                          T.C. Memo. 2008-272



                        UNITED STATES TAX COURT



              HOWARD & REBECCA PATE, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 10006-07.                Filed December 9, 2008.



     Howard and Rebecca Pate, pro sese.

     Randall Durfee and Gordon Sanz, for respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:     Respondent determined deficiencies of $16,339

and $19,409 in petitioners’ Federal income taxes for 2003 and

2004, respectively.    Respondent also determined penalties under

section 6662(a) of $3,267.80 and $3,881.80 for 2003 and 2004,

respectively.    The issues for decision are:     (1) Whether the Pate

Association and Pate Joint Venture are disregarded for Federal
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tax purposes and their income for the years in issue is

attributed to petitioners; (2) whether petitioners are liable for

self-employment tax; (3) whether petitioners are entitled to any

deductions beyond those conceded by respondent; and (4) whether

petitioners are liable for the penalties under section 6662(a).

Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the years in issue, and all

Rule references are to the Tax Court Rules of Practice and

Procedure.

                         FINDINGS OF FACT

     Petitioners resided in Texas at the time that they filed

their petition.   During 2003 and 2004, petitioner Howard W. Pate

(Mr. Pate) conducted a business as a pipeline inspector and

consultant.   Mr. Pate worked exclusively for Anadarko Petroleum

Corp. or its affiliate, Anadarko Gathering Co. (Anadarko).

Anadarko reported nonemployee compensation on Forms 1099-MISC,

Miscellaneous Income, that it issued to Mr. Pate for those years.

The amounts received by Mr. Pate and reported as nonemployee

compensation were $98,200 for 2003 and $107,065 for 2004.

     During 2003 and 2004, Rebecca Pate (Ms. Pate) was employed

full time as a school teacher for the Bryan Independent School

District in Bryan, Texas.   Petitioners had two young children

living at home during the years in issue.
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     Petitioners owned approximately 52 acres of land in Bryan,

Texas.    By the end of 2004, petitioners maintained no more than

30 cows on the property.    They did not sell any cows or calves

during 2003 or 2004.    Petitioners did not maintain books and

records of their cattle activity or any record showing profit and

loss from that activity.    Mr. Pate was away from home on business

much of the time, leaving Ms. Pate and their children to feed the

cattle.    Petitioners’ cattle activity was not conducted in a

businesslike manner and was not operated with an actual and

honest profit objective.

     Petitioners filed Forms 1040, U.S. Individual Income Tax

Return, for 2003 and 2004.    The amounts paid to Mr. Pate in

relation to his business, $98,200 for 2003 and $107,065 for 2004,

were initially set out as gross income on Schedules C, Profit or

Loss From Business.    Petitioners, however, reduced these gross

income amounts to zero by claiming “other expenses” of equal

amounts.    Petitioners supposedly validated these Schedule C

expenses by noting that the business was “pass thru” and a “Form

1099 issued to above taxpayer ID# are properly reported” for 2003

“on Schedule E, page 2. Joint Venture” and for 2004 “on Form

1120 S”.    The gross income set out on each Schedule C was

therefore not included in the computation of taxable income.

     The 2003 Schedule E, Supplemental Income and Loss, reflected

a much smaller amount of income, $49,820, than that set out on
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Schedule C, $98,200.   Petitioners reported that this income had

been earned by the “Pate Joint Venture”.   Petitioners filed the

2004 Form 1120S, U.S. Income Tax Return for an S Corporation, for

a so-called Pate Association that used the same address as

petitioners’ residence.   The Form 1120S reported gross receipts

of $107,289, claimed cost of goods sold of $15,594 and business

deductions of $63,959, and reported net business income of

$27,736.

     The Pate Association and Pate Joint Venture were concepts

that, in Mr. Pate’s words, “put all of our stuff under one and so

we could file everything as one to make it easy for us to file

our income tax.”   Mr. Pate did not know whether the Pate

Association and Pate Joint Venture were one and the same or two

separate entities.   These two concepts, which had no purpose

other than to reduce petitioners’ Federal income taxes, had been

suggested by Richard Ohendalski, a certified public accountant

(C.P.A.) associated with the Legacy Group.   Employees of the

Legacy Group prepared petitioners’ income tax returns for 2003

and 2004.

     As a result of the manner in which their Federal income tax

returns for 2003 and 2004 were prepared, petitioners failed to

report self-employment tax due on Mr. Pate’s business profit.    In

addition, deductions claimed as business deductions included

personal expenses and other nondeductible items.   The amounts and
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the nature of the specific items claimed were not disclosed on

petitioners’ returns.

     During an audit of their Federal income tax returns for 2003

and 2004, petitioners presented various receipts and schedules to

support deductible business expenses.     Only the following amounts

were substantiated to the satisfaction of respondent:

      Year                 Description                 Amount

      2003              Repairs                          $309
                        Utilities and phone             1,809
                        Automobile                     18,948
                        Dues & fees                       216
                        Legal/accounting                  425

      2004              Automobile                     21,890
                        Telephone                         904

                                OPINION

     A taxpayer has the right to elect a business form to

minimize or altogether avoid the incidence of taxation by any

means that the law permits.     See Gregory v. Helvering, 293 U.S.

465, 469 (1935).   While a taxpayer is free to adopt a corporate

or partnership form of doing business, the entity must have been

organized for a substantial business purpose or actually engage

in substantive income-producing activity in order to be

recognized as a separate taxable entity.      See Commissioner v.

