Schneider & Company, Inc., dba James J. Schneider, CPA, Plaintiff v. United States of America, Defendant [99-2 USTC ¶50,663]

U.S. District Court, So. Dist. Ind., Indianapolis Div., IP-98-0015-C-D/F, 6/24/99

The issue of whether an accounting firm recklessly and intentionally disregarded rules and regulations in determining a corporate client's business expense deductions and was, thus, subject to the return preparer penalty, was properly suited to a jury.

Since additional evidence was necessary to a determination of whether an accounting firm's classification of a corporation owner's office as a home office constituted intentional or reckless disregard of tax regulations, neither the accounting firm nor the IRS was entitled to summary judgment on the issue.

The issue of whether an accounting firm was subject to the return preparer penalty for recklessly and intentionally disregarding rules and regulations in determining a corporate client's business expense deductions was properly suited to a jury. Therefore, neither the IRS nor the accounting firm were entitled to summary judgment on the issue.

ENTRY


This cause comes before the Court on the parties' countering motions for summary judgment. For the following reasons, the motions are denied.


Background


DILLIN, District Judge:


Plaintiff Schneider & Company is an accounting firm owned and operated by James J. Schneider, who is a licensed certified public accountant. During the relevant time period, David and Terry Ham (David and Terry) and David's Subchapter S corporation, Precision Tool Supply, Inc. (Precision), were Schneider & Company clients. Precision is a representative for manufacturers of heavy machinery used in the automobile industry.


Schneider & Company prepared tax returns for Precision and for the Hams. Following an audit of certain tax returns of Precision and the Hams, the Internal Revenue Service (IRS) imposed on Schneider & Company a return preparer penalty totaling $2,000 for 1992 and 1993. Schneider & Company appealed the $2,000 penalty administratively, but its claim was denied. Plaintiff thereafter, on January 5, 1998, filed the present case for a determination of Schneider & Company's liability for the penalty the IRS assessed against it. On March 19, 1999 and March 22, 1999, the defendant and the plaintiff, respectively, filed summary judgment motions. We turn now to a discussion of these motions.


Discussion


Summary judgment is appropriate when there are no genuine issues of material fact, leaving the moving party entitled to judgment as a matter of law. Fed. R. Civ. P. 56(c). While facts are viewed in the light most favorable to the nonmoving party, there is an affirmative burden of production on the nonmoving party to defeat a proper summary judgment motion. Baucher v. Eastern Ind. Prod. Credit Ass'n, 906 F.2d 332, 334 (7th Cir. 1990) (following Celotex Corp. v. Catrett, 477 U.S. 317, 323-24 (1986) Before the Court denies summary judgment, it must be determined whether there is sufficient evidence for a jury to find a verdict in favor of the nonmoving party. Id. (following Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 249-50 (1986)).


The government based its penalty against Schneider & Company on 26 U.S.C. §6694(b)(2), which stipulates as follows:


Understatement of taxpayer's liability by income tax return preparer


(b) Willful or reckless conduct.--If any part of any understatement of liability with respect to any return or claim for refund is due--


(2) to any reckless or intentional disregard of rules or regulations by any such person, such person shall pay a penalty of $1,000 with respect to such return or claim. . . .


Id.


Treasury regulations promulgated as a result of the aforequoted statute define "reckless or intentional disregard" as follows:


Reckless or intentional disregard. (1) Except as provided in paragraphs (c)(2) and (c)(3) of this section, a preparer is considered to have recklessly or intentionally disregarded a rule or regulation if the preparer takes a position on the return or claim for refund that is contrary to a rule or regulation (as defined in paragraph (f) of this section) and the preparer knows of, or is reckless in not knowing of, the rule or regulation in question. A preparer is reckless in not knowing of a rule or regulation if the preparer makes little or no effort to determine whether a rule or regulation exists, under circumstances which demonstrate a substantial deviation from the standard of conduct that a reasonable preparer would observe in the situation.


26 C.F.R. §1.6694-3(2)(c).


Finally, according to IRS regulations, the preparer--in this case, Schneider & Company--has the burden of proving that it did not recklessly or intentionally disregard a rule or regulation. 26 C.F.R. §1.6694-3(h)(1).


