                        T.C. Memo. 2003-187



                      UNITED STATES TAX COURT



      JOHN M. MERRITT AND CAROLYN MERRITT, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

            J.M.A. & ASSOCIATES, P.C., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 16214-98, 16715-98.      Filed June 30, 2003.



     Donald K. Groom, for petitioners.

     Denise G. Dengler, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     SWIFT, Judge:   In these consolidated cases, respondent

determined deficiencies in Federal income tax, additions to tax,

and penalties against petitioners as follows:
                                  - 2 -


John M. and Carolyn Merritt1

                                                    Accuracy-
                               Addition to Tax   Related Penalty
      Year     Deficiency      Sec. 6651(a)(1)     Sec. 6662(a)
      1994      $ 83,920            $20,980          $16,784
      1995       108,096              5,405           21,619


J.M.A. & Associates, P.C.

      1994      $264,558            $13,228          $52,912
      1995       220,564             22,056           44,113


       Unless otherwise indicated, all section references are to

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

all Rule references are to the Tax Court Rules of Practice and

Procedure.

       After settlement of some issues, the primary issues for

decision are as follows:

       (1) Whether petitioner should include in his 1994 income

$129,000 in compensation that he received from his law firm,

petitioner J.M.A. & Associates, P.C. (the law firm or the firm),

but which $129,000 petitioner returned to the firm later in 1994;

and

       (2) Whether, for its taxable years ending November 30, 1994,

and November 30, 1995, the law firm is entitled to ordinary and

necessary business expense deductions for litigation costs it

advanced on behalf of its contingent fee clients.


1
     Hereinafter references to petitioner in the singular are to
petitioner John M. Merritt.
                              - 3 -


                        FINDINGS OF FACT

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

     At the time the petitions were filed, petitioners John M.

and Carolyn Merritt resided in, and the principal place of

business of the law firm was located in, Oklahoma City, Oklahoma.

     During the years in issue, petitioner was a licensed,

practicing lawyer who was the founder, president, and sole owner

of the law firm, a personal service law corporation which

specialized in representing victims in personal injury and

product liability cases on a contingent fee basis.

     Under the terms of the firm’s contingent fee contracts with

its clients, the clients agreed to repay the firm litigation

costs advanced by the firm in the event a recovery was eventually

obtained on behalf of the clients.    If no recovery was obtained,

the clients were under no obligation to reimburse the law firm

litigation costs it had advanced.2




2
     More specifically, the firm generally entered into the
following two types of contingent fee contracts with its clients
under which the clients agreed to repay the firm litigation costs
advanced by the firm, in the event a recovery was obtained:
(1) From a gross recovery the clients would reimburse the firm
for litigation costs advanced by the firm, and then the clients
would pay the firm an attorney’s fee equal to 50 percent of the
net funds remaining; or (2) the clients would pay the firm an
attorney’s fee equal to 33-1/3 percent of the gross recovery, and
the firm would then be reimbursed litigation costs it had
advanced out of the clients’ remaining 66-2/3 percent share of
the gross recovery.
                                - 4 -

     In 1994 and 1995, petitioner received compensation from the

firm in the total amounts of $703,800 and $299,925, respectively,

denominated by the firm as wages and independent contractor fees

as follows:


                         Petitioner’s Compensation
        Year         Wages        Fee Income       Total
        1994       $200,000       $503,800     $703,800
        1995        200,000          99,925      299,925


     In December of 1994, petitioner transferred back to the firm

$129,000 which petitioner in 1994 had received from the firm as

independent contractor fees.    Initially, the firm’s bookkeeper

classified the returned $129,000 as a reduction of the firm’s

independent contractor fee expense account.     However, in February

of 1995, the law firm’s bookkeeper, for reasons unclear,

reclassified the transfer from petitioner to the law firm of the

$129,000 as a reduction in the firm’s accounts receivable due

from petitioner.

     For the law firm’s taxable years ending November 30, 1994

and 1995, litigation costs were advanced by the firm relating to

contingent fee contracts with its clients in the total amounts of

$737,652 and $1,069,275, respectively.

