                           T.C. Memo. 2007-168



                       UNITED STATES TAX COURT



            EDWARD W. AND EDITH M. ARNOLD, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 16573-05.                  Filed June 27, 2007.



     Edward W. and Edith M. Arnold, pro sese.

     Kelley A. Blaine, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     VASQUEZ, Judge:   Respondent determined the following

deficiencies in, addition to, and penalties on petitioners’

Federal income tax:

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

     2002        $31,482                –-          $6,296.40
     2003         16,996            $2,275.90        3,399.20
                                 -2-

Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the years in issue, and all

Rule references are to the Tax Court Rules of Practice and

Procedure.

       After a concession by respondent,1 the issues for decision

are:    (1) Whether petitioners substantiated deductions, losses,

and/or cost of goods sold in excess of amounts respondent allowed

or conceded for 2002 and 2003, (2) whether petitioners are liable

for self-employment tax in 2002 and 2003, (3) whether petitioners

are liable for the section 6651(a)(1) addition to tax for 2003,

and (4) whether petitioners are liable for the section 6662(a)

penalty for 2002 and 2003.

                          FINDINGS OF FACT

       None of the facts have been stipulated.   Confronted with

petitioners’ refusal to work toward a stipulation of facts,

respondent filed, among other things, requests for admission

pursuant to Rule 90.    After the Court granted a motion by

petitioners to extend the time for their reply to respondent’s

requests for admission, petitioners did not file a response

within the time permitted to respondent’s requests for admission,

including the extension of time granted by the Court.




       1
        Respondent concedes that petitioners substantiated
$3,122.52 in labor expenses for 2003 (attributable to services
performed by William Ray).
                                 -3-

Accordingly, each matter in the requests for admission was deemed

admitted pursuant to Rule 90(c).

       Approximately 1 week after the matters of which respondent

requested admission were deemed admitted pursuant to Rule 90(c),

petitioners served on the Court an untimely response to

respondent’s requests for admission.    The Court ordered the

deemed admissions withdrawn and ordered petitioners’ response to

requests for admission be filed.    The facts petitioners admitted

in the response to requests for admission are conclusively

established and are so found.    See Rule 90(f).   Unless otherwise

indicated, all facts relate to the years in issue--2002 and 2003.

       At the time they filed the petition, petitioners resided in

Portland, Oregon.

I.   Income (Self-Employment Tax)

       Edith Arnold was a realtor associated with Coldwell Banker,

and Edward Arnold was an accountant and tax return preparer.

       Mrs. Arnold was the 100-percent owner of Edith M. Arnold,

P.C. (EAPC).    Mrs. Arnold operated EAPC as a vehicle for her real

estate practice.    Mrs. Arnold assigned to EAPC the payments she

earned for her services as a realtor.    EAPC has never paid Mrs.

Arnold wages or a salary.    EAPC has never withheld payroll taxes

on the money it distributed to Mrs. Arnold.    Mrs. Arnold had

complete control over whether EAPC paid and/or reported wages to

her.    Mrs. Arnold used her own name, not EAPC and without
                                -4-

reference to EAPC, on documents accounting for expenses,

payments, and sales commissions connected with her real estate

practice associated with Coldwell Banker.

     Mr. Arnold was the 100-percent owner of Pacific Controller,

Inc. (PCI).   Mr. Arnold operated PCI as a vehicle for his

accounting and tax preparation business.    Mr. Arnold assigned to

PCI the payments he received from customers for his personal

accounting services.   PCI has never paid Mr. Arnold wages or a

salary.   Mr. Arnold had complete control over whether PCI paid

and/or reported wages to him.   PCI has never withheld payroll

taxes on the money it distributed to Mr. Arnold.   There was no

contract between Mr. Arnold and PCI giving PCI the right to

control Mr. Arnold’s performance of services.

     EAPC and PCI are S corporations.   Petitioners reported

nonpassive income (distributions of net income after expenses)

from EAPC and PCI on Schedules E, Supplemental Income and Loss,

of their 2002 and 2003 joint Federal income tax returns.     Mr.

Arnold prepared the 2002 and 2003 tax returns for petitioners,

EAPC, and PCI.   Petitioners reported zero wage income on their

2002 and 2003 joint Federal income tax returns.
                                   -5-

II.    Disallowed Deductions and Other Amounts Claimed by
       Petitioners

       A.   Interest

       On Schedule E of their 2002 return, petitioners deducted

$10,045 in interest.      Neither petitioner paid any interest to

PCI.

       B.   Labor Expenses

       On Schedules E of their 2002 and 2003 returns, petitioners

deducted $16,757 and $24,171, respectively, of labor expenses.

