                                T.C. Memo. 2012-290



                          UNITED STATES TAX COURT



                      H & M, INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 16612-09.                          Filed October 15, 2012.



      Jon J. Jensen, for petitioner.

      William R. Peck and John P. Healy, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      HOLMES, Judge: H & M, Inc. is a small corporation that sold its biggest

asset, an insurance-brokerage business, to a local bank in 1992. H & M’s owner

kept the corporation active--he says--to exploit his two patented inventions. He

himself went to work for the bank that bought the brokerage business, and now the
                                         -2-

[*2] Commissioner says some of his wages were actually disguised purchase-price

payments to the corporation, while interest payments the corporation deducted were

actually dividends to him. The Commissioner also contests a number of expenses

that H & M tried to deduct even after the patents expired. There are also accuracy-

related penalties for us to look at.

                                 FINDINGS OF FACT

I.    Background

      Not very many people live in Harvey, North Dakota, a small town in north

central North Dakota that sits on the eastern edge of the Williston Basin, site of

what is now the biggest American oil boom in decades. The town has only a couple

thousand residents, and at least before the boom only about a half dozen people

moved there in any given year, fewer than died or moved away. But though it’s a

small town, Harvey has a business district, and people from the surrounding areas--

even smaller towns as well as farms--come to Harvey for their errands.

      Harold Schmeets moved to Harvey in the late 1960s, and began selling

insurance as an employee of the National Bank of Harvey’s insurance agency,

which at the time was housed in the same building as the bank. But Schmeets

wanted to have his own business, and in the 1970s began to buy the bank’s
                                         -3-

[*3] insurance agency a little bit at a time after the bank’s owners decided to sell

their shares in the agency. By around 1980 Schmeets had become the agency’s sole

shareholder. Even after the sale, however, he continued to operate the agency--now

called Harvey Insurance Agency, Inc.--in the same building as the bank. In 1983,

however, the bank built a new and bigger office and got back into the insurance

business. Schmeets, with his former employer now a rival, moved to a different

building a few blocks away.

      The bank was not Schmeets’s only competition, especially in the property and

casualty insurance business. At the time Schmeets moved his business, there were

around 15 independent insurance agents in Harvey and the surrounding

communities, most within a 30-mile radius. Fortunately for them, their customer

base was more than just the residents of Harvey--there were roughly 5,000 to 6,000

people, mostly farmers, in the area the agents served. The area’s stable population

made for a difficult market, though, and getting a new customer often meant taking

him away from his old agent. And the insurance business in the area was

“extremely personal”--running a successful agency depended largely on the

individual agent’s relationships with his customers.

      Despite the competitive market, Schmeets stood out among insurance agents

in the area. He had experience in all insurance lines and all facets of running an
                                        -4-

[*4] insurance agency, including accounting, management, and employee training.

He also had experience in a specialized area of insurance called bonding,1 and his

agency was the only agency in the area, aside from the bank’s, that did this kind of

work. There was convincing testimony that in the area around Harvey no one knew

insurance better than Schmeets, and even some of his competitors called him the

“King of Insurance.” We also find that when people came to Harvey Insurance to

buy insurance, they were buying it from Harold Schmeets, and that he had far more

name recognition as an individual than Harvey Insurance did as a firm. Under

Schmeets’s direction, Harvey Insurance did well enough to hire several employees--

though Schmeets was the only one who actively solicited insurance business--but it

paid Schmeets only about $29,000 per year.

      After its split from Schmeets, the bank’s new insurance business–called

National Insurance Agency, Inc.--grew slowly.2 It was a one-man agency and had

two different managers during the time it competed with Schmeets. The managers

didn’t have as much experience as Schmeets, didn’t know how to deal with some


      1
        Bonds--for example, bid, payment, and performance bonds to contractors--
are financial guaranties that the bond’s purchaser will meet his obligations.
      2
        We refer to the bank’s insurance “agency” or “business” throughout, but
note here that the insurance agency is the bank’s sister corporation and both are
owned by the same holding company.
                                          -5-

[*5] of the large insurance companies as well as Schmeets, and soon had difficulty

turning a profit and keeping customers.

      Despite being competitors, Schmeets and Gary Bergstrom, the bank’s

president since 1984, spoke frequently about the insurance business. (They had met

when Bergstrom started to work for the bank in 1972.) Schmeets even wrote an

occasional policy for National Insurance when the bank’s insurance agent was too

inexperienced or didn’t do business with a particular insurance company.

      As the ‘80s turned into the ‘90s, the insurance industry--especially the big

companies--began to demand volume from independent agents. This was a problem

in rural parts of the country, and Schmeets and Bergstrom often found their

conversations turning to the difficulty their respective agencies had in finding

enough customers to keep their contracts with large insurance companies. A major

reason for the difficulty was that each insurance company didn’t write all the types

of insurance policies that customers in a place like Harvey needed. This meant that

conscientious agents needed to contract with a large number of insurance

companies, but then ran into the demand from insurance companies that agents

maintain a certain volume of business. One large insurance company, St. Paul

Insurance, did cut off Schmeets’s agency because the company didn’t want to
                                          -6-

[*6] write and service policies off the main highways of North Dakota, where there

just wasn’t enough business.

II.   Sale of Harvey Insurance

      In January 1992 Bergstrom and Schmeets began to chat about whether to

merge the two agencies. Both thought that it would help them stay in business by

shoring up their shrinking customer base. The bank also thought a merger would

revive its own insurance business’s profitability. Schmeets agreed that the bank’s

daily foot traffic could be helpful in attracting clients. He also thought joining

agencies would help him--he had employees who wanted benefits, and his agency

was not in a position to provide them.

      These chats ripened into negotiations. Schmeets knew what he wanted for

the next six years, and the parties began their negotiations from there. Schmeets

was most concerned with guaranteed employment, and he wanted deferred

compensation payments to provide for his family and pay for his children’s college

educations. The parties were not focused on a particular number or the deal’s tax

consequences, but looked to see if a particular compensation package fit Schmeets’s

needs and then if it worked from National Insurance’s perspective. After going

back and forth several times, they eventually made a deal.
                                         -7-

[*7] The bank’s legal counsel prepared the two key documents: a purchase

agreement and an employment agreement.3 Under the purchase agreement, Harvey

Insurance agreed to sell “all files, customer lists, insurance agency or brokerage

contracts, the name of Harvey Insurance, and all the good will of Harvey Insurance”

to National Insurance for $20,000, payable in six equal annual installments plus

interest. This purchase agreement was contingent on the parties’ execution of an

employment agreement with Schmeets. And it contained a noncompete provision

which specified that Harvey Insurance and Schmeets would not compete with

National Insurance for 15 years and, if they did, National Insurance could terminate

any unpaid purchase price payments to Harvey Insurance and the employment

agreement with Schmeets.

