                  T.C. Summary Opinion 2005-96



                     UNITED STATES TAX COURT



          MARIO O. AND ELSIE R. GARZA, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 779-04S.                Filed July 21, 2005.



     Mario O. and Elsie R. Garza, pro se.

     Thomas D. Greenaway, for respondent.



     COUVILLION, Special Trial Judge:    This case was heard

pursuant to section 7463 of the Internal Revenue Code in effect

at the time the petition was filed.1    The decision to be entered




     1
      Unless otherwise indicated, subsequent section references
are to the Internal Revenue Code in effect for the years at
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
                                 - 2 -

is not reviewable by any other court, and this opinion should not

be cited as authority.

     Respondent determined deficiencies of $5,939, $5,472, and

$4,318 in petitioners’ Federal income taxes for 1999, 2000, and

2001, respectively.     Respondent also determined an accuracy-

related penalty under section 6662(a) in the amount of $863 for

2001.    The issues for decision are:    (1) Whether Mario O. Garza

(petitioner) received income from American Income Life Insurance

Co. (American Life) during 1999, 2000, and 2001 under section

61(a);    (2) whether petitioner is liable for self-employment

taxes for 1999, 2000, and 2001 under section 1401(a); and     (3)

whether petitioners are liable for the accuracy-related penalty

for 2001 under section 6662(a) for negligence, disregard of rules

or regulations, or a substantial understatement of income tax.2

        Some of the facts were stipulated.   Those facts, with the

annexed exhibits, are so found and are made a part hereof.

Petitioners’ legal residence at the time the petition was filed

was Fresno, California.

        At the time of trial, petitioner and his wife, Elsie R.

Garza (Ms. Garza), were seeking a divorce.      However, they were



     2
      Respondent did not determine any penalty for the years 1999
or 2000. Additionally, in the notice of deficiency, some of
petitioners’ itemized deductions for the 3 years at issue were
disallowed. The notice of deficiency states that petitioners
agreed to those adjustments. Petitioners did not challenge these
adjustments at trial.
                                - 3 -

married and resided together at all times during the years at

issue.

     Petitioner was employed as an independent insurance agent

(agent) with American Life from 1987 to 1988 and again from 1989

to 1998.3   As an agent for American Life, petitioner sold

insurance policies.   For each policy he sold, petitioner earned a

commission.   American Life would advance to petitioner the

anticipated first-year commission on that policy.   This

advancement was referred to as a loan against anticipated

first-year commissions and not taxable at the time of receipt.

In the event the policy was terminated before the year ended,

petitioner was obligated to pay the commission back to American

Life.    Additionally, American Life paid certain expenses for

petitioner that were added to petitioner’s outstanding account

balances due to American Life.4    According to account ledgers

produced by respondent from American Life, during the term of

petitioner’s employment, petitioner received advances against



     3
      There is a dispute as to whether petitioner terminated his
employment in 1997 or 1998. Petitioner contends that he was no
longer employed by American Life in 1997; however, he stipulated
to working for American Life until 1998. This discrepancy has no
bearing on the issue.
     4
      At the time of the audit, Ms. Garza went through the
documents provided by American Life, which set out the advances
and expenses paid by American Life on petitioner’s behalf.
Ms. Garza contacted American Life requesting an explanation of
the expenses on the account. Petitioners presented no evidence
at trial with respect to these expenses.
                                - 4 -

future commissions and had certain expenses paid for by American

Life that amounted to almost $90,000.   When asked at trial

whether he kept books or records to keep track of the advances

made, expenses paid, and the commissions earned, petitioner

stated that he may have kept records but did not know where they

were at the time.

     When petitioner left American Life in 1998, his accounts

were terminated fully vested.   The term “fully vested” meant that

petitioner would continue earning commissions on all policy

renewals in his accounts even if he was no longer working for

American Life.   During 1999, 2000, and 2001, several of

petitioner’s former accounts with American Life were renewed.

Petitioner was entitled to commissions on these renewals.