Respondent concedes that petitioners paid $3,122.52 in labor

expenses for 2003 (attributable to services performed by William

Ray).

       C.   Western Timber Farms, Inc.

       On each of their 2002 and 2003 returns, petitioners claimed

a Schedule E loss relating to an entity known as Western Timber

Farms, Inc.

       D.   Orion:   Cost of Goods Sold/Capital Loss

       On Schedule C, Profit or Loss From Business, of their 2002

return, petitioners claimed $40,000 in cost of goods sold related

to Orion Venture (Orion).      The “Principal business or

professional activity code” entered on the Schedule C for Orion

is 523900, which the Schedule C instructions state is for “Other

financial investment activities (including investment advice)”.

       On their 2002 and 2003 returns, petitioners indicated that

they did not have an interest in a financial account in a foreign
                                 -6-

country (such as a bank account, securities account, or other

financial account).   In 2001 and 2002, however, petitioners sent

money to Orion via wire transfers to banks and beneficiaries in

St. Kitts, West Indies, and Nevis, West Indies.

     Orion purportedly invested in foreign currency trades that

could net returns of 6 percent to 8 percent per month and 60

percent to 200 percent per year.   Orion appears to have been, in

part,2 a Ponzi scheme.   Many investors, however, successfully

withdrew funds from Orion, which built customer confidence that

Orion’s operations were legitimate and that the returns and gains

Orion reported to customers, including petitioners, were real.

     In December 2003, petitioners received a letter from the

U.S. Postal Inspection Service (USPIS), dated December 15, 2003,

that indicated that petitioners might have been victims of fraud

associated with Orion.   Following receipt of the December 15,

2003, letter from the USPIS, petitioners attempted to recover

funds they had transferred to Orion.   During 2004, a newspaper

printed a story about Orion which stated that the founder of

Orion was suspected of misusing money provided to Orion.

Sometime after reading the 2004 newspaper article, petitioners

believed that any money they provided to Orion was lost and that

their interest in Orion was worthless.



     2
          Some of the money Orion received was invested in currency
trades.
                                 -7-

     On their 2002 and 2003 returns, petitioners claimed earned

income credits (EIC) of $352,854 and $489,827, respectively.       On

their 2002 return, petitioners did not report any of the gains

that Orion reported in statements to petitioners (which

petitioners received during 2002).     On November 15, 2004,

petitioners signed their 2003 return.     On November 18, 2004,

respondent received petitioners 2003 return.

                              OPINION

     Generally, respondent’s deficiency determinations set forth

in the notice of deficiency are presumed correct, and petitioners

bear the burden of showing the determinations are in error.       Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).     Section

7491(a), however, shifts the burden of proof to the Commissioner

with respect to a factual issue affecting the tax liability of a

taxpayer who meets certain conditions.

     Petitioners have neither claimed nor shown that they

satisfied the requirements of section 7491(a) to shift the burden

of proof to respondent with regard to any factual issue affecting

the deficiencies in their tax.   Accordingly, petitioners bear the

burden of proof.   See Rule 142(a).
                                 -8-

I.   Self-Employment Tax

      Section 1401 imposes self-employment tax on self-employment

income.   Section 1402 defines net earnings from self-employment

as the gross income derived by an individual from the carrying on

of any trade or business by such individual less allowable

deductions attributable to such trade or business.

      A fundamental principle of tax law is that income is taxed

to the person who earns it.    Commissioner v. Culbertson, 337 U.S.

733, 739 (1949); Lucas v. Earl, 281 U.S. 111, 114 (1930);

Johnston v. Commissioner, T.C. Memo. 2000-315.    The existence of

a validly organized and operated corporation does not preclude

taxation of income to the service provider instead of the

corporation.   Wilson v. United States, 530 F.2d 772, 777-778 (8th

Cir. 1976); Haag v. Commissioner, 88 T.C. 604, 610-611 (1987),

affd. without published opinion 855 F.2d 855 (8th Cir. 1988); see

also Commissioner v. Culbertson, supra at 739-740.    Deciding

whether the corporation or the service provider earned the income

requires that we decide whether the corporation or its

service-performing agent or shareholder controls the earning of

the income.    Johnson v. Commissioner, 78 T.C. 882, 891 (1982)

(and cases cited thereat), affd. without published opinion 734

F.2d 20 (9th Cir. 1984).

      A corporation earns the income if:   (a) The service provider

is an employee of a corporation which has the right to direct or
                                -9-

control that employee in some meaningful sense; and (b) there

exists a contract or similar arrangement between the corporation

and the person or entity using the services which recognizes the

corporation’s right to direct or control the work of the service

provider.   Haag v. Commissioner, supra at 611; Johnson v.