     During the years in issue, certain office management tasks

and all bookkeeping tasks of the firm were performed by a third

party bookkeeper hired by petitioner.
                               - 5 -

     Petitioners’ Federal income tax returns were prepared by a

certified public accountant (C.P.A.) who was also licensed to

practice law, with whom petitioner had a business relationship

for more than 20 years.

     On July 10, and November 14, 1996, respectively, Mr. and

Mrs. Merritt filed late their joint Federal individual income tax

returns for 1994 and 1995.   On their 1994 return, Mr. and

Mrs. Merritt did not include the $129,000 independent contractor

fee income that petitioner returned to the law firm in December

of 1994.

     On July 6, 1998, respondent determined a deficiency in

Mr. and Mrs. Merritt’s joint Federal income tax liability for

1994 based on, among other things, respondent’s inclusion in

income of the $129,000 that petitioner received as fee income in

1994 but which petitioner returned to the firm.

     Also, for 1994 and 1995, respondent determined against

Mr. and Mrs. Merritt additions to tax under section 6651(a)(1) in

the amounts of $20,980 and $5,405, respectively, for failure to

timely file their Federal income tax returns and accuracy-related

penalties under section 6662 in the amounts of $16,784 and

$21,619, respectively.

     On August 28, 1995, and on October 3, 1996, respectively,

the law firm filed late its corporate Federal income tax returns

for its taxable years ending November 30, 1994 and 1995.     On
                              - 6 -

those returns, the firm claimed ordinary and necessary business

expense deductions for the litigation costs that the firm during

those taxable years advanced on behalf of its contingent fee

clients in the respective amounts of $705,647 and $629,834 that

related to contingent fee client matters not resolved by yearend.

On audit, respondent, among other things, disallowed these

claimed business expense deductions and determined deficiencies

in the firm’s income taxes for those years.

     Also, for the years ending November 30, 1994 and 1995,

respondent determined against the law firm additions to tax under

section 6651(a)(1) in the amounts of $13,228 and $22,056,

respectively, based on the firm’s failure to timely file its tax

returns and accuracy-related penalties under section 6662 in the

amounts of $52,912 and $44,113, respectively, based on

substantial understatements of tax due or, alternatively,

negligence or disregard of the rules or regulations.


                             OPINION

Returned Compensation

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

income from whatever source derived”, including compensation for

services and fees.

     The Supreme Court has held that gross income includes all

“accessions to wealth, clearly realized, and over which the

taxpayers have complete dominion”, Commissioner v. Glenshaw Glass
                                - 7 -

Co., 348 U.S. 426, 431 (1955), “without * * * an obligation to

repay, and without restriction as to their disposition”, James v.

United States, 366 U.S. 213, 219 (1961); see also N. Am. Oil

Consol. Co. v. Burnet, 286 U.S. 417, 424 (1932).

       In Crary v. Commissioner, T.C. Memo. 1970-40, after

receiving a paycheck from his employer, the taxpayer on the same

day wrote a check to his employer for the same amount and did not

include the paycheck in his income.     We held that the taxpayer

was not permitted to exclude the paycheck from his income.     Id.

       In Jones v. Commissioner, 82 T.C. 586, 588-590 (1984), a

taxpayer relinquished his rights to a profit-sharing plan and

withdrew funds from the plan, but then gave the funds back to his

employer.    We held that the unconditional receipt of the funds

resulted in taxable income in the year of receipt.     Id. at 590-

592.

       Respondent argues primarily that because petitioner was not

obligated by any agreement to return to the firm the $129,000 in

independent contractor fees, the $129,000 constituted income to

petitioner when received, and no justification exists for

excluding the $129,000 from petitioner’s income.

       Petitioners, citing Gregory v. Helvering, 293 U.S. 465, 469

(1935), argue that taxpayers are entitled to structure

transactions to pay the least Federal income tax (namely, to
                              - 8 -

reduce their Federal income tax by returning the fees to the

firm).

     No evidence indicates that when petitioner received the

$129,000 he had any restrictions on his use of the $129,000 or

that he had any obligation to return the $129,000 to the firm.

