
year. This petitioner concedes that it is not entitled to deduct rental expenses of
$2,800 and $7,100 for the 2003 and 2005 tax years, respectively. Respondent
concedes that this petitioner is entitled to deduct taxes and licenses expenses of
$19,198, $19,110, and $6,009 for the 2003, 2004, and 2005 tax years, respectively.
This petitioner concedes that it is not entitled to deduct expenses of $56 and $103
for the 2003 and 2005 tax years, respectively. It also concedes that it is not entitled
to other deductions of $26,464, $15,432, and $8,924 for the 2003, 2004, and 2005
tax years. This petitioner concedes that it is not entitled to deduct advertising
expenses of $45 or employee benefit programs expenses of $2,852 for the 2003 tax
year. Respondent concedes that this petitioner is entitled to deduct $20 for the
disallowed contribution for the 2003 tax year, and this petitioner concedes that it is
not entitled to deduct $150 of the same for the 2003 tax year. This petitioner
concedes that it is liable for the sec. 6662 accuracy-related penalty with respect to
all of its concessions listed in this paragraph.
                                        -4-

[*4] for the 2003, 2004, and 2005 tax years, including the pension plan

contributions paid on behalf of Robert A. and Pearl Fletcher for the 2003 and 2004

tax years,

      (2) whether the compensation TORCH paid to the Fletchers’ daughter,

Grace-Ann Strick, was reasonable under section 162 for the 2003, 2004, and 2005

tax years,

      (3) whether TORCH is liable for excise tax of $44,710.90 and $91,128.30

under section 4972 for the 2003 and 2004 tax years, respectively,

      (4) whether TORCH is liable for section 6651(a)(1) failure to file additions to

tax of $10,050.95 and $20,503.87 for the 2003 and 2004 tax years, respectively,

      (5) whether TORCH is liable for section 6651(a)(2) failure to pay additions to

tax of $11,177.73 and $22,326.43 for the 2003 and 2004 tax years, respectively,

and

      (6) whether petitioners Robert A. and Pearl Fletcher are liable for the section

6662(a) accuracy-related penalty for the 2003, 2004, and 2005 tax years and

whether TORCH is liable for the section 6662(a) accuracy-related penalty for the

2002, 2003, 2004, and 2005 tax years.
                                          -5-

[*5]                            FINDINGS OF FACT

       The parties’ stipulation of facts and supplemental stipulation of facts, with

accompanying exhibits, and the stipulations of settled issues are incorporated herein

by this reference. At the time they filed their respective Tax Court petitions, the

individual petitioners resided in California and the corporate petitioner maintained

its principal place of business in California.

Robert and Pearl Fletcher’s Background--Lighting the Torch

       Dr. Robert A. Fletcher began his career as an accountant for the Salvation

Army Grace Hospital in Windsor, Ontario. He received formal training by taking

charter accountant’s courses offered by an accountant’s association in Windsor,

Ontario. He then became the business manager of the office staff at Leamington

Memorial Hospital in Leamington, Ontario. Dr. Fletcher then moved to the United

States in 1962 and began working at Seaside Oil, which merged with Tidewater

Flying A Oil Co. that then merged with Getty Oil Co. He then became the chief

accountant for Getty Oil.

       After leaving Getty Oil Dr. Fletcher decided to attend Cleveland Chiropractic

College in Los Angeles. After graduation Dr. Fletcher became a California licensed

chiropractor and began a chiropractic business in 1969.
                                          -6-

[*6] Starting in 1974 Dr. Fletcher operated his chiropractic practice as an owner-

employee of Robert A. Fletcher Chiropractic Corp., which was incorporated on

October 30, 1974. Dr. Fletcher spent approximately 30 hours per week at his

chiropractic practice until he retired from practicing chiropractic medicine in 1995.

      Ms. Fletcher is a registered nurse. She went through three years of training at

the Grace Hospital in Toronto and received a nursing degree in 1959. After

receiving her nursing degree, Ms. Fletcher’s first job was at Hotel Dieu Hospital in

Windsor, Canada, working in the operating room for about six months. After that,

she worked at Leamington Memorial Hospital in Ontario, where she ran the

recovery room. After the Fletchers moved to California Ms. Fletcher began working

at the St. Francis Hospital in Santa Barbara in the intensive care unit and in the labor

and delivery room.

      After a few years Ms. Fletcher then went to work at the Granada Hills

Community Hospital, where she ran one of the shifts in the large extended care unit.

Her duties there included: overseeing the nurse’s aides, dispensing medication,

writing all of the reports and recordings on patients’ charts, overseeing lab results,

calling doctors, taking orders, and interacting with patients’ families.
                                         -7-

[*7] Thousand Oaks Residential Care I (Corporation)--Carrying the Torch

        On June 30, 1973, the Fletchers purchased a struggling corporation called

Thousand Oaks Residential Care I from John and Edith Breen. Dr. Fletcher

explained that they paid $25,000 and assumed the debt obligations of the

corporation, which were several hundreds of thousands of dollars, including the real

property mortgage.4 The corporation owned and operated TORCH an assisted

living facility in Thousand Oaks, California.5

       Dr. Fletcher was the corporation’s sole shareholder. From 1973 to 2005 the

corporation’s board of directors consisted of three members: Robert A. Fletcher,

Pearl Fletcher, and Lorne Muth, Pearl Fletcher’s brother.

      Dr. Fletcher oversaw TORCH’s general operations, handled its finances, and

supervised its maintenance workers. He also performed substantial maintenance

work himself. After Dr. Fletcher retired from his chiropractic practice in 1995 he


       4
       Although Dr. Fletcher’s testimony was that they paid $25,000 and assumed
the debt obligations, the corporation’s Federal Form 1120, U.S. Corporation Income
Tax Return, page 4 balance sheet for 2005 shows a common stock balance of
$24,000, and the record does not reveal any stock redemptions. We believe Dr.
Fletcher’s testimony that they initially paid $25,000 for the corporation.
       5
        An assisted living center, also known as a residential care home or
residential care facility, provides care and supervision to seniors above the age of 60
without skilled nursing services. A nursing home is a facility that provides
rehabilitation and skilled nursing services.
                                        -8-

[*8] worked full time for TORCH. Ms. Fletcher worked on and managed the

assisted care personnel aspects of TORCH. She worked with residents, learned of

their diagnoses, handicaps and illnesses, handled family matters, communicated with

the nurses and nurses’ aides, communicated with doctors and pharmacists, worked

with dietitians, and supervised the housekeeping staff. The Fletchers received Forms

