Thursday, November 29, 2007

Tax Return Preparer – section 6694 - Fraudulent tax returns: False statements.



Two tax return preparers and their accounting services organization were permanently enjoined under Code Sec. 7408 because they engaged in conduct subject to penalty under Code Secs. 6700 and 6701. The preparers organized and marketed the scheme that assisted their customers in preparing false tax returns. They falsely stated that those who participated in the scheme had a right to exclude compensation for personal services or labor from taxation. Moreover, the preparers had knowledge that their representations and advice were false or fraudulent and the documents prepared by them would be used to understate their customers' correct tax liabilities. Additionally, there was no indication that the preparers would not engage in violation of the tax code.




ORDER OF DEFAULT JUDGMENT OF PERMANENT INJUNCTION


NICHOLAS, United States District Court: This matter come before the Court on plaintiff's motion for Default Judgement of Permanent Injunction. Defendants Archie J. Pugh, Jr., and Theodore Pugh were properly served and have failed to appear in this matter. Entry of Default was made against them on August 27, 2007. (Docket No. 6). Having reviewed the record in this case, the Court makes the following findings of fact and conclusions of law and enters this permanent injunction against Archie J. Pugh, Jr., and Theodore Pugh.


FINDINGS OF FACT


Defendants Archie J. Pugh, Jr., and Theodore Pugh are marketing the so-called "Claim of Right" tax-evasion scheme. Accordingly to the complaint, the Pughs falsely claim that all compensation or earnings are deemed nontaxable. Moreover, defendants also prepare income tax returns for customers based on the fraudulent Claim of Right program. Defendants market the Claim of Right program to customers of Archie's Tax and Accounting Service. The Pughs charge customers $250 to have the Claim of Right tax returns prepared.

As part of the scheme, defendants falsely tell their customers that they have a common-law and constitutional right (under the Fourteenth Amendment to the United States Constitution) to exclude from taxation all compensation for personal services or labor rendered. Defendants falsely state that I.R.C. § 1341 codifies this so-called common-law or constitutional right and entitles their customers to take a deduction in the amount of compensation earned, which in most cases eliminates a participant's tax liability. Defendants state that this can be done by claiming an itemized deduction to offset wages reported on W-2 forms, or by taking a Schedule C deduction to offset any net income from self-employment.

As part of their marketing ploy, defendants make numerous false or fraudulent statements in support of their abusive program, including:
 Compensation earned is immune from taxation.

 Money earned in exchange for personal labor or services does not constitute taxable income and may be deducted.

 Income earned for labor is a not for profit activity and thus deductible on tax returns.

 Their "claim of right" claim is a "mandatory deduction allowed by United States law."

Defendants' claims regarding the tax benefits associated with their Claim of Right program are false. In addition, the tax returns defendants have prepared based on the Claim of Right tax-evasion scheme are fraudulent, and understate their customers' income based on this false, discredited concept.

Moreover, defendants know or have reason to know that the tax-fraud scheme they promote is unlawful and that their statements to customers about the scheme's tax benefits are false. Indeed, other federal courts have permanently enjoined other persons from promoting similar Claim of Right tax-fraud schemes, such as United States v. Lloyd, 2005 U.S. Dist. LEXIS 32747 (M.D.N.C. 2005), aff'd, 2006 U.S. App. LEXIS 16254 (4 th Cir. 2006). (Cmplt. ¶¶ 21-23.)


CONCLUSIONS OF LAW




A. Default Judgment Standard

Rule 55 of the Federal Rules of Civil Procedure provides that where a party fails to plead or otherwise defend against a complaint, and after entry of default, default judgment may be entered against such person. Upon entry of default, the well-pleaded allegations of the complaint relating to a defendant's liability are taken as true, with the exception of the allegations as to the amount of damages, which is not an issue here because the United States is seeking injunctive, not monetary, relief. 1 Default judgment should not be different in kind than what is sought in the complaint. 2 Here, the United States seeks only the injunctive relief requested in the complaint.



B. The United States' Substantive Claims Set Forth in its Complaint Satisfy the Standards for a Permanent Injunction Under IRC § 7407.

Section 7407 authorizes the Court to enjoin a federal-tax-return preparer from engaging in conduct subject to penalty under I.R.C. §§ 6694 or 6695 if the Court finds that injunctive relief is appropriate. 3 Where a return preparer's conduct subjecting them to penalty under IRC §§ 6694 or 6695 has been continual or repeated, the Court may enjoin them from preparing any federal returns if the Court finds that a more narrow injunction prohibiting only specific misconduct would be insufficient to prevent further interference with the administration of the internal revenue laws. 4 Because the Pughs are continually and repeatedly engaging in conduct subject to penalty under both IRC §§ 6694 and 6695, the Court finds that a permanent injunction under IRC § 7407 is necessary to bar them from preparing federal tax returns. 5



1. Defendants Have Continually and Repeatedly Engaged in Conduct Subject to Penalty Under IRC § 6694.

Section 6694 penalizes preparers on two grounds. First, under § 6694(a), a preparer is subject to penalty for negligently understating a customer's tax liability due to unrealistic positions. Second, under § 6694(b), a preparer is subject to penalty for any willful attempt to understate the tax liability of customer or any reckless or intentional disregard of rules or regulations.



a. Negligently Understating a Customer's Tax Liability Due to Unrealistic Positions under IRC § 6694(a).

A return preparer is subject to penalty under IRC § 6694(a) if (1) the preparer submits a return that contains an understatement of liability; (2) the understatement is based upon a position taken for which there was not a realistic possibility of being sustained. These elements are met. The Pughs have prepared numerous false Forms 1040, Forms 1041, and Schedules C in order to support false and fictitious claims for refund on behalf of customers. Moreover, they have advanced unrealistic positions deducting from income the amount paid to their customers' for wages --based on the frivolous "claim of right" scheme. 6



b. Willful Understatement of Tax Liability or Intentional or Reckless Disregard of Rules and Regulations under IRC § 6694(b).

A return preparer is subject to penalty under Code § 6694(b) if any part of an understatement of a tax liability is due to (1) "a willful attempt in any manner to understate the liability for tax by a person who is an income tax return preparer with respect to such return or claim" or (2) "any reckless or intentional disregard of rules or regulations." In this case, defendants deduct wages from income under their frivolous Claim of Right program, thus subjecting them to penalty under § 6694(b).



2. Defendants Have Continually and Repeatedly Engaged in Conduct Subject to Penalty Under IRC § 6695.

IRC § 6695(b)-(c) penalizes a return preparer who fails to list his trade name or other identifying information, or sign returns. See IRC § 6695(b)-(c) & 6109(a)(4). Here, the Pughs prepared, but failed to sign their customers' income returns or identify themselves as the income tax return preparer. Their failure to do so subjects them to penalty under IRC § 6695(b)-(c).



3. Defendants Have Repeatedly Engaged in Conduct Proscribed by IRC § 7407(b).

Defendants have also engaged in conduct proscribed by IRC § 7407(b). The Pughs have engaged in conduct proscribed by Section 7407(b)(1)(D) by asserting the frivolous Claim-of-Right deductions on numerous returns for customers, and by failing to present completed copies of returns to customers before filing with the IRS. 7 Moreover, defendants' fraudulent and deceptive conduct has interfered with the internal revenue laws and the IRS conservatively estimates that they have cost the U.S. Treasury roughly $2.4 million.



4. Defendants Are Barred from Preparing Federal Tax Returns.

Since a narrow injunction would not prevent the Pugh's conduct, they should be barred from preparing returns altogether. 8 Defendants entire return preparation business is focused on preparing fraudulent returns that interfere with the administration of the internal revenue laws. Moreover, the Pugh's fraudulent returns limited to misuse of a single IRS form, or a single factual misrepresentation. Rather, the Pugh's have falsified Forms 1040, Forms 1041A, and Schedules C. For these reasons, the Court enjoins them from preparing all federal tax returns.



C. The United States is Entitled to Injunctive Relief under IRC § 7408

An injunction under IRC § 7408 is warranted to enjoin a person from further engaging in conduct subject to penalty under IRC §§ 6700 or 6701. The facts in this case establish that defendants engaged in such conduct and that injunctive relief is appropriate to prevent recurrence of that conduct.



1. Defendants Engaged in Conduct Subject to Penalty under IRC § 6700

Section 7408 authorizes a court to enjoin persons who have engaged in any conduct subject to penalty under § 6700 if the Court finds that injunctive relief is appropriate to prevent the recurrence of such conduct. Under § 6700, any plan or arrangement "having some connection to taxes can serve as a 'tax shelter' and will be an 'abusive' tax shelter if the defendant makes the requisite false or fraudulent statements concerning the tax benefits of participation." 9 To establish a violation of § 6700 warranting an injunction under § 7408, the United States must show that:
(1) the defendant organized or sold, or participated in the organization or sale of, an entity, plan, or arrangement; (2) he made or caused to be made, false or fraudulent statements concerning the tax benefits to be derived from the entity, plan, or arrangement; (3) he knew or had reason to know that the statements were false or fraudulent; (4) the false or fraudulent statements pertained to a material matter; and (5) an injunction is necessary to prevent recurrence of this conduct. 10

This Court has the authority to grant the requested injunction if the Government establishes that defendant engaged in conduct subject to penalty under § 6700 and injunctive relief is appropriate to prevent the recurrence of such conduct. The record submitted with this motion makes that showing.



a. Defendant organized and sold a plan or arrangement.