Petitioner does not qualify for an exclusion from income of the

$129,000 that he received from and later returned to his firm in

late 1994.   See Commissioner v. Glenshaw Glass Co., supra at 431;

Jones v. Commissioner, supra at 591-592; Crary v. Commissioner,

supra.


Litigation Costs

     Generally, litigation costs advanced or paid by lawyers on

behalf of their clients based on contingent fee contracts under

which the clients are obligated to repay the litigation costs to

the lawyers if the client matters are resolved successfully are

to be treated in the year paid as loans to their client, not as

ordinary and necessary business expenses.   Canelo v.

Commissioner, 53 T.C. 217, 225-226 (1969), affd. per curiam 447

F.2d 484 (9th Cir. 1971); Hearn v. Commissioner, 36 T.C. 672,

674-675 (1961), affd. 309 F.2d 431 (9th Cir. 1962).     Upon

resolution of the contingent fee matters, at that time, if the

lawyers do not receive repayment of the litigation costs advanced

on behalf of their clients, the lawyers are entitled to deduct
                              - 9 -

the unpaid litigation costs as bad debts.   Canelo v.

Commissioner, supra at 225-226.

     Petitioners note that the lawyers involved in Canelo

carefully screened their contingent fee clients and had “good

hopes” of recovery, id. at 224, and petitioners argue that the

facts of that and similar cases are distinguishable (namely,

petitioners claim that the law firm’s contingent fee clients were

not screened based on the probability of recovery and that often

any recovery was doubtful).

     Even if, as petitioners claim, the law firm’s contingent fee

contracts were not screened with regard to the probability of

obtaining a recovery and even if the probability of a recovery

was often doubtful, we conclude that the litigation costs in

dispute are to be treated, in the year advanced by the firm, as

loans, not as ordinary and necessary business expenses of the

firm.


Section 6651(a)(1) Additions to Tax

     For a taxpayer’s failure to timely file Federal income tax

returns, section 6651(a)(1) imposes an addition to tax generally

equal to 5 percent of the tax required to be shown as due on the

return for every month the return is late, up to a maximum of 25

percent, unless such failure is due to reasonable cause and not

to willful neglect.
                               - 10 -

     Petitioners claim that they provided complete and timely

information to their C.P.A. and that it was the C.P.A. who did

not timely file the income tax returns.

     Petitioner, a practicing lawyer, was fully capable of making

sure that the income tax returns for himself, his wife, and his

firm were completed and filed on time.    Petitioner’s alleged

reliance on the C.P.A. is not credible.

     Petitioners are liable for the additions to tax under

section 6651(a)(1) for the failure to timely file their income

tax returns for the years in issue.


Section 6662 Accuracy-Related Penalties

     Section 6662 imposes an accuracy-related penalty of 20

percent on underpayments of tax attributable to:    (1) Negligence

or to disregard of the rules or the regulations; and

(2) substantial understatements of income tax.

     Section 6662(d)(1) defines “substantial understatements” as

the greater of:    (1) More than 10 percent of the tax required to

be shown on the tax return; or (2) $5,000 in the case of an

individual, and $10,000 in the case of a corporation.

     The section 6662 accuracy-related penalty is not imposed

with respect to portions of underpayments of tax for which

taxpayers acted with reasonable cause and in good faith.     See

sec. 6664(c)(1).   The decision as to whether taxpayers acted with

reasonable cause and in good faith depends upon all the pertinent
                              - 11 -

facts and circumstances.   Sec. 1.6664-4(b)(1), Income Tax Regs.

Relevant factors include the taxpayer's efforts to assess his

proper tax liability, including the taxpayer's reasonable and

good-faith reliance on a tax professional, such as an accountant.

Id.

      On the facts and testimony before us and in light of the tax

adjustments involved herein, we believe that petitioners

reasonably relied on the advice of their C.P.A. in the

preparation of the tax returns in issue.     Petitioners had

reasonable cause for the deficiencies in issue, and petitioners

acted in good faith.   Petitioners are not liable for the

accuracy-related penalties determined by respondent under section

6662 with respect to the deficiencies in issue herein.

      To reflect the foregoing,


                                       Decisions will be entered

                                  under Rule 155.