Additionally, during 1999, 2000, and 2001, petitioner was

entitled to commissions from renewals on policies written by

agents who were subordinate to petitioner while he was employed

by American Life.

     During the years at issue, all commissions coming to and

creditable to petitioner were applied to the liquidation of

petitioner’s outstanding account balances owed to American Life.

American Life credited to petitioner’s accounts $20,9575 of such




     5
      These amounts are rounded to the whole dollar.
                               - 5 -

commissions in 1999, $17,705 in 2000, and $14,673 in 2001.6

American Life issued Forms 1099-MISC, Miscellaneous Income, for

these amounts in the respective years.

     Petitioners filed timely joint Federal income tax returns

for 1999, 2000, and 2001.   However, because petitioners were

confused by the Forms 1099 sent to them by American Life, they

did not report the income reflected on those forms for any of the

years at issue.7

     On October 10, 2003, respondent issued the notice of

deficiency (notice) for the years in question.   As stated above,

respondent determined deficiencies of $5,939, $5,472, and $4,318

in petitioners’ Federal income taxes for 1999, 2000, and 2001,

respectively.   In the notice, respondent explained:

     According to American Income Life Insurance Company,
     the income on 1099 you received is income to you.
     These are your earning[s] from commission on prior
     sales. According to American, you took advance monies
     on your future earnings and the 1099 amounts are what
     was applied to the amount due. * * * These earnings
     are to be reported as income either in the year you
     received the monies or the year earned.



     6
      The amounts in the ledgers for 2001, attached as part of
the Stipulation of Facts, do not equal the amount on the Form
1099-MISC, Miscellaneous Income, from American Life for that
year. There is a $32 difference in petitioner’s favor on the
Form 1099. For purposes of this opinion, the Court considers the
amounts determined in the notice of deficiency to be correct, as
no evidence was presented to establish the $32 difference.
     7
      Although petitioners claim they contacted American Life
questioning the Forms 1099, no evidence was presented to show
that the amounts on the Forms 1099 were incorrect.
                              - 6 -

The deficiencies also included self-employment taxes for 1999,

2000, and 2001, as respondent determined these commissions

constituted self-employment income.   Additionally, respondent

determined an accuracy-related penalty under section 6662(a) in

the amount of $863 only for 2001.

     The first issue is whether petitioner earned income from

American Life during 1999, 2000, and 2001 under section 61(a)

based on commissions that he was entitled to after he no longer

worked for American Life that were not paid directly to him but

were diverted or applied to his debit accounts to offset the

balances he owed.

     The determinations of the Commissioner in a notice of

deficiency are presumed correct, and the burden is on the

taxpayer to prove that the determinations are in error.

Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933).8




     8
      Sec. 7491 shifts the burden of proof to the Commissioner if
the taxpayer introduces credible evidence with respect to any
factual issue relevant to ascertaining a tax liability provided
the taxpayer has maintained books and records and has cooperated
with reasonable requests by the Commissioner for witnesses,
information, documents, meetings, and interviews. The burden of
proof does not shift in this case principally because petitioners
did not maintain accurate books and records of the commissions
earned by petitioner with American Life. Had petitioners
maintained accurate books and records, there likely would have
been no need for these proceedings. The questions raised by
petitioner are attributable solely to his failure to maintain
books and records. Sec. 7491(c), however, places upon the
Commissioner the burden of production with respect to any penalty
or addition to tax.
                                - 7 -

       Section 61(a)(1) provides that gross income includes “all

income from whatever source derived, including (but not limited

to) * * * compensation for services, including fees, commissions,

fringe benefits, and similar items”, unless otherwise provided.

The Supreme Court has consistently given this definition of gross

income a liberal construction “in recognition of the intention of

Congress to tax all gains except those specifically exempted”.

Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 430 (1955); see

also Roemer v. Commissioner, 716 F.2d 693, 696 (9th Cir. 1983),

revg. 79 T.C. 398 (1982) (“[all] realized accessions to wealth

are presumed to be taxable income, unless the taxpayer can

demonstrate that an acquisition is specifically exempted from

taxation”).    Moreover, section 1.61-2(a)(1), Income Tax Regs.,

provides that “wages, salaries, commissions paid salesmen, * * *,

commissions on insurance premiums, * * * are income to the

recipients unless excluded by law”.

       “In the situation where the advances are actually loans,

when the repayments are offset directly by the future earned

commissions, then the agent will have either commission income or

cancellation of indebtedness income at the time of the offsets.”

Diers v. Commissioner, T.C. Memo. 2003-229; Cox v. Commissioner,

T.C. Memo. 1996-241; cf. Warden v. Commissioner, T.C. Memo. 1988-

165.    Although petitioner’s employment with American Life

terminated in 1998, he continued to thereafter earn renewal
                                 - 8 -

commissions on policies he had sold before his departure.

Instead of paying these commissions to petitioner, American Life

diverted the commissions to his accounts showing balances owed by

petitioner for the advances and expense payments previously

described.   When American Life previously made advances to

petitioner, he was not taxable on such advances because the

advances were loans secured and payable through future earned

commissions.   Beaver v. Commissioner, 55 T.C. 85, 91 (1970);

Diers v. Commissioner, supra.     When American Life applied the

renewal commissions to petitioner’s outstanding account balances,

petitioner’s obligation to repay the loans was reduced by those

amounts, and the reduction of his obligations constituted his

receipt of taxable income.    Diers v. Commissioner, supra; Newmark

v. Commissioner, 311 F.2d 913, 915 (2d Cir. 1962), affg. T.C.

Memo. 1961-285.   Therefore, the Court holds that petitioner

received commission income during 1999, 2000, and 2001, in the

amounts of $20,957, $17,705, and $14,673, respectively, as

determined in the notice of deficiency.    Respondent, therefore,

is sustained on this issue.

     The second issue is whether petitioners are liable for

self-employment taxes for 1999, 2000, and 2001 under section 1401

based on the aforesaid income.

     Section 1401(a) imposes a tax upon the self-employment

income of every individual.   In general, self-employment income
                                 - 9 -

consists of the net earnings derived by an individual (other than

a nonresident alien) from a trade or business carried on by such

individual.     Sec. 1402(a) and (b); sec. 1.1401-1(c), Income Tax

Regs.   To constitute self-employment income, “there must be a

nexus between the income received and a trade or business that

is, or was, actually carried on.”        Newberry v. Commissioner, 76

T.C. 441, 444 (1981).    The “income must arise from some actual

(whether present, past, or future) income-producing activity”.

Id. at 446.   Additionally, section 1.1402(a)-1(c), Income Tax

Regs., provides that gross income derived from an individual’s

trade or business may be subject to self-employment tax even when

it is attributable to services rendered in a prior taxable year.

Jackson v. Commissioner, 108 T.C. 130, 134 (1997); Schelble v.

Commissioner, 130 F.3d 1388, 1392 (10th Cir. 1997), affg. T.C.

Memo. 1996-296.

     In order to be derived from a trade or business the payment

received by an insurance agent after termination must be “tied to

the quantity or quality of the taxpayer’s prior labor, rather

than the mere fact that the taxpayer worked or works for the

payor.”   Milligan v. Commissioner, 38 F.3d 1094, 1098 (9th Cir.

1994), revg. T.C. Memo. 1992-655; see Jackson v. Commissioner,

supra at 135.    The taxpayer in Milligan was not liable for

self-employment tax because “none of his business activity was

the ‘source’ of the Termination Payments.       * * *   Nor were they
                              - 10 -

renewal commissions on previously-generated policies”.     Milligan

v. Commissioner, supra at 1099 (citing Erickson v. Commissioner,

T.C. Memo. 1992-585, affd. without published opinion 1 F.3d 1231

(1st Cir. 1993)).   In Erickson v. Commissioner, supra, the Court

found that the payments under the settlement agreement entered

into between the taxpayer and the insurance company represented

renewal commissions and were taxable as self-employment income

under section 1401(a).

