                              T.C. Memo. 2017-190



                        UNITED STATES TAX COURT



          WESTERN PROPERTY RESTORATION, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

                 MICHAEL B. SPRAGUE, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 30207-14, 30229-14.             Filed September 26, 2017.



      Walter D. Channels, for petitioners.

      Cassidy B. Collins, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      MORRISON, Judge: During the 2011 and 2012 tax years, Michael B.

Sprague was the sole shareholder of Western Property Restoration, Inc., a

subchapter C corporation. These consolidated cases involve income-tax

deficiencies determined against Sprague and Western Property Restoration for
                                        -2-

[*2] both years. We have jurisdiction to resolve the cases under section 6214(a).

Unless otherwise indicated, all references to sections are to the Internal Revenue

Code of 1986, as amended.

      We hold: (1) Sprague received dividends from Western Property

Restoration totaling $82,461 in 2011 and $102,507 in 2012 and (2) Western

Property Restoration is liable for section 6662 penalties for 2011 and 2012.

                              FINDINGS OF FACT

      Sprague was the sole shareholder of Western Property Restoration during

2011 and 2012.

      During 2011 Western Property Restoration made direct payments to

Sprague totaling $107,500. It also paid $4,961 of Sprague’s personal expenses.

      During 2012 Western Property Restoration made direct payments to

Sprague totaling $130,000. It also paid $5,007 of Sprague’s personal expenses.

      Western Property Restoration’s federal-income-tax return for 2011 reported

that it paid Sprague $30,000 in compensation. Sprague’s federal-income-tax

return for 2011 reported that he earned $30,000 in compensation. His return

reported no dividends.
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[*3] Western Property Restoration’s return for 2012 reported that it paid Sprague

$32,500 in compensation. Sprague’s return for 2012 reported that he earned

$32,500 in compensation. His return reported no dividends.

      Western Property Restoration’s returns also reported the following items:

               Item                      2011                    2012
    “Other” deductions                  $74,739                $93,007
    Advertising deduction                15,751                 19,662
    Rent-expense deduction                   9,000              16,399
    Cost of goods sold                  117,585                 86,466

Additionally, for 2012 Western Property Restoration reported a net-operating-loss

deduction of $41,486.

      In September 2014 the Internal Revenue Service (IRS) mailed a notice of

deficiency to Sprague determining deficiencies of $5,635 for 2011 and $3,841 for

2012. The notice also determined section 6662 penalties of $1,127 for 2011 and

$768.20 for 2012. Among other adjustments, the notice determined that Sprague

had received dividends from Western Property Restoration totaling $27,184.03 in

2011 and $19,578.55 in 2012.

      In September 2014 the IRS mailed a notice of deficiency to Western

Property Restoration determining deficiencies of $81,131 for 2011 and $87,117
                                         -4-

[*4] for 2012. The notice also determined section 6662 penalties of $16,226.20

for 2011 and $17,423.40 for 2012. Among other adjustments, the notice

disallowed portions of the amounts reported in each year for “[o]ther” deductions,

advertising deductions, and cost of goods sold. The notice also disallowed the

$41,486 net-operating-loss deduction that Western Property Restoration claimed

on its 2012 return.

      Sprague and Western Property Restoration filed timely petitions for

redetermination of the deficiencies. At the time, Sprague resided in California;

Western Property Restoration’s principal place of business was also in California.

      In December 2015 the IRS amended its answer to assert that Sprague

received dividends of $82,616 for 2011 and $101,635 for 2012 and that he had

deficiencies of $13,950 for 2011 and $13,704 for 2012.

      Before trial, the parties resolved many of the issues through stipulations.

They stipulated that the amounts reported by Western Property Restoration on its

returns should be adjusted as follows:
                                          -5-

[*5]
                                                Agreed-upon amount
                 Item
                                          2011                     2012
       “Other” deductions               $74,739                  $93,007
                                         !5,193                   !5,112
                                         69,546                   87,895
       Advertising deduction             15,751                   19,662
                                         !1,198                   !4,691
                                         14,553                   14,971
       Rent-expense deduction              9,000                  16,399
                                              !0                  !5,801
                                           9,000                  10,598
       Cost of goods sold               117,585                   86,466
                                        !45,000                  !59,187
                                         72,585                   27,279

They further stipulated that Western Property Restoration is not entitled to a net-

operating-loss deduction for 2012.

         The parties stipulated that of the $107,500 in direct payments that Western

Property Restoration made to Sprague during 2011, Sprague correctly reported

$30,000 as compensation. The parties stipulated that they disagree as to whether

the remaining direct payments, amounting to $77,500, should be treated as

dividends (the IRS’s position) or a tax-free return of capital (Sprague’s position).

The stipulation did not resolve the tax treatment of Western Property Restoration’s

payment of $4,961 of Sprague’s personal expenses in 2011.
                                          -6-

[*6] The parties stipulated that of the $130,000 in direct payments that Western

Property Restoration made to Sprague during 2012, Sprague correctly reported

$32,500 as compensation. The parties stipulated that they disagree as to whether

the remaining direct payments, amounting to $97,500, should be treated as

dividends (the IRS’s position) or a tax-free return of capital (Sprague’s position).

The stipulation did not resolve the tax treatment of Western Property Restoration’s

payment of $5,007 of Sprague’s personal expenses in 2012.

      In its opening brief, the IRS concedes that Sprague is not liable for section

6662 penalties. It continues to take the position that Western Property Restoration

is liable for section 6662 penalties.

                                        OPINION

1.    Dividends earned by Sprague in 2011 and 2012

      The tax treatment of a distribution of property made by a corporation to a

shareholder with respect to its stock is set forth in section 301(c). Sec. 301(a).