Commissioner, supra at 891; see also Leavell v. Commissioner, 104

T.C. 140, 151-152 (1995).

      Petitioners admitted that there was no contract between Mr.

Arnold and PCI recognizing the right of PCI to control Mr.

Arnold’s performance of services.     There is no credible evidence

that Mrs. Arnold contracted with EAPC to perform real estate

services or that EAPC controlled Mrs. Arnold in some meaningful

sense.

      We conclude that EAPC did not control Mrs. Arnold’s

performance of real estate services and that PCI did not control

Mr. Arnold’s performance of accounting or return preparation

services.   Accordingly, we sustain respondent’s determination

that petitioners are subject to self-employment tax in 2002 and

2003 on income from their accounting/return preparation and real

estate activities.

II.   Deductions

      Deductions are a matter of legislative grace, and

petitioners have the burden of showing that they are entitled to

any deduction claimed.   See Rule 142(a); New Colonial Ice Co. v.
                                -10-

Helvering, 292 U.S. 435, 440 (1934).    Taxpayers are required to

maintain records that are sufficient to enable the Commissioner

to determine their correct tax liability.    See sec. 6001; sec.

1.6001-1(a), Income Tax Regs.   Additionally, taxpayers bear the

burden of substantiating the amount and purpose of the item they

claimed as a deduction.   See Hradesky v. Commissioner, 65 T.C.

87, 89 (1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976).

     Petitioners rely on their own testimony to substantiate the

claimed expenses and deductions at issue.3   The Court is not

required to accept petitioners’ unsubstantiated testimony.      See

Wood v. Commissioner, 338 F.2d 602, 605 (9th Cir. 1964), affg. 41

T.C. 593 (1964).   We found petitioners’ testimony to be general,

vague, conclusory, and/or questionable in certain material

respects.   On the record, we repeatedly noted Mr. Arnold’s lack

of credibility.    Under the circumstances presented herein, we are

not required to, and generally do not, rely on petitioners’

testimony to sustain their burden of establishing error in

respondent’s determinations.    See Lerch v. Commissioner, 877 F.2d

624, 631-632 (7th Cir. 1989), affg. T.C. Memo. 1987-295; Geiger

v. Commissioner, 440 F.2d 688, 689-690 (9th Cir. 1971), affg. per


     3
        Petitioners also may rely on the testimony of William
Ray. Apart from Mr. Ray’s testimony that he was paid $3,122.52
for services rendered during 2003, most of Mr. Ray’s testimony
was general, vague, and conclusory. With the exception of the
amount he was paid, he generally lacked sufficient knowledge
about the items/facts in issue. Mr. Ray’s testimony is not
sufficient to support petitioners’ assertions.
                                 -11-

curiam T.C. Memo. 1969-159; Tokarski v. Commissioner, 87 T.C. 74,

77 (1986).

     If taxpayers establish that they have incurred deductible

expenses but are unable to substantiate the exact amounts, we can

in some circumstances estimate the deductible amounts, but only

if the taxpayer presents sufficient evidence to establish a

rational basis for making the estimates.     See Cohan v.

Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); Vanicek v.

Commissioner, 85 T.C. 731, 742-743 (1985).      In estimating the

amounts allowable, we bear heavily upon the taxpayer whose

inexactitude is of his own making.      See Cohan v. Commissioner,

supra at 544.   We shall not rely on the Cohan rule as petitioners

have not presented sufficient evidence to establish a rational

basis for making an estimate.    Furthermore, the evidence does not

establish that petitioners incurred any interest expense or had

any cost of goods sold.

     Accordingly, we sustain respondent’s disallowance of the

interest expense, the labor expenses, the Western Timber Farms,

Inc. losses, and the cost of goods sold.

     At trial, petitioners contended that they suffered a $20,000

capital loss related to Orion.    The parties tried this issue by

consent.   See Rule 41(b).4


     4
        When issues not raised by the pleadings are tried by
express or implied consent of the parties, the issues shall be
                                                   (continued...)
                                 -12-

     Section 165(a) provides that there shall be allowed as a

deduction any loss sustained during the taxable year and not

compensated by insurance or otherwise.    Section 165(c) limits the

loss deduction for individuals to losses incurred in a trade or

business, losses incurred in a transaction entered into for

profit, and certain other losses including those arising from a

casualty or from theft.   Section 165(g)(1) provides that if any

“security” which is a capital asset becomes worthless during the

taxable year, then the resulting loss shall be treated as a loss

from the sale or exchange, on the last day of the taxable year,

of a capital asset.   Section 165(g)(2) defines “security” for

purposes of section 165(g) as a share of stock in a corporation;

a right to subscribe for, or to receive, a share of stock in a

corporation; or a bond, debenture, note, or certificate, or other

evidence of indebtedness, issued by a corporation or by a

government or political subdivision thereof, with interest

coupons or in registered form.