There is no question that defendants organized and sold a plan or arrangement. The Claim of Right program is organized and marketed by the defendants through word-of mouth, and defendants assist customers in preparing false income tax returns based on the scheme. Moreover, defendants charge for participation in the program. Thus, defendants organized and marketed the Claim of Right program within the meaning of IRC § 6700. 11



b. Defendant made false or fraudulent statements regarding the tax benefits associated with their "claim of right" program.

Defendants also misrepresent the tax benefits of the Claim of Right program. The Pughs falsely states that participants have a right to exclude compensation for personal services or labor from taxation. They maintain that participants are entitled to a "Claim of Right" deduction on their federal income tax returns in the amount of compensation earned on their labor, and that the deduction is based on IRC §§ 183, 212 or 1341.

The Pugh's purported reliance on §1341 is groundless. 12 IRC § 1341 applies only to those situations where a taxpayer properly reports income in one year and later repays all or a portion of it in a later year because the taxpayer, in fact, did not have an unrestricted right to that income. The section allows the taxpayer to take a deduction in the later year for the amount repaid. (It is not a mechanism for amending the previous year's return.) See Wicor, Inc. v. United States, 263 F.3d 659, 661 (7th Cir. 2001); Rev. Rul. 2004-29, 2004-12 I.R.B. 627. It does not apply unless it is "established after the close of [the] prior taxable year (or years) that the taxpayer did not have an unrestricted right to such [income]." IRC § 1341(a)(2). There is simply no "Claim of Right" doctrine under that IRC section or any other statute that allows an individual to take the position espoused by the Pughs that neither the individual nor the individual's income is subject to federal income taxes.

Furthermore, IRC § 1341 requires a taxpayer to return the funds that he previously reported as taxable income before he can claim a deduction. See Chernin v. United States, 149 F.3d 805, 815-16 (8th Cir. 1998); Treas. Reg. 1-1341-1(a). The Pugh's are certainly not telling customers that they have to return their earned income to their employers in order to participate in the tax scheme. IRC § 1341 has no application to the defendant's frivolous Claim of Right program.

The Pughs also rely on IRC §§ 183 and 212 for their Claim of Right program. The purported reliance on §§ 183 and 212 is equally groundless. IRC § 183 prohibits an individual taxpayer from deducting expenses attributable to an activity that is not engaged in for profit. "Activity not engaged in for profit" includes all activities other than those with respect to which deductions are allowable, inter alia, under § 212 as expenses incurred in the production of income or for management, conservation or maintenance of property held for production of income. IRC § 183(a). Earnings from employment cannot qualify as expenses incurred in the "production or collection" of that same income. Neither § 183 nor § 212, nor any combination thereof, stands for the proposition that income or compensation for services rendered is deductible.

In simple terms, the Claim of Right program is a rehash of the oft-rejected anti-tax argument that wages and other compensation for services rendered are not subject to income tax. For federal income tax purposes, "gross income" means all income from whatever source derived and includes compensation for services. See IRC § 61. Any income, from whatever source, is presumed to be income under § 61, unless the taxpayer can prove that it is specifically exempt or excluded. Reese v. United States, 24 F.3d 228, 230 (Fed. Cir. 1994). If a taxpayer is not able to sustain the burden that his income is excluded, then that amount must be included as income. All compensation for personal services, no matter what the form of payment, must be included in gross taxable income. This includes salary or wages paid in cash, as well as the value of property and other economic benefits received because of services performed, or to be performed in the future. Commissioner v. Kowalski, 434 U.S. 77 (1977); Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955) (income not limited to gains or profits); Ledford v. Commissioner, 297 F.3d 1378, 1381 (Fed. Cir. 2002); United States v. Connor, 898 F.2d 942, 943-44 (3d Cir.) ("Every court which has ever considered the issue has unequivocally rejected the argument that wages are not income."), cert. denied, 497 U.S. 1029 (1990); United States v. Sassak, 881 F.2d 276, 281 (6th Cir. 1989); Casper v. Commissioner, 805 F.2d 902 (10th Cir. 1986); Coleman v, United States, 791 F.2d 68 (7th Cir. 1986) (all individuals must pay income tax on their wages); Stelly v. Commissioner, 761 F.2d 1113, 1115 (5th Cir. 1985) (finding argument that taxing wages and salary is unconstitutional, because compensation for labor is an even exchange, obviously frivolous); Connor v. Commissioner, 770 F.2d. 17, 20 (2d Cir. 1985); United States v. Romero, 640 F.2d. 1014 (9th Cir. 1981). See also Lonsdale v. United States, 919 F.2d 1440, 1448 (10th Cir. 1990); Biermann v. Commissioner, 769 F.2d 707 (11th Cir. 1985).

Finally, defendants blatantly and falsely claim that the Claim of Right program is in compliance with the Internal Revenue Code. As stated above, the Claim of Right program is annually reported on the IRS's consumer alert of tax scams that taxpayers are urged to avoid.



c. Defendant knew or had reason to know that their tax statements were false or fraudulent.

Defendants knew or had reason to know that their statements regarding the tax consequences of purchasing the tax programs were false or fraudulent. The United States is not required to establish that the defendants acted with subjective bad faith, i.e., to show that defendants actually knew, at the time they sold the program, that they were espousing false and fraudulent statements. Rather, it is sufficient (for the purpose of establishing a violation of § 6700) for the Government to show that, as a result of the courts' uniform rejection of the same or similar statements, the defendant should have known that their representations regarding the tax benefits of their program were false or fraudulent. 13 White, 769 F.2d at 515 (person knew or had reason to know of false or fraudulent statements because such statements had been consistently rejected by courts); Buttorff, 761 F.2d at 1062.

The "knew or had reason to know" standard includes "what a reasonable person in the [defendant's] ... subjective position would have discovered." Estate Pres. Servs., 202 F.3d at 1103. As shown above, the law is well settled that the tax statements made by defendants are false or fraudulent. "[T]he average citizen knows that the payment of income taxes is legally required." Schiff v. United States, 919 F.2d 830, 834 (2d Cir. 1990). The Pughs prepare income tax returns for others, and are, thus, charged with a minimal understanding of the tax laws. A modicum of research would have revealed to them that the Claim of Right program simply rehashes discredited positions espoused by tax protesters.



d. Defendant's false or fraudulent statements were material.

In proving materiality, the Government need not demonstrate that a purchaser has relied on the promoter's misrepresentations. Rather, "[m]aterial matters are those which would have a substantial impact on the decision-making process of a reasonably prudent investor and includes matters relevant to the availability of a tax benefit." United States v. Campbell, 897 F.2d 1317, 1320 (5th Cir. 1990) (citing Buttorff, and S. Rep. No. 97-494, at 267 (1982), reprinted in 1982 U.S.C.C.A.N. 781, 1015). The false representations contained in the defendant's promotion are "material" because, as explained in White, 769 F.2d at 515, "[t]he taxpayers who have been or are now being audited by the IRS or are involved in litigation because they relied upon [the promoters' representations] should certainly have been informed about their complete lack of merit." The representations made by defendants concerning the Claim of Right program undoubtedly affect the decision making process of a purchaser of the program. Statements pertaining to the "availability of tax deductions, credits, or to other mechanisms for reducing tax liability ... clearly qualify as 'material'" under § 6700. United States v. Estate Pres. Servs., 38 F. Supp.2d 846, 855 (E.D. Cal. 1998), aff'd 202 F.3d 1093 (9th Cir. 2000). In that the primary purpose of defendants' programs is tax avoidance, the tax statements made in the promotion of the programs are certainly material. 14



e. An injunction is appropriate and necessary to prevent future violations of IRC § 6700.

The need for injunctive relief in order to prevent future violations of IRC § 6700 in the present case is readily apparent. Through their marketing techniques, defendants are canvassing this district encouraging persons to put into practice discredited theories of federal tax laws. Their customers have been harmed by the abusive promotions because the customers have paid defendant significant sums to prepare tax returns that understate their income tax liabilities. The United States is harmed because defendants' customers are not paying the correct amount of taxes to the United States Treasury. Moreover, given the IRS's limited resources, identifying and recovering all revenues lost from the Pugh's abusive schemes may be impossible, resulting in a permanent loss to the Treasury. The public is harmed because the IRS is forced to devote some of its limited resources to identifying and attempting to recover revenue lost as a result of the defendants' programs, thereby reducing the level of service that the IRS can give to other taxpayers.

The extent of the defendants' participation in the abusive programs is broad. Defendants are attempting to wrench tax statutes out of context to encourage a willful misreading of the law. The conduct is recurrent and defendants have never renounced the promised tax aspects of the program. As income tax return preparers, defendants promote themselves as knowledgeable about the Claim of Right program. Absent an injunction there is no indication that defendants will cease engaging in violations of the tax code. Defendants' conduct in promoting their abusive tax program thus warrants an injunction under IRC § 7408.



2. Defendants Engaged in Conduct Subject to Penalty under IRC § 6701

IRC § 6701 imposes a penalty on any person who aids in or advises with respect to the preparation of any portion of a tax return, claim for refund or other document that the person knows, if used, would result in an understatement of tax liability. As part of the Claim of Right program, defendants advise customers to take improper deductions and prepares or assists in filing false or fraudulent income tax returns. Defendants have knowledge that their advice and those documents would be used to understate their customers' correct tax liabilities. As such, defendants' conduct is subject to penalty under § 6701, and therefore further grounds exist for an injunction under IRC § 7408.