      The employment agreement made Schmeets the manager of National

Insurance for a six-year term beginning in March 1992. Schmeets promised to

perform an extensive list of managerial duties, which included developing

insurance sales and products, hiring and training employees, and keeping the

agency’s books and records. National Insurance promised to pay him an “annual


      3
         Schmeets didn’t hire his own lawyer for the negotiations, and it was only
after the documents were ready for his signature that he asked H & M’s accountant,
Mark Larson, to take a look at them. He never sought advice from Larson,
however, on how to structure the deal.
                                        -8-

[*8] base wage” of $38,936, “annual variable compensation” equal to the greater of

$50,000 or 45% of “net adjusted income” for the year,4 and “deferred

compensation” of $74,000 at the end of the six-year term. 5 If Schmeets died,

National Insurance still had to pay Schmeets the “annual base wage” and “deferred

compensation” for services already performed. The total compensation under the

agreement was over $600,000 for Schmeets’s services during the six years. Both

parties thought the compensation package was fair, and they did not have anyone

appraise Schmeets’s insurance agency. The bank didn’t even look at the agency’s

financial records.

      In March 1993 National Insurance and Schmeets changed the timing of the

compensation payments that National Insurance had promised to pay Schmeets.

The revised agreement provided that part of Schmeets’s compensation would be

deferred and earn interest, and then be paid out over a seven-year period beginning

in March 1999. If Schmeets died before the complete payout of the deferred-


      4
       The “net adjusted income” was based on total accrued income, total accrued
expenses, accounts receivable, and premiums National Insurance paid on the key-
man insurance policy it took out on the life of Schmeets.
      5
        The employment agreement contained a noncompete provision similar to the
one in the purchase agreement, which said that National Insurance could terminate
the contract and stop making payments if Schmeets competed with National
Insurance during his employment or for 10 years after.
                                        -9-

[*9] compensation balance, National Insurance still had to make annual payments to

Schmeets’s estate. The total amount of deferred compensation under the agreement

ended up being more than $340,000, as reflected in a Form W-2 the agency issued

Schmeets in 1998.

      Both parties kept their word. The bank’s insurance agency dropped its name

in favor of Harvey Insurance Agency, Inc. because Harvey Insurance had been

around longer and had more name recognition because of its association with

Schmeets. Schmeets served as its manager for the entire six-year term of the

employment agreement, and the bank reported his compensation as wages subject to

withholding and Federal Insurance Contributions Act (FICA) tax. Schmeets rewrote

existing insurance policies, took new applications, supervised and trained the

agency’s four employees, attended bank planning sessions, negotiated commissions

with insurance companies, and did the agency’s bookkeeping. The transition

multiplied his responsibilities, and Schmeets went from a 40-hour work week before

the sale to almost double that after.

      At the end of the six-year term, the bank was pleased with Schmeets’s

performance and asked him to continue to manage the agency under year-to-year

contracts. Schmeets agreed and kept working several days a week for about

$30,000 per year to help train his replacement. The replacement was an insurance
                                        - 10 -

[*10] salesman that didn’t have as much experience as Schmeets–he didn’t do

bonding work, and he had never been a manager. Despite this lack of experience,

the bank paid the new man an annual salary of between $55,000 and $65,000.

Having managed this last transition, Schmeets then retired.

III.   H & M and the Note Payable

       Instead of liquidating the old Harvey Insurance Agency after its name and

assets passed to the bank, the corporation’s board of directors--which consisted of

Schmeets, his wife Mona, and their son Stuart--decided to keep the corporate entity

alive. The corporation reissued its stock under the new name of H & M, Inc.

Schmeets remained the sole shareholder and president, and Mona continued to serve

as its secretary/treasurer. The board of directors stayed the same.

       In the months leading up to the sale this board agreed that Schmeets had been

undercompensated for his services to the insurance agency in past years, though it

never specified which years and what amounts. It recognized that the deal with

National Insurance could free up some money to pay him, but postponed a decision

on giving any of that extra cash to Schmeets.
                                         - 11 -

[*11] At the end of March 1992 H & M issued Schmeets a promissory note, which

Schmeets signed as H & M’s president.6 Under the note H & M promised to pay

Schmeets $120,000 plus interest at the rate of 10%. The note didn’t include any

payment terms or a maturity date, and it was unsecured.7 H & M treated the

$120,000 obligation as accrued officer compensation on its 1992 income tax return,

but didn’t actually deduct it that year. That same return’s balance sheet reflects that

H & M had around $272,000 in retained earnings and $157,000 in cash at the end of

1992 and that it didn’t make any distributions to Schmeets during the year.

      H & M never paid anything--either interest or principal--on the note until

1999, and even after that, its payments were sporadic:




      6
        H & M’s minutes don’t reflect the board’s decision to issue the note, but
minutes from a meeting held near the end of March 1992 reflect Schmeets’s
statement that “it will help to have at least the interest (on the old money) coming, it
should be about $12,000.00 per year until we start a new business with the H&M
corp.”
      7
         The note was on a preprinted form with a number of blanks. Schmeets filled
in the amount and interest rate, but left blank the maturity date, interest accrual date,
interest payment terms, whether the note was secured or unsecured, and the purpose
of the credit.
                                         - 12 -

[*12]
                 Year            Interest             Principal
                 1999            $16,307                 -0-
                 2000              8,000                 -0-
                 2001              -0-                   -0-
                 2002             10,134                 -0-
                 2003             10,000                 -0-
                 2004             10,000                 -0-
                 2005             10,000                 -0-
                 2006              -0-                   -0-
                 2007              -0-                   -0-
                 2008              -0-                   -0-
                 2009            130,123              $120,000
                   Total         194,564               120,000

H & M deducted the amounts it paid as interest in tax years 2002, 2003, 2004, and

2005. The balance sheets of H & M’s tax returns for those years list the $120,000

salary payable as a liability. They also indicate that H & M had more than

$190,000 in cash and $240,000 in retained earnings at the beginning and end of

each of those years and that H & M didn’t make any distributions to Schmeets.

IV.     Use of H & M To Exploit Patents

        Once Schmeets got out of the insurance business, he began to work on

developing two inventions which he had created sometime before 1996--a boat
                                         - 13 -

[*13] step and a collapsible shelf bracket. With the help of a lawyer from

Fargo, North Dakota, Schmeets obtained patents for the inventions in 1998.

       The boat step is a step that can be quickly attached to the frame or tongue of

a boat trailer. Schmeets designed it to give boat users a better place to stand than on

the frame of the boat trailer itself while winching the boat onto a trailer. Schmeets

kept a “boat step history” log, which he used to document his work on the

invention.

       His collapsible shelf bracket is an iron bracket that he designed to bolt to a

wall. It can hold a shelf and a tabletop and has two pieces that, when removed,

collapse the bracket against the wall and out of the user’s way. And when the

bracket is not supporting a shelf or a tabletop, its user can hang various objects

(such as a garden hose) on the bracket and adjust the bracket upward so nothing

slips off.

       Beginning in 1993 Schmeets used H & M to exploit his patents and work on

perfecting their designs. He built prototypes, took his designs to various

manufacturers for cost estimates, and experimented with different materials to

discover the most cost-effective way to produce them. Schmeets testified that he

used a pickup truck H & M owned to take the boat step and the shelf bracket to the

manufacturers and to attend boat shows to learn about new trailer designs. He also
                                         - 14 -

[*14] said he used the pickup to pull his boat to a marina one time and demonstrate

his boat step to the general public. Because H & M had people testing the boat-step

invention, it obtained product-liability insurance.

