                  T.C. Memo. 2000-293



                UNITED STATES TAX COURT



       CALYPSO MUSIC INCORPORATED, Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 12683-99.          Filed September 20, 2000.

     P was incorporated by K. K is a motion picture
music editor and P’s sole shareholder, director, and
officer. P contracted with motion picture studios for
K’s services as a music editor. Each of the contracts
was memorialized, in part, by a “loan-out agreement” or
a “deal memorandum”. Each contract made specific
reference to the services of K.

     R determined P was a personal holding company as
defined in sec. 542 I.R.C. for its 1996 and 1997
taxable years. R also determined that P was liable for
accuracy related penalties under sec. 6662(a) I.R.C..

     Held: P was a personal holding company for its
taxable years of 1996 and 1997.

     Held, further: P in good faith and reasonably
relied on the return preparers for the position taken
on its returns and is not liable for penalties under
sec. 6662(a) I.R.C. pursuant to sec. 6664(c) I.R.C..
                                 - 2 -

     Patrick E. McGinnis, for petitioner.

     Jonathan H. Sloat, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


        LARO, Judge: Respondent determined deficiencies of $10,565

and $18,226 in petitioner’s personal holding company tax for 1996

and 1997, respectively.    Respondent also determined accuracy-

related penalties under section 6662(a)1 of $2,113 and $3,6452

for 1996 and 1997 respectively.    We must decide whether

petitioner is subject to the personal holding company tax imposed

by section 541 for its taxable years ending January 31, 1996, and

1997.     Secondly, we must decide whether petitioner is liable for

the accuracy-related penalty pursuant to section 6662(a) for each

of those years.

                           FINDINGS OF FACT

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

The stipulation of fact and attached exhibits are incorporated

herein by this reference.    Petitioner’s principal place of

business was in the State of California when the petition was

filed.


     1
       Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years in issue. Rule
references are to the Tax Court Rules of Practice and Procedure.
     2
         Dollar amounts are rounded to the nearest whole dollar.
                                 - 3 -

     Daryl Kell is a highly regarded and eminently qualified

music editor.    Petitioner, through Daryl Kell, rendered music

editing services for productions of feature films, television

movies, and programs.    The music editing service that petitioner

provides involves the rental and use of petitioner’s computer

equipment.   Music editing is an artistic and technical

undertaking requiring judgment, artistic ability, and discretion.

Daryl Kell's work as a music editor for petitioner’s clients

requires creative decision making.       Music editing is a

collaborative effort by all involved in a given production and

involves forming very close relationships between music editors

and those with whom they work.

     Petitioner had taxable years ending on January 31 for each

year in issue.    At all times during the taxable years in issue,

Daryl Kell owned 100 percent of petitioner’s stock, and he was

petitioner’s sole officer and director.       Other than officer’s

compensation paid to Daryl Kell, petitioner paid no salary or

compensation to employees.

     The International Alliance of Theatrical and Stage Employees

(IATSE) is a union.    In the productions in which petitioner was

involved music editors were required to be members of IATSE.

Daryl Kell was a member of IATSE.    In order to employ a music

editor who was a member of IATSE the employer was required to be

a signatory to the IATSE agreement.       Petitioner was not a
                                   - 4 -

signatory company to the IATSE agreement.

     Petitioner’s music editing services were provided to the

studios in accordance with a deal memorandum or a loan-out

agreement which memorialized some of the terms of those

contracts.    Daryl Kell’s personal services as a music editor were

specifically designated as required in the deal memorandum and

loan-out agreement.    The loan-out agreement and deal memorandum

provide that Daryl Kell "render music editorial services,

whenever and wherever the producer may require."            The payments

made to petitioner were supplemented by payments to IATSE for

benefits accruing to Daryl Kell under the IATSE agreement.

     Petitioner's general ledgers were prepared by Jessica

Shields-Hamper.    Jessica Shields-Hamper is petitioner's and Daryl

Kell's agent.    Petitioner’s 1996 tax return was prepared by

Robert Fogelman, C.P.A.    Petitioner’s 1997 return was prepared by

Steven McNulty of Feddersen & Co. C.P.A.(s).

