                         T.C. Summary Opinion 2012-124



                         UNITED STATES TAX COURT



     PATRICK M. HERBERT AND SUZANNE M. HERBERT, Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 16483-11S.                         Filed December 26, 2012.



      Patrick M. and Suzanne M. Herbert, pro se.

      Shaina E. Boatright, for respondent.



                              SUMMARY OPINION


      SWIFT, Judge: This case was heard pursuant to the provisions of section

7463 of the Internal Revenue Code in effect when the petition was filed.1



      1
       References to other sections are to the Internal Revenue Code applicable for
the year in issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure.
                                          -2-

Pursuant to section 7463(b), the decision to be entered is not reviewable by any

other court, and this opinion shall not be treated as precedent for any other case.

Respondent determined a $16,135 deficiency in petitioners’ Federal income tax for

2007 and a penalty under section 6662(a) of $3,227.

      After partial settlement, the primary issue remaining for decision is whether

$52,600 petitioner Patrick Herbert received in 2007 from a subchapter S corporation

should be treated as additional wages subject to employment taxes.

                                      Background

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

filed their petition, petitioners resided in Minnesota.

      For the last six months of 2002 and in 2003 Patrick Herbert (petitioner)

worked as a salesman and a manager for Gopher Delivery Systems (Gopher

Delivery), operator of a delivery and courier business in the Minneapolis-St. Paul

metropolitan area and throughout Minnesota, Wisconsin, and Iowa. For the second

half of 2002 and for 2003, petitioner received total wages from Gopher Delivery as

follows:
                                        -3-

                          Year                      Amount

                          2002                      $13,803
                          2003                       46,498

      In 2004 petitioners purchased the courier business from the owners of Gopher

Delivery, and they continued to operate it through 2009. Petitioners’ courier

business was operated as a subchapter S corporation under the name H & H

Transportation, Inc. (H&H).

      Petitioner owned 49% and petitioner Suzanne E. Herbert owned 51% of the

stock in H&H. Petitioner was president and general manager and a full-time

employee of H&H. Petitioner Suzanne Herbert was not employed by H&H and was

not involved in H&H’s day-to-day business activities.

      In 2004, 2005, and 2006 petitioner received from H&H total wages as

follows:

                          Year                      Amount

                          2004                      $25,127
                          2005                       24,542
                          2006                       28,452

      To make deliveries in its three delivery trucks (a 26-foot dock truck, a 16-

foot flatbed F150 turbo diesel truck, and a 2004 cargo van), H&H used contract
                                          -4-

truck drivers whom petitioner hired. Petitioner generally paid the truck drivers

weekly with checks written on one of H&H’s three bank accounts.

      In 2007 H&H received gross receipts of $580,220 from its delivery and

courier business.

      An analysis of H&H’s bank accounts reflects payments in 2007 to contract

truck drivers in the total amount of $306,442, which is also reflected in H&H’s

QuickBook records.

      Over and above funds paid to the contract truck drivers for making deliveries

(for 2007, $306,442 per H&H’s QuickBook records) petitioner often would make

supplemental cash payments to the truck drivers to compensate them for making

repairs on H&H’s trucks. With regard to the cash payments to the truck drivers,

petitioner and H&H did not receive receipts from the truck drivers, and petitioners’

records are not complete as to the amount of cash actually paid to the truck drivers

in 2007.

      During petitioners’ operation of H&H up to some point in 2009, H&H either

lost money every year or earned little income. In 2009 petitioners finally closed the

business down, after losing their home on account of losses incurred in the business

and their inability to make payments on a home equity loan obtained in 2004 to

finance their purchase of the business.
                                        -5-

      During 2007 petitioner received from H&H approximately $60,000 that was

deposited into petitioners’ bank account. H&H and petitioner treated only $2,400

thereof as wages subject to employment taxes. Petitioner’s receipt of this

approximate $60,000 is evidenced by an analysis of petitioners’ bank account.

Petitioner used a portion of the H&H funds transferred into petitioners’ bank

account to pay with cash expenses of H&H, such as the supplemental payments to

the truck drivers for truck repairs.

      H&H’s bank records and H&H’s QuickBook records show payment of

$9,148 in rent expenses.

      The accountant whom petitioner and H&H used to prepare petitioners’ and

H&H’s tax returns for 2006 and 2007 did not properly account for a number of

H&H’s expenses. In 2008 H&H hired a new accountant.