      Neither patent proved very lucrative. Sometime around 2004 Schmeets saw

a shelf bracket similar to his own in a book with hardware supplies for sale. He

called the company that manufactured the shelf to say it was infringing on his patent,

but the company’s representative looked up Schmeets’s patents and told him they

had expired. It turned out that Schmeets had failed to pay the required maintenance

fees. Schmeets memorialized the event in the boat-step history log: His one and

only entry for 2004 reads: “A pause in activity due to researching patents as we

have been informed that both patents have expired and we cannot locate the original

patent attorney.” His next entry after that wasn’t until February 2006.

V.    Audit

      The Commissioner audited H & M’s returns for tax years 2001 through 2005.

The audit dragged on, and the Commissioner sent a notice of deficiency in 2009 that

determined about $70,000 in total deficiencies and penalties.

      The notice of deficiency raised many issues, but the biggest-dollar one was

whether H & M had received long-term capital gain and interest income in each of
                                         - 15 -

[*15] the tax years at issue from the sale of Harvey Insurance back in 1992. The

Commissioner’s theory was that Schmeets’s wages under the employment and

salary-deferment agreements were actually payments to H & M for the sale of the

insurance business. He also disallowed H & M’s deduction for interest that it paid

to Schmeets in tax years 2002 through 2005 on the promissory note. And, finally,

he disallowed a number of other deductions, including a 2001 net operating loss and

the expenses that H & M claimed that it had incurred in 2004 and 2005 to develop

Schmeets’s patents.

      H & M is a North Dakota corporation whose principal office was located in

Harvey when it filed its petition.

                                      OPINION

I.    Employment Agreement Payments

      The big issue in this case is whether the money Schmeets got under the

employment and salary-deferment agreements was really part of the purchase price

the bank paid to H & M for the sale of Harvey Insurance back in 1992.8 During


      8
        We don’t need to decide whether the burden of proof shifts to the
Commissioner under section 7491(a). (Unless we say otherwise, all section
references are to the Internal Revenue Code in effect for the years at issue, and Rule
references are to the Tax Court Rules of Practice and Procedure.) Although the
Eighth Circuit held in Griffin v. Commissioner, 315 F.3d 1017, 1022 (8th Cir.
2003), vacating and remanding T.C. Memo. 2002-6, that we can’t simply conclude
                                                                          (continued...)
                                         - 16 -

[*16] the years at issue, Schmeets received money from the bank’s agency under

their agreements. The Commissioner determined that all of the amounts paid to

Schmeets in those years were really principal and interest payments to H & M for

the sale of its insurance business. This recharacterization resulted in capital gain

and interest income to H & M for each of the years at issue:

                     Year         Capital gain      Interest income
                     2001           $39,065             $18,560
                     2002            45,650               11,975
                     2003            43,894               13,731
                     2004            46,511               11,113
                     2005            49,277                8,348




      8
        (...continued)
the outcome is the same no matter which party bears the burden of proof, and this
case is appealable (absent a stipulation to the contrary) to that circuit, see Golsen v.
Commissioner, 54 T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971), it
later explained that the burden of proof is relevant only in the event there is an
evidentiary tie, see Blodgett v. Commissioner, 394 F.3d 1030, 1039 (8th Cir. 2005),
aff’g T.C. Memo. 2003-212. Both parties satisfied their burden of production by
offering some evidence, so we decide this case on the weight of the evidence and
instead of on an allocation of the burden of proof. See id.; see also Knudsen v.
Commissioner, 131 T.C. 185, 189 (2008).
                                        - 17 -

[*17] The Commissioner urges us to apply the substance-over-form doctrine9 to find

that the parties undervalued the assets of Harvey Insurance in the 1992 sale. He

says the parties did the deal the way they did for the tax benefits: The bank wanted

to deduct the compensation it paid to Schmeets, and Schmeets wanted to avoid

being taxed twice on the proceeds of the sale--once at the corporate level when H &

M received the purchase-price payments, and then again when he received

dividends from H & M.

      According to the Commissioner, a substance-over-form analysis shows that

the value of the assets that National Insurance bought should include not only the

$20,000 purchase price paid to H & M, but also the $38,936 “annual base wage”

and $74,000 “deferred compensation” under the employment agreement paid to

Schmeets.10 This would leave only the annual variable compensation (the greater

of $50,000 or 45% of “net adjusted income” for the year) as payment for

Schmeets’s services. This allocation, the Commissioner says, more accurately

reflects the fair market value of Schmeets’s services to the bank’s agency, as well



      9
        The doctrine tells us to ignore the form of a transaction in cases where the
objective economic realities are to the contrary. See Frank Lyon Co. v. United
States, 435 U.S. 561, 573 (1978).
      10
       The Commissioner says recharacterizing the annual base wage and deferred
compensation payments would result in a total purchase price of $327,616.
                                         - 18 -

[*18] as Harvey Insurance’s value at the time of the sale, because only this

allocation would account for goodwill and the corporation’s other intangible assets.

The Commissioner points to several factors that he argues show that the form of the

transaction doesn’t match its substance:

      •      Schmeets’s estate would still receive the entire annual base wage and
             deferred compensation if he died;

      •      the parties lacked documentation supporting the allocation;

      •      the parties did not have adverse interests in the transaction because
             there were tax advantages to allocating more of the overall price to
             compensation; and

      •      the fair market value of Schmeets’s services to the bank’s agency was
             much less than the amount he was being paid.

      H & M counters that recharacterizing all of the compensation payments as

purchase-price payments is inappropriate because the parties’ allocation does

reflect the economic realities of the transaction. It takes issue with the

Commissioner’s allocation of all of the insurance business’s goodwill to a

corporation few people knew about and argues that any goodwill of the business

was attributable to Schmeets personally. It also says that Schmeets’s

compensation under the agreement was reasonable because the bank needed

Schmeets to keep the insurance business going, and Schmeets had significant

responsibilities as the manager of the bank’s agency after the sale. And it points
                                        - 19 -

[*19] out that instead of focusing on the tax consequences of the transaction, both

parties wanted to create an employment relationship and both consistently treated

the deal as if they had.11

       We begin with the parties’ arguments about goodwill. Goodwill is often

defined as the expectation of continued patronage by existing customers. Newark

Morning Ledger Co. v. United States, 507 U.S. 546, 572-73 (1993). It is an asset

that can be sold with a professional practice. LaRue v. Commissioner, 37 T.C. 39,

44 (1961). And a professional practice’s goodwill can attach to both the

professional and the business. See, e.g., Schilbach v. Commissioner, T.C. Memo.

1991-556. Because there is no specific rule for determining the value of goodwill,

we must consider and decide each case in light of its own particular facts.

