[90-2 USTC ¶50,525] Kenneth R. Chandler, Plaintiff v. United States of America, Defendant

U.S. District Court, West. Dist. Ky., Louisville, Civ. C 89-0001-L(A), 10/1/90


[Code Sec. 6694 ]


An income tax preparer was improperly assessed tax preparer penalties with respect to a joint return submitted with a business deduction for payment of wages to the taxpayer's husband and reflecting income in the same amount as paid to the husband from the taxpayer's insurance business. The return preparer acted with due care in treating the spouse as having received compensation in a situation where the spouse worked in the business and received benefits but did not actually receive a check designated as "payroll." The business was necessarily a sole proprietorship rather than a partnership, because only the taxpayer was licensed with the insurance company and with the state permitting her to receive commissions on sales by agents under her supervision; the taxpayer's husband could not be a principal in the business. The return preparer was presented with ample evidence that the husband worked full time for the agency and received personal benefit from the joint account into which the commissions were deposited.

MEMORANDUM OPINION


ALLEN, Senior District Judge:


This case presents the claim of plaintiff, a tax preparer, that the Internal Revenue Service improperly assessed tax preparer penalties against plaintiff under 26 U.S.C. Sec. 6694 . The court previously declined to enter summary judgment, explicitly stating that issues of fact remained, primarily involving intent. Nonetheless, the parties have waived trial, asking that the Court resolve the factual issues and decide the case on the merits on the basis of the paper record in lieu of live testimony. After careful examination of the materials of record, we are of the opinion that plaintiff is entitled to judgment.


The statute authorizes imposition of a penalty of $100 if part of any understatement of liability "is due to the negligent or intentional disregard of rules and regulations by . . . an income tax preparer." 26 U.S.C. Sec. 6694(a) . Subsection (b) permits assessment of a $500 penalty if the understatement "is due to a willful attempt . . . to understate the liability." "Negligent" disregard has been interpreted to mean "lack of due care or failure to do what an ordinary reasonably prudent person would do under the circumstances." Swart v. United States [83-2 USTC ¶9545 ], 568 F.Supp. 763, 765 (C.D. Cal. 1982), aff'd 714 F.2d 154 (1983). The imposition of a penalty is presumed correct and the challenging preparer bears the burden of showing reasonable prudence. 26 C.F.R. 1.6694-1(a)(5).


In early April 1986, Sharon and Wayne Holsclaw approached plaintiff, a Certified Public Accountant, to ask him to prepare their tax return for the 1985 year. Sharon Holsclaw was a sales manager for a large insurance operation, and she held state licenses that permitted her to receive commissions on sales by agents under her supervision. Wayne Holsclaw did not hold any such license and was not entitled to direct receipt of any such commission, but it is undisputed that he performed substantial work for Sharon [Powell Depo. 14-16].


Sharon Holsclaw deposited her commission checks into an account owned jointly by her and Wayne. From that account, Wayne wrote checks for the business expenses, for the couple's joint expenses, and for his personal expenses, including his car, clothing, etc. [Chandler Depo. 11-12]. Sharon had not had a bookkeeper since the first quarter of 1985, and it was necessary for plaintiff to go through extensive records to prepare the income tax return. As part of that work, plaintiff classified each check that had been written as to type of expenditure [Chandler Depo. 8].


Circumstances did not permit a filing extension, and plaintiff completed the return by April 15. The joint return as submitted reflected all of the commission income as income to Sharon Holsclaw's sole proprietorship. It also reflected a business deduction for payment of $10,000 in wages to Wayne, and income to Wayne in the amount of $10,000. Plaintiff testified that he arrived at the $10,000 as a conservative figure based on an analysis of the work Wayne performed and the checks written for Wayne's personal benefit [Chandler Depo. 42]. There is no question that all income received by Sharon was accurately reported, and she did not claim an amount of business deduction for salary greater than the amount of salary reported by those working in her office. However, because Sharon and Wayne were related, the circumstances as reported resulted in some tax savings to the couple because of a small differential in the amount of self-employment tax.