The government contends that three separate points direct this Court summarily to affirm its assessment of a penalty against Schneider & Company. According to the government, Schneider & Company improperly reported certain home office expenses, improperly reported certain advertising expenses, and also improperly categorized certain expenses as advertising expenses. 1


In its preparation of Precision's 1992 and 1993 tax returns, Schneider & Company claimed David's race car expenses as a necessary and ordinary advertising expense for Precision. 2 The race car carried Precision's name, as did David's racing suit. Involvement in racing activity reportedly placed David among Precision's customers and potential customers.


Nevertheless, the government posits, the amounts Schneider & Company claimed as advertising and promotion expenses plainly were unreasonable. For the year 1992, Precision's tax return reported race car expenses totaling 21.7 percent of its gross income. Precision's 1993 tax return listed race car expenses totaling 20.9 percent of the company's gross income. Deducting these percentages of gross income, the government insists, patently is unreasonable and such conduct supports the penalty presently under consideration. The government argues that reported cases illustrate that the tax court never has allowed a business to deduct more than 5.1 percent of gross receipts in promotion and advertising expenses. Hence, the government concludes, the willful or reckless nature of Schneider & Company's actions is apparent.


Schneider & Company contends that the government's position is flawed. First, plaintiff argues that reasonableness is an issue for the finder of fact--herein, the jury. Moreover, Schneider & Company asserts, the case law upon which the government builds its argument of unreasonableness is not solid ground for such argument. In particular, §6694(b)(2) refers to intentional or reckless disregard of "rules and regulations." Significantly, such phrase is defined in the Code of Federal Regulations as "provisions of the Internal Revenue Code, temporary or final Treasury regulations issued under the Code, and revenue rulings or notices . . . issued by the Internal Revenue Service and published in the Internal Revenue Bulletin." 26 C.F.R. §1.6694-3(f). Case law, Schneider & Company emphasizes, is not within the definition of "rules and regulations." Furthermore, Schneider & Company points out, there is no rule or regulation establishing a ceiling on deductible ordinary and necessary advertising expenses. Thus, the plaintiff posits, summary judgment in favor of the government would be inappropriate. In fact, plaintiff continues, the nonexistence of a rule or regulation governing race car expenses supports summary judgment on this issue in plaintiff's favor.


An examination of the record leads this Court to conclude that summary judgment on the issue of advertising or promotion expenses would be improper. The evidence contains no evidence demonstrating that Schneider & Company intentionally disregarded a rule or regulation. Furthermore, in accordance with the governing regulation, a preparer is reckless if his conduct in a given circumstance deviates substantially from that of a reasonable preparer. The Court is convinced that a trier of fact must hear testimony regarding what a reasonable preparer would have done under the facts and circumstances of this case. Would a reasonable tax preparer have determined through research that, since the largest advertising deduction allowed in case law was 5.1 percent of gross receipts, the 21.7 percent and 20.9 percent Precision was claiming were unreasonable under §162(a)? Would those reasonable preparers hold this opinion no matter what the nature of the taxpaying business? Furthermore, if the trier of fact finds the amount unreasonable, it also must determine whether Schneider & Company's conduct was a substantial deviation from that of a reasonable preparer.


We proceed to a discussion of the second issue at hand--home office deductions. Herein, we must refer to §162(a), quoted supra in footnote one, and 26 U.S.C. §280A. In relevant part, §280A stipulates that


(a) General rule.--Except as otherwise provided in this section, in the case of a taxpayer who is an individual or an S corporation, no deduction otherwise allowable under this chapter shall be allowed with respect to the use of a dwelling unit which is used by the taxpayer during the taxable year as a residence.


. . .


(c) Exceptions for certain business or rental use; limitation on deductions for such use.--


(1) Certain business use.--Subsection (a) shall not apply to any item to the extent such item is allocable to a portion of the dwelling unit which is exclusively used on a regular basis--


(A) the principal place of business for any trade or business of the taxpayer.


. . . .

