                               T.C. Memo. 2016-147



                         UNITED STATES TAX COURT



             LITTLE MOUNTAIN CORPORATION, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 581-15.                            Filed August 8, 2016.



      Steven A. Wilson, for petitioner.

      Rollin George Thorley, David W. Sorensen, and Rebekah A. Myers, for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


      KERRIGAN, Judge: Respondent determined a deficiency in petitioner’s

Federal income tax of $361,080 for its taxable year ending October 31, 2011.

Unless otherwise indicated, all section references are to the Internal Revenue Code

(Code) in effect for the year in issue, and all Rule references are to the Tax Court
                                        -2-

[*2] Rules of Practice and Procedure. All monetary amounts are rounded to the

nearest dollar.

      Before trial petitioner conceded that it was not entitled to an investment

expense deduction of $83,756 or a deduction of $52,879 for payments against

promissory notes. The remaining issue for consideration is whether petitioner may

deduct consulting fees of $896,493 for tax year 2011.

                               FINDINGS OF FACT

      Some of the facts have been stipulated, and the stipulated facts are

incorporated in our findings by this reference.1 Little Mountain Corporation

(Little Mountain) is organized under the laws of Nevada. Petitioner’s legal office

of record and mailing address were in Nevada when it timely filed its petition.

Petitioner’s Organizational Structure

      On March 10, 1998, petitioner was incorporated under the laws of Nevada.

From the date of its organization through the year in issue, petitioner had two

shareholders: Uisge-Beatha Partners (UBP), a limited partnership owning 51%,

and the Balm of Gilead Irrevocable Trust (BGIT), which owned the remaining

      1
        The parties both reserved objections to some of the stipulations, and
indicated that they would address these objections in their posttrial briefs. The
parties, however, did not address in their briefs the stipulations for which they had
reservations beyond the objections included in the stipulations. The parties’
reserved objections are therefore deemed waived.
                                        -3-

[*3] 49%. UBP was formed in 1998 with general partner Susan Sanders owning

1% and BGIT owning the other 99%. Mrs. Sanders also formed BGIT in 1998,

contributing a farmhouse in West Point, Tennessee, to the trust for the benefit of

her seven children.

      Mrs. Sanders has served as petitioner’s assistant secretary and assistant

treasurer for over 10 years, including the tax year in issue. Her duties include

maintaining books, records, and vendor invoices, preparing the general ledger,

keeping up with correspondences and paying bills. She also performs

administrative tasks, including customer service, reloading printer cartridges, and

stocking paper.

      Mrs. Sanders is petitioner’s custodian of records and receives $100 per year

to act as petitioner’s resident agent in Tennessee. Other than the resident agent

fee, petitioner does not compensate Mrs. Sanders for her services. During the year

in issue Mrs. Sanders was neither a shareholder nor a director of petitioner.

      Scott Burnett is petitioner’s president, secretary, and treasurer. He also

serves as petitioner’s nominee director and does not have any authority to make

decisions on petitioner’s behalf; his duties are limited to helping supervise

meetings of the shareholders. Johnny R. Bain is petitioner’s vice president, and

Mrs. Sanders’ son-in-law. In 2011 petitioner’s officers were Mr. Burnett,
                                       -4-

[*4] Mr. Bain, and Mrs. Sanders. During the tax year in issue petitioner did not

have any employees who received Forms W-2, Wage and Tax Statement.

Petitioner’s Business

      During 2011 petitioner was a gold and silver brokerage business that also

published a monthly Internet financial newsletter. Petitioner purchased its

business on November 17, 1998, from Mrs. Sanders’ husband, Franklin Sanders.

Little Mountain acquired Mr. Sanders’ two sole proprietorships, the

Moneychanger and Franklin Sanders, S.P., for $200,500 on the following terms: a

$500 payment to Mr. Sanders upon the execution of the contract and a $200,000

promissory note, with the balance to be paid in full within 20 years from the date

of the execution of the contract and interest not to exceed 8%. Petitioner operated

its business in an office in the back of the farmhouse that Mrs. Sanders contributed

to BGIT for the benefit of her seven children.

      Mr. Sanders operated his sole proprietorships, Franklins Sanders, S.P., and

the Moneychanger, for approximately 30 years before selling them to petitioner.

Franklin Sanders, S.P., operated as a gold and silver exchange, and the

Moneychanger was, and continues to be, a monthly Internet newsletter that

covered the gold and silver market. The nature of the businesses remained the
                                        -5-

[*5] same after petitioner’s acquisition. Mr. Sanders was never a shareholder of

petitioner.

      On its Form 1120, U.S. Corporation Income Tax Return, petitioner reported

$63,002,681of gross receipts and $61,719,599 of cost of goods sold. It deducted

$896,493 for consulting services. Its Form 1120 shows no salaries or wages paid

for tax year 2011. Petitioner did not distribute dividends to its shareholders for tax

year 2011 or any prior year.

      Pursuant to the minutes of a special meeting of petitioner’s directors dated

November 17, 1998, it was resolved that Mr. Sanders would be paid as an

independent contractor on a “by-the-job” basis. Petitioner also authorized Mr.

Sanders to receive an annual bonus of one-fourth of 1% on any amount of

petitioner’s stated gross income that exceeded $10 million. Mr. Sanders operated

his business, Always Frank Consulting (AFC), as a sole proprietorship.

      Petitioner provided no consulting fee schedule, hourly rate, or specific

breakdown of Mr. Sanders’ tasks. No written contract existed between petitioner

and AFC or Mr. Sanders. Mrs. Sanders testified that there was only an oral

agreement because “that’s how it’s done a lot of times in the South”. AFC

operated out of the same property as petitioner.
                                        -6-

[*6] The invoices from AFC provided the amounts due for “consulting, writing,

and managerial fees”. The invoices did not detail what services were performed

that accounted for the totals on the invoices. Neither Mr. Sanders nor Mrs.