D. An Injunction Should Issue Based Upon IRC § 7402 to Prevent Defendants from Engaging in Activities that Interfere with the Enforcement of the Internal Revenue Laws.

This Court is authorized by IRC § 7402 to issue an injunction "as may be necessary or appropriate for the enforcement of the internal revenue laws." That statute manifests "a Congressional intention to provide the district courts with a full arsenal of powers to compel compliance with the internal revenue laws," 15 and "has been used to enjoin interference with tax enforcement even when such interference does not violate any particular tax statute." 16 The legislative history accompanying § 7408 explicitly states that "the court will continue to have full authority under [ § 7402] and will continue to possess the great latitude inherent in equity jurisdiction to fashion appropriate relief." 17 "Courts interpreting this section have concluded that the traditional equitable injunction factors should be considered in determining the propriety of a preliminary injunction." 18 Those factors are: (1) the likelihood that the plaintiff will sustain irreparable injury as a result of the defendant's conduct; (2) the likelihood of harm to the defendant if an injunction is entered; (3) the likelihood the plaintiff will ultimately prevail on the merits; and (4) the public interest.

Here, injunctive relief under § 7402 is appropriate to prevent defendants from continuing to interfere with tax enforcement. Defendants' false tax advice to customers and their abusive program interferes with the enforcement of the internal revenue laws by delaying examination and collection and by discouraging their customers from complying with the internal revenue laws. The defendants' activities undermine public confidence in the fairness of the federal tax system and incite violations of the internal revenue laws. The defendants' promotion causes the Government irreparable harm and the Government's remedies at law are inadequate.

Customers who follow defendants' advice file improper, inaccurate tax returns or do not pay their proper federal income taxes. In short, defendants' activities will cause irreparable harm to the Government, the public, and their customers unless they are not enjoined. 19 The injunction causes no harm to defendants, on the other hand, because it only requires them to follow the law. Because defendants' tax-fraud scheme has been thoroughly discredited, the Government's likelihood of success is unquestionable. Injunctive relief under § 7402 is therefore necessary and appropriate to prevent defendants from continuing to disrupt the federal tax system.


ORDER


Based on the foregoing finding of fact and for good cause shown the Court ORDERS

A. That pursuant to IRC §§ 7402, 7407 and 7408, Archie J. Pugh, Jr. And Theodore Pugh individually and doing business as Archie's Tax Service, and anyone acting in concert with them, is permanently enjoined from:
(1) Organizing, promoting, marketing, or selling any tax shelter, plan or arrangement that advises or incites customers to attempt to violate the internal revenue laws or unlawfully evade the assessment or collection of their federal tax liabilities;

(2) Making false or fraudulent statements about the securing of any tax benefit by the reason of participating in any tax plan or arrangement, including the false statements that individuals can obtain tax freedom by participating in their program and that wages or compensation for labor constitutes nontaxable income;

(3) Encouraging, instructing, advising and assisting others to violate the tax laws, including to evade the payment of taxes;

(4) Engaging in conduct subject to penalty under 26 U.S.C. § 6694, including preparing a return or claim for refund that includes an unrealistic or frivolous position;

(5) Engaging in conduct subject to penalty under 26 U.S.C. § 6695, including failing to sign income tax returns, or failing to furnish a customer list upon request of the Internal Revenue Service;

(6) Engaging in conduct subject to penalty under 26 U.S.C. § 6700, i.e., by making or furnishing, in connection with the organization or sale of a shelter, plan, or arrangement, a statement the defendant knows or has reason to know to be false or fraudulent as to any material matter under the federal tax laws;

(7) Engaging in conduct subject to penalty under 26 U.S.C. § 6701, i.e., preparing or assisting others in the preparation of any tax forms or other documents to be used in connection with any material matter arising under the internal revenue laws and which the defendant knows will (if so used) result in the understatement of tax liability;

(8) Acting as federal income tax return preparers, or providing any tax advice or services for compensation, including preparing or filing, or assisting in preparing or filing tax returns for any other person or entity, providing consultative services, or representing any persons or entities before the Internal Revenue Service in any manner, either directly or indirectly; and

(9) Engaging in any conduct that interferes with the administration and enforcement of the internal revenue laws.

B. That pursuant to IRC § 7402, the Pughs are ORDERED to contact all persons and entities for whom they prepared any federal income tax returns or other tax-related documents after January 1, 2000, and inform those persons of the entry of the Court's findings concerning the falsity of representations defendants made on their customers' tax returns, and that a permanent injunction has been entered against them within 30 days of service of this Order.

C. That pursuant to IRC § 7402, defendants are ORDERED to provide counsel for the United States a list of the names, addresses, e-mail addresses, phone numbers, and Social Security numbers of all individuals or entities for whom they prepared or helped to prepare any tax-related documents, including claims for refund or tax returns since January 1, 2000; and

D. That the United States is permitted to engage in post-judgment discovery to ensure compliance with the permanent injunction.

1 Merrill Lynch Mortg. Corp. v. Narayan, 908 F.2d 246, 253 (7 th Cir. 1990); Angelo lafrate Const., LLC v. Potashnick Const., Inc., 370 F.3d 715, 721-22 (8 th Cir. 2004).

2 Fed. R. Civ. P. 54(c).

3 IRC § 7407(b).

4 Id.

5 Because § 7408 expressly provides for an injunction, the traditional guidelines for equitable relief do not have to be established for an injunction to issue. Id.; United States v. H & L Schwartz, Inc., 60 A.F.T.R.2d 87-6031, 87-6036 (C.D. Cal. 1987) ( "Traditional equity grounds need not be proven in order for an injunction that is authorized by statute is issued.") The same is true for an injunction under § 7407. United States v. Gray, 2007 U.S. Dist. LEXIS 19833 (W.D. Mich., March 19, 2007).

6 United States v. Saladino, 2005 U.S. Dist. LEXIS 38080 (C.D. Cal. 2005), aff'd, 2006 U.S. App. LEXIS 7881 (9 th Cir. 2006) (discussing the frivolous nature of the "claim of right" program).

7 United States v. Venie, 691 F.Supp. 834, 838 (M.D. Pa. 1988) (held that the fraudulent overstatement of child care expenses based on a frivolous position subjected defendant to punishment under § 7407(b)(1)(D)); See also, United States v. Franchi, 756 F.Supp. 889, 893 (W.D. Pa. 1991) (same).

8 United States v. Gray, 2007 U.S. Dist. LEXIS 19833 (W.D. Mich. March 19, 2007) (enjoining tax preparer from preparing any tax returns because he had continuously falsified numerous IRS forms and persisted in maintaining an unrealistic position.)

9 United States v. Raymond, 228 F.3d 804, 811 (7 th Cir. 2000).

10 United States v. Estate Pres. Servs., 202 F.3d 1093, 1098 (9 th Cir. 2000); see also Abdo v. United States Internal Revenue Service, 234 F. Supp.2d 553, 561 (M.D.N.C. 2002).

11 United States v. Schulz, 2007 WL 2286410, at *3 (N.D. N.Y. 2007) (discussing selling and organizing a "tax shelter" within the meaning of IRC § 6700.)

12 United States v. Saladino, 2005 U.S. Dist. LEXIS 38080 (C.D. Cal. 2005), aff'd, 2006 U.S. App. LEXIS 7881 (9 th Cir. 2006) (discussing the frivolous nature of the "claim of right" program); United States v. Lloyd, 2005 U.S. Dist. LEXIS 32747 (M.D.N.C. 2005), aff'd, 2006 U.S. App. LEXIS 16254 (4 th Cir. 2006) (same).

13 If it is clear beyond any doubt that a scheme is illegal under established principles of tax law, then the participants have fair notice of its illegality even if no court has so ruled. See United States v. Ingredient Technology Corp., 698 F.2d 88 (2d Cir. 1983).

14 United States v. Schulz, 2007 WL 2286410, at *7 (N.D. N.Y. 2007).

15 Body v. United States, 243 F.2d 378, 384 (1 st Cir. 1957). See United States v. First Nat'l City Bank, 568 F.2d 853 (2 nd Cir. 1977).

16 United States v. Ernst & Whinney, 735 F.2d 1296, 1300 (11 th Cir. 1984). See United States v. Kaun, 633 F. Supp. 406, 409 (E.D. Wis. 1986) ( "federal courts have routinely relied on [ § 7402(a)] ... to preclude individuals ... from disseminating their rather perverse notions about compliance with the Internal Revenue laws or from promoting certain tax avoidance schemes"), aff'd, 827 F.2d 1144 (7 th Cir. 1987).

17 S. Rep. No. 97-494, 97th Cong., 2d Sess. at 266 (1982 U.S. Code Cong. & Ad. News 781, 1014).

18 Ernst & Whinney, 735 F.2d at 1301; United States v. Bell, 238 F. Supp. 2d 696 (M.D. Pa. 2003), aff'd, 414 F.3d 474 (3 rd Cir. 2005).

19 United States v. Schulz, 2007 WL 2286410, at *7 (N.D. N.Y. 2007).

Alvin S. Brown, Esq.
Tax Attorney
703 425-1400 ex 106
www.irstaxattorney.com

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Monday, November 26, 2007

IRS Problem - not a valid IRA rollover under section 72

Ramzy M. and Lena Kopty v. Commissioner.