MacDonald v. Commissioner, 3 T.C. 720, 726 (1944). There will be no salable

goodwill, however, where the business of a corporation depends on the personal

relationships of a key individual, see Martin Ice Cream Co. v. Commissioner, 110

T.C. 189, 207-08 (1998), unless he transfers his goodwill to the corporation by

entering into a covenant not to compete or other agreement so that his



       11
        H & M also argues that the IRS employee responsible for its audit was
biased. What goes on during audits, however, is generally irrelevant because of the
de novo record on which we decide deficiency cases. Greenberg’s Express, Inc. v.
Commissioner, 62 T.C. 324, 327-28 (1974).
                                           - 20 -

[*20] relationships become property of the corporation, see Norwalk v.

Commissioner, T.C. Memo. 1998-279, 1998 WL 430084, at *7.

      In MacDonald, the taxpayers--who were husband and wife--were the

shareholders of a corporation primarily engaged in the insurance-brokerage

business. MacDonald, 3 T.C. at 721. The husband was experienced in the

insurance business, and the development of the corporation’s insurance-brokerage

business was due to his personal ability and relationships with customers. Id. at

723. The MacDonalds liquidated their corporation and distributed all its assets--

including goodwill--to the husband. Id. at 721-22. The husband then set up a new

insurance agency under the same name. Id. The Commissioner argued that

valuable goodwill passed from the corporation to the taxpayers when they liquidated

the corporation, and that therefore they had unreported taxable income. Id. at 725-

26. We held, however, that no goodwill passed to the taxpayers since the husband

“was the Company” and any goodwill of the business “was due to the personal

ability, business acquaintanceship, and other individualistic qualities of [the

husband].” Id. at 727. We also found that the corporation didn’t have any value

beyond its tangible assets, since the husband’s personal ability wasn’t a corporate

asset and there wasn’t a contract or other agreement between the husband and the

corporation for his future services. Id.
                                        - 21 -

[*21] Time hasn’t seen much change in this part of the law. Martin Ice Cream Co.

is a much more recent case, but we held there that a corporation could not be taxed

on payments made to its controlling shareholder for his customer relationships, 110

T.C. at 209. The ice-cream company in that case distributed its products (including

Häagen-Dazs) to both supermarkets and small stores. Id. at 192-93. Its controlling

shareholder personally developed the valuable relationships with the supermarkets,

and the corporation spun off its supermarket-distribution rights to a subsidiary

wholly owned by that controlling shareholder, who then transferred them to Häagen-

Dazs along with the subsidiary’s business records, customer records, and associated

goodwill. Id. at 195-203. The shareholder himself signed a consulting and

noncompete agreement with Häagen-Dazs. Id. at 203-04. The Commissioner

argued that the ice-cream company should be taxed on the gain from the sale of the

sub, but we held that the customer relationships and distribution rights were the

shareholder’s personal assets and, since he never had a covenant not to compete or

other agreement with the ice-cream company, the company couldn’t be taxed on

Häagen-Dazs’s payments for them. Id. at 206-09.

      This case is like MacDonald and Martin Ice Cream Co. The insurance

business in Harvey is “extremely personal,” and the development of Harvey

Insurance’s business before the sale was due to Schmeets’s ability to form
                                         - 22 -

[*22] relationships with customers and keep big insurance companies interested in a

small insurance market. He grew relationships with large insurance companies that

other brokers in the area didn’t.12 And we specifically find that when customers

came to his agency, they came to buy from him--it was his name and his reputation

that brought them there. We also find he had no agreement with H & M at the time

of its sale that prevented him from taking his relationships, reputation, and skill

elsewhere, which was precisely what he did when he began working for the bank’s

renamed insurance agency.

      Beyond the business’s goodwill, the Commissioner doesn’t specify what

other purchased intangible assets, other than the name Harvey Insurance, he thinks

were not accounted for in the purchase price. We have already found that the

name Harold Schmeets had by far more name recognition in the community than

Harvey Insurance. And the Commissioner hasn’t given us any persuasive

evidence that the name of the corporation had much value other than its

connection with Harold Schmeets himself. See Norwalk, 1998 WL 430084, at *7.

The mere fact that National Insurance changed its name to Harvey Insurance

after the sale doesn’t account for the more than $300,000 in value that the


      12
        As we note above, Schmeets even used his relationships with the large
insurance companies to write an occasional policy for National Insurance while they
were competitors.
                                        - 23 -

[*23] Commissioner wants to attribute to the corporation or show that the

corporation had goodwill apart from its connection with Schmeets. See

MacDonald, 3 T.C. at 720-21, 730.

      In light of Schmeets’s personal relationships, his experience in running all

facets of an insurance agency, and his responsibilities as manager of the bank’s

agency, we find that the compensation that the bank paid him was reasonable. The

employment agreement contained an extensive list of duties Schmeets was required

to perform as the agency’s manager, and Schmeets went from working around 40

hours per week before the sale to double that afterward. His replacement was paid

roughly $55,000 to $65,000 per year, though he was by comparison a mere Baron or

Earl of Insurance in Harvey. And even after Schmeets’s six-year employment term

was up, the bank still paid him around $30,000 per year for part-time work to train

his replacement.13

      The Commissioner’s expert’s report, which estimated the fair market value of

Schmeets’s services to be $22,700 in 1994 and 1995; and $38,300 in 1996, 1997,

and 1998, is entirely unbelievable. It ignored that Schmeets was more than an

insurance salesman and that he had significant management and bookkeeping



      13
        We also point out that the Commissioner said at trial he wasn’t contesting
that Schmeets had been undercompensated for his services in years before the sale.
                                        - 24 -

[*24] responsibilities as manager of the bank’s insurance agency.14 It also didn’t

account for his level of experience in the insurance industry and failed to explain

why the fair market value of Schmeets’s services was only $22,700 to $38,300

despite the fact that Schmeets’s replacement, who was less experienced than

Schmeets, was paid $55,000 to $65,000 per year. We give the report no weight.

      Even though we disagree with the Commissioner that the amounts the

bank’s agency paid Schmeets under their agreements were disguised purchase-

price payments, we agree that the payments don’t simply represent the fair market

value of his services. Not only did Schmeets bring his personal goodwill to the

bank’s agency, but he also signed agreements with National Insurance that

contained noncompete provisions. His employment agreement specifically said that

“[a]s part of the consideration for this employment agreement * * * Schmeets agrees

during the period of this employment contract, and for a period of ten years

thereafter, not to compete with National Insurance.” Though we think it’s clear

some part of his compensation wasn’t for his services, it’s not necessary for us to




      14
        The Commissioner’s expert placed Schmeets in the category “Sales Agents
and Placers, Insurance,” which the 1998 Bureau of Labor Statistics Occupational
Employment Statistics publication defined as “[s]ell life, endowments, fire, accident,
and other types of insurance. May refer clients to independent brokers, work as
independent broker, or be employed by an insurance company.”
                                         - 25 -

[*25] determine the exact allocation between what he was paid for his services to

the agency, his personal goodwill, and his promise not to compete, since Schmeets’s

individual tax liability is not before us. Cf. Kennedy v. Commissioner, T.C. Memo.