W-2, Wage and Tax Statement, from TORCH reporting the following incomes:6

             Year                  Ms. Fletcher                 Dr. Fletcher
           1973-1983                    -0-                         -0-
             1984                      $6,000                       -0-
             1985                      13,000                     $12,923
             1986                      15,521                      18,764
             1987                      26,769                      29,077
             1988                      36,000                      36,000
             1989                      36,000                      36,000
             1990                       4,154                       4,154
             1991                       -0-                         -0-
             1992                      20,800                       -0-
             1993                      20,800                       -0-




       6
       All amounts have been rounded to the nearest whole number. No Forms W-
2 were presented for any year where the amount paid was “-0-”.
                                            -9-

           [*9] 1994                       23,331                       -0-
              1995                         25,885                       -0-
              1996                         26,500                       -0-
              1997                         26,500                       -0-
              1998                         26,500                       -0-
              1999                         26,112                      3,112
              2000                         25,072                     19,669
              2001                         25,011                     26,000
              2002                      129,030                      130,000
               Total                    512,985                      315,699

         The corporation did not begin to cover its expenses and was losing money

until the Fletchers had owned it for 18 months. The corporation paid all of its other

employees at the market rate for their services. The corporation reported the

following revenue information on its Forms 1120 for the 1987 through 2005 tax

years:

                  Gross          Taxable            Depreciation    Taxable income
   Year          receipts        income               expense      before deprecation1
   1987         $863,021         $35,863              $24,277           $60,140
   1988          864,899          24,754               31,133            55,887
   1989          826,847          (8,748)              25,907            17,159
   1990          679,545         (28,066)              15,636           (12,430)
   1991          840,221           3,075               19,586            22,661
                                          - 10 -

  [*10]

   1992         894,853         (26,117)            25,441                 (676)
   1993         957,930          (8,463)            31,601               23,138
   1994         982,305          34,585             32,410               66,995
   1995       1,066,006          22,767             20,702               43,469
   1996       1,127,454          16,063             33,092               49,155
   1997       1,169,540          22,903             18,346               41,249
   1998       1,238,596          44,632             30,033               74,665
   1999       1,265,554          81,916             12,980               94,896
   2000       1,250,983          29,479             10,380               39,859
   2001       1,327,452         (27,516)            15,546              (11,970)
   2002       1,001,110         297,798             13,949             311,747
  20032           -0-           925,640              1,072             926,712
   2004           -0-          (917,045)              -0-              (917,045)
   2005           -0-             (3,943)             -0-                (3,943)
    Total 16,356,316             519,577           362,091              881,668
      1
        The Court has derived this column of information from the reported taxable
income and depreciation amounts on the Forms 1120.
      2
        The facility was sold in 2002, and thereafter the corporation did not receive
any gross receipts.

      In July 2002 the corporation hired the Fletchers’ daughter, Grace-Ann Strick,

at $10 per hour. Beginning in October 2002 (after the sale of TORCH, see infra),

the corporation paid Ms. Strick $2,000 per month.
                                        - 11 -

[*11] Passing the Torch

      On October 1, 2002, the corporation sold its sole asset, the assisted living

facility, in an installment sale for $3,400,000 to Inga Jakobavich.7 The corporation

allocated the $3,400,000 sale proceeds as follows: (1) $83,000 to furniture,

equipment and machines, (2) $17,000 to a 1999 Windstar Van, (3) $200,000 to

goodwill, and (4) $3,100,000 to building and land. Ms. Jakobavich has owned and

operated an assisted living facility called Hillcrest Royale Retirement Community

(Hillcrest) since 1989. After the purchase Ms. Jakobavich changed the name from

TORCH to Thousand Oaks Royale Retirement Community. Since 2003 Ms.

Jakobavich has paid herself $240,000 a year as the owner-operator of Hillcrest.

      When TORCH was sold it had about 85 residents and between 45 and 50

employees on staff. As part of the sale agreement, Dr. Fletcher entered into an

interim lease back and management agreement starting on October 1, 2002, and

ending on the earlier of April 30, 2003, or when Ms. Jakobovich obtained her own




       7
        Ms. Jakobovich agreed to pay the following amounts: (i) $700,000 at 8%
interest with a monthly payment of $5,402.71 from November 1, 2002, to October
1, 2007; and (ii) $2,120,000 at 7% interest with a monthly payment of $14,983.72
from November 1, 2002, to April 1, 2003, when the entire principal balance together
with interest was due.
                                         - 12 -

[*12] license. The Fletchers continued to work at TORCH for nine months

following its sale.

After the Sale of TORCH

      The corporation created a defined benefit plan (pension plan), effective

January 1, 2003. The Fletchers and Ms. Strick were the only participants of the plan.

      The corporation paid Dr. Fletcher Form W-2 wages of $200,000, $200,000,

and $30,000 in 2003, 2004, and 2005, respectively. It also contributed $191,433 and

$259,506 to the pension plan for the benefit of Dr. Fletcher in 2003 and 2004,

respectively, for a total compensation package of $880,939. The corporation paid

Ms. Fletcher Form W-2 wages of $200,000, $200,000, and $30,000 in 2003, 2004,

and 2005, respectively.8 It also contributed $191,433 and $198,915 to the pension

plan for the benefit of Ms. Fletcher in 2003 and 2004, respectively for a total

compensation package of $820,348.

      The corporation’s annual board minutes dated November 28, 2003, state:

“Compensation to Administrators was approved for payment of back salaries that



       8
         The Schedules E for 2004 and 2005 appear to mistakenly leave off the
$200,000 and $30,000 of executive compensation for each of the Fletchers. The
Fletchers do not dispute receiving this income, and their accountant explained at
trial that the expense for the Fletchers’ compensation was included in the cost of
labor elsewhere on the return.
                                        - 13 -

[*13] were not paid in prior years due to insufficient cash flow.” The corporation’s

annual board minutes dated November 26, 2004, reiterated that the salaries approved

in the prior year would remain the same, and the annual board minutes dated

December 26, 2005, again state that the compensation paid to the Fletchers was

intended as catchup compensation for inadequate compensation from prior years.