Dkt. No. 4188-05 , TC Memo. 2007-343, November 21, 2007.

[Appealable, barring stipulation to the contrary, to CA-DC. --CCH.]

[Code Secs. 72 and 408]
IRA rollovers: Premature IRA distributions: --
A husband and wife were liable for income tax and the additional tax on early distributions from a rollover IRA because they did not introduce evidence that the brokerage account they established was not an IRA, or that the distributions from it were attributable to the husband's being disabled. Although the husband claimed that he did not intend to roll over his balance in an employee stock ownership plan (ESOP) into the IRA, the paperwork he executed was consistent with an intent to make a rollover, rather than take a distribution, and satisfied the requirements for establishing an IRA rollover account. The husband's heart problems, while serious, did not constitute a disability that would have avoided the additional tax on premature IRA distributions.


[Code Sec. 6651]
Penalties, civil: Late-filing penalty. --
A husband and wife were liable for a late-filing penalty because, despite the husband's health problems, and their ongoing correspondence with both the IRS and their financial institutions concerning an IRA distribution, they did not establish that their failure to file a return was due to reasonable cause.


[Code Sec. 6662]
Penalties, civil: Accuracy-related penalty. --
A husband and wife were liable for the accuracy-related penalty despite the husband's health problems, and their ongoing correspondence with both the IRS and their financial institutions concerning an IRA distribution. The taxpayers did not establish that their failure to report the IRA distribution was due to reasonable cause. -





Ramzy M. and Lena Kopty, pro se; Cleve Lisecki, for respondent.





MEMORANDUM FINDINGS OF FACT AND OPINION



WHALEN, Judge: Respondent determined the following deficiencies in, and penalties with respect to, petitioners' Federal income tax for 1999 and 2000:





Additions to Tax/Penalties

Year Deficiency Sec. 6651(a)(1) Sec. 6662(a)

2000 1,000.00 None None

1999 $94,699.32 $23,674.83 $12,793.13





Unless stated otherwise, all section references in this opinion are to the Internal Revenue Code as in effect during the years in issue.



The issues for decision are: (1) Whether the distributions received by petitioners during 1999 and 2000 from petitioner Ramzy M. Kopty's individual retirement account (IRA) in the aggregate amounts of $331,500 and $10,000, respectively, are includable in petitioners' gross income, pursuant to section 408(d); (2) whether petitioners are subject to the 10-percent additional tax on early distributions imposed by section 72(t) on the distributions received by petitioners from Mr. Kopty's IRA during 1999 and 2000; (3) whether petitioners are liable for the addition to tax of $23,674.83 determined by respondent under section 6651(a)(1) for failure to file a timely return for 1999; and (4) whether petitioners are subject to the accuracy-related penalty of $12,793.13 determined by respondent under section 6662(a) with respect to their 1999 return.





FINDINGS OF FACT



Petitioners are husband and wife. They resided in Waterloo, Belgium, at the time they filed their petition in this case. In this opinion, references to petitioner are references to Mr. Ramzy M. Kopty.



From March 18, 1991, through the end of 1997, petitioner was employed by a software company, J.D. Edwards & Co. On or about July 1, 1992, he began participating in the J.D. Edwards Employee Stock Ownership Plan (ESOP), a qualified plan under which the company made contributions of its stock to petitioner's account in the plan. By December 31, 1997, when petitioner left the employ of J.D. Edwards & Co., the company had contributed 10,323.9064 shares of its stock into petitioner's ESOP account. Set out below are the number of shares of J.D. Edwards & Co. stock, the aggregate value of those shares of stock, the cash held in petitioner's ESOP account, and the total value of petitioner's account, at the end of each of the years 1992 through and including 1997:





Year Shares Value Cash Total

1992 20.3100 $3,756.70 ($57.43) $3,699.27

1993 36.1085 6,818.47 1,608.94 8,427.41

1994 66.0084 15,698.12 1,725.72 17,423.84

1995 108.1071 46,776.86 6.29 46,783.15

1996 144.5164 108,732.69 30.90 108,763.59

1 Number of
shares
restated to
reflect a
70-to-1
stock
split.

1996 10,116.1480

1997 10,323.9064 304,555.24 10.31 304,565.55





After petitioner left J.D. Edwards & Co. at the end of 1997, he began working through a sole proprietorship, Kopty Management Consulting. In that capacity, he provided management, scientific, and technical consulting services to various clients. The Schedules C, Profit or Loss From Business, for petitioner's sole proprietorship that were filed with petitioners' returns for 1998, 1999, and 2000 are summarized below:





1998 1999 2000

Income:

1 Gross receipts or sales $114,634 -0- -0-

2 Returns and allowances -0-

3 Subtract line 2 from line 1 114,634

4 Cost of goods sold -0-

5 Gross profit, subtract line 4
from line 3 114,634

6 Other income -0-

7 Gross income. Add lines 5 and 6 114,634

Expenses:

10 Car and truck expenses 2,340 $2,340.00 $1,270

11 Commissions and fees 7,900 8,560.00 5,330

13 Depreciation and section 179
expense deduction 3,756 3,756.00 1,430

18 Office expense -0- 667.59 267

20 Rent or lease

a Vehicles, machinery, and
equipment

b Other business property 1,500 24,931.51 18,670

24 Travel, meals, and entertainment

a Travel 33,288 10,208.49 2,450

b Meals and entertainment $5,000 $3,415.00 $1,760

c Enter nondeductible amount 2,500 1,707.50 880

d Subtract line 24c from line
24b 2,500 1,707.50 880

25 Utilities -0- 1,744.96 1,460

26 Wages (less employment credits) None 28,916.44 14,320

27 Other expenses

Telephone 7,191 12,588.64 6,380

Other misc. 2,300 -0- -0-

Total expenses 60,775 95,421.13 52,457

Net profit or (loss) 53,859 -95,421.13 -52,457





Circa June of 1999, petitioner's wife and children moved from Dubai in the United Arab Emirates to Waterloo, Belgium. Until sometime during 2000, petitioner's business activities were based in Dubai, and he retained a residence there. Between June 1999 and the latter part of 2000, petitioner traveled between Belgium, where he and his family resided, and Dubai, where his business activities were centered. Some of the expenses claimed on the above Schedules C for 1999 and 2000 reflect Mr. Kopty's travel between his home in Belgium and his business in the United Arab Emirates.



On or about July 1, 1998, after leaving the employ of J.D. Edwards & Co., petitioner sent a distribution request form to the company asking the company to distribute to him the shares of stock and cash held in his ESOP account. As completed by petitioner, the distribution request form states: "I elect a payout of all my whole shares of J.D. Edwards stock, plus cash, * * * payable to me with the applicable taxes withheld for federal tax."



On the following day, petitioner transmitted a facsimile of the distribution request form to a representative of Norwest Investment Services, Inc. (hereinafter Norwest). Several days later, on or about July 8, 1998, petitioner applied to open a self-directed IRA with Norwest. As completed by petitioner, the application states that petitioner wanted to establish a "Rollover IRA".



On or about July 15, 1998, in response to petitioner's distribution request, the ESOP's trustee, Wells Fargo Bank, sent 10,323 shares of J.D. Edwards & Co. stock to the transfer agent and registrar of the stock, Harris Trust Co. of California, with instructions to reissue the stock in petitioner's name. In accordance with those instructions, on or about July 30, 1998, the transfer agent mailed to petitioner a stock certificate for 10,323 shares of J.D. Edwards & Co. stock. The stock certificate, No. JDE1185, was dated July 15, 1998. The shares represented by that stock certificate had not been registered under the Securities Act of 1933, and the stock certificate bore the following restricted legend:



THESE SECURITIES HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933. THEY MAY NOT BE SOLD, OFFERED FOR SALE, PLEDGED OR HYPOTHECATED IN THE ABSENCE OF AN EFFECTIVE REGISTRATION STATEMENT UNDER SAID ACT OR OPINION OF COUNSEL SATISFACTORY TO THE COMPANY THAT SUCH REGISTRATION IS NOT REQUIRED. * * *



Petitioner received the stock certificate from the transfer agent, but the record does not reveal precisely when he received it.



On August 4, 1998, 5 days after the stock certificate had been mailed to him by the transfer agent, petitioner hand-delivered it to Norwest. In return, a representative of Norwest gave petitioner a receipt for the stock certificate. The receipt states that the purpose of receiving the stock certificate was "Deposit to account". Thus, according to the receipt, Norwest received the J.D. Edwards & Co. stock certificate from petitioner for the purpose of depositing the shares into petitioner's rollover IRA at Norwest.



Mr. Kopty's rollover of the stock distribution from his ESOP account to his IRA was confirmed by the statement for petitioner's IRA which was issued by Norwest for the period ending August 31, 1998. That statement records a "stock rollover DS" on August 24, 1998, consisting of 10,323 shares of J.D. Edwards & Co. stock valued at $40.50 per share in the aggregate amount $418,081.50. It is not clear from the record why the rollover was not booked into petitioner's account as of August 4, 1998, the date of the receipt issued by Norwest for petitioner's J.D. Edwards & Co. stock certificate.