2010-206, 2010 WL 3703347, at *10 (whether payments to individual taxpayer

arising from the sale of his business were proceeds from the sale of a capital asset or

ordinary income required determination of whether they were for his services to the

buyer after the sale, his personal goodwill, or his promise not to compete with the

buyer).

      We are satisfied that Schmeets and National Insurance were genuinely

interested in creating an employment relationship and were not just massaging the

paperwork for its tax consequences. Both insurance agencies feared going out of

business, and both knew that there would be advantages to Schmeets’s moving

over to the bank. The bank’s agency needed a more experienced manager who

had good relationships with the big insurance companies. Schmeets wanted

guaranteed employment and saw the potential to cross-sell to the bank’s

customers. There was virtually no discussion about the tax consequences of the

transaction,15 and the parties treated the transaction as an asset sale and


      15
        The only tax discussions during the negotiations appeared to be about how
the bank’s agency would have to pay income tax withholding, FICA tax, etc. on
                                                                      (continued...)
                                         - 26 -

[*26] employment relationship. Though we agree with the Commissioner that it

would’ve been a lot easier if the parties had provided more documentation

supporting their allocation, this doesn’t mean their allocation was without substance.

As the Supreme Court itself has held,

      where * * * there is a genuine multiple-party transaction with economic
      substance which is compelled or encouraged by business or regulatory
      realities, is imbued with tax-independent considerations, and is not shaped
      solely by tax-avoidance features that have meaningless labels attached, the
      Government should honor the allocation of rights and duties effectuated by
      the parties. * * *

Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978).

      We therefore find that payments to Schmeets were not disguised purchase-

price payments to H & M.

II.   Deductibility of Note Payments

      The next issue is whether H & M can deduct as interest what it paid on the

promissory note it gave to Schmeets in 1992. In the note--which didn’t include any

payment terms or a maturity date--H & M promised to pay Schmeets $120,000 plus

interest at the rate of 10%. Though it didn’t make any principal payments on the

note until 2009, H & M did pay and deduct as interest on the note the following

amounts during the tax years at issue:


      15
      (...continued)
Schmeets’s wages.
                                           - 27 -

[*27]
                                    Year        Amount
                                   2002        $10,134
                                   2003         10,000
                                   2004         10,000
                                   2005         10,000

H & M argues that it should be able to deduct the amounts it paid to Schmeets as

interest because the note represented a valid business debt. It says the corporation’s

board agreed that Schmeets had not been adequately compensated for his services to

Harvey Insurance before the sale and that it decided to issue him the note and make

payments--but only to the extent possible after meeting the cash needs that the

corporation would have in exploiting the patents.

        The Commissioner says the note was more like equity than a debt. He points

to H & M’s sporadic payments, the identity of interests between

H & M and Schmeets, and the fact that the note had no maturity date. If he’s right,

the amounts H & M paid to Schmeets in tax years 2002 through 2005 aren’t

deductible as interest.

        Section 163 allows a deduction for “all interest paid or accrued within the

taxable year on indebtedness.” Sec. 163(a). To be deductible, however, the interest

must be on a genuine debt owed by the taxpayer. Knetsch v. United
                                        - 28 -

[*28] States, 364 U.S. 361, 365 (1960); Midkiff v. Commissioner, 96 T.C. 724, 735

(1991), aff’d sub nom. Noguchi v. Commissioner, 922 F.2d 226 (9th Cir. 1993).

The essence of bona fide indebtedness is that it is “an existing, unconditional, and

legally enforceable obligation for the payment of a principal sum.” Howlett v.

Commissioner, 56 T.C. 951, 960 (1971).

      Whether a payment represents debt or equity is a question of fact, Delta

Plastics, Inc. v. Commissioner, T.C. Memo. 2003-54, 2003 WL 648856, at *3, and

we look for both objective and subjective evidence of the parties’ intent, see United

States v. Uneco (In re Uneco, Inc.), 532 F.2d 1204, 1209 (8th Cir. 1976). The

Eighth Circuit lists a number of factors to solve debt-versus-equity problems:

      •      whether the corporation is so grossly undercapitalized that the loans
             are in fact needed for capital purposes and are actually intended to be
             risked capital rather than a loan;

      •      whether the purported loans were made in proportion to equity
             holdings;

      •      whether the repayment of the loan was predicated on the success of the
             venture;

      •      whether there was a fixed date for payment of the note and a
             reasonable expectation of payment by that date;

      •      whether the note was subordinated to other corporate debts;

      •      whether third parties would have made the loan under the same
             conditions;
                                        - 29 -

      [*29] •       whether the claimed loan was secured by a mortgage or
                    otherwise;

      •      whether a provision was made for a sinking fund to retire the loan;

      •      whether the person making the purported loan participated in the
             management of the corporation; and

      •      whether the corporation had a large proportion of debt to equity.

J. S. Biritz Constr. Co. v. Commissioner, 387 F.2d 451, 457 (8th Cir. 1967), rev’g

T.C. Memo. 1966-227; see also Uneco, 532 F.2d at 1208.

      The factors are not equally significant, and no one factor is determinative.

Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493 (1980). And because debt-

equity questions can arise in so many different circumstances, not all the factors are

relevant to every case. J. S. Biritz Constr. Co., 387 F.2d at 456-57. This is

especially true when the case involves a sole shareholder making a loan advance to

his corporation. Id. at 457-58. Our overall analysis seeks to determine “whether

there was an intent to create a debt with a reasonable expectation of repayment and,

if so, whether that intent comports with the economic reality of creating a debtor-

creditor relationship.” Delta Plastics, 2003 WL 648856, at *3 (citing Litton Bus.

Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973)).

      We agree with the Commissioner that the relevant factors in this case make it

more likely than not that the note didn’t represent a bona fide debt. The note here
                                         - 30 -

[*30] had no maturity date--that blank was not filled in. And H & M issued the note

in 1992, but didn’t make a single principal payment until it paid off the note in 2009.

The absence of a fixed maturity date indicates “that repayment was in some way tied

to the fortunes of the business, indicative of an equity advance.” Estate of Mixon v.

United States, 464 F.2d 394, 404 (5th Cir. 1972); see also Am. Offshore, Inc. v.

Commissioner, 97 T.C. 579, 602 (1991). The Commissioner wins this point.

       It is unlikely that a third party would lend money to H & M with terms that

included no maturity date, no principal payments for 17 years, and only sporadic

payments of interest in varying amounts. When a corporation gets a loan that it could

not acquire on similar terms from an outside lender, that “loan” looks more like

equity than debt. Segel v. Commissioner, 89 T.C. 816, 828-29 (1987). This factor

supports the Commissioner.

      The note was also unsecured--the parties left blank that portion of the note

form. A lack of security for repayment of a purported debt is some support for

calling it equity, but security isn’t as important when related parties are involved.