     For the 1996 tax year, petitioner reported total income of

$133,977, of which the following amounts were for music editing

services:

            Film                           Editing Income
            Fair Game                          $70,227
            Moll Flanders                       28,955
            Other editing income                10,415
               Total                           109,597
                                   - 5 -

     For the 1997 tax year, petitioner reported total income of

$282,124, of which the following amounts were for music editing

services:

            Film                           Editing Income
            Kazaam                             $75,629
            The Associate                       71,722
            Breakdown                           65,694
            Moll Flanders                        1,063
            Other editing income                 8,350
               Total                           222,458


     Petitioner's general ledgers for the 1996 and 1997 tax years

reflect amounts received by petitioner from the studios for the

rental of music editing equipment owned by petitioner.      For the

1996 and 1997 tax years, petitioner received rental income in the

amounts of $24,400 and $68,100, respectively.3

                               OPINION

     The personal holding company tax was originally enacted in

1934 to remedy the effects of the "incorporated pocket book" and

“incorporated talent” which served to avoid the higher tax rates

imposed on individuals.    Cedarburg Canning Co. v. Commissioner,

149 F.2d 526, 528 (7th Cir. 1945), affg. a Memorandum Opinion of

this Court.    The purpose of the tax is to force corporations to

distribute personal holding company income through the imposition

of a tax in addition to the ordinary income tax imposed upon the

     3
       We have been unable to reconcile petitioner’s 1997 ledgers
which show editing income of $222,458 and rental income of
$68,100 totaling $290,557 with petitioner’s tax return which
shows gross sales of $281,746.
                               - 6 -

corporation.   See Fulman v. United States, 434 U.S. 528, 531

(1978).   The additional tax is imposed by section 541, which

provides:

          In addition to other taxes imposed by this
     chapter, there is hereby imposed for each taxable year
     on the undistributed personal holding company income
     (as defined in section 545) of every personal holding
     company (as defined in section 542) a personal holding
     company tax equal to 39.6 percent of the undistributed
     personal holding company income.


     A corporation is a personal holding company if two

requirements are satisfied.   See sec. 542(a).   Those two

requirements have been described as the "stock ownership" and

"tainted income" tests.   See Kenyatta Corp. v. Commissioner, 86

T.C. 171 (1986), affd. 812 F.2d 577 (9th Cir. 1987).    The "stock

ownership" test is satisfied if "At any time during the last half

of the taxable year more than 50 percent in value of * * * [the

corporation's] outstanding stock is owned, directly or

indirectly, by or for not more than 5 individuals."    Sec.

542(a)(2).   The "tainted income" test is satisfied where "At

least 60 percent of [the corporation's] adjusted ordinary gross

income (as defined in section 543(b)(2)) for the taxable year is

personal holding company income (as defined in section 543(a))".

Sec. 542(a)(1).   Section 543(a), which defines personal holding

company income, provides in pertinent part:
                                 - 7 -

        SEC. 543(a) General Rule.--
   For purposes of this subtitle, the term “personal
   holding company income” means the portion of the
   adjusted ordinary gross income which consists of:

      *          *         *       *       *       *       *

          (2) Rents.–The adjusted income from rents;

      *          *         *       *       *       *       *

          (7) Personal service contracts.--

               (A) Amounts received under a contract under
           which the corporation is to furnish
           personal services; if some person other
           than the corporation has the right to
           designate (by name or by description) the
           individual who is to perform the services,
           or if the individual who is to perform the
           services is designated (by name or by
           description) in the contract; and

               (B) amounts received from the sale or other
           disposition of such a contract.

           This paragraph shall apply with respect to
           amounts received for services under a particular
           contract only if at some time during the taxable
           year 25 percent or more in value of the
           outstanding stock of the corporation is owned,
           directly or indirectly, by or for the individual
           who has performed, is to perform, or may be
           designated (by name or by description) as the
           one to perform, such services.


     At all material times, Daryl Kell owned all of the shares

in petitioner.       We therefore find that the stock ownership

requirement of section 542(a)(2) was met for both the 1996 and

1997 tax years.

     Next, we must determine whether the “tainted income”

requirement of section 542(a)(1) has also been met.       At least
                                - 8 -

 60 percent of petitioner’s adjusted ordinary gross income4 for

 the taxable year must be personal holding company income to

 satisfy this requirement.     Petitioner’s adjusted ordinary gross

 income for 1996 and 1997 tax years was $133,977 and $282,124

 respectively.

         In pertinent part, section 543(a)(7) provides that

 petitioner’s income from the performance of a contract for

 music editing services will be personal holding company income

 if the individual who is to perform the services is designated

 (by name or by description) in the contract and at some time

 during the taxable year 25 percent or more in value of the

 outstanding stock of the corporation is owned, directly or

 indirectly, by or for the individual who has performed, is to

 perform, or may be designated (by name or by description) as

 the one to perform, such services.