      In 1987 the long-term debt of the corporation was $758,071. In 2002 the

long-term debt was $16,228, but the corporation owed $141,167 to its shareholders.

The corporation’s 2005 Form 1120 page 4 shows that at the end of the year the

corporation had assets of $151,734 in cash on hand, $200 in current assets, and

$700,000 in mortgage and real estate loans. It also shows that the corporation had

liabilities of $149,262 in loans from shareholders, $515,987 in mortgages, notes,

bonds payable in a year or more, $24,000 in common stock, and $162,685 in

retained earnings.

      Ragnar Storm-Larsen’s accounting firm, Storm-Larsen & Co., Inc., has

prepared petitioners’ returns and accounting records since the early 1990s. Mr.

Storm-Larsen is an enrolled agent and has an M.B.A. degree from the California

Lutheran University. It was Mr. Storm-Larsen’s regular business practice to ask the

taxpayer to review and approve a return before it was filed.
                                        - 14 -

[*14] Dr. Fletcher approached Mr. Storm-Larsen when he believed that the sale of

TORCH was imminent and that he and Ms. Fletcher would be paying a large amount

of tax. Mr. Storm-Larsen researched catchup compensation and explained to Dr.

Fletcher that if he had not been paid reasonable compensation in the past then he

could make an adjustment and pay himself more. Mr. Storm-Larsen also advised Dr.

Fletcher that a contribution to the pension plan was a benefit and that he could

include it as compensation not previously received. Mr. Storm-Larsen advised the

Fletchers that the compensation was reasonable.

Expert Report--Elizabeth Newlon, Ph.D.

      Respondent commissioned Elizabeth Newlon, Ph.D., a senior consultant of

National Economic Research Associates, Inc., to assess the compensation Dr. and

Ms. Fletcher could reasonably expect for work performed at TORCH. Dr. Newlon

has a B.S. degree in economics from Ohio State University and an M.A. degree and

a Ph.D. in economics from Carnegie Mellon University. She is a published writer

and has worked on discrimination, wage-and-hour, and wrongful termination suits

and provided compensation estimates for medical directors.

      In order to compare the Fletchers’ compensation with the nationwide data

available, Dr. Newlon first determined that Ms. Fletcher’s responsibilities were

those of a medical and health services manager and that Dr. Fletcher’s
                                          - 15 -

[*15] responsibilities were those of a general and operations manager, although she

questioned “that there was a need for a full-time manager of this type”. Dr. Newlon

then compared the Fletchers’ compensation with that of individuals doing similar

types of work at residential care facilities in California.

      Dr. Newlon used labor rates from the Bureau of Labor Statistics’

Occupational Employment Statistics program. That data is available only for 2002-

2010; therefore Dr. Newlon deflated the compensation back to 1973 using the

average decrease in compensation year to year, working backwards from 2010 to

2002. Dr. Newlon also adjusted the data to control for differences in the prevailing

wages in California. She increased the national figures using the ratio of the median

California medical and health services manager wages for Ms. Fletcher and the

median general and operations manager wages for Dr. Fletcher to the national

median wages for those positions (which worked out to be 118% for both). Dr.

Newlon then decreased Dr. Fletcher’s estimated compensation to reflect the amount

she believed he was working, i.e. to 25% of the estimated amount for the years his

tax statements stated that he worked 25% of his time at TORCH, 100% for the years

after his retirement, and 25% for the years after the Fletchers sold TORCH. The

following table shows Dr. Newlon’s conclusions as to reasonable compensation for

the Fletchers:
                                 - 16 -

[*16] Year   Ms. Fletcher   % Mr. Fletcher Worked   Mr. Fletcher
  2003           $61,622             25%                 $6,952
                               Nov. - Dec. 25             2,614
  2002            57,437
                               Jan. - Oct. 100           52,286
  2001            55,111             100                 56,526
  2000            53,169             100                 54,223
  1999            51,296             100                 52,014
  1998            49,489             100                 49,895
  1997            47,746             100                 47,862
  1996            46,064             100                 45,912
  1995            44,441             100                 44,042
  1994            42,876              25                 10,562
  1993            41,365              25                 10,132
  1992            39,908              25                  9,179
  1991            38,502              25                  9,323
  1990            37,146              25                  8,943
  1989            35,837              25                  8,579
  1988            34,575              25                  8,229
  1987            33,357              25                  7,894
  1986            32,182              25                  7,572
  1985            31,048              25                  7,264
  1984            29,955              25                  6,968
  1983            28,899              25                  6,684
  1982            27,881              25                  6,412
                                         - 17 -

  [*17] 1981             26,899               25                       6,151
     1980                25,952               25                       5,900
     1979                25,037               25                       5,660
     1978                24,155               25                       5,429
     1977                23,304               25                       5,208
     1976                22,484               25                       4,996
     1975                21,691               25                       4,792
     1974                20,927               25                       4,597
     1973                20,190               25                       2,205
      Total           1,130,545                                    565,005

Procedural Background

      Respondent issued notices of deficiency on: October 21, 2009, for Dr. and

Ms. Fletcher’s 2003, 2004, and 2005 tax years; October 21, 2006, for Thousand

Oaks Residential Home, Inc., for its tax years ended December 31, 2002, 2003,

2004, and 2005; and October 21, 2009, for Thousand Oaks Residential Care Home,

for its tax years ended December 31, 2003 and 2004, showing income tax

deficiencies and penalties of:9




       9
           All values have been rounded to the nearest whole number.
                                       - 18 -

          [*18]                                                 Accuracy-related
                                                                    penalty
        Petitioner              Year            Deficiency        Sec. 6662(a)
 Robert A. & Pearl
   Fletcher, docket
   No. 1481-10                  2003             $29,750             $5,950
                                2004              31,191                6,238
                                2005              16,729              3,346
                                                                Accuracy-related
                                                                    penalty
        Petitioner          TYE Dec. 31         Deficiency       Sec. 6662(a)
 TORCH, docket No.
   1480-10                      2002             $99,391            $19,878
                                2003             526,695            105,399
                                2004                 701                  104
                                2005              18,916                3,783
                                                                Additions to tax
        Petitioner          TYE Dec. 31         Deficiency   Sec. 6651(a)(1) and (2)
 TORCH, docket No.
   1448-10                      2003             $44,711      $10,060       $11,178
                                2004              91,128       20,504           22,326

                                     OPINION

I.    Burden of Proof

      The Commissioner’s determination of a taxpayer’s liability for an income tax

deficiency is generally presumed correct, and the taxpayer bears the burden of

proving that the determination is improper. See Rule 142(a); Welch v. Helvering,
                                          - 19 -

[*19] 290 U.S. 111, 115 (1933). However, pursuant to section 7491(a)(1), the

burden of proof on factual issues that affect the taxpayer’s tax liability may be shifted

to the Commissioner where the “taxpayer introduces credible evidence with respect

to * * * such issue.” The burden will shift only if the taxpayer has, inter alia,

complied with substantiation requirements pursuant to the Code and “maintained all

records required under this title and has cooperated with reasonable requests by the

Secretary for witnesses, information, documents, meetings, and interviews”. Sec.