See Litton Bus. Sys., Inc., 61 T.C. at 381; Am. Underwriters, Inc. v. Commissioner,

T.C. Memo. 1996-548, 1996 WL 726365, at *8. And few parties are as closely

related as a 100% owner and his corporation. This “adequately substitutes for an

independent security interest” or at least minimizes its importance. Litton
                                         - 31 -

[*31] Bus. Sys., Inc., 61 T.C. at 381; see also J. S. Biritz Constr. Co., 387 F.2d at

459. We give this factor no weight.

      Even though H & M had enough cash and retained earnings to pay off the

note in full in 1992 and the years at issue, H & M didn’t make any principal

payments on the note until 2009. And H & M paid off the note in full in 2009 only

after the Commissioner questioned the transaction. See O. H. Kruse Grain &

Milling v. Commissioner, 279 F.2d 123, 126 (9th Cir. 1960), aff’g T.C. Memo.

1959-110. Schmeets testified that he couldn’t recall why H & M didn’t pay interest

in some years and that the amounts H & M did sometimes pay as interest beginning

in 1999 were based on what he and his wife thought the corporation should pay and

not on what was actually due under the note. Schmeets--both the noteholder and

100% shareholder--was also H & M’s president and had check-signing authority.

This gave him the ability to pay the note, but he never did until the Commissioner

started H & M’s audit. We have to find that Schmeets didn’t intend to enforce

payment of his note and wouldn’t have asserted his rights as a creditor to do so.

Evidence that a creditor didn’t intend to enforce payment of the note or was

indifferent as to when the note was to be repaid shows there wasn’t a valid loan.

See, e.g., Gooding Amusement Co. v. Commissioner, 23 T.C. 408, 419 (1954),

aff’d, 236 F.2d 159 (6th Cir. 1956); Todd v. Commissioner, T.C. Memo. 2011-123,
                                        - 32 -

[*32] 2011 WL 2183767, at *5, aff’d, 2012 WL 3530259 (5th Cir. Aug. 16, 2012).

This factor definitely favors the Commissioner.

      We think that H & M’s purported business purpose for compensating

Schmeets with a promissory note rather than just paying him in 1992 is also

questionable. Schmeets testified that although H & M had the funds available to pay

off the note in full in 1992, it didn’t want to make a lump-sum payment because it

was going to use some of the funds to develop his inventions. But there isn’t any

evidence to back this up--the record doesn’t reflect that Schmeets had even invented

the boat step or the collapsible shelf bracket by 1992, and the corporation’s board

minutes from that year make no mention of the inventions. And even if the

inventions existed in 1992 and H & M paid Schmeets sporadically because it needed

the funds to develop the inventions, this would show that the note’s repayment was

tied to the success of H & M’s business--more proof that the note was equity. See

Provost v. Commissioner, T.C. Memo. 2000-177, 2000 WL 687889, at *5, *8.

      Even though H & M consistently treated the note as a liability on its tax

returns and deducted the amounts it paid to Schmeets as interest, our review of the

relevant factors shows that neither H & M nor Schmeets intended to create a bona

fide debt. The history of sporadic payments on the note and the fact that H & M
                                         - 33 -

[*33] didn’t pay any dividends in the years at issue reflect that Schmeets used the

note as a way to get money out of the corporation whenever he and his wife felt like

it. We therefore find that H & M payments on the note were not deductible

interest.16

III.   Net Operating Loss

       On its 2001 tax return H & M claimed a net operating loss deduction of

$18,661. Section 172 generally allows taxpayers to deduct net operating loss

carrybacks and carryovers. H & M concedes in its posttrial brief that its net

operating loss deduction for 2001 depended entirely on whether the note issued to

Schmeets represented a valid debt--it says the disallowance of the interest deductions

eliminates the net operating loss entirely. Our finding that the note didn’t represent

bona fide indebtedness means that we have to entirely disallow H & M’s 2001 net

operating loss deduction.




       16
         H & M also asks us to determine when Schmeets constructively received
the note because he disagrees with the Commissioner’s decision to assess
employment taxes on a theory that Schmeets constructively received the note in
1992. We do not have jurisdiction to review the Commissioner’s assessment of
employment taxes in a deficiency case. See sec. 7442; Judd v. Commissioner, 74
T.C. 651, 653 (1980); Griffin v. Commissioner, T.C. Memo. 1995-246, 1995 WL
338552, at *2.
                                              - 34 -

[*34] IV.       Other Deductions

        Section 162(a) allows taxpayers to deduct “all the ordinary and necessary

expenses paid or incurred during the taxable year in carrying on any trade or

business.” Sec. 162(a). But taxpayers must substantiate their deductions by

maintaining adequate supporting records. See sec. 1.6001-1(a), Income Tax Regs.

The mere fact that taxpayers report deductions on their returns isn’t alone enough to

substantiate them. See, e.g., Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979).

And section 274(d) adds even stricter substantiation requirements for some

categories of deduction. See sec. 274(d); sec. 1.274-5T(a), Temporary Income Tax

Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985); Sanford v. Commissioner, 50 T.C. 823,

827-28 (1968), aff’d, 412 F.2d 201 (2d Cir. 1969).

        We’ll look at those first.

        A.      Section 274 Expenses

                                                           Vehicle
              Depreciation           Travel               insurance     License fees
              Per     Per       Per       Per           Per      Per    Per     Per
 Year        return   IRS      return     IRS          return    IRS   return   IRS
 2004       $1,775    $501     $1,322     $179         $517      $65    $80     $10
 2005        1,775     501      2,146     268           517       65    1171      10

        1
        The notice of deficiency mistakenly says that H & M deducted $80 for
license fees in 2005 and includes $37 as part of the amount deducted for “dues”.
Based on the documentation H & M provided at trial, we find $117 was the
                                         - 35 -

[*35] appropriate amount and have adjusted accordingly the amount
      deducted for “dues” in the table below.

Section 274 subjects all travel expenses, including vehicle expenses, to more detailed

substantiation requirements. See secs. 274(d), 280F(d)(4)(A). To satisfy section

274, a taxpayer must substantiate--by adequate records or other corroborating

evidence--the amount, time, place, and business purpose of the expense. Sec.

274(d). A combination of records and documentary evidence will satisfy the

adequate records requirement if it sufficiently establishes each element of the

claimed expense. Sec. 1.274-5T(c)(1) and (2), Temporary Income Tax Regs., 50

Fed. Reg. 46016-46017 (Nov. 6, 1985).

      While a contemporaneous log isn’t necessary to satisfy the adequate records

requirement, a taxpayer must provide evidence to corroborate his reconstruction of

each of the elements. Id. Without adequate records, a taxpayer may establish an

element by his “own statement, whether written or oral, containing specific

information in detail as to such element,” and by “other corroborative evidence

sufficient to establish such element.” Sec. 1.274-5T(c)(3), Temporary Income Tax

Regs., 50 Fed. Reg. 46020 (Nov. 6, 1985).

             1.     Travel Expenses

       H & M offered a reconstructed auto log for 2004 and a collection of

handwritten notes, receipts, and credit-card statements to substantiate its travel
                                          - 36 -

[*36] expenses for 2004 and 2005. Schmeets put together the 2004 log with the help

of H & M’s accountant using at least in part his noncontemporaneous oral statements

about trips he took and the purposes of those trips. But the log contained a number

of inaccuracies--for example, it listed at least four trips in 2004 to a business called

T.J. Manufacturing, a firm that was out of business by then--and doesn’t appear to be

based on any contemporaneous records.