      H&H’s 2007 Form 1120S, U.S. Income Tax Return for an S Corporation, as

filed with respondent reported the total gross receipts of $580,220 and reported

many business expenses as costs of goods sold (COGS) in the total amount of

$350,404. The reported $350,404 COGS included $331,708 for contract labor

expenses, $15,766 for fuel expenses, a franchise fee of $256, and subcontractor

fees of $2,674.
                                          -6-

         The $331,708 reported for contract labor expenses is approximately $25,000

more than the $306,919 reflected in H&H’s Quickbook records for contract labor

expenses.

         Also claimed on H&H’s 2007 tax return were miscellaneous transportation

expense deductions totaling $86,222.45, which consisted of vehicle leases payments

of $24,889.92, vehicle gas expenses of $46,117.12, auto repair expenses of

$10,044.41, and other expenses of $5,171.

         After additional deductions (which included rent of $36,430 and the reported

wages for petitioner of $2,4002), H&H’s 2007 Form 1120S reported net income of

$1,377, and pursuant to section 1366(a)(1) the reported $1,377 net income flowed

through to petitioners’ 2007 joint individual income tax return.

         On their Schedule E, Supplemental Income and Loss, of their 2007 joint

individual Federal income tax return, petitioners reported the $1,377 flowthrough

H&H income and the $2,400 as petitioner’s H&H wages subject to employment

taxes.

         The approximate $57,600 balance of the funds that in 2007 were transferred

from H&H into petitioners’ bank account ($60,000 less $2,400 equals $57,600)

         2
       On their 2007 joint individual Federal income tax return petitioners actually
reported wages for petitioner from H&H of $2,600. For purposes of our opinion,
we generally use the $2,400 H&H reported.
                                         -7-

was not treated by H&H and petitioners as taxable wages or salary to petitioner.

Rather, H&H and petitioners treated the $57,600 as cash that petitioner used to pay

expenses of H&H.

      On audit respondent determined that the $2,400 which H&H and petitioner

reported as petitioner’s 2007 wages was unreasonably low and that $55,000 (of

H&H’s funds transferred into petitioners’ bank account in 2007) should be treated

as petitioner’s H&H wages subject to employment taxes. Accordingly respondent

increased petitioner’s H&H wages by $52,600 ($55,000 less $2,400 equals

$52,600). Consistent with this adjustment to petitioner’s wages, respondent also

increased H&H’s business expense deduction for wages paid to petitioner by

$52,600. As a result, respondent’s adjustment to petitioner’s H&H wages produced

only an increase in petitioners’ employment taxes, not an increase in petitioners’

income tax.

      On audit respondent also disallowed for duplication $32,308 of the reported

COGS contract labor expenses and all $15,766 of the reported COGS vehicle fuel

expense (together totaling a disallowance of $48,074) and thereby reduced H&H’s

allowable deduction for COGS to $302,330 ($350,404 less $48,074 equals

$302,330).
                                        -8-

      Of the total $86,222 miscellaneous transportation expenses claimed on

H&H’s 2007 tax return, respondent disallowed $25,579, which included $3,800 for

lease payments, $11,641 for additional fuel expenses, $4,967 for repairs, and $5,171

of other expenses.

      Lastly on audit respondent reduced H&H’s business expense deduction for

rent to $9,148, a disallowance of $27,282 from the $36,430 reported rent expense.3

                                    Discussion

H&H Wages

      Petitioners contend that H&H lost money every year and that petitioner used

most of the approximately $60,000 transferred from H&H during 2007 into

petitioners’ bank account to pay additional H&H business expenses with cash.

Petitioner argues that (over and above his reported $2,400 in H&H wages) the H&H

funds he received were not used by him for personal purposes and should not be

treated as wages subject to employment taxes.

      Petitioner acknowledges that he lost, misplaced, or never kept receipts for

many H&H expenses he paid with cash and therefore that they were not properly




      3
       On audit respondent made a number of additional adjustments which have
been settled by the parties and are not discussed herein.
                                           -9-

recorded in H&H’s Quickbook records and were not reflected on 2007 H&H’s tax

return.

       Respondent notes that for employment tax purposes shareholder/employees

of S corporations have an incentive to treat corporate payments to shareholders as

something other than compensation for services rendered. Whether amounts paid to

shareholders are to be treated as compensation for services (i.e., as wages or salary)

and subject to employment taxes involves a question of fact. David E. Watson, P.C.

v. United States, 668 F.3d 1008, 1017-1018 (8th Cir. 2012); Brewer Quality

Homes, Inc. v. Commissioner, T.C. Memo. 2003-200, aff’d, 122 Fed. Appx. 88 (5th

Cir. 2004).

       To support his $52,600 increase in petitioner’s 2007 H&H wages respondent

relies largely on one year (2003) when petitioner was paid by Gopher Delivery

wages of $46,498 and on petitioners’ burden of proof. We note that respondent

does not argue that petitioner’s reported wages for Gopher Delivery and H&H in

years before 2007 were unreasonably low.