26 U.S.C. §280A.


The government first argues that plaintiff incorrectly relied solely upon §162(a) in deciding that certain home office expenses were deductible. Schneider & Company's failure to consider §280A's effect on the deductibility of those expenses, the government asserts, constitutes an intentional or reckless disregard of §280A and, thus, supports the $2,000 penalty here at issue. Furthermore, the government states, even if plaintiff intended to satisfy §280A, the United States Supreme Court already had decided Commissioner v. Soliman [93-1 USTC ¶50,014], 506 U.S. 168 (1993), which case, the government posits, clearly illustrates that Precision's home office did not qualify as the company's "principal place of business." Consequently, the government opines, even under this scenario Schneider & Company recklessly disregarded §280A and the penalty assessed against it should be upheld on summary judgment.


Preliminarily, Schneider & Company points out that the amount of home office expenses disallowed by the IRS audit agent was minimal. For 1992, the agent rejected $1,423.02 for home office expenses, which was .8 percent of that year's gross receipts. For 1993, the agent disallowed $1,372.59, or .4 percent of gross receipts. Moreover, the plaintiff notes that the government's attempt to justify its imposition of a penalty with arguments pertaining to home office deductions is of recent origin. According to plaintiff, no such argument was made at the administrative level of review. Plaintiff contends that the untimeliness of the defendant's assertion of this issue justifies either precluding the government from relying on it or shifting the burden or proof on this issue to the government.


On a more substantive note, Schneider & Company argues that its employees reasonably categorized the particular home office expenses as "ordinary and necessary" expenses under §162(a). Schneider & Company personnel reportedly believed that those "ordinary and necessary" expenses were not "with respect to the use of a dwelling," as described in §280A. Thus, they concluded that the limitations of §280A were inapplicable.


Schneider & Company further asserts that a Precision employee was responsible for determining whether particular expenses were deductible and for entering such items on a detail trial balance. Plaintiff states that its employees merely used the information Precision provided and notes that no evidence suggests its personnel "were aware of any inappropriately-deducted item."


Finally, Schneider & Company counters the government's position that the Hams' home did not serve as Precision's principal place of business. According to plaintiff, the Soliman Court held that a facts and circumstances test is used to determine whether a home office is a "principal place of business." Moreover, Schneider & Company argues, consideration of the facts of this case not only lead to the conclusion that the plaintiff's employees did not intentionally or recklessly disregard §280A, but also lead to the conclusion that its employees were correct in categorizing the Hams' home as Precision's principal place of business.


In Soliman, the Supreme Court stated that "the ultimate determination of the principal place of business [is] dependent upon the particular facts of each case." Soliman [93-1 USTC ¶50,014], 506 U.S. at 175. The Court held that the "principal place of business" is "the most important or significant place of the business" and announced two primary considerations for determining whether a home office is the principal place of business: (1) the relative importance of the activities performed at each business location and (2) the time spent at each place. Id. The Soliman Court noted that within the context of the first consideration "the point where goods and services are delivered must be given great weight." Id.


The government argues that the "point where services and products supplied by Precision Tool Supply was [sic] delivered--that is the income-generating tasks . . .--clearly was not in the office in Mr. Ham's home." Thus, the government concludes that plaintiff's deduction of the subject home office expenses was an intentional or reckless disregard of applicable rules or regulations.


While we are convinced that §280A was a rule or regulation applicable to Precision's home office, we are not persuaded by the government's position that the home office did not serve as Precision's principal place of business. First, although Soliman is relevant to the definition of "principal place of business," Soliman is not a rule or regulation, but rather a decision of the Supreme Court. Under 26 C.F.R. §1.6694-3(2)(c), a preparer is reckless if he makes no effort to discover a rule or regulation under circumstances demonstrating a "substantial deviation from the standard of conduct that a reasonable preparer would observe in the situation." Perhaps a jury would determine that reasonable tax preparers were aware of Soliman's holding; perhaps it would not. Moreover, even if a jury would so determine, it also could determine that the plaintiff, in concluding that the Hams' home qualified as a home-office, did not intentionally or recklessly disregard the rule or regulation flowing from that decision. As the owner of Precision, David represented manufacturers of heavy machinery used in the automobile industry. Precision, itself, did not make the machinery. Apparently, Precision acted as a "middleman" between the manufacturer and the buyer. Additional evidence further will enlighten the finder of fact about Precision's most important business activities as deemed significant by the Soliman Court. Additionally, the opposing parties will have the opportunity to present to the jury the various tax regulations that were effective during the relevant time period. The jury, then, can determine whether Schneider & Company's classification of the Hams' office as a home office for purposes of §280A was an intentional or reckless disregard of the rules and regulations.