     Petitioners have failed to prove they held a “security” for

purposes of section 165(g) with respect to Orion, if and when

Orion became “worthless”, and that they suffered a loss related

to Orion during the years in issue.     See secs. 1001, 1011, 1012.




     4
     (...continued)
treated as if they had been raised in the pleadings.     Rule 41(b).
                                 -13-

Accordingly, we conclude that petitioners are not entitled to a

deduction for a loss related to Orion during the years in issue.5

III.   Addition to Tax and Penalties

       Section 7491(c) provides that the Commissioner will bear the

burden of production with respect to the liability of any

individual for additions to tax.     “The Commissioner’s burden of

production under section 7491(c) is to produce evidence that it

is appropriate to impose the relevant penalty, addition to tax,

or additional amount”.     Swain v. Commissioner, 118 T.C. 358, 363

(2002); see also Higbee v. Commissioner, 116 T.C. 438, 446

(2001).     The Commissioner, however, does not have the obligation

to introduce evidence regarding reasonable cause or substantial

authority.     Higbee v. Commissioner, supra at 446-447.

       A.   Section 6651(a)(1) Addition to Tax

       Section 6651(a)(1) imposes an addition to tax for failure to

file a return on the date prescribed (determined with regard to

any extension of time for filing), unless the taxpayer can

establish that such failure is due to reasonable cause and not

due to willful neglect.    A Federal income tax return made on the



       5
        We note that the issue regarding the alleged $20,000
capital loss related to Orion first arose at trial. In their
opening brief, petitioners state that the issue regarding Orion
“[opened] the possibility of reporting the loss as a
Casualty/Theft loss. With full disclosure, Petitioner [sic] has
elected the capital loss as all they knew in 2002, [sic] was that
the investment was worthless.” Accordingly, whether there was a
theft loss is not at issue.
                                 -14-

basis of a calendar year must be filed on or before April 15,

following the close of the calendar year unless the due date is

extended.    Sec. 6072(a).   On brief respondent notes that

petitioners’ 2003 return was due on October 15, 2004 (presumably

on account of an extension of time to file).     Petitioners filed

their 2003 return on November 18, 2004.     Accordingly, respondent

has met his burden of production on this issue.

       Petitioners claimed their failure to timely file for 2003

was due to reasonable cause and not willful neglect because Mr.

Arnold was ill at the time.     Petitioners rely on their own

testimony.

       The Court is not required to accept petitioners’

unsubstantiated testimony.     See Wood v. Commissioner, 338 F.2d at

605.    The Court need not accept at face value a witness’s

testimony that is self-interested or otherwise questionable.    See

Archer v. Commissioner, 227 F.2d 270, 273 (5th Cir. 1955), affg.

a Memorandum Opinion of this Court; Weiss v. Commissioner, 221

F.2d 152, 156 (8th Cir. 1955), affg. T.C. Memo. 1954-51;

Schroeder v. Commissioner, T.C. Memo. 1986-467.     This is so even

when the testimony is uncontroverted if it is improbable,

unreasonable, or questionable.     Archer v. Commissioner, supra at

273; Weiss v. Commissioner, supra at 156; see Quock Ting v.

United States, 140 U.S. 417 (1891).     We found petitioners’

testimony to be conclusory and/or questionable in certain
                               -15-

material respects.   Under the circumstances presented here, we

are not required to, and generally do not, rely on petitioners’

testimony.   See Lerch v. Commissioner, 877 F.2d at 631-632;

Geiger v. Commissioner, 440 F.2d at 689-690; Tokarski v.

Commissioner, 87 T.C. at 77.

     Petitioners did not call any medical professionals as

witnesses to testify about Mr. Arnold’s health.   We infer that

such testimony would not have been favorable to petitioners.    See

Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165

(1946), affd. 162 F.2d 513 (10th Cir. 1947).

     During the same period Mr. Arnold was supposedly too ill to

timely file petitioners’ 2003 return, Mr. Arnold worked as a

return preparer, went to his office, and oversaw the preparation

of tax returns.   Additionally, during the same period of Mr.

Arnold’s alleged illness or incapacity, petitioners timely filed

their 2002 return.   Furthermore, there is no credible evidence

that Mrs. Arnold could not have timely filed petitioners’ 2003

return (or a separate return for herself for 2003).