A letter to petitioner dated August 11, 1998, written by a representative of the ESOP's trustee, Wells Fargo Bank, states as follows:



You elected to take a distribution from the J.D. Edwards & Company (the "Company") Employee Stock Ownership Plan (the "ESOP"). In accordance with the terms of the ESOP and your distribution request form, a stock certificate in the amount of 10,323 shares. [sic] You will receive your stock certificate from J.D. Edwards in the near future.



You elected not to rollover your ESOP account balance. As a result, the cash balance, consisting of your cash account and fractional shares, has been withheld for tax purposes. You will receive a 1099R in January 1999 to reflect your distribution. You may be liable for additional taxes concerning this distribution.



The above letter is wrong on two important points. First, as discussed above, by August 11, 1998, the date of the letter, petitioner had already received the stock certificate for 10,323 shares of J.D. Edwards & Co. stock from the transfer agent. Second, by the date of the letter, petitioner had already hand-delivered the stock certificate to Norwest for deposit into his rollover IRA.



Enclosed in the above letter is a "Settlement Statement (Prepared 8/11/98 with values as of 7/15/98)". According to that statement, the market value of petitioner's current vested account balance in the ESOP amounted to $467,817.48. The statement says that $467,766.10 of that amount was paid to petitioner in the form of 10,323 shares of J.D. Edwards & Co. stock. The stock was valued as of July 15, 1998, at $45.31 per share. The statement also says that the payment to petitioner was "less withholding" of $51.38 "consisting of your cash account and fractional shares". We note that the value of petitioner's fractional share, $41.07 (i.e., 0.90164 x $45.31), plus the cash balance in his account, $10.31, is $51.38.



On October 2, 1998, petitioner executed a Norwest form entitled Self-Directed IRA Rollover/Direct Rollover Documentation. According to that form, petitioner's signature signified his irrevocable election, "pursuant to IRS regulation 1.402(a)(5)-1T, to treat this contribution [viz. of 10,323 shares of J.D. Edwards & Co. stock] as a rollover contribution." Petitioner's signature appears on the form a second time in order to give Norwest the following "Commingling Authorization":



The undersigned authorizes the Trustee/Custodian to commingle regular IRA contributions with rollover/direct rollover contributions pursuant to Part II above. I understand that commingling regular IRA contributions with rollover/direct rollover contributions from employer plans may preclude me from rolling over funds in my rollover IRA into another qualified plan or 403(b) plan. With such knowledge, I authorize and direct the Trustee/Custodian to place regular IRA contributions in my rollover IRA or vice versa.



Sometime after petitioner had hand-delivered his J.D. Edwards & Co. stock certificate to Norwest, representatives of Norwest prepared the paperwork necessary to permit the registration and sale of petitioner's shares, and they sent the paperwork to petitioner for completion. The completed paperwork was received from petitioner by Norwest's office in Boulder, Colorado, on or about October 7, 1998, and was forwarded to Norwest's home office in Minneapolis, Minnesota. The paperwork and the stock certificate were then sent to the transfer agent on or about October 20, 1998, and the shares of stock were registered in unrestricted form on or about November 4, 1998.



Norwest sold petitioner's J.D. Edwards & Co. stock on or about November 16, 1998. The statement for petitioner's IRA for the period ending November 30, 1998, reflects the following sales of J.D. Edwards & Co. stock:





Net Proceeds
(after
Trade Date Shares Price Commissions)

Nov. 19, 1998 300 $32.750 $9,786.79

Nov. 19, 1998 23 32.750 750.62

Nov. 19, 1998 8,000 32.625 260,087.75

Nov. 19, 1998 2,000 32.812 65,396.92

10,323 32.737 336,022.08





The above proceeds were invested in a money-market mutual fund and earned dividend income in the amount $509.90 for the remaining 12 days of November and $1,322.35 for the month of December. Thus, through the end of 1998, petitioner's IRA earned dividend income in the aggregate amount of $1,832.25 on the net proceeds realized from the sale of his J.D. Edwards & Co. stock.



In early 1999, the ESOP's trustee, Wells Fargo Bank, issued to petitioner a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for tax year 1998. According to that form, during 1998, petitioner had received gross distributions from the J.D. Edwards ESOP of $467,817.48 of which the taxable amount is $42,695.14, and on which Federal income tax of $51.38 had been withheld. Similarly, Norwest Bank Minnesota, N.A., issued to petitioner a Form 5498, IRA Contribution Information, on behalf of Norwest Bank MN NA IRA C/F Ramzy Kopty reporting rollover contributions of $411,629.63 for 1998. According to that form, the fair market value of petitioner's IRA account was $337,854.33.



During 1999, petitioner's IRA earned dividend income in the aggregate amount of $6,093.21. During the year, petitioner caused Norwest to make distributions from his IRA in the aggregate amount of $331,500, as follows:





Date Amount

Jan. 4, 1999 $70,000

Jan. 4, 1999 20,000

Feb. 1, 1999 15,000

Apr. 26, 1999 30,000

May 13, 1999 30,000

May 31, 1999 15,000

July 19, 1999 20,000

July 19, 1999 50,000

Sept. 20, 1999 10,000

Oct. 18, 1999 20,000

Oct. 18, 1999 10,000

Oct. 25, 1999 17,000

Nov. 15, 1999 10,000

Nov. 29, 1999 10,000

Dec. 1, 1999 4,500

331,500





With one exception, all of the distributions that petitioner requested from his IRA were accompanied by a Norwest form entitled "Self-Directed IRA Withdrawal Request". According to each such form, the type of withdrawal that petitioner requested was "Premature Distribution (under age 59 1/2) (no known exception)". Each form also instructed Norwest not to withhold Federal income tax from the amount distributed. The form states:



If I elect not to have Federal income tax withheld, I am still liable for payment of Federal income tax on the taxable portion of my distribution; I also may be subject to tax penalties under the estimated tax payment rules, if my payments or estimated tax and withholding, if any, are not adequate.



Finally, as the source of the funds, each form states that "Funds will first be withdrawn from the liquid asset portion of my IRA."



Subsequently, during the year 2000, Norwest Bank Minnesota, NA, sent a Form 1099-R to petitioners reporting gross distributions of $331,500 from petitioner's IRA during 1999.



During 2000, the money invested in petitioner's IRA earned mutual fund dividends in the amount of $141.27. During that year, petitioner requested distributions of $10,000 from his IRA. By the end of 2000, the value of petitioner's IRA was zero. Wells Fargo Investments, LLC, later issued a Form 1099-R to petitioners reporting gross distributions of $10,000 from petitioner's IRA during the year 2000. The record of this case suggests that Wells Fargo Bank acquired Norwest, but it does not say when the acquisition took place.



Petitioners filed their Federal income tax return for 1998 on October 18, 2000. The return had been prepared by Arthur Anderson. Consistent with the Form 1099-R issued to petitioners by Wells Fargo Bank, and the Form 5498, IRA Contribution Information, issued by Norwest Bank Minnesota, N.A., petitioners' 1998 return reports total pensions and annuities of $467,817. Petitioners' 1998 return reports that the taxable amount of the distribution is "NONE". Petitioners' 1998 return also reports income tax withholding of $51. Finally, petitioners' 1998 return reports none of the dividend income earned by petitioners' IRA during 1998 in the aggregate amount of $1,832.25.



In passing, we note that by October 18, 2000, when petitioners filed their return for 1998, and reported that "NONE" of the ESOP distribution was taxable, they had already withdrawn most, if not all, of the money from the IRA. Stated differently, by October 18, 2000, the distributions received from Mr. Kopty's IRA amounted to most, if not all, of the proceeds realized from the sale of the J.D. Edwards & Co. stock and the income realized on those proceeds.



Prior to filing petitioners' return for 1998, Mr. Kopty had sent a letter to the Internal Revenue Service dated May 27, 2000, in which he explained why petitioners' 1998 return had not been filed. Petitioner's letter, which was mailed on June 6, 2000, states as follows:



Please be informed that the 1998 taxes are held up due to an error made by my ex-employer J.D. Edwards in the preparation of the Form 1099. Please take note of the following:



1. The 1099 Form of J.D. Edwards indicates that the gross distribution is US $467,817.48 attached.



2. J.D. Edwards claims that the calculation for the above is based on 10,323 shares x $45.313 per share.



3. According to the bank statement, Norwest Investment Services the shares were $31.00 per share when they were finally "free and clear" on November 4, 1998. As a matter of fact, the shares were sold by Norwest Investment Services on November 16, 1998, for a total of $339,203 which is an average per share of $32.85. This was put in an IRA account.



4. I re-addressed this issue again with J.D. Edwards and based on their last response they believe that their calculation is correct. From what appears to be the issue is that J.D. Edwards has made their calculation at a much higher price per share on July 15, 1998. On the other hand, the shares were not "free and clear" on that date of preparation which was solely under JDEdwards control.



5. We are considering to hand this matter over to a legal adviser to resolve this matter since it has material repercussions on lost amounts and taxable income.



In order to avoid penalties and interests, we have forwarded to you earlier a check amount of US $13,529.00 to be considered as a pre-payment for the time being. Also we would like to request from you any suggestions that will help us resolve this matter. [Emphasis added.]