Finally in this arena, we disagree with plaintiff that defendant's untimely assertion of home office deductions somehow should shift the burden of proof or preclude a jury's consideration of it. We, however, are persuaded that defendant's eleventh hour assertion of this defense renders the government's reliance on it suspect, a further reason for denying summary judgment on this issue. Lastly, the Court turns to the defendant's third argument: according, to the government, the $1,000 penalty for 1993 should be upheld because Schneider & Company mislabeled certain race car expenses in preparation of that year's taxes for the Hams.


Precision purchased a car chassis, engine and other automotive parts in 1993, with which David intended to develop a new car named the Intruder. David apparently also intended to market the Intruder. The government states that such expenses were incurred as a result of contemplating a new business--that of selling the Intruder commercially--and, hence, were pre-opening expenses for that business. Pre-opening expenses, the government continues, only can be capitalized and depreciated, never expensed, and only can be capitalized and depreciated if the contemplated business actually is entered. Thus, the government contends, the 1993 penalty it assessed against the plaintiff should be sustained because Schneider & Company intentionally or recklessly disregarded §162(a) in expensing the Intruder expenditures on Precision's 1993 return. Schneider & Company counters that David never informed it that he had started or was contemplating starting a new business. The record, plaintiff states, includes no evidence indicating otherwise.


Schneider & Company agrees with the government that ordinary and necessary business expenses under §162(a) have to be incurred in connection with a trade or business and that it must be a pre-existing trade or business. Plaintiff points out, however, that "[w]hether or not a business activity is a new trade or business, or an expansion of an existing trade or business, is determined by the facts and circumstances of the particular case." Pl.'s Resp. Br. at 15. Schneider & Company contends that even if David did intend to market the Intruder, such conduct would be an expansion of Precision, which owned the vehicle, not the creation of a new one. In its reply brief, the government counters that no jury reasonably could deem the business of selling a race car an expansion of Precision's existing business of being a sales representative for manufacturers of heavy machinery.


Neither party has presented to the Court evidence or case law convincing the Court of its position as a matter of law. The government lodges the self-serving argument that its position is the only reasonable one; the plaintiff insists that none of its employees acted in a reckless manner. Testimony revealing the standard of conduct a reasonable tax preparer observes greatly will assist the trier of fact in its ultimate determination of this issue, as well as the others in this case. We are persuaded that whether Schneider & Company, in preparing the subject tax returns, acted in a reckless manner--that is, deviated substantially from the standard of conduct a reasonable preparer would have observed in a like situation--is an issue properly suited for a jury.


For the foregoing reasons, the Court denies both parties' motions for summary judgment.


1 Plaintiff argues that in defending the assessed penalties the government should be limited to the one theory it originally launched--that is, that the deductions giving rise to the preparer penalties were improper hobby losses. Plaintiff seeks to have the Court strike the government's defense as it relates to start-up costs and home office deductions, discussed infra in the text.


We readily reject plaintiff's argument pertaining to start-up costs. In an August 18, 1995 letter, plaintiff informed the government that Schneider & Company would not permit defendant to conduct a general review of its files regarding the tax returns in issue. Rather, Schneider & Company forced the government to identify "specific allegations" it wished to address. Moreover, on September 29, 1995, Schneider & Company refused the government's request to meet and discuss the subject tax returns unless the defendant, inter alia, paid it $110 an hour and issued it a $2,500 retainer.


This Court will not endorse plaintiff's unwillingness to cooperate in an IRS review by now considering an argument that would not exist had Schneider & Company initially cooperated with the IRS. We, therefore, must reject Schneider & Company's attempt to omit a theory under which the penalties can be sustained on review when that very theory did not surface until after the government gained access to the necessary documents through discovery. For the same reason, we will not entertain plaintiff's contention that based on the untimeliness of the government's defense as it relates to start up costs, the burden of proof on that issue should shift to the defendant.


Finally, we discuss plaintiff's argument as it relates to the government's assertion of Schneider & Company's allegedly improper deduction of home office expenses infra in the text.


2 Under 26 U.S.C. §162(a), a taxpayer may deduct "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Id.