     Petitioner was an independent agent for American Life until

1998.   Upon the termination of his employment, he was fully

vested in his accounts, which entitled him to receive commissions

on the renewal of any policies that he wrote while he was an

active agent.   Petitioner did not dispute or challenge whether

the commissions earned, and applied to his outstanding balances,

were commissions on the renewal of policies that he wrote.     He

did not contend or establish that he was a statutory employee

pursuant to section 3121(d)(3)(B).     See Diers v. Commissioner,

supra at n.6.   Accordingly, the Court holds that petitioner

earned renewal commission income and is, therefore, liable for

self-employment tax on that income.

     The final issue is whether petitioners are liable for the

accuracy-related penalty for the year 2001 under section 6662(a)

for negligence, disregard of rules or regulations, or a
                              - 11 -

substantial understatement of income tax.     As noted above, the

burden of production is on respondent.     Sec. 7491(c).

     Section 6662(a) provides that, if it is applicable to any

portion of an underpayment in tax, there shall be added to the

tax an amount equal to 20 percent of the portion of the

underpayment to which section 6662 applies.     Section 6662(b)(1)

provides that section 6662 shall apply to any underpayment

attributable to negligence or disregard of rules or regulations.

Section 6662(b)(2) provides that section 6662 shall apply to any

substantial understatement of income tax.

     Section 6662(c) provides that the term "negligence" includes

any failure to make a reasonable attempt to comply with the

provisions of the internal revenue laws, and the term "disregard"

includes any careless, reckless, or intentional disregard of

rules or regulations.   Negligence is the 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).

     Under section 6662(d)(1), there is a substantial

understatement of income tax if the amount of the understatement

exceeds the greater of (1) 10 percent of the tax required to be

shown on the return or (2) $5,000.     For purposes of section

6662(d)(1), "understatement" is defined as the excess of tax

required to be shown on the return over the amount of tax that is
                              - 12 -

shown on the return, reduced by any rebate.   Sec. 6662(d)(2)(A).

Section 6662(d)(2)(B) provides that the amount of the

understatement shall be reduced by that portion of the

understatement that is attributable to the tax treatment of any

item by the taxpayer if there is or was substantial authority for

the treatment or to any item with respect to which (1) the

relevant facts affecting the item's tax treatment are adequately

disclosed in the return or in a statement attached to the return,

and (2) there is a reasonable basis for such treatment.

     Under section 6664(c), however, no penalty shall be imposed

under section 6662(a) with respect to any portion of an

underpayment if it is shown that there was a reasonable cause for

the portion and that the taxpayer acted in good faith with

respect to the portion of the underpayment.

     The determination of whether a taxpayer acted with

reasonable cause and in good faith depends upon the facts and

circumstances of each particular case.   Sec. 1.6664-4(b)(1),

Income Tax Regs.   The taxpayer has the burden of proving that he

acted with reasonable cause and in good faith.   Higbee v.

Commissioner, 116 T.C. 438, 446-449 (2001).

     Due to the failure to report petitioner’s commission income

in 2001, petitioners had an understatement of tax in the amount

of $4,318.   The amount of tax required to be shown on the 2001

return was $6,932; thus, the amount of the understatement exceeds
                              - 13 -

10 percent of the tax required to be shown on the return.

Therefore, there was a substantial understatement of tax under

section 6662(d)(1).   Petitioners received a Form 1099 for 2001

and failed to include that income on their 2001 income tax

return.   Because the requirements for relief from the section

6662 substantial understatement penalty have not been met and

petitioners have not given any reasonable cause for failing to

report the income, petitioners are liable for the

accuracy-related penalty under section 6662.9

     Reviewed and adopted as the report of the Small Tax Case

Division.

     To reflect the foregoing,



                                         Decision will be entered

                                    for respondent.




     9
      Because it is clear that there was a substantial
understatement of tax on the 2001 return, it is not necessary for
the Court to determine whether petitioners were negligent in not
reporting the commission income for that year.