         In the 1996 taxable year $99,182 was received by

 petitioner for the editing services of Daryl Kell on the

 pictures Fair Game and Moll Flanders.     The loan-out agreement

 and deal memoranda for these two pictures specifically




     4
       “Adjusted ordinary gross income” is defined in sec. 543(b)
as gross income minus gains from the sale or other disposition of
capital assets or sec. 1231(b) assets, and minus depreciation,
taxes, interest, and rent incurred in connection with certain
rental income and mineral royalties. In the instant case,
petitioner's adjusted ordinary gross income would equal its gross
income.
                              - 9 -

 designate Daryl Kell to perform the editing services.5       In the

 1997 taxable year $214,106 was received by petitioner for the

 editing services of Daryl Kell on the pictures Kazaam, The

 Associate, Breakdown, and Moll Flanders.    The deal memoranda

 for these pictures also specifically designate Daryl Kell to

 perform the editing services.6   In the 1996 and 1997 taxable

 years Daryl Kell, the individual designated to perform the

 services for petitioner, owned more than 25 percent of the

 shares in petitioner.   Therefore, we find that the income

 received from the enumerated motion picture contracts was

 personal holding company income.     See Kenyatta Corp. v.

 Commissioner, supra at 184 (and cases cited therein).



     5
       The deal memorandum for Fair Game provides: “EMPLOYER
[Petitioner] hereby lends to PRODUCER [Warner Bros.] the
exclusive services of EMPLOYEE [Daryl Kell]”. The deal
memorandum for Moll Flanders provides: “Daryl Kell will provide
music editing services for O’Trilogy Productions”. Additionally
the Executive Vice President-Post production of Warner Bros.
testified that Daryl Kell was the only person to perform the
required services under the loan-out agreement.
     6
       The deal memorandum for Kazaam provides: “Daryl B.
Kell/Calypso Music Inc. will provide music editing services for
Interscope Communications * * *”; “Daryl Kell will render music
editorial services”. The deal memorandum for The Associate
provides: “Daryl B. Kell/Calypso Music Inc. will provide music
editing services for Interscope Communications * * *”; “Daryl
Kell will render music editorial services”. The deal memorandum
for Breakdown provides: “Daryl Kell (Editor) Calypso Music, Inc.
(Lender) will provide music editing services to Dino DeLaurentiis
Co. (Producer)”; “Editor [Daryl Kell] will render music editorial
services”. The deal memorandum for Moll Flanders provides:
“Daryl Kell will provide music editing services for O’Trilogy
Productions”.
                             - 10 -

     The income received for editing services for Fair Game and

Moll Flanders, personal holding company income, constitutes 74

percent of petitioner’s adjusted ordinary gross income in the

1996 taxable year.   The income received for editing services

for Kazaam, The Associate, Breakdown, and Moll Flanders,

personal holding company income, amounts to 76 percent of

petitioner’s adjusted ordinary gross income for 1997.

     For the 1996 and 1997 tax years, petitioner’s ledgers

indicate it received rental income in the amounts of $24,400

and $68,100 respectively.   Respondent determined that these

amounts constitute personal holding company income as defined

in section 542(a)(2).   Respondent’s determination is entitled

to a presumption of correctness; petitioner bears the burden of

proof to establish the determination is in error.   See Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Petitioner advances no meaningful argument on brief that

respondent’s determination is erroneous.   We therefore find

that the rental income in the years in issue is personal

holding company income.

     We hold that petitioner is a personal holding company, as

defined in section 542, for the 1996 and 1997 taxable years.

As a consequence, petitioner is liable for personal holding

company tax, imposed by section 541, equal to 39.6 percent of

the undistributed personal holding company income for each of
                             - 11 -

the years in issue.

     Respondent determined that petitioner was liable for an

accuracy-related penalty, under section 6662(a) and (b)(1) or

(2), for negligence or intentional disregard of rules and

regulations or substantial understatement of income tax.

Petitioner argues that it is not so liable.   Petitioner asserts

that a certified public accountant prepared its returns and

that the accountant had access to all of the materials now

before the Court.   Petitioner argues that it reasonably relied

on professional advice in preparing its returns and therefore

should not be held liable for the accuracy-related penalty.

     Section 6662(a) imposes a 20-percent accuracy-related

penalty on the portion of an underpayment that is due to one or

more of the causes enumerated in section 6662(b).   Respondent

relies on subsections (b)(1) (negligence or intentional

disregard of rules or regulations) and/or (b)(2) (substantial

understatement of income tax).

     Negligence includes a failure to attempt reasonably to

comply with the Code.   See sec. 6662(c).   Disregard includes a

careless, reckless, or intentional disregard.   See id.