      And while receipts can be sufficient evidence by providing the amount,

name, location, and date of a travel expense,17 H & M’s collection of oil-change and

gas-station receipts fails to show a business purpose. See, e.g., Irwin v.

Commissioner, T.C. Memo. 1996-490, 1996 WL 626334, at *6, aff’d without

published opinion, 131 F.3d 146 (9th Cir. 1997). H & M’s only proof of that

essential datum was Schmeets’s vague testimony about how he used H & M’s

pickup truck to drive to manufacturers and one time to pull a boat to a marina to

demonstrate the boat step. But H & M failed to show that these events occurred in



      17
          Documents like receipts are generally sufficient proof of an expenditure as
long as there is enough information to identify the amount, date, place, and character
of the transaction. See sec. 1.274-5(c)(2)(iii), Income Tax Regs. For example, a
restaurant receipt is sufficient evidence of a business meal if it identifies the name
and location of the restaurant, the date and amount of the meal, and the number of
people served. Id. Receipts often fail as proof because they don’t show any
particular business purpose. Id.
                                         - 37 -

[*37] 2004 and 2005,18 and Schmeets’s mere recollection isn’t enough to

substantiate H & M’s claim. Even though the Commissioner could’ve disallowed

these expenses entirely, he allowed $179 for 2004 and $268 for 2005, so we will

limit H & M’s travel expenses to these amounts.

             2.     Depreciation

      H & M also claimed depreciation deductions in 2004 and 2005 for its pickup

truck, though it didn’t specify on its returns the actual “[b]usiness/investment use

percentage” for those years.19 Section 167 allows taxpayers to deduct a reasonable

allowance for the exhaustion and wear and tear of property used in a trade or

business. Sec. 167(a); see also sec.1.167(a)-1(a), Income Tax Regs. The purpose

is to allow taxpayers to recover the cost of their investments as they are used.

United States v. Ludey, 274 U.S. 295, 300-01 (1927). But section 274 limits

depreciation of listed property, which includes “any passenger automobile” and

“any other property used as a means of transportation.” See secs. 274(d),

280F(d)(4)(A)(i) and (ii). Since H & M has failed to adequately substantiate the

      18
       While H & M offered invoices and other documents related to the
manufacture of the boat step in earlier years, it didn’t offer any for 2004 or 2005;
and Schmeets’s boat-step log even noted a “pause in activity” in those years.
      19
        Its 2004 log did say it used the truck over 57% of the time for business, but
we have found that log unreliable. And it didn’t offer any evidence to show a
percentage of use for 2005.
                                          - 38 -

[*38] business purpose for its use of the pickup truck, we sustain the

Commissioner’s determination disallowing most of H & M’s depreciation

deductions.

              3.      Vehicle Insurance

       To substantiate its vehicle-insurance deductions, H & M provided copies of

two insurance-premium invoices from 2004 in the amounts of $247 and $270 and

two invoices from 2005 in the amounts of $280 and $273.50 from Nodak Mutual

Insurance Company and addressed to H & M. But only one of the invoices states

that it is for vehicle insurance, and the policy number listed on that invoice doesn’t

match the others. It also appears, based on these invoices, that H & M deducted the

full amounts of the premiums on its 2004 and 2005 returns, even though its 2004 log

showed personal use of its vehicles. Because H & M’s other documents don’t

adequately substantiate business purpose either, we agree with the Commissioner on

this issue as well.

              4.      License Fees

       H & M produced two checks made out to the North Dakota Department of

Transportation--a 2004 check for $80 and a 2005 check for $117--to show it paid the

vehicle-license fees at issue. While the checks make clear that H & M spent
                                          - 39 -

[*39] these amounts, H & M has not specified the fees’ business purpose as section

274 requires, so we find for the Commissioner on this issue.

      B.       Other Expenses

             Expense                     Tax year 2004             Tax year 2005
                                    Per return       Per IRS   Per return   Per IRS
               Legal                  $750            $525       $690        $690
  Insurance--product liability         486             -0-        486            401
          Insurance--other           1,714             -0-       2,102        -0-
    Magazine subscription                39            -0-          39        -0-
          Office supplies              201             -0-          96        -0-
           Miscellaneous               391             -0-        -0-         -0-
               Fees                      30            -0-        526         -0-
               Dues                     -0-            -0-        290         -0-

      1
         The notice of deficiency mistakenly says H & M deducted $446 for product-
liability insurance in 2005, so it disallowed only that amount.

               1.      Legal and Professional Fees

      The Commissioner disallowed a portion--$225 for tax year 2004--of the legal

and professional fees H & M deducted on its returns as being attributable to a

nondeductible personal expense. H & M admitted at trial that the disallowed

portion of these expenses was to prepare Schmeets’s Social Security application
                                        - 40 -

[*40] form. This was obviously a personal expense. H & M can deduct only the

amounts the Commissioner already allowed for legal expenses.

             2.    Product-Liability Insurance

      On its 2004 and 2005 tax returns H & M deducted the premium payments it

made on a business-liability insurance policy. To support its deduction, H & M

provided copies of the policy and copies of payment notices for $486 each addressed

to H & M for 2004 and 2005. Schmeets also credibly testified at trial that H & M

had obtained the policy because it had several individuals testing the boat step during

those years and, as someone experienced in the insurance industry, he didn’t want to

distribute a product to the general public without insurance. Considering the

documentation H & M provided and Schmeets’s testimony, we find the premium

payments were an expense incurred in H & M’s business of developing the two

inventions, and it is entitled to deduct $486 in tax years 2004 and 2005. See sec.

1.162-1(a), Income Tax Regs.; see also sec. 174; Snow v. Commissioner, 416 U.S.

500, 503-04 (1974).

             3.    Other Insurance

      H & M also claimed deductions in 2004 and 2005 for premiums paid on

long-term care insurance coverage for Schmeets and his wife. Schmeets testified

that H & M paid these premiums as compensation for their services as its directors,
                                        - 41 -

[*41] and that H & M provided billing statements to substantiate its deductions. But

these billing statements are addressed to Harold H. Schmeets and Mona F.

Schmeets--not to H & M--and H & M didn’t provide us with any evidence that it

actually paid the premium amounts. We find for the Commissioner.

             4.    Magazine Subscription

      The Commissioner disallowed H & M’s deduction for a magazine subscription

in 2004 and 2005 as a nondeductible personal expense. H & M did pay for a

subscription to Bottom Line/Personal for those years, but general-interest subscrip-

tions are generally nondeductible personal expenses. See sec. 262; Wallendal v.

Commissioner, 31 T.C. 1249, 1252 (1959); Coffman v. Commissioner, T.C. Memo.