In substance, the above letter states that the filing of petitioners' 1998 return was delayed due to an error made by Mr. Kopty's ex-employer, J.D. Edwards & Co., in preparing his Form 1099-R for 1998. Petitioner complains that the gross distribution shown on the Form 1099-R in the amount of $467,817.48, valued as of July 15, 1998, greatly exceeds the proceeds realized from the sale of the shares on November 16, 1998, in the amount of $339,230. Petitioner complains that the value of the distribution reported to the Internal Revenue Service on the Form 1099-R was based upon the higher price per share on July 15, 1998, when "the shares were not 'free and clear'". In effect, petitioner's letter suggests that the Form 1099-R overstates the value of the stock issued to petitioner and, thus, overstates the amount includable in petitioners' income. The letter refers to the fact that petitioner had made a "pre-payment" of tax of $13,529, and it requests "any suggestions that will help us resolve this matter."



When petitioner transmitted his 1998 Federal income tax return to the IRS, he did so with a cover letter dated October 4, 2000, which states as follows:



Reference - 1998 taxes (Ramzy Kopty - SSN * * *)



The error in the 1099-R was discovered during the tax preparation in December 1999 which would have added an additional income of $42,695.14. Immediately I contacted JD Edwards for the problem & did not receive any correction or attention to this date.



April, 2000 - with no correction from JD Edwards/their bank, and in avoidance of delay of payments I did a rough calculation without the $42,695.14 & immediately I forwarded a check on April 17, 2000 for the amount of $13,529.00 (copy attached)



June 2000 - and still, with no correction from JD Edwards/their bank I sent a detailed explanation to the IRS on June 6, 2000 [i.e., above-quoted letter dated May 27, 2000] with all the supporting documents (Attached) & requested any suggestions that will help resolve the matter. I did not get a response from the IRS on this issue, and contrary, I received a letter dated September 18, 2000 (cover sheet attached for your reference) which included name & a contact of Robert Stathntan (telephone - 215- * * *)



Upon Receipt and on September 26, 2000 I called the IRS & talked to Ms. Kazlauskas who was very understanding to the issues and we agreed that I file the tax return (attached) citing the error & the pervious correspondence



Under the circumstance I would like you to consider all the above points while reviewing this situation and confirm to me your finding. Additionally there was a medical factor involved in this time frame (attached medical report). In view of my health situation I have also applied for long term disability with the Social security (Social security confirmation attached).



Thus, petitioner's transmittal letter of October 4, 2000, again raises the issue discussed in his letter dated May 27, 2000, quoted above. That issue involves his contention that the gross distribution reported on the Form 1099-R issued for 1998, consisting of the stock of J.D. Edwards & Co., is overstated, as shown by the fact that the amount reported on the Form 1099-R greatly exceeds the proceeds realized from the sale of the stock. The transmittal letter expresses petitioner's concern that the amount of the gross distribution reported on the Form 1099-R would cause additional income of $42,695.14 for 1998.



Petitioners filed their 1999 Federal income tax return on or about November 21, 2001. That return does not report any of the distributions from petitioner's IRA at Norwest during 1999 in the aggregate amount of $331,500. At the same time, the return reports none of the dividend income in the aggregate amount of $6,093.21 realized by petitioner's IRA during the year.



Petitioners also filed their 2000 Federal income tax return on or about November 21, 2001. That return does not report the distributions of $10,000 received from petitioner's IRA during 2000. Furthermore, that return does not report the dividends of $141.27 realized on the moneys invested in petitioner's IRA during 2000.



In the later part of 1999, petitioner consulted doctors at the cardiopulmonary department of the American Hospital in Dubai. He was briefly treated in the emergency room of the American Hospital in Dubai on November 29, 1999, and approximately one week later, on December 6, 1999, he returned to the hospital to engage in a treadmill test. The interpretation of that test states the following:



Exercise EKG positive for Ischemie by EKG criteria. No exercise induced chest pains or arrhythmia. Normal BP response to exercise. Impaired functional capacity for patient's age achieving 10.6 METS.



Subsequently, Mr. Kopty was admitted to the American Hospital in Dubai on March 3, 2000, with the symptoms of a heart attack. Approximately 2 weeks later he was transported to the Universite Catholique De Louvain Cliniques Universitaires Saint-Luc, a hospital in Belgium, where he underwent coronary bypass and mitral valve repair on March 25, 2000. Mr. Kopty was released on April 10, 2000, but was readmitted from time to time for further treatment through the end of June 2000.



The medical records submitted by petitioners make it clear that Mr. Kopty's heart attack and related medical problems between March and June of 2000 were serious. Mr. Kopty's treating physician in Belgium wrote on July 29, 2000, "since March 3, 2000 Mr. Kopty had to stop his professional activities. It seems obvious that these activities will have to be strongly reduced in the future."



In November of 2004, after the Internal Revenue Service audited petitioners' returns for 1999 and 2000 and issued the notice of deficiency which is at issue in this case, Mr. Kopty contacted Wells Fargo and asked the bank to issue a new Form 5498, IRA Contribution Information, for taxable year 1998 and new Forms 1099-R for taxable years 1999 and 2000. Pursuant to his request, Wells Fargo issued a new Form 5498 for 1998 stating that his IRA contribution for the year was zero, and it issued new Forms 1099-R reporting gross distributions from his account at Norwest of zero for 1999 and 2000.





OPINION




Taxability of the Distributions From Petitioner's IRA During 1999 and 2000


The principal issue in this case is whether petitioners are subject to tax, as provided by section 408(d)(1), on the aggregate distributions of $331,500 and $10,000 that they received from petitioner's IRA during 1999 and 2000, respectively. Petitioners argue that they are not subject to tax on those distributions because the account from which the distributions were made was not an IRA.



Mr. Kopty had established that account with Norwest in 1998, and he funded it by making a purported rollover contribution of the stock he had received as a distribution from the J.D. Edwards ESOP. According to petitioners, they learned in 2004, during the audit of their returns for 1999 and 2000, that Mr. Kopty had failed to complete the rollover contribution within 60 days following the day on which he had received the stock from the ESOP, as required by section 402(c)(3). We discuss the basis for petitioners' assertion that Mr. Kopty failed to make a valid rollover in more detail below.



Based on the factual premise that Mr. Kopty failed to make a valid rollover, petitioners contend that Mr. Kopty's account at Norwest was not an IRA within the meaning of section 408(a) and they are not subject to tax on the distributions from that account. Furthermore, petitioners argue that the determination made by respondent in the notice of deficiency is based upon Norwest's incorrect conclusion that Mr. Kopty had made a valid rollover of his J.D. Edwards & Co. stock in 1998. They argue that, because Norwest's conclusion was wrong, the notice of deficiency, based thereon, must also be wrong. According to petitioners:



respondents [sic] relied on the erroneous bank determination that the 1998 roll over of the ESOP to the IRA account * * * was valid and relied on the erroneous reporting that followed that determination by the bank. * * * Hence, respondent's determination in paragraph 3 [of the notice of deficiency] and consequently the deficiency notice is null and void.



Petitioners do not explain the legal basis, or cite any authority, for their conclusion that they are not subject to tax on the distributions from Mr. Kopty's account at Norwest. The general rule is that any amount "paid or distributed out of" an IRA is subject to tax as prescribed by section 72. See sec. 408(d)(1). Petitioners seem to be arguing that Mr. Kopty's Norwest account is disqualified from being an IRA because it was funded by an excess contribution. To the contrary, an IRA is not necessarily disqualified by the fact that it accepted excess contributions, even if it was funded entirely with excess contributions. See Orzechowski v. Commissioner, 69 T.C. 750 (1978), affd. 592 F.2d 677 (2d Cir. 1979); see also Boggs v. Commissioner, 83 T.C. 132 (1984), affd. 774 F.2d 740 (7th Cir. 1985); Benbow v. Commissioner, 82 T.C. 941 (1984). In another context we concluded that excess contributions were not subject to tax when distributed by an IRA. See Campbell v. Commissioner, 108 T.C. 54 (1997) (holding that the taxpayer received basis to the extent of his "investment in the contract" under section 72(e)(6)). Petitioners have not made any such argument in this case.



Respondent urges the Court to reject petitioner's position. Respondent asserts that "the record clearly reflects that the position taken by petitioners on their 1998 return was correct" and that a valid rollover of the distribution received from the ESOP was made in that year. Furthermore, respondent points out that petitioners' 1998 return reported the receipt of the ESOP distribution in the amount of $467,817 and reported that the taxable amount of such distribution was "NONE". Respondent asserts that "petitioners are estopped, pursuant to the duty of consistency doctrine, from adopting a position on their 1999 and 2000 tax returns inconsistent with the position taken on their 1998 Return."



We agree with respondent that, under the facts of this case, Mr. Kopty made a valid rollover of the stock distribution he received from the J.D. Edwards ESOP in 1998. Accordingly, we reject the factual premise of petitioners' argument that Mr. Kopty's account at Norwest was not an IRA, and we find that the distributions from that account during 1999 and 2000 are subject to tax under sections 408(d)(1) and 72(a). We do not reach respondent's second point that petitioners are estopped under the duty of consistency from taking a different position on their 1999 and 2000 returns.



In order to fully address petitioners' argument, we must set out petitioners' argument in more detail. Petitioners acknowledge that they physically transferred the J.D. Edwards & Co. stock certificate to Norwest within 60 days of the date on which they received it, but they contend that they did not irrevocably elect to make a rollover contribution to the IRA at that time. According to petitioners, the stock certificate "was hand-delivered to Norwest Bank [only] for safekeeping until the shares become our [sic] unrestricted and eventually sold." They assert that "the bank placed the restricted shares by mistake in the new account while the bank proceeded with the paperwork to un-restrict and sell the shares."