Culbertson, 337 U.S. 733, 743 (1949); Moline Props., Inc. v.

Commissioner, 319 U.S. 436, 439 (1943).       The Government, however,

is not required to simply accept a taxpayer’s election of

business form where that form is unreal.       Higgins v. Smith, 308
                               - 6 -

U.S. 473, 477 (1940).   Instead, the Government should disregard

such an entity, as any other result would allow the schemes of

the taxpayer to supersede the law.     Id.

     Mr. Pate testified and petitioners do not deny that they

adopted their tax-reporting methodology solely for tax reasons.

The so-called Pate Association and Pate Joint Venture had no

business purpose.   They merely supported a methodology designed

to avoid reporting and paying Federal income tax and self-

employment tax on Mr. Pate’s earnings during the years in issue

and to allow the amounts and the nature of particular expenses to

be concealed.   Petitioners could not provide credible evidence

that the Pate Association and Pate Joint Venture were viable

entities separate from petitioners for Federal tax purposes.

Because these “entities” have no economic substance and separate

legal existence, the income in issue is attributed to petitioners

and subject to Federal income tax.

     With respect to their liability for self-employment taxes,

petitioners’ brief asserts the following frivolous position:

     Self-employment tax
          In the notice of deficiency respondent seeks to
     assert self-employment tax. Self-employment taxes are
     imposed only upon the operations of a “trade or
     business”. “Trade or business” is defined in the
     Internal Revenue Code as “...the performance of the
     functions of a public office.” See IRC 7701(a)(26).
     Self-employment tax also depends upon the definition of
     “trade or business” as in IRC 162. IRC section 162
     makes no changes to the code wide definition in section
     7701 as applies to petitioner.
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Section 7701(a)(26) provides that, for purposes of the Internal

Revenue Code, “The term `trade or business’ includes the

performance of the functions of a public office.”     Frivolous

arguments based on converting the term “includes” in a section of

title 26 to “includes only” have been soundly rejected.      See

United States v. Ward, 833 F.2d 1538, 1539 (11th Cir. 1987);

United States v. Latham, 754 F.2d 747, 750 (7th Cir. 1985).

Petitioners’ argument is patently fallacious and deserves no

further consideration.    See Crain v. Commissioner, 737 F.2d 1417

(5th Cir. 1984).    Petitioners are liable for self-employment tax

on the net income of Mr. Pate’s business as a pipeline inspector

and consultant.    See generally secs. 1401(a), 1402(b); sec.

1.1402(a)-1, Income Tax Regs.

     Although copies of various receipts and schedules were

marked as exhibits at trial, petitioners did not provide any

testimony or otherwise explain the amounts claimed as deductions

that were not substantiated to the satisfaction of respondent.

Respondent did not stipulate that the exhibits established that

petitioners incurred expenses in the conduct of the trade or

business or with the intention of making a profit or that they

reflected ordinary and necessary business expenses.    The

documents are not self-proving and, to the extent that they are

legible, include many items that are not deductible.    They are

not reliable evidence of deductibility.   It is impossible to tell
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from the record which items supported the deductions respondent

agreed to.

     The parties dispute whether petitioners’ cattle activity was

engaged in for profit and whether expenses related to it would be

deductible under section 162.    Petitioners’ brief makes several

factual arguments that are not supported by the evidence.      The

limited evidence in the record is to the effect that petitioners

did not conduct the activity in a manner demonstrating an actual

and honest profit objective.    See sec. 1.183-2(a), Income Tax

Regs.   We need not conduct a detailed analysis of the factors,

however, because petitioners have not identified or explained on

their tax returns or during their testimony the items in dispute

that they claim related to the cattle activity.    Petitioners have

not presented any testimony or evidence that they are entitled to

deductions beyond those respondent conceded, and they have failed

to satisfy their burden of proving that they are entitled to

deductions.   See sec. 7491(a)(2); INDOPCO, Inc. v. Commissioner,

503 U.S. 79, 84 (1992); Hradesky v. Commissioner, 65 T.C. 87

(1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976).

     Section 6662(a) provides a penalty in an amount equal to 20

percent of the portion of an underpayment which is attributable

to various factors, including negligence, disregard of rules or

regulations, or any substantial understatement of income tax.

See sec. 6662(b)(1) and (2).    Respondent has the burden of
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production with respect to any penalty.     See sec. 7491(c).    The

evidence produced establishes erroneous tax return reporting and

improper deductions resulting in a substantial understatement of

income tax.

     Although petitioners claim to have relied upon the advice of

a C.P.A. in adopting their filing methodology, they did not

present evidence of what information they gave the return

preparers or what advice the accountant gave them before filing

the returns for the years in issue.     See Neonatology Associates,

P.A. v. Commissioner, 115 T.C. 43, 100 (2000), affd. 299 F.3d 221

(3d Cir. 2002).    They have failed to identify any reasonable

basis for the methodology or any other ground for reducing the

understatement of tax subject to the penalty.    See sec.

6662(d)(2)(B).    The penalties are appropriate and will be

sustained.

     We have considered the other arguments of the parties, and

they are either without merit or need not be addressed in view of

our resolution of the issues.

     To reflect respondent’s concessions,


                                           Decision will be entered

                                      under Rule 155.