7491(a)(2). Because we decide these cases on the preponderance of the evidence,

we need not address who bears the burden of proof.

II.   Reasonable Compensation

      Respondent contends that the compensation packages paid to the Fletchers

were not reasonable under section 162 for the 2003, 2004, and 2005 tax years and

disallowed deductions for all of the compensation.10 Petitioners contend that

compensation paid in those years was reasonable and included catchup payments


       10
         On brief respondent raises the issue of whether the fact that the corporation
 made only two payments to the defined benefit plan included in the Fletchers’
 compensation package makes the plan a temporary rather than a permanent one
 under sec. 1.401-1(b)(2) Income Tax Regs. Respondent never challenged the plan
 previously, and we decline to address this argument here, noting only that as
 petitioners correctly point out: “[t]he permanency requirement referred to in the
 regulations does not contemplate perpetual contributions”. Estate of Benjamin v.
 Commissioner, 54 T.C. 953, 967 (1970), aff’d, 465 F.2d 982 (7th Cir. 1972).
                                       - 20 -

[*20] for prior years in which they were undercompensated. In determining the

reasonableness of compensation, we look at the compensation package as a whole,

which includes salary and pension plan contributions. Bianchi v. Commissioner, 66

T.C. 324, 330 (1976), aff’d, 553 F.2d 93 (2d Cir. 1977).

      A.    Overview of Section 162(a)(1)

      Section 162(a)(1) provides a deduction for ordinary and necessary business

expenses, including “a reasonable allowance for salaries or other compensation for

personal services actually rendered”. The deductibility of compensation is

determined through a two-prong test: the amount of compensation must be

reasonable, and the payment must be purely for services rendered. Nor-Cal

Adjusters v. Commissioner, 503 F.2d 359, 362 (9th Cir. 1974), aff’g T.C. Memo.

1971-200; sec. 1.162-7, Income Tax Regs. We consider the reasonableness of the

combined salary payments and the contributions to the defined benefit plan.11 See

Rutter v. Commissioner, 853 F.2d 1267, 1274 (5th Cir. 1988), aff’g T.C. Memo.

1986-407; Bianchi v. Commissioner, 66 T.C. at 333-334.




       11
        Contributions to defined benefit plans are not generally deductible under
sec. 162 unless they meet the requirements of sec. 404(a). Sec. 404(a) incorporates
the reasonable compensation standard of sec. 162. See LaMastro v. Commissioner,
72 T.C. 377, 381-382 (1979).
                                        - 21 -

[*21] B.     Catchup Compensation & Services Actually Rendered

      Compensation for prior years’ services is deductible in the current year as long

as the employee was actually under compensated in prior years and the current

payments are intended as compensation for past services. R.J. Nicoll Co. v.

Commissioner, 59 T.C. 37, 50-51 (1972). When the compensation was actually for

prior years of service, it need not be reasonable in the year it was paid. Devine

Bros., Inc., v. Commissioner, T.C. Memo. 2003-15. Therefore, we shall evaluate the

Fletchers’ compensation in its entirety. In order for an employer to deduct

compensation under section 162(a)(1) the compensation packages need to be both

reasonable and for services actually provided. Nor-Cal Adjusters v. Commissioner,

503 F.2d at 362; sec. 1.162-7, Income Tax Regs.

      The corporation’s annual board minutes dated November 28, 2003, explicitly

state: “Compensation to Administrators was approved for payment of back salaries

that were not paid in prior years due to insufficient cash flow.” The corporation’s

annual board minutes dated November 26, 2004, reiterated that the salaries

approved in the prior year would remain the same, and we infer that this means

that the board also intended those compensation packages as payment of back

salaries for prior years. The corporation’s annual board minutes dated December
                                          - 22 -

[*22] 26, 2005, again state that the compensation paid to the Fletchers was for

inadequate compensation from prior years.

      We found the Fletchers’ testimony that the compensation was intended as

catchup compensation for prior years credible and, when viewed along with the

corporation’s annual board minutes, we find that the compensation was intended as

compensation for each of the three years at issue, respectively, and as catchup

compensation for prior services actually rendered. Now we must determine whether

the catchup compensation was reasonable.

      C.     Reasonableness of Payments

      The reasonableness of the payments is considered with reference to five broad

factors set forth in Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983),

rev’g T.C. Memo. 1980-282. No single factor is dispositive. Id. at 1245. The

relevant factors are: (1) the employee’s role in the company; (2) a comparison of the

employee’s salary with salaries paid by similar companies for similar services; (3)

the character and condition of the company; (4) potential conflicts of interest; and (5)

internal consistency. Id. at 1245-1247.

      The Court of Appeals for the Ninth Circuit, to which an appeal in these cases

would lie absent stipulation to the contrary, adds an additional factor: whether an

independent investor would be willing to compensate the employee as he was so
                                          - 23 -

[*23] compensated. Metro Leasing & Dev. Corp. v. Commissioner, 376 F.3d 1015,

1019 (9th Cir. 2004), aff’g 119 T.C. 8 (2002). The Court of Appeals notes that “the

perspective of an independent investor is but one of many factors that are to be

considered when assessing the reasonableness of an executive officer’s

compensation.” Id. at 1021. The reasonableness of compensation is a question of

fact to be determined on the basis of all the facts and circumstances. Pac. Grains,

Inc. v. Commissioner, 399 F.2d 603, 606 (9th Cir. 1968), aff’g T.C. Memo. 1967-7.

             1.     Employee’s Role in the Company

      This factor looks to the overall significance of the employee to the company.

Elliotts, Inc. v. Commissioner, 716 F.2d at 1245. “Relevant considerations include

the position held by the employee, hours worked, and duties performed, Am.