Petitioners contend that the stock certificate did not properly become invested in the IRA account until October 2, 1998, when Mr. Kopty executed the Norwest form entitled "Self-Directed IRA Rollover/Direct Rollover Documentation". Petitioners point out that October 2, 1998, is 79 days after Mr. Kopty had constructively "received" the certificate on July 15, 1998, and is beyond the 60-day period specified in section 402(c)(3) during which a distributee is required to transfer the property distributed to an eligible retirement plan. Petitioners further contend that the form executed on October 2, 1998, was not properly completed and did not serve to transfer the stock to Norwest. In effect, petitioners' position is that Mr. Kopty did not elect to treat the contribution of his J.D. Edwards & Co. stock certificate as a rollover contribution until October 2, 1998, when he executed the Norwest form entitled "Self-Directed IRA Rollover/Direct Rollover Documentation".



According to the regulations promulgated under section 402, an election to treat a contribution to an IRA as a rollover contribution is made simply by designating the contribution as a rollover contribution. The regulations promulgated under section 402 provide as follows:



In order for a contribution of an eligible rollover distribution to an individual retirement plan to constitute a rollover and, thus, to qualify for current exclusion from gross income, a distributee must elect, at the time the contribution is made, to treat the contribution as a rollover contribution. An election is made by designating to the trustee, issuer, or custodian of the eligible retirement plan that the contribution is a rollover contribution. This election is irrevocable. Once any portion of an eligible rollover distribution has been contributed to an individual retirement plan and designated as a rollover distribution, taxation of the withdrawal of the contribution from the individual retirement plan is determined under section 408(d) rather than under section 402 or 403. Therefore, the eligible rollover distribution is not eligible for capital gains treatment, five-year or ten-year averaging, or the exclusion from gross income for net unrealized appreciation on employer stock. [Sec. 1.402(c)-2, Q&A-13, Income Tax Regs.; emphasis added.]



Thus, no particular form is required by the regulations in order to designate a contribution as a rollover contribution.



In this case, petitioner opened a "Rollover IRA" at Norwest on July 8, 1998, and he hand-delivered his J.D. Edwards & Co. stock certificate to Norwest on August 4, 1998, several days after the transfer agent had mailed the stock certificate to him. According to the receipt issued to petitioner by a representative of Norwest, "Deposit to account" was the purpose for which Norwest received petitioner's stock certificate. Petitioner's only account at Norwest was the "Rollover IRA" which he had opened by submitting an application to Norwest on or about July 8, 1998. Furthermore, the statement issued by Norwest for petitioner's IRA for the period ending August 31, 1998, reflects a "stock rollover" of 10,323 shares of J.D. Edwards & Co. stock on August 24, 1998. Thus, it is evident that Norwest, the trustee, issuer, or custodian of the IRA, believed that petitioner had designated his J.D. Edwards & Co. stock as a "rollover contribution" to his IRA. See sec. 1.402(c)-2, Q&A-13, Income Tax Regs.



Petitioner's contribution of J.D. Edwards & Co. stock to his IRA and his designation of the contribution as a rollover contribution took place well within 60 days of receipt as required by section 402(c)(3). This is true no matter what we use as the starting date, that is, "the day on which the distributee received the property distributed." See sec. 402(c)(3). In this case, the starting date of the 60-day period could be the date on which petitioner constructively received the stock, July 15, 1998. See generally Rev. Rul. 82-75, 1982-1 C.B. 116 and Rev. Rul. 81-158, 1981-1 C.B. 205 (holding that, for purposes of section 402, the distributee received shares from an employer established profit-sharing plan that qualified under section 401(a) when the trustee of the plan delivered to the transfer agent stock certificates previously issued in the trustee's name, together with written instructions to reissue the certificates in the name of the distributee). The starting date could also be the date on which petitioner actually received the stock. Petitioner actually received the stock certificate between July 30, 1998, when the transfer agent mailed it to him, and August 4, 1998, when he hand-delivered the stock certificate to Norwest.



Furthermore, in this case, the 60-day period is satisfied regardless of the date used as the date of the "transfer of a distribution". See sec. 402(c)(3). That date could be August 4, 1998, the day on which petitioner hand-delivered the certificate to Norwest, or August 24, 1998, the day on which Norwest recorded the transfer on its statement for petitioner's IRA for the period ending August 31, 1998.



Petitioners do not deny that they intended to rollover the distribution which Mr. Kopty received in 1998 from the J.D. Edwards & Co. ESOP. Further, they do not deny that Mr. Kopty delivered his J.D. Edwards & Co. stock certificate to Norwest on August 4, 1998. What they argue is that when Mr. Kopty hand-delivered the stock certificate to Norwest on August 4, 1998, he intended to give the certificate to Norwest only for safekeeping, pending the reissuance of the stock without restriction and its sale. Petitioners assert that Norwest made a mistake by depositing the stock into petitioner's IRA before October 2, 1998, the date on which petitioner executed the Norwest form entitled "Self-Directed IRA Rollover/Direct Rollover Documentation".



One problem we have with this factual contention is that there is nothing in the record, other than petitioners' testimony, to substantiate it. Certainly, Mr. Kopty did nothing to call this alleged mistake to the attention of the Norwest representative who issued the receipt for Mr. Kopty's stock certificate. Additionally, Mr. Kopty said nothing about this alleged mistake when he received the August 1998 statement for his IRA on which was recorded a "stock rollover DS" on August 24, 1998, consisting of 10,323 shares of J.D. Edwards & Co. stock.



Furthermore, petitioners' argument presupposes that no rollover to Mr. Kopty's IRA at Norwest could take place for purposes of section 402(c) unless and until the form entitled "Self-Directed IRA Rollover/Direct Rollover Documentation" was submitted to Norwest. To the contrary, as discussed above, the regulations promulgated under section 402 merely require the contribution to be designated a rollover contribution. The Norwest form which petitioner executed on October 2, 1998, entitled "Self-Directed IRA Rollover/Direct Rollover Documentation" may have been helpful in terms of petitioner's relationship with Norwest, to document Mr. Kopty's wishes, but it was not essential for purposes of finding a rollover contribution under section 402(c).



Finally, petitioners' assertion that Mr. Kopty transferred the stock certificate to Norwest only for safekeeping until the shares could be reissued in unrestricted form and sold is contradicted by Mr. Kopty's actions. The fact is that Mr. Kopty executed the form on October 2, 1998, well before the shares were registered in unrestricted form and sold on November 16, 1998. Indeed, it appears that Mr. Kopty may have executed the form even before he returned to Norwest the paperwork necessary to permit the registration and sale of the shares. As mentioned above, the completed paperwork to permit the registration and sale of petitioner's stock was not received from petitioner by Norwest's office in Boulder until October 7, 1998.



Based on the facts of this case, we find that Mr. Kopty made an irrevocable election to roll over, to his IRA, the distribution of stock he had received from the J.D. Edwards ESOP. We further find that petitioner made this irrevocable election within the 60-day period required by section 402(c)(3).




Ten Percent Additional Tax on Early Distributions


The second issue in this case is whether petitioners are liable for the 10-percent additional tax on early distributions from qualified retirement plans imposed by section 72(t)(1). Respondent applied the 10-percent additional tax on the aggregate distributions of $331,500 made by petitioner's IRA in 1999 and the aggregate distributions of $10,000 made by the IRA in 2000. Accordingly, respondent determined taxes under section 72(t)(1) for 1999 and 2000 in the amounts of $31,500 and $1,000, respectively.



Petitioners argue that section 72(t)(1) does not apply to any of the subject distributions because all of them qualify under the exception set forth in section 72(t)(2)(A)(iii) for distributions "attributable to the employee's being disabled within the meaning of subsection (m)(7)". Section 72(m)(7) provides as follows: "an individual shall be considered disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration". See also sec. 1.72-17A(f)(1), Income Tax Regs. Whether an impairment constitutes a disability is to be determined with reference to all of the facts in the case. Sec. 1.72-17A(f)(2), Income Tax Regs. The regulations provide examples of impairments which would ordinarily be considered as preventing substantial gainful activity. One of those examples is the following:



Diseases of the heart, lungs, or blood vessels which have resulted in major loss of heart or lung reserve as evidenced by X-ray, electrocardiogram, or other objective findings, so that despite medical treatment breathlessness, pain, or fatigue is produced on slight exertion, such as walking several blocks, using public transportation, or doing small chores * * * [Sec. 1.72-17A(f)(2)(iii), Income Tax Regs.]



The regulations point out that the existence of one or more of the impairments described therein, including the one quoted above, "will not, however, in and of itself always permit a finding that an individual is disabled as defined in section 72(m)(7)." See sec. 1.72-17A(f)(2), Income Tax Regs. Furthermore, the regulations caution that any impairment must be evaluated in terms of whether it does in fact prevent the individual from engaging in his customary or any comparable substantial gainful activity. Id. In order to meet the requirements of section 72(m)(7), the regulations provide that "an impairment must be expected either to continue for a long and indefinite period or to result in death." Sec. 1.72-17A(f)(3), Income Tax Regs. An impairment which is remediable does not constitute a disability, and an individual will not be deemed disabled if it can be diminished to the extent that the individual can engage in his customary or any comparable substantial gainful activity. Sec. 1.72-17A(f)(4), Income Tax Regs. Furthermore, a taxpayer may be engaged in a gainful activity even though he realizes a net loss from that activity during the year. See Dwyer v. Commissioner, 106 T.C. 337, 341 (1996).