In early 1987, defendant, through Agent Powell, commenced an audit of the Holsclaws' 1985 return. After meeting with the Holsclaws and plaintiff and reviewing the records, Powell proposed to them an agreement by which the $10,000 wage figure would be removed, and the Holsclaws would pay the difference in taxes. Significantly, defendant did not propose to impose on the Holsclaws a penalty for either intentional or negligent action.


The parties agree that discussions between Powell and the Holsclaws took place through plaintiff. Powell and Chandler agree that their conversation concerning the proposed audit report took place in July 1987 [Powell Depo. 37, Chandler Depo. 27]. However, they disagree concerning the specifics of that telephone conversation.


Plaintiff recounts the conversation as having involved his questioning why all taxpayer penalties were being waived:


[Powell] said he felt that because of the time pressure and the lack of good bookkeeping that the circumstances were out of the control of the Holsclaws. And I immediately followed that question with are you contemplating any tax preparer penalties. He said no.


Chandler Depo. 28.


Powell agreed that one of the reasons for waiving taxpayer penalty was that the Holsclaws were without a bookkeeper for nine months, but his recollection of the July 1987 telephone conversation with Chandler is slightly different:


Q. Now, did [Chandler] ask you whether or not you were going to assess a tax preparer's penalty?


A. Yes, he did.


Q. And what was your reply then?


A. My reply was, it has not been considered at this point.


Powell Depo. 18.


No party has suggested that the United States would have been bound in any event by Powell's response to the inquiry concerning tax preparer penalty. Nonetheless, the dispute concerning the phone call has significance because of subsequent events.


Plaintiff explained to the Holsclaws the agreement that had been offered, and he explained as well the expenses that would be involved if the Holsclaws wanted to challenge Powell's conclusion in Tax Court. The Holsclaws decided the small additional assessment, with no penalties involved, was not worth a Tax Court fight [Chandler Depo. 29].


In late February 1988, after the Holsclaws had agreed to the additional assessment, defendant informed plaintiff of the assessment of a tax preparer penalty for both negligent and willful acts in preparing the Holsclaw 1985 return. It is undisputed, however, that the assessment was actually made in July 1987--i.e., around the time of the telephone conversation described above. When asked the reason for the delay, Powell candidly responded:


because it's such a touchy situation and you have an agreed report at the individual level, then you will wait until the individuals get assessed until you will pursue the preparer penalty.


Powell Depo. 21. Powell later explained that the reason he and his supervisor had decided to tell Chandler the tax preparer penalty had not been considered was "basically to delay it until the individual return went through and was assessed and we had no problems with getting that prepared [sic] penalty through" [Powell Depo. 37-38]. At another point, Powell appeared to rely on the agreement as evidence that the tax return had been prepared improperly:


It did not show to me that he had proper reason for deducting wages paid to spouse and he did not question it by the taxpayer's signing and agreeing with the, with the form.


Powell Depo. 33.


We can imagine circumstances in which a taxpayer's agreement to additional assessment might be some evidence in a challenge to a tax preparer penalty. In this case, however, given the timing, the dispute about the telephone conversation, and Powell's testimony that defendant was interested in getting the taxpayer agreement finalized before revealing the tax preparer assessment, we are of the opinion that the Holsclaws' agreement to the audit report is no evidence whatsoever of wrongdoing by plaintiff.


Powell testified that he had two reasons for making the tax preparer penalty assessment. First, he stated that when he inquired of plaintiff why a spouse's income in a family business would be reported (admitting that his question was born of curiosity and unfamiliarity with public accounting), plaintiff told him about the reduced self-employment tax. However, Powell admits that the regulations clearly permit avoidance of a portion of self-employment tax when wages are paid to a spouse [Powell Depo. 31]. Thus, Chandler's answer was nothing more than an accurate statement of tax law, and it cannot be used to demonstrate negligence or other wrongdoing on his part.