Foundry v. Commissioner, 536 F.2d 289, 291-292 (9th Cir. 1976), as well as the

general importance of the employee to the success of the company”. Id.

      The Fletchers were hands-on owner-operators of TORCH. Although

TORCH was only moderately profitable, the Fletchers explained that they bought

the facility for very little cash (i.e., $25,000) plus assumed liabilities, when the

revenues from the facility could not even cover its bills and that within 18 months

they had turned it around. Dr. Fletcher was the president and overall manager of
                                         - 24 -

[*24] TORCH, and Ms. Fletcher was the head nurse and was in charge of personnel

and resident relations. We find this factor weighs in favor of petitioners.

              2.    Comparison With Salaries Paid by Similar Companies

      The next relevant factor is a comparison of the employee’s salary with salaries

paid by similar companies providing similar services. Elliotts, Inc. v. Commissioner,

716 F.2d at 1246; Hoffman Radio Corp. v. Commissioner, 177 F.2d 264, 266 (9th

Cir. 1949).

      Petitioners did not provide the Court with any evidence of employees of other

companies providing similar services with the exception of Ms. Jakobavich, who

testified that she has paid herself $240,000 a year as the owner-operator of Hillcrest

since 2003. However, we know nothing of Ms. Jakobavich’s job description, duties,

hours, or the profitability of Hillcrest. Respondent presented an expert witness to

compare the Fletchers’ compensation with nationwide data.12




       12
       We note that we evaluate expert opinions in the light of each expert’s
demonstrated qualifications and all other evidence in the record. See Parker v.
Commissioner, 86 T.C. 547, 561 (1986). We are not bound by an expert’s opinion
and may accept or reject an expert opinion in full or in part in the exercise of sound
judgment. See Helvering v. Nat’l Grocery Co., 304 U.S. 282, 295 (1938); Parker v.
Commissioner, 86 T.C. at 561-562. We may also reach a determination of value
based on our own examination of the evidence in the record. Silverman v.
Commissioner, 538 F.2d 927, 933 (2d Cir. 1976), aff’g T.C. Memo. 1974-285.
                                       - 25 -

[*25] Combining two of the tables supra, we can summarize respondent’s expert’s

findings as to the adequacy of Dr. Fletcher’s and Ms. Fletcher’s compensation:

            Ms.          Ms.       Amount           Dr.         Dr.       Amount
          Fletcher     Fletcher   under-paid     Fletcher     Fletcher    under-
 Year    (estimate)     actual                  (estimate)     actual      paid
 2002      $57,437    $129,030     ($71,593)     $54,900     $130,000    ($75,100)
 2001        55,111     25,011       30,100       56,526       26,000      30,526
 2000        53,169     25,072       28,097       54,223       19,669      34,554
 1999        51,296     26,112       25,184       52,014        3,112      48,902
 1998        49,489     26,500       22,989       49,895        -0-        49,895
 1997        47,746     26,500       21,246       47,862        -0-        47,862
 1996        46,064     26,500       19,564       45,912        -0-        45,912
 1995        44,441     25,885       18,556       44,042        -0-        44,042
 1994        42,876     23,331       19,545       10,562        -0-        10,562
 1993        41,365     20,800       20,565       10,132        -0-        10,132
 1992        39,908     20,800       19,108        9,179        -0-         9,179
 1991        38,502      -0-         38,502        9,323        -0-         9,323
 1990        37,146      4,154       32,992        8,943        4,154       4,789
 1989        35,837     36,000         (163)       8,579       36,000     (27,421)
 1988        34,575     36,000       (1,425)       8,229       36,000     (27,771)
 1987        33,357     26,769        6,588        7,894       29,077     (21,183)
 1986        32,182     15,521       16,661        7,572       18,764     (11,192)
 1985        31,048     13,000       18,048        7,264       12,923      (5,659)
 1984        29,955      6,000       23,955        6,968        -0-         6,968
                                           - 26 -

 [*26]
 1983          28,899        -0-         28,899        6,684         -0-         6,684
 1982          27,881        -0-         27,881        6,412         -0-         6,412
 1981          26,899        -0-         26,899        6,151         -0-         6,151
 1980          25,952        -0-         25,952        5,900         -0-         5,900
 1979          25,037        -0-         25,037        5,660         -0-         5,660
 1978          24,155        -0-         24,155        5,429         -0-         5,429
 1977          23,304        -0-         23,304        5,208         -0-         5,208
 1976          22,484        -0-         22,484        4,996         -0-         4,996
 1975          21,691        -0-         21,691        4,792         -0-         4,792
 1974          20,927        -0-         20,927        4,597         -0-         4,597
 1973          20,190        -0-         20,190        2,205         -0-         2,205
 Total      1,068,923     512,985      555,938       558,053       315,699    242,354

         For the years for which a “-0-” appears in the above table, petitioners did not

supply a Form W-2. The Fletchers credibly testified that for the years for which they

did not have a Form W-2 from the corporation, the corporation did not have

sufficient funds to pay them a salary, making a Form W-2 unnecessary. Respondent

did not establish that the Fletchers received a salary in any of those years and failed

to produce any further Forms W-2.

         Looking at the above table, even respondent’s own expert, whom the Court

found knowledgeable, agrees that the Fletchers were underpaid in comparison with
                                        - 27 -

[*27] data from a national survey.13 Using the data from this chart, respondent’s

expert shows that before the years at issue Ms. Fletcher was underpaid by $555,938

and Dr. Fletcher was underpaid by $242,354.

      In the years at issue, as we determined above, Dr. Fletcher received a total

compensation package of $880,939 and Ms. Fletcher received a total compensation

package of $820,348 for services rendered. After subtracting the amounts by which

the Fletchers were underpaid in prior years as determined by respondent’s expert,

Dr. Fletcher’s combined compensation for the years at issue was $638,585 and Ms.

Fletcher’s combined compensation for the years at issue was $264,410.

      Respondent’s expert, Dr. Newlon, used labor rates from the Bureau of Labor

Statistics’ Occupational Employment Statistics program to determine the figures

represented in the table above. That data for 2003 through 2005 shows that a

combined compensation inflated for California wages and assuming full- time

employment, would be $187,537.40 for Dr. Fletcher and $195,785.60 for Ms.