2000-7, 2000 WL 10438, at *2. And Bottom Line/Personal is, as its title indicates, a

general-interest magazine that contains a significant amount of information that is

inherently personal. Even though the magazine does appear to contain some invest-

ment-related articles and Schmeets testified that H & M subscribed to Bottom Line

for its investment advice, we are not convinced the magazine was an ordinary and

necessary business expense and therefore sustain the Commissioner’s disallowance.
                                         - 42 -

[*42]         5.    Office Supplies

        H & M also claimed deductions for various office supplies, including postage,

ink cartridges, and computer software, which the Commissioner disallowed in full for

tax years 2004 and 2005. At trial, Schmeets testified that

H & M bought the supplies because they were trying to make bifold sales brochures.

But H & M never provided samples of these sales brochures or evidence that they

were ever made. This is a close question, but such supplies are so commonly used

for personal purposes that we find it more likely than not that

H & M--which produced only evidence of the cost of these supplies--didn’t actually

buy them as an ordinary and necessary expense of developing the boat step and

collapsible shelf inventions. The Commissioner wins this one.

              6.    Miscellaneous Expenses

        On its 2004 tax return H & M deducted $391 as miscellaneous business ex-

penses. H & M provided us only with several receipts (one barely legible and one

dated in 2005) totaling $90, and, outside its scribbled notations across the receipts,

failed to produce any evidence showing the business purpose of the expenses. We

disallow H & M’s claimed deduction for miscellaneous expenses in full.
                                         - 43 -

[*43]         7.    Fees

        To support its 2004 and 2005 deductions for fees, H & M produced two

checks for 2004 made out to the secretary of state and the North Dakota Department

of Revenue for $25 and $5, respectively,20 and three checks for 2005--one for $25

made out to the secretary of state, one for $250 made out to Mona Schmeets, and

one for $250 made out to Harold Schmeets. H & M indicated that the two $25

checks to the secretary of state were corporate filing fees for its annual report and the

$5 check to the North Dakota Department of Revenue was a late fee for its sales tax

filing. Except for the nondeductible $5 late fee, sec. 162(f); see sec. 1.162-21(a),

Income Tax Regs., we agree with H & M that these expenses were ordinary and

necessary expenses incurred in its trade or business and will allow them.

        As to the two $250 checks, Schmeets testified that H & M paid these fees to

him and his wife for serving as the corporation’s directors. But H & M failed to

provide--though Schmeets testified to its purported existence--its minute book

establishing that Schmeets and his wife devoted time to directors activities in 2005.

The only evidence H & M offered to show its directors’ services was Schmeets’s



        20
         H & M also claimed a deduction for directors’ fees totaling $500 in 2004,
but the Commissioner didn’t challenge the deduction in the notice of deficiency, so
those fees are not at issue.
                                          - 44 -

[*44] testimony that he and his wife would talk about the business and fill out the

minute book and that they came up with an amount they thought was a “conservative

figure” for directors services and paid it. In the absence of the corporation’s minute

book entries for 2005, we find the expense wasn’t an ordinary and necessary

business expense and therefore disallow H & M’s deduction for directors fees in

2005.

              8.    Dues

        The Commissioner also disallowed H & M’s deduction for $290 in dues for

tax year 2005. H & M did provide a 2005 check for $290 made out to Harvey

Country Club, but it did not show that this expense had any business purpose. We

therefore find for the Commissioner on this issue.

V.      Penalties

        The Commissioner seeks a 20% accuracy-related penalty under section

6662(a) for underpayments of tax in the years at issue. He has to peg this penalty

to (1) negligence, (2) disregard of rules or regulations, or (3) a substantial

understatement of income tax by H & M. See sec. 6662(b)(1), (2).

        Once the Commissioner provides some evidence that an underpayment is

attributable to negligence, disregard of the Code and regulations, or a substantial

understatement, the taxpayer has the burden of proving the Commissioner’s penalty
                                         - 45 -

[*45] determination was incorrect. See Rule 142(a); Higbee v. Commissioner, 116

T.C. 438, 446-47 (2001). A taxpayer can meet this burden by showing that, under

all the facts and circumstances, it acted with reasonable cause and in good faith.

Sec. 6664(c)(1); sec. 1.6664-4(b)(1), Income Tax Regs.

       When an underpayment of tax is attributable to negligence or disregard of

rules or regulations, we can impose a 20% accuracy-related penalty. Sec. 6662(a)

and (b)(1). Negligence is “lack of due care or failure to do what a reasonable and

ordinarily prudent person would do under the circumstances.” Neely v.

Commissioner, 85 T.C. 934, 947 (1985). The Code and accompanying regulations

define negligence as the failure to make a reasonable attempt to prepare one’s tax

returns, keep adequate books and records, substantiate items properly, or otherwise

comply with the Code. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs.

Disregard of rules includes careless, reckless, or intentional disregard of Code

provisions or regulations. Sec. 6662(c); sec. 1.6662-3(b)(2), Income Tax Regs. A

disregard of rules is careless if the taxpayer doesn’t exercise reasonable diligence to

determine the correctness of a return position that is contrary to rules or regulations.

Sec. 1.6662-3(b)(2), Income Tax Regs. An understatement is substantial if it is more

than $10,000 or 10% of the tax required to be shown on the return, whichever is

greater. Sec. 6662(d)(1)(B).
                                         - 46 -

[*46] We have found that the payments Schmeets received under the employment

and salary-deferment agreements were not disguised purchase-price payments to

H & M. H & M is therefore not liable for the section 6662(a) penalty on this issue.

Because we found for H & M on the first issue, we don’t think H & M’s

understatement of income tax will exceed $10,000, so the Commissioner’s only

remaining grounds for imposing the section 6662(a) penalty are negligence or

disregard of the rules or regulations.

      As to H & M’s disallowed deductions for payments it made to Schmeets under

the $120,000 note in tax years 2002 through 2005 and the disallowed net operating

loss for 2001, we find H & M’s underpayments were due to negligence and it is

liable for the 20% penalty. H & M failed to treat the note as a bona fide debt by not

making principal payments for 17 years and by making interest payments in varying

amounts only in certain years. Despite its treatment of the note, H & M deducted the

payments it made to Schmeets as interest and did not make a reasonable attempt to

comply with the Code and regulations. This caused H & M to report a bogus net

operating loss in 2001.

      We also find H & M liable for the 20% accuracy-related penalty on the

portions of the underpayments due to the disallowed business expense deductions for

2004 and 2005. H & M didn’t keep adequate records to substantiate its vehicle-
                                          - 47 -

[*47] expense deductions, and to any reasonable person many of the other expenses

it deducted were nondeductible personal expenses. This shows a lack of due care on

H & M’s part and a failure to do what a reasonably prudent corporation would do

under the circumstances.

      H & M did not make any arguments as to why it wasn’t liable for the

accuracy-related penalty under section 6662(a) for the tax years at issue, other than

that “[t]his case presents clearly defined issues which are questions of fact. H & M,

Inc. has asserted positions that are reasonable in light of the facts and it is impossible

to reach the conclusion that H & M, Inc. acted in either a negligent manner or in

disregard of existing rules or regulations.” We do not think H & M has met its

burden to prove the Commissioner’s penalty determinations were erroneous.


                                                         Decision will be entered

                                                   under Rule 155.