       We believe and accept petitioner’s testimony that he in fact paid significant

H&H expenses with cash using funds received from H&H. For example,

petitioner credibly testified that after finishing deliveries, truck drivers often

would assist with repairs on the trucks and that he would pay the drivers cash for
                                        - 10 -

their assistance. No evidence indicates any unusual personal use by petitioners of

the funds in question received from H&H.

      In spite of the limited evidence before us, we believe it improper and

excessive to charge petitioner with receipt from H&H in 2007 of $52,600 in

additional wages. However, we also believe petitioner’s reported H&H wages of

$2,400 are unreasonably low.

      To estimate what portion of the funds petitioner received from H&H in 2007

is to be treated as wages, we believe it appropriate to average petitioner’s wages for

2002 through 2006 and to use the average wage amount as the total for petitioner’s

2007 H&H wages subject to employment taxes--namely, $30,445.4 See Mayson

Mfg. Co. v. Commissioner, 178 F.2d 115, 119 (6th Cir. 1949).

      We thus conclude that an additional $27,845 ($30,445 less reported wages of

$2,600 equals $27,845) should be treated as wages petitioner received from H&H in

2007 and is subject to employment taxes.




      4
       Using an annualized wage for 2002 of $27,606, petitioner received total
wages from H&H during 2002 through 2006 of $152,225, which, divided by 5,
equals $30,445. On brief respondent suggests that his revenue agent did an informal
Internet search of compensation paid to managers of delivery and courier
businesses. However, no documentary or other evidence of such an Internet search
was offered into evidence. Respondent’s revenue agent did not testify.
                                          - 11 -

Disallowed Expenses

      Section 162(a) allows a deduction for ordinary and necessary business

expenses paid or incurred in carrying on a trade or business. However, a taxpayer is

required to maintain adequate records, sec. 6001; sec. 1.6001-1(a), Income Tax

Regs., and the Commissioner’s determination in a notice of deficiency is presumed

correct.

      Further, taxpayers generally bear the burden of proof to substantiate claimed

expenses. 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); Welch v. Helvering,

290 U.S. 111, 115 (1933). Because they provided insufficient documentation to

respondent during the audit, petitioners do not qualify for a shift in the burden of

proof under section 7491.

COGS--Disallowed $48,074 ($32,308 Contract Labor and $15,766 Fuel)

      In their posttrial brief, for lack of substantiation petitioners state that they

concede respondent’s $48,074 reduction to H&H’s COGS. H&H is allowed a total

COGS deduction for 2007 of $302,330.
                                        - 12 -

Transportation Expenses--$25,579 ($3,800 Lease Payments; $11,641 Fuel
Expenses; $4,967 Repairs; and $5,171 Other)

      Of the total $86,222 miscellaneous transportation expense deduction claimed

on H&H’s 2007 tax return, respondent disallowed $25,579, which included $3,800

lease payments, $11,641 fuel expenses, $4,967 repairs, and all $5,171 other

expenses.

      On brief petitioners state that they no longer dispute respondent’s

disallowance of the $3,800 relating to lease payments.

      With regard to respondent’s disallowance of $11,641 for fuel and $4,967 for

repair expenses, petitioners on brief claim to have found (and made available to

respondent) copies of receipts that would support an additional $3,400 in fuel

expenses (over the $34,476 respondent allowed) and $7,103 in repair expenses

(over the $5,077 respondent allowed).

      For settlement purposes, the Court encouraged respondent to consider

petitioners’ alleged new receipts relating to fuel and repair expenses. The parties

were not able to reach a settlement. The alleged new receipts are not in evidence

and are not evidence we can consider at this time.

      No evidence regarding the disallowed other expenses of $5,171 has been

offered.
                                       - 13 -

      We sustain respondent’s disallowance of the $25,579 in transportation

expenses.

Rent Expenses--$27,282

      At trial petitioners admitted that the $36,430 reported on H&H’s 2007

Federal tax return for rent expenses was excessive. H&H’s bank and QuickBook

records substantiate payment of only $9,148 in rent expenses. Petitioners have not

produced lease agreements or receipts to substantiate additional rent expenses.

      We sustain respondent’s disallowance of $27,282 in claimed rent expenses.

Section 6662 20% Penalty

      Respondent’s adjustments we sustain herein satisfy respondent’s burden of

production under section 7491(c).

      Petitioner effectively acknowledges that H&H’s inadequate and often

inconsistent records support imposition of the section 6662 penalty.

      We sustain respondent’s imposition of the section 6662 penalty.


                                                      Decision will be entered

                                                under Rule 155.