Fletcher.14 Because of the large difference between the actual compensation and

       13
        We note that Dr. Newlon did not account for the time value of money.
Because the Fletchers were required to wait for compensation for prior years, their
catchup compensation should also have been inflated for the time value of money.
       14
         These figures were taken from a table included in Dr. Newlon’s expert
report that reported data from the Bureau of Labor Statistics’ Occupational
                                                                       (continued...)
                                         - 28 -

[*28] respondent’s expert’s opinion, this factor weighs in favor of finding that the

Fletchers’ compensation was unreasonable.

             3.     Character and Condition of the Company

      Under this factor we analyze the character and condition of the company,

focusing on the company’s size, complexity, net income, and general economic

condition. Elliotts, Inc. v. Commissioner, 716 F.2d at 1246.

      First, we note that one of the reasons the Fletchers determined to pay

themselves catchup compensation is that in multiple years the corporation had

insufficient cashflow and profit to pay them adequate compensation. However, the

corporation’s profitability is not the only indication of the character and condition

of the company.

      In 1987 the long-term debt of the corporation was $758,071. By 2002 the

long-term debt had been reduced to $16,228, and the corporation owed $141,167

in loans from shareholders.15 Had the Fletchers chosen to pay themselves higher

salaries in years they chose to aggressively pay down the loans, the outstanding

      14
       (...continued)
Employment Statistics program. Dr. Newlon did not reach any conclusions for
these numbers; however, she did not believe that the Fletchers were each fully
employed by the corporation for each of years at issue.
       15
         With stated capital of only $25,000 the corporation was thinly capitalized
and some of the loans from shareholders might arguably in substance have been
capital. Respondent has never raised this issue; consequently, we shall treat the
“loans” as loans.
                                          - 29 -

[*29] debt would have been higher when TORCH was sold and the Fletchers would

have made less on the sale. Also, as we noted above, TORCH was only moderately

profitable, but the Fletchers bought the facility when the revenues it generated could

not even cover its bills and within 18 months had turned it around. Although the

corporation was not profitable enough to pay the Fletchers in some years, the

Fletchers paid down long-term debt, and upon purchasing TORCH, managed to

make it profitable enough to pay its own bills and to command a substantial price

when it was sold. Therefore we find this factor slightly favors petitioners.

             4.     Potential Conflicts of Interest

      This factor focuses on any indicia that there may be a conflict of interest. Id.

Primarily we are concerned whether a relationship exists between the employee and

the company that may permit the disguise of nondeductible corporate distributions

as salary expenditures. Id.

      The Fletchers, as owner-operators who never received a dividend and who

used all of the profits of TORCH’s sale to pay themselves income, undoubtedly had

a conflict of interest. Petitioners’ opening brief agrees that “a conflict of interest

clearly existed”. With petitioners’ concession we find that this factor weighs
                                        - 30 -

[*30] against finding that the compensation the Fletchers received was reasonable

and deductible under section 162.

             5.     Internal Consistency

      “[E]vidence of an internal inconsistency in a company’s treatment of

payments to employees may indicate that the payments go beyond reasonable

compensation.” Elliotts, Inc. v. Commissioner, 716 F.2d at 1247. In most of the

years before the years at issue, the Fletchers’ compensation was indeed inconsistent

with the payments to other employees, but the Fletchers discriminated against

themselves. In years when the corporation experienced cashflow problems or was

not profitable they took no, or very little, salary. Respondent correctly points out

that during the years at issue the Fletchers had large salaries; however, as discussed

above, we found that the Fletchers were paying themselves previously earned

compensation for years in which they were under compensated. We find that this

factor weights in favor of finding that the compensation the Fletchers received was

reasonable and deductible under section 162.

             6.     Additional Factor: The Independent Investor

      While we found supra that the Fletchers did intend the compensation as

catchup compensation for prior services rendered, paying out compensation

packages that deplete the rest of the corporation’s assets denies the corporation’s
                                         - 31 -

[*31] equity owners a fair return on their capital investment. In Elliotts, Inc. v.

Commissioner, 716 F.2d at 1247, the Court of Appeals for the Ninth Circuit noted

that

       If the bulk of the corporation’s earnings are being paid out in the form
       of compensation, so that the corporate profits, after payment of the
       compensation, do not represent a reasonable return on the
       shareholder’s equity in the corporation, then an independent
       shareholder would probably not approve of the compensation
       arrangement. If, however, that is not the case and the company’s
       earnings on equity remain at a level that would satisfy an independent
       investor, there is a strong indication that management is providing
       compensable services and that profits are not being siphoned out of the
       company disguised as salary. [Fn. ref. omitted.]

       The Fletchers purchased TORCH for $25,000 in 1973, and the record does

not indicate if they paid in any additional amounts.16 A reasonable investor would

expect to receive a return on this initial investment and would not approve of a


       16
        The record does not reveal whether the Fletchers were personally liable for
the loans assumed upon the purchase of TORCH, which would warrant an increased
return on the investment. And the record does not indicate whether the Fletchers
contributed additional amounts to TORCH during the periods it could not cover its
bills. Because the record is so sparse as to additional paid-in capital, we will
assume that TORCH took loans from the shareholders and then repaid them when
there was money.
       Also, as discussed supra note 4, Dr. Fletcher testified that the Fletchers paid
$25,000 and assumed the debt obligations when they purchased the corporation;
however, the corporation’s Form 1120, page 4 balance sheet for 2005 shows a
common stock balance of $24,000, and the record does not reveal any stock
redemptions. We find Dr. Fletcher’s testimony credible that they initially paid
$25,000 for the corporation.
                                        - 32 -

[*32] salary package that entirely depletes the corporation’s assets. Id. (20% return

on equity “would satisfy independent investor”); L & B Pipe & Supply Co. v.

Commissioner, T.C. Memo. 1994-187 (investor would have been happy with either

6% dividend return plus 10% growth in retained earnings or 20% growth in

shareholders’ equity).