In this case, petitioners introduced into evidence certain medical records involving the medical treatment of Mr. Kopty's heart condition. Based upon those records they claim that "from 1999 onwards, Ramzy Kopty was disabled due to heart failure and unable to engage in any substantial gainful activity." According to petitioners, Mr. Kopty "had no income after 2000 which is reflected in petitioners['] tax returns for the years 2001, 2002, 2003, 2004." Petitioners assert that Mr. Kopty receives long-term disability benefits from the U.S. Social Security Administration. Based upon Mr. Kopty's heart disease, petitioners assert that they are not subject to the 10-percent additional tax on early distributions under section 72(t) because all of the distributions are attributable to Mr. Kopty's being disabled within the meaning of section 72(m)(7).



As to the distributions made during 1999, we do not accept petitioners' assertion that the distributions are attributable to Mr. Kopty's being disabled. According to the medical records submitted by petitioners, Mr. Kopty was briefly treated in the emergency room of the American Hospital in Dubai on November 29, 1999, and approximately 1 week later, on December 6, 1999, returned to engage in a treadmill test. According to petitioners' brief: "petitioner was diagnosed in 1999 with Pectoris Spasm and Ischemia which limited petitioner's ability to have gainful activity from 1999 onwards and that the same disease led to an myocardial infarction (MI) in March 2000." That diagnosis, however, did not even take place until December 6, 1999, at the earliest. By that time, all of the distributions for 1999 had been made. In our view, the record of this case fails to show that any of the distributions made during 1999 in the amount of $331,500 were attributable to Mr. Kopty's being disabled.



As to the distributions made during 2000, Mr. Kopty was admitted to the American Hospital in Dubai on March 3, 2000, with the symptoms of a heart attack. Approximately 2 weeks later, he was transported to a hospital in Belgium where he underwent coronary bypass and mitral valve repair on March 25, 2000. Mr. Kopty was released on April 10, 2000, but was readmitted from time to time for further treatment through the end of June 2000. The medical records submitted by petitioners make it clear that Mr. Kopty's heart attack and related medical problems between March and June of 2000 were serious. Mr. Kopty's treating physician in Belgium wrote on July 29, 2000: "since March 3, 2000 Mr. Kopty had to stop his professional activities. It seems obvious that these activities will have to be strongly reduced in the future."



The record in this case, however, makes it difficult to find that Mr. Kopty was "disabled" within the meaning of section 72(m)(7) by his heart condition. First, after June of 2000 he continued to travel between Dubai and Belgium. He testified at trial about the steps which he had to take in order to close his business in Dubai and "relocate" to Belgium. Furthermore, petitioners' income tax return for 2000 includes a Schedule C of Mr. Kopty's sole proprietorship which reflects business expenses of $52,457 for the year. The expenses claimed on that Schedule C include travel expenses of $2,450, expenses for meals of $1,760, and telephone expenses of $6,380. The business activities suggested by those expenses belie petitioners' claim that Mr. Kopty was "unable to engage in any substantial gainful activity" during the year. See sec. 72(m)(7). Significantly, petitioners' return for 2000 also reports that Mr. Kopty received wages of $22,795.28 from J.D. Edwards World Solutions. Finally, Mr. Kopty presented his case at trial. The Court had an opportunity to observe him over the course of 2 days. The Court detected no medical disability in his presentation of the case to the Court.




Addition to Tax Under Section 6651(a)(1) Determined With Respect to Petitioners' 1999 Return


The time for filing petitioners' 1999 return was extended to December 15, 2000. Petitioners filed their 1999 return on November 21, 2001, and, thus, they failed to file a timely return. Accordingly, respondent determined an addition to tax under section 6651(a)(1) of $23,674.83 in the notice of deficiency. We find that respondent satisfied his burdens of production under section 7491(c) with respect to the addition to tax under section 6651(a). See Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001).



Petitioners argue that they are not liable for the addition to tax under section 6651(a)(1) because their failure to file a timely return for 1999 was due to reasonable cause and not due to willful neglect. See sec. 6651(a)(1). According to petitioners, reasonable cause for the late filing of their 1999 return is demonstrated by three points: First, Mr. Kopty's medical history, including his heart attack on March 3, 2000, and his related medical issues; second, the alleged fact that petitioners never received the Form 1099-R issued by Norwest for 1999 reporting the distributions from Mr. Kopty's IRA during the year totaling $331,500; and third, the fact that petitioners reported a loss on their 1999 return and did not believe that the filing of their 1999 return was an urgent matter, especially in light of Mr. Kopty's medical problems during that year.



Petitioners assert the late filing of their 1999 return was not due to willful neglect. According to petitioners, they were "proactive with the ESOP issue" in that they corresponded with J.D. Edwards & Co. through Mr. Kopty's letter dated February 9, 2000, and they communicated with the Internal Revenue Service through Mr. Kopty's letters dated April 15, 2000, May 27, 2000, and October 4, 2000, and Mr. Kopty's telephone call on September 26, 2000.



We do not believe that petitioners have shown that their failure to file a timely 1999 return was due to reasonable cause and not due to willful neglect. As stated above, we agree that Mr. Kopty's heart attack in March of 2000 and his related surgeries and medical care through June of 2000 were serious. Nevertheless, the record of Mr. Kopty's correspondence and other activities during the year fails to explain why petitioners did not file, or could not have filed, their return for 1999 on or before the due date, December 15, 2000. Indeed, notwithstanding Mr. Kopty's medical condition, petitioners filed their 1998 return on October 18, 2000. At that point, they had ample time before the due date of the 1999 return in which to file that return as well. Furthermore, we reject petitioners' assertion that they should be relieved of the addition to tax under section 6651(a)(1) because they did not receive the Form 1099-R from Norwest or because they did not think that the filing of that return was "an urgent matter".




Imposition of the Accuracy-Related Penalty Under Section 6662(a) With Respect to Petitioners' 1999 Return


Respondent determined petitioners' liability for the accuracy-related penalty under section 6662(a) to be $12,793.13. Respondent determined that a portion of the underpayment of tax required to be shown on petitioners' 1999 return is attributable to negligence or disregard of rules or regulations, or to a substantial understatement of income tax. See sec. 6662(b)(1) and (2). For this purpose, "the term 'negligence' includes any failure to make a reasonable attempt to comply with the provisions of this title, and the term 'disregard' includes any careless, reckless, or intentional disregard." Sec. 6662(c). An understatement of income tax is "substantial" if the amount of the understatement exceeds the greater of (a) 10 percent of the tax required to be shown on the return, or (b) $5,000. Sec. 6662(d)(1)(A).



We agree with respondent that the portion of the underpayment of tax on which respondent imposed the accuracy-related penalty is attributable to negligence or disregard of rules or regulations. Furthermore, we find that respondent has carried his burden of production with respect to the addition to tax under section 6662(a). See Higbee v. Commissioner, supra at 448-449.



Petitioners' return for 1998 reported the ESOP distribution of $467,817 and further reported the taxable amount of that distribution as "NONE". That return is consistent with the Form 5498 issued by Norwest for the year 1998 which shows rollover contributions of $411,629.63, and it is consistent with the Norwest statement for petitioner's IRA for the period ending August 31, 1998, showing a stock rollover into the account on August 24, 1998, consisting of 10,323 shares of J.D. Edwards & Co. stock. Petitioners' 1998 return was not filed until October 4, 2000, by which time almost all of the money in Mr. Kopty's IRA had been withdrawn. In filing their 1998 return claiming that the ESOP distribution was not taxable, petitioners knew, or should have known, that the distributions from Mr. Kopty's IRA during 1999 and 2000 were subject to tax under section 408(d). Accordingly, when they filed their return for 1999 on November 21, 2001, and reported none of the distributions as income, we agree with respondent that the portion of the underpayment of tax resulting therefrom is attributable to negligence or disregard of rules or regulations. Furthermore, petitioners not only failed to report the IRA distributions during 1999 as taxable income, but they also failed to report any of the dividend income in the amount of $6,093.21 earned by the IRA during 1999.



Petitioners assert that they are not liable for the accuracy-related penalty under section 6662(a) for three reasons. First, petitioners claim that, at the time they filed their 1999 return, they did not know whether the rollover in 1998 was valid because "respondents [sic] never answered their several assistance appeals" and petitioners had not received the Form 1099-R for 1999 from Norwest. Second, petitioners assert that respondent has determined their liability for the accuracy-related penalty "to hide their [sic] [respondent's] negligence of not responding to petitioners appeal for assistance with the ESOP transaction". Third, petitioners assert that they "exercised extreme duty of care towards to the ESOP transaction issue under severe circumstances of being abroad and seriously ill".



In summary, petitioners argue that, before they filed their 1999 return, they asked for advice from respondent concerning the validity of the rollover in 1998, and, when they received no response from their inquiries from respondent, they did the best they could under the circumstances of being abroad and with Mr. Kopty's health issues. Petitioners appear to invoke the reasonable cause exception under section 6664(c) which provides that no penalty shall be imposed with respect to any portion of an understatement if it is shown that there was a reasonable cause for such portion and the taxpayer acted in good faith with respect to such portion.



We agree that petitioners corresponded with representatives of the Internal Revenue Service prior to filing their