     Having had the opportunity to observe petitioners, we find

their claim not credible.   Petitioners’ failure to file was not

due to reasonable cause; it was due to willful neglect.

Accordingly, we sustain respondent’s determination that

petitioners are liable for the addition to tax pursuant to

section 6651(a)(1) for 2003.
                                 -16-

     B.   Section 6662 Penalty

     Pursuant to section 6662(a), a taxpayer may be liable for a

penalty of 20 percent on the portion of an underpayment of tax

attributable to:    (1) Negligence or disregard of rules or

regulations or (2) a substantial understatement of income tax.

Sec. 6662(b)(1) and (2).     Whether applied because of a

substantial understatement of income tax or negligence or

disregard of rules or regulations, the accuracy-related penalty

is not imposed with respect to any portion of the underpayment as

to which the taxpayer acted with reasonable cause and in good

faith.    Sec. 6664(c)(1).   The decision as to whether the taxpayer

acted with reasonable cause and in good faith depends upon all

the pertinent facts and circumstances.     See sec. 1.6664-4(b)(1),

Income Tax Regs.

     Negligence includes any failure to make a reasonable attempt

to comply with the Internal Revenue Code.     Sec. 6662(c).

Respondent established that (1) petitioners failed to

substantiate items properly, and (2) on their 2002 and 2003

returns, (a) petitioners claimed EICs of $352,854 and $489,827,

respectively (which is patently frivolous as the maximum EIC for

both 2002 and 2003 was less than $5,000), and (b) petitioners

reported that they did not have an interest in a financial

account in a foreign country even though in 2001 and 2002

petitioners sent money to Orion via wire transfers to banks and
                                  -17-

beneficiaries in St. Kitts, West Indies, and Nevis, West Indies.

See sec. 1.6662-3(b)(1), Income Tax Regs.     Accordingly,

respondent met his burden of production for the section 6662

penalty for the years in issue.

     Petitioners failed to establish that they had reasonable

cause or acted in good faith for the years in issue.

Accordingly, petitioners are liable for the section 6662(a)

penalty for 2002 and 2003.

     C.   Section 6673(a)(1)

     The Court considers, sua sponte, whether petitioners have

engaged in behavior that warrants imposition of a penalty

pursuant to section 6673.      Section 6673(a)(1) authorizes the Tax

Court to require a taxpayer to pay to the United States a penalty

not in excess of $25,000 whenever it appears that proceedings

have been instituted or maintained by the taxpayer primarily for

delay.

     The circumstances herein suggest that petitioners may have

instituted and maintained this proceeding primarily for purposes

of delay.   Petitioners filed three motions for continuance--the

first was filed shortly before trial, the second was filed at

calendar call, and the last was filed on the date of trial.     The

Court denied all three motions for continuance.

     Furthermore, Arnold v. Commissioner, T.C. Memo. 2005-256

(Arnold I), involved petitioners’ 1999, 2000, and 2001 tax years
                                 -18-

(the years immediately preceding the years at issue in the case

at bar).    In Arnold I, petitioners failed to substantiate the

same or similar deductions/items.       In Arnold I, on the basis of

facts substantially similar to those of the case at bar the Court

sustained respondent’s determination regarding the Western Timber

Farms, Inc., labor, and interest deductions; held that

petitioners were subject to self-employment tax on their return

preparation income and realtor income; and upheld the imposition

of accuracy-related penalties.

     In the case at bar, petitioners made the same arguments

regarding the same or similar items that the Court rejected in

Arnold I.    The Court issued the opinion in Arnold I before the

notice of trial was sent to petitioners in the case at bar and

the decision in Arnold I was final--petitioners did not appeal

the decision in Arnold I--before the opening briefs were due in

the case at bar.    See sec. 7482(a); Fed. R. App. P. 13.

Accordingly, petitioners knew their arguments had been rejected

well before trial.    Additionally, petitioners failed to provide

respondent with information requested until they were compelled

to do so by the Court, failed to substantiate items, and

repeatedly sought to delay the trial of the case at bar.

     We, however, shall not impose a penalty pursuant to section

6673(a)(1).    We take this opportunity to admonish petitioners

that the Court will strongly consider imposing such a penalty if
                                 -19-

they return to the Court and proceed in a similar fashion in the

future.

     In reaching all of our holdings herein, we have considered

all arguments made by the parties, and to the extent not

mentioned above, we find them to be irrelevant or without merit.

     To reflect the foregoing,


                                             Decision will be entered

                                        under Rule 155.