Sanders could testify with specificity as to what services were performed that

accounted for the totals on the invoices.

      Mrs. Sanders reviewed the invoices and determined whether they would be

paid. Some invoices requested that petitioner issue several checks for the total

amount due. All AFC invoices for “consulting” services requested that checks be

issued in amounts less than $10,000. Mrs. Sanders kept a general ledger and

recorded the payments to AFC on a monthly basis by writing the check number,

the amount of the check, and whether the check was paid.

      Mr. Sanders testified that he requested that petitioner make the checks

payable to cash. Mr. Sanders further testified that he asked for several checks to

be made out for each invoice because he did not want to keep a lot of cash around

at one time. He did not report any amounts received from petitioner on his income

tax return, and he did not file an income tax return for tax year 2011. Little

Mountain never provided Mr. Sanders or AFC a Form 1099-MISC, Miscellaneous

Income, for the consulting fees.
                                             -7-

[*7]                                     OPINION

         This case involves the strange situation of a corporation that claims to have

no employees and no written contracts with any independent contractors, issued no

information reports to any independent contractors, and enjoyed enormous

amounts of income during the tax year in issue without paying any dividends to its

shareholders. The corporation is owned by, through, or on behalf of family

members of Mr. Sanders, who has not filed a Federal income tax return since

1991.2

         Corporate records show that petitioner issued checks totaling $896,493 to a

“consultant” during the year in issue, but the checks were made payable to “cash”

and were negotiated by various individuals other than Mr. Sanders, some who had

no visible role with respect to the corporation. The corporation’s Federal income

tax return for its fiscal year ending October 31, 2011, shows an $896,493

deduction for “compensation” attributable to these checks. This deduction is

disallowed in the notice of deficiency and is here in dispute.

         The taxpayer generally bears the burden of proving the Commissioner’s

determinations are erroneous. Rule 142(a). The taxpayer bears the burden of

substantiating the amount and purpose of each item claimed as a deduction. See

         2
             The record strongly suggests that the corporation is Mr. Sanders’ alter ego.
                                        -8-

[*8] Higbee v. Commissioner, 116 T.C. 438, 440 (2001). Section 7491(a)(1)

provides that if a taxpayer introduces credible evidence with respect to any factual

issues relevant to ascertaining the taxpayer’s liability, the Commissioner shall

have the burden of proof with respect to that issue. Section 7491(a)(1) applies,

however, only if the taxpayer complies with all substantiation and recordkeeping

requirements under the Code. Sec. 7491(a)(2)(A) and (B).

      Petitioner failed to substantiate that compensation was paid to Mr. Sanders

or AFC and offered no evidence that the compensation was reasonable. The

burden of proof remains with petitioner.

      Deductions are a matter of legislative grace, and a taxpayer must prove its

entitlement to any deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). To that end

a taxpayer is required to substantiate the item underlying each claimed deduction

by maintaining records sufficient to establish the amount of the item and to enable

the Commissioner to determine the correct tax liability. Sec. 6001; Higbee v.

Commissioner, 116 T.C. at 440; sec. 1.6001-1(a), Income Tax Regs.

      Section 162 permits a taxpayer to deduct ordinary and necessary business

expenses paid or incurred during the taxable year, including “a reasonable

allowance for salaries or other compensation for personal services actually
                                        -9-

[*9] rendered”. Sec. 162(a)(1). Petitioner contends that the compensation was

paid to Mr. Sanders, who claims to have received the cash proceeds from the

checks but who “wouldn’t call it compensation” during his testimony.3 The

checks issued to “cash” did not bear any stated purpose for the expense.

      Only the portion of an expense that is reasonable qualifies for deduction

under section 162(a). United States v. Haskel Eng’g & Supply Co., 380 F.2d 786,

788-789 (9th Cir. 1967); Fuhrman v. Commissioner, T.C. Memo. 2011-236, slip

op. at 6. The reasonableness concept has particular significance in determining

whether payments between related parties represent ordinary and necessary

expenses. See Fuhrman v. Commissioner, slip op. at 7; see also Bittker &

Lokken, Federal Taxation of Income, Estates, and Gifts, para. 20.1.5, at 20-18 (3d

ed. 1999). Given the intrafamily transactions, a heightened level of scrutiny is

applied. See Harwood v. Commissioner, 82 T.C. 239, 258 (1984), aff’d without

published opinion, 786 F.2d 1174 (9th Cir. 1986); Holden v. Commissioner, T.C.

Memo. 2015-83.

      Petitioner provided neither documentary evidence nor testimony regarding

how the consulting fees were determined. Petitioner provided no consulting fee

      3
        Mr. Sanders’ testimony concerning his failure to have filed Federal income
tax returns for the relevant periods is certainly consistent with the position he has
taken on this point.
                                         - 10 -

[*10] schedule, hourly rate, or specific breakdown of its “consultant’s” tasks.

Neither Mr. nor Mrs. Sanders could testify with specificity as to what services

were performed that accounted for the totals on the checks issued. There was no

written contract for the consulting fees, and petitioner never issued any Forms

1099.

        Petitioner did not provide us with sufficient evidence to persuade us that the

expense was both ordinary and necessary, and reasonable. Applying a heightened

level of scrutiny, we sustain respondent’s disallowance of the consulting fees.

        Any contentions we have not addressed are irrelevant, moot, or meritless.

        To reflect the foregoing,


                                                        Decision will be entered

                                                  for respondent.