       As the cases above show, the Court has found a return on investment of

between 10% and 20% tends to indicate compensation was reasonable.17 A 10%

return on $25,000 compounded annually for 31.5 years (1973-2005) is roughly

$503,300, and a 20% return is $7,800,982.18 Because TORCH was a small highly

leveraged business purchased with a large amount of debt, a hypothetical investor in

TORCH might be satisfied with a 10% return on this investment. Therefore the

corporation should have had $503,300 left for distribution after payment of the

      17
        We note that in June 1973 the prime interest rate was between 7.5% and
7.75% and that a 10-year Treasury note had a 6.46% interest rate. Because of the
nature of TORCH an investor would have expected to earn a higher rate of return
than the Treasury note.
      18
         Although as explained in Miller & Sons Drywall, Inc. v. Commissioner,
T.C. Memo. 2005-114, “this Court has generally calculated a corporation’s ROE
[return on equity] by dividing its net income after tax for a specific year by its
shareholders equity” instead of using compound growth rates, we find that under the
specific facts of these cases using compound growth rates paints a more accurate
picture. As the table supra page 9 shows, the corporation had minimal income in
most of the years it was in business and in both 2004 and 2005 had negative
income.
                                        - 33 -

[*33] compensation packages. Because the compensation packages did not leave

enough of the corporation’s assets to be paid back to the hypothetical investor as a

return on investment, we find that this factor weighs against a finding of reasonable

compensation.

             7.    Conclusion

      After reviewing each factor discussed above, we find that the compensation

packages the Fletchers received as compensation for the 2003, 2004, and 2005 tax

years were unreasonable. Taking into account the rate of return a reasonable

investor would have expected, we find that the Fletchers were overpaid by a total of

$282,615.19 A reasonable investor would require at least this amount remain in


      19
         We have found that the corporation should have had on hand $503,300 to
pay the hypothetical investor, and the corporation had $162,685 in retained earnings
at the end of the 2005 tax year. We disallowed Ms. Strick’s compensation of
$59,000 infra (that in substance amounted to a dividend or distribution to
shareholders and a gift by them to their daughter), which increased the amount the
corporation had left on hand. Therefore, the Fletchers were overpaid by a total of
$282,615 (i.e. $503,300 - $161,685 - $59,000 = $282,615).

       The Fletchers’ combined total compensation for the years at issue was
$1,701,287. Dr. Fletcher’s combined compensation accounted for 51.8% of that
amount, and Ms. Fletcher’s accounted for 48.2%. Therefore we attribute $146,395
of the overpayment to Dr. Fletcher and $136,220 to Ms. Fletcher. Of Dr. Fletcher’s
combined compensation his salary accounted for 48.8% and the pension plan
contribution accounted for 51.2%. Therefore we find that Dr. Fletcher was overpaid
in salary by $71,441 (which is not deductible) and had a nondeductible pension plan
                                                                       (continued...)
                                        - 34 -

[*34] the corporation to be paid out to the investor as a return on the investment.

We again note that the reasonableness of compensation is a question of fact to be

determined on the basis of all the facts and circumstances. Pacific Grains, Inc. v.

Commissioner, 399 F.2d at 606.

III.   Compensation Paid to Grace-Ann Strick

       Respondent contends that the compensation paid to Ms. Strick was not

reasonable under section 162 for the 2003, 2004, and 2005 tax years. As discussed

supra, section 162(a)(1) provides a deduction for ordinary and necessary business

expenses, including reasonable compensation for services rendered. Under the two-

prong test the amount of compensation must be reasonable, and the payment must

be purely for services rendered. Nor-Cal Adjusters v. Commissioner, 503 F.2d at

362; sec. 1.162-7, Income Tax Regs.

       In July 2002 the corporation hired Ms. Strick at $10 per hour. The

corporation was sold on October 1, 2002, and beginning in October 2002, the

corporation paid Ms. Strick $2,000 per month.



       19
        (...continued)
contribution of $74,954. Of Ms. Fletcher’s combined compensation her salary
accounted for 52.4% and the pension plan contribution accounted for 47.6%.
Therefore we find that Ms. Fletcher was overpaid in salary by $71,380 (which is not
deductible) and had a nondeductible pension plan contribution of $64,840.
                                         - 35 -

[*35] Petitioners contend that Ms. Strick was hired to handle third-party vendors

and worker’s compensation claims filed by former employees against the

corporation. Petitioners provided documents related to worker’s compensation

claims filed by Paula Muriel and Amparo Villasenor to substantiate Ms. Strick’s

employment. Ms. Muriel’s accident occurred on or about February 11, 2002, and

was settled on or about March 21, 2002. As this was before Ms. Strick began

working for TORCH, we do not find this evidence substantiates Ms. Strick’s

employment.

      Petitioners also provided documents related to the claim filed by Amparo

Villasenor. Mr. Villasenor was injured on or about May 13, 2000. Although the

file is much more extensive than that of Ms. Muriel and it appears that petitioners

hired and paid attorneys through 2003 to handle the appeal of the worker’s

compensation claim, Ms. Strick’s name does not appear on any of the documents,

and she did not testify at trial to explain what services she provided. On the basis of

the preponderance of the evidence we find that all of the compensation paid to

Grace-Ann Stick was not reasonable under section 162 for the 2003, 2004, and

2005 tax years and the corporation is not entitled to deduct it.
                                         - 36 -

[*36] IV.    Section 4972 Excise Tax

      Because TORCH did not file Form 5330, Return of Excise Taxes Related to

Employee Benefit Plans, respondent contends that the corporation is liable for

excise tax of $44,710.90 and $91,128.30 under section 4972 for the 2003 and 2004

tax years, respectively. Section 4972 imposes a 10% tax on any nondeductible

contributions to qualified employer plans. See Citrus Valley Estates, Inc. v.

Commissioner, 99 T.C. 379 (1992), aff’d in part, remanded in part, 49 F.3d 1410

(9th Cir. 1995). Because we found supra that a portion of TORCH’s contributions

to the pension plan was unreasonable compensation and therefore not deductible

under section 162 (and thereby section 404), the 10% section 4972 excise tax

applies to that extent.

V.    Section 6651(a)(1) and (2) Additions to Tax

      Respondent contends that the corporation is liable for section 6651(a)(1)

failure to file additions to tax of $10,050.95 and $20,503.87 for the 2003 and 2004

tax years, respectively. As a general rule, “any person made liable for any tax

* * * shall make a return or statement according to the forms and regulations

prescribed by the Secretary.” Sec. 6011(a); see also Citrus Valley Estates, Inc. v.

Commissioner, 99 T.C. at 462 (holding section 6651(a) is applicable to the failure to

file a Form 5330). Section 6651(a)(1), in the case of a failure to file a return on
                                          - 37 -

[*37] time, imposes an addition to tax of 5% of the tax required to be shown on the

return for each month or fraction thereof for which there is a failure to file, not to

exceed 25% in the aggregate.20 The addition to tax will not apply if it is shown that

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

6651(a)(1).