Powell's other basis for his assessment was "the handling of the $10,000 income" [Powell Depo. 25]. Powell admitted that he was specifically looking for any checks made payable to Wayne Holsclaw [Depo. 23], and that he knew that Wayne worked in the business and did not have other income [Depo. 41]. Indeed, Sharon Holsclaw testified that she would have had to pay $30,000 or more to hire someone else to do the work that Wayne did for the agency [S.Holsclaw Depo. 9]. Neither does defendant appear to dispute the fact that Wayne received personal benefit from the funds he withdrew from the joint account.


Powell agreed that if the agency's income had been paid into a joint account, and "payroll" checks had been written out of it to Holsclaw in the amount of $10,000, the salary deduction would have been perfectly all right [Powell Depo. 26]. Accordingly, this case comes down to a simple question: Would a reasonable tax preparer in April 1986 have been acting with due care in treating a spouse as having received salary where the spouse worked in the business and received benefits but did not actually receive a check designated as "payroll"?


In our opinion, this question must be answered in the affirmative. Plaintiff pointed out that the business was necessarily a sole proprietorship rather than a partnership, because only Sharon was licensed with the insurance company and with the state. Wayne could not be a principal in the business [Chandler Depo. 15]. Plaintiff was presented with ample evidence that Wayne worked full-time for the agency, and that he received personal benefit from the joint account into which the commissions were deposited. Regardless of whether the IRS or the Tax Court would ultimately agree with plaintiff, we are unable to conclude that he acted unreasonably or without due care. 26 C.F.R. Sec. 1.6694-1(a)(4) .


This case differs dramatically from Weidmann v. U.S. Dept. of Treasury [89-1 USTC ¶9197 ], 713 F.Supp. 569 (W.D.N.Y. 1989), in which tax preparer penalties were upheld. In Weidmann, the plaintiff had prepared joint returns for a number of married couples. In each case, one spouse was self-employed, and the other spouse was listed as employed by that sole proprietorship, although in many cases the salary paid was minimal, and in almost all cases, the "employee" spouse was employed full-time elsewhere. The purpose of the "employment" relationship was to obtain deductibility for food and housing expenses, and was attempted by having the self-employed spouse execute a document requiring the "employee" spouse to live and take meals on the premises (i.e., the residence). The court held that Weidmann had failed to carry his burden of showing that the tax preparer penalty was in error, relying primarily on expert testimony for that conclusion.


In Weidmann, there was good reason to doubt the preparer's good faith in identifying a bona fide employer-employee relationship:


In all cases, the so-called employee-spouse performed few services. It was similar to the kind of help that most spouses render to the other on a sporadic, casual basis.


[89-1 USTC ¶9197 ], 713 F.Supp. at 571. We might observe that this is not only very different from the direct and consistent work Wayne performed for Sharon's business, but it also appears similar to the sporadic assistance the Holsclaws' children rendered to the business; it is, perhaps, of interest to note that plaintiff did not suggest the Holsclaw children were employees.


Whether the position taken in the Holsclaws' 1985 return is one with which the IRS agreed, whether it would still be a reasonable position in light of subsequent authority, or whether it would be reasonable under other circumstances, are all questions not before us. We determine only that under all of the circumstances, it cannot be said that a prudent person in plaintiff's position would not have behaved as he behaved.


A judgment in conformity has this day entered.


JUDGMENT


This matter having come before the Court by agreement of the parties on the written record in lieu of trial, and the Court having entered its memorandum opinion and being advised,


IT IS ORDERED AND ADJUDGED that judgment is entered in favor of plaintiff, that the injunction previously entered is made permanent, and that defendant is directed to return to plaintiff the amount paid on the penalty.


This is a final and appealable order and there is no just cause for delay.