     A substantial understatement of income tax is defined to

be the greater of 10 percent of the income tax required to be

shown on the return for the taxable year or $5,000.   See sec.

6662(d).   In the instant case $5,000 is the greater amount for
                             - 12 -

the 1996 and 1997 taxable years.    Respondent determined

understatements of tax of $10,565 and $18,226 for the 1996 and

1997 taxable years, respectively.

     No penalty shall be imposed, however, for either

negligence or intentional disregard of rules or regulations or

a substantial understatement of income tax to the extent that

the taxpayer shows that the underpayment is due to the

taxpayer's reasonable cause and good faith.    See sec. 6664(c);

secs. 1.6662-3(a), 1.6664-4(a), Income Tax Regs.

     Reasonable cause requires that the taxpayer have exercised

ordinary business care and prudence as to the disputed item.

See United States v. Boyle, 469 U.S. 241 (1985); see also

Estate of Young v. Commissioner, 110 T.C. 297, 317 (1998).       The

good faith, reasonable reliance on the advice of an

independent, competent professional as to the tax treatment of

an item may meet this requirement.    See United States v. Boyle,

supra; sec. 1.6664-4(b), Income Tax Regs.; see also Ewing v.

Commissioner, 91 T.C. 396, 423 (1988), affd. without published

opinion 940 F.2d 1534 (9th Cir. 1991).

     Whether a taxpayer relies on advice and whether such

reliance is reasonable hinge on the facts and circumstances of

the case and the law that applies to those facts and

circumstances.   See sec. 1.6664-4(c)(i), Income Tax Regs.   A

professional may render advice that may be relied upon
                              - 13 -

reasonably when he or she arrives at that advice independently,

taking into account, among other things, the taxpayer's

purposes for entering into the underlying transaction.    See

sec. 1.6664-4(c)(i), Income Tax Regs.; see also Leonhart v.

Commissioner, 414 F.2d 749 (4th Cir. 1969), affg. T.C. Memo.

1968-98.    Reliance may be unreasonable when it is placed upon

insiders, promoters, or their offering materials, or when the

person relied upon has an inherent conflict of interest that

the taxpayer knew or should have known about.    See Goldman v.

Commissioner, 39 F.3d 402 (2d Cir. 1994), affg. T.C. Memo.

1993-480; LaVerne v. Commissioner, 94 T.C. 637, 652-653 (1990),

affd. without published opinion 956 F.2d 274 (9th Cir. 1992),

affd. in part without published opinion sub nom. Cowles v.

Commissioner, 949 F.2d 401 (10th Cir. 1991).    Reliance also is

unreasonable when the taxpayer knew, or should have known, that

the adviser lacked the requisite expertise to opine on the tax

treatment of the disputed item.    See sec. 1.6664-4(c), Income

Tax Regs.

     In sum, for a taxpayer to rely reasonably upon advice so

as possibly to negate a section 6662(a) accuracy-related

penalty determined by the Commissioner, the taxpayer must prove

by a preponderance of the evidence that the taxpayer meets each

requirement of the following three-prong test: (1) The adviser

was a competent professional who had sufficient expertise to
                                - 14 -

 justify reliance, (2) the taxpayer provided necessary and

 accurate information to the adviser, and (3) the taxpayer

 actually relied in good faith on the adviser's judgment.       See

 Ellwest Stereo Theatres, Inc. v. Commissioner, T.C. Memo. 1995-

 610; see also Rule 142(a).

        We have no doubt on the record before us that Daryl Kell,

 petitioner’s only officer, actually relied in good faith on the

 certified public accountants who prepared the returns.       We note

 that the 1996 and 1997 returns were prepared by different firms

 of public accountants.7    Petitioner was justified in its

 reliance on its advisers.     We find credible Mr. Kell’s

 testimony that he made available all necessary information to

 the return preparers.     In this circumstance, we shall not

 sustain respondent’s determination of the accuracy-related

 penalties.

        Accordingly,



                                         Decision will be entered

                                  under Rule 155.


    7
       Respondent argues petitioner did not offer the testimony
of its return preparers, Robert Fogleman and Steven McNulty. The
failure to introduce the testimony of the return preparers which
if true would have been favorable to petitioner, gives rise to
the presumption that such testimony would not have been
favorable. See Wichita Terminal Elevator Co. v. Commissioner, 6
T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th Cir. 1947).
Having found Mr. Kell’s testimony in this regard credible, we
find the presumption overcome.
- 15 -