Section 301(c) provides: (1) the portion of the distribution which is a dividend is

included in the shareholder’s income, (2) the portion of the distribution which is

not a dividend is applied against and reduces the adjusted basis of the stock, and

(3) the portion of the distribution which is not a dividend, to the extent that it

exceeds the adjusted basis of the stock, is treated as gain from the sale or exchange
                                          -7-

[*7] of property. A dividend is defined by section 316(a) as a distribution of

property by a corporation to its shareholders out of its earnings and profits. For

this purpose, a distribution is considered to be made out of earnings and profits to

the extent of earnings and profits. Id.

      In his brief, Sprague concedes that the payment by Western Property

Restoration of $4,961 of his personal expenses in 2011 constitutes a dividend.

However, he contends that the $77,500 of noncompensation payments by Western

Property Restoration to him are a tax-free return of capital. He does not dispute

that for the 2011 tax year Western Property Restoration had earnings and profits at

least equal to the distributions it made to him that year ($4,961 + $77,500 =

$82,461). He argues that Western Property Restoration intended the $77,500 in

payments to be distributions of capital rather than earnings. He also argues that

Western Property Restoration recorded the distributions in its books as reductions

to paid-in capital rather than as dividends.

      A distribution to a shareholder is a dividend if it is made out of earnings and

profits. Sec. 316(a). A distribution is made out of earnings and profits if earnings

and profits is at least equal to the amount of the distribution. Id. Western Property

Restoration’s earnings and profits for the 2011 tax year was at least $82,461, the

amount of the distributions it made during 2011. Therefore, the distributions
                                         -8-

[*8] totaling $82,461 are dividends within the meaning of section 316(a). That

Western Property Restoration intended the distributions to consist of returned

capital is irrelevant. See Boulware v. United States, 552 U.S. 421, 430-431

(2008). It is also irrelevant that the company treated the distributions as returned

capital on its books. See id.

      For 2012, Sprague’s brief concedes that the payment by Western Property

Restoration of $5,007 of his personal expenses constitutes a dividend. He

contends that the $97,500 in noncompensation payments made in 2012 should be

treated as a tax-free return of capital for the same reasons he gives regarding the

2011 distributions. He does not contest that Western Property Restoration’s

earnings and profits for the 2012 tax year was at least $102,507, the total amount

of the distributions it made during 2012 ($102,507 ' $97,500 + $5,007).

Therefore, the distributions of $102,507 are dividends. See sec. 316(a).

       Our determination of this dividend issue does not depend on the resolution

of disputed facts. Thus, we need not determine which party bears the burden of

proof. We hold that Sprague received $82,461 of dividends in 2011 and $102,507

of dividends in 2012.
                                          -9-

[*9] 2.      Western Property Restoration’s liability for section 6662 penalties for
             2011 and 2012

      Section 6662(a) and (b)(1) and (2) imposes an “accuracy-related penalty” of

20% of the portion of an underpayment of tax that is attributable to the taxpayer’s

negligence or disregard of rules or regulations or that is attributable to any

substantial understatement of income tax. The IRS determined that for the tax

years 2011 and 2012 Western Property Restoration is liable for accuracy-related

penalties for underpayments attributable to negligence or substantial

understatements of income tax.

      Negligence includes the failure to exercise ordinary and reasonable care in

the preparation of a tax return. Sec. 1.6662-3(b)(1), Income Tax Regs.

Negligence also includes any failure by the taxpayer to keep adequate books and

records or to substantiate items properly. Id. Western Property Restoration

exhibited a lack of ordinary and reasonable care in: (1) improperly claiming cost-

of-goods-sold allowances for both years, (2) improperly claiming “[o]ther”

deductions and advertising deductions for both years, (3) improperly claiming a

net-operating-loss deduction for 2012, and (4) not maintaining adequate books or

records to substantiate the allowances and the deductions. It was negligent with

respect to the underpayments for 2011 and 2012.
                                         -10-

[*10] Alternatively, each annual understatement of income tax on Western

Property Restoration’s returns is substantial (and each underpayment is

attributable to a substantial understatement of income tax) if the understatement

exceeds “the lesser of--(i) 10 percent of the tax required to be shown on the return

for the taxable year (or, if greater, $10,000), or (ii) $10,000,000.” See sec.

6662(d)(1)(B). Whether the understatements are substantial will be determined by

post-opinion computations under Tax Court Rule of Practice and Procedure 155.1

      Under section 6664(c)(1), a taxpayer who is otherwise liable for the

accuracy-related penalty may avoid the liability by showing “that there was a

reasonable cause” for the underpayment and that the taxpayer “acted in good faith

with respect to” the underpayment. Western Property Restoration notes that a

certified public accountant (CPA) reviewed its books and records and aided in the

preparation of its tax returns. It is not a defense to the accuracy-related penalty

merely that a return was prepared by a CPA, as “the mere fact that a certified

public accountant has prepared a tax return does not mean that he or she has

opined on any or all of the items reported therein.” Neonatology Assocs., P.A. v.

Commissioner, 115 T.C. 43, 100 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

      1
       The penalty applies only once to a portion of an underpayment, even if that
portion is attributable to both negligence and a substantial understatement of
income tax. See sec. 1.6662-2(c), Income Tax Regs.
                                          -11-

[*11] There is no evidence that the CPA or any other tax professional advised

Western Property Restoration regarding any of the positions taken on its tax

returns. Therefore, Western Property Restoration has no reasonable cause and is

liable for accuracy-related penalties.

      To reflect the foregoing,


                                                 Decisions will be entered under

                                         Tax Court Rule of Practice and Procedure

                                         155.