      Respondent also contends that the corporation is liable for section 6651(a)(2)

failure to pay additions to tax of $11,177.73 and $22,326.43 for the 2003 and 2004

tax years, respectively, because the corporation did not pay the excise tax due to be

shown on Form 5330. Section 6651(a)(2) provides for an addition to tax of 0.5%

per month up to 25% for failure to pay the amount shown on a return unless it is

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

      Petitioners contend that they reasonably relied on the advice of Mr. Storm-

Larsen that the compensation package was reasonable and therefore deductible, thus

TORCH need not file Form 5330. They argue that the failure to file and failure to

pay were due to reasonable cause and not willful neglect. When Dr. Fletcher

understood that after the sale of TORCH they would be paying a large amount

of tax, he sought Mr. Storm-Larsen’s advice. Mr. Storm-Larsen researched

      20
        The sec. 6651(a)(1) addition to tax is reduced by the amount of the sec.
6651(a)(2) addition to tax for any month (or fraction thereof) to which an addition to
tax applies under both sec. 6651(a)(1) and (2). See sec. 6651(c)(1).
                                         - 38 -

[*38] catchup compensation and explained to Dr. Fletcher that if he had not been

paid reasonable compensation in the past then he could make an adjustment and pay

himself more. Mr. Storm-Larsen also told Dr. Fletcher that a contribution to the

pension plan was a benefit and that he could pay himself for compensation not

previously received. Mr. Storm-Larsen advised the Fletchers that the compensation

was reasonable, which would therefore not require a Form 5330 filing.

      The Supreme Court of the United States has explained that “Courts have

frequently held that “reasonable cause” is established when a taxpayer shows that

he reasonably relied on the advice of an accountant or attorney that it was

unnecessary to file a return, even when such advice turned out to have been

mistaken.” United States v. Boyle, 469 U.S. 241, 250 (1985). We agree with

petitioners that they reasonably relied on the advice of their accountant and TORCH

is not liable for the section 6651(a)(1) and (2) additions to tax.

VI.   Section 6662(a) Accuracy-Related Penalty

      Respondent also contends that petitioners Robert A. and Pearl Fletcher are

liable for the section 6662(a) accuracy-related penalty for the 2003, 2004, and 2005

tax years and petitioner TORCH is liable for the section 6662(a) accuracy-related

penalty for the 2002, 2003, 2004, and 2005 tax years.
                                        - 39 -

[*39] Subsection (a) of section 6662 imposes an accuracy-related penalty of 20% of

any underpayment that is attributable to causes specified in subsection (b).

Respondent asserts that one or both of two causes justify the imposition of the

penalty for each year: a substantial understatement of income tax and negligence.

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

      There is a “substantial understatement” of income tax for any tax year where,

in the case of an individual, the amount of the understatement exceeds the greater of

(1) 10% of the tax required to be shown on the return for the tax year or (2) $5,000.

Sec. 6662(d)(1)(A). In the case of corporations (other than S corporations or

personal holding companies) the amount of the understatement exceeds the greater

of (1) 10% of the tax required to be shown on the return for the tax year or (2)

$10,000,000. Sec. 6662(d)(1)(B).

      Section 6662(a) also imposes a penalty for negligence or disregard of the

rules or regulations. Under this section “‘negligence’ includes any failure to make

a reasonable attempt to comply with the provisions of this title”. Sec. 6662(c).

Under caselaw, “‘Negligence is a lack of due care or the failure to do what a

reasonable and ordinarily prudent person would do under the circumstances.’”

Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quoting Marcello v.

Commissioner, 380 F.2d 499, 506 (5th Cir. 1967), aff’g on this issue 43 T.C. 168
                                         - 40 -

[*40] (1964) and T.C. Memo. 1964-299), aff’d, 904 F.2d 1011 (5th Cir. 1990),

aff’d, 501 U.S. 868 (1991).

        There is an exception to the section 6662(a) penalty when a taxpayer can

demonstrate (1) reasonable cause for the underpayment and (2) that the taxpayer

acted in good faith with respect to the underpayment. Sec. 6664(c)(1). Regulations

promulgated under section 6664(c) further provide that the determination of

reasonable cause and good faith “is made on a case-by-case basis, taking into

account all pertinent facts and circumstances.” Sec. 1.6664-4(b)(1), Income Tax

Regs.

        Reliance on the advice of a tax professional may, but does not necessarily,

establish reasonable cause and good faith for the purpose of avoiding a section

6662(a) penalty. See Boyle, 469 U.S. at 251 (“Reliance by a lay person on a

lawyer [or accountant] is of course common; but that reliance cannot function as a

substitute for compliance with an unambiguous statute.”).

        The caselaw sets forth the following three requirements in order for a

taxpayer to use reliance on a tax professional to avoid liability for a section 6662(a)

penalty: “(1) The adviser was a competent professional who had sufficient

expertise to justify reliance, (2) the taxpayer provided necessary and accurate

information to the adviser, and (3) the taxpayer actually relied in good faith on the
                                         - 41 -

[*41] adviser’s judgment.” See Neonatology Asscos., P.A. v. Commissioner, 115

T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002); see also Charlotte’s Office

Boutique, Inc. v. Commissioner, 425 F.3d 1203, 1212 n.8 (9th Cir. 2005) (quoting

and with approval the above three-prong test), aff’g 121 T.C. 89 (2003).

      With respect to the employment plan contributions, we find that petitioners

actually relied on the advice of their accountant, who was a competent professional,

and that they provided him with the necessary and accurate information. Therefore,

petitioners are not liable for the section 6662(a) accuracy-related penalty related to

the contributions.

      However, as discussed supra, we found that the compensation paid to Ms.

Strick was not for services actually rendered and therefore not reasonable

compensation. We do not find that Dr. and Ms. Fletcher actually relied on the

advice of their accountant with respect to those payments, and TORCH is therefore

liable for the section 6662(a) accuracy-related penalty related to those amounts.

      The Court has considered all of the parties’ contentions, arguments, requests,

and statements. To the extent not discussed herein, the Court concludes that they

are meritless, moot, or irrelevant.
                                  - 42 -

[*42] To reflect the foregoing,


                                           Decisions will be entered

                                  under Rule 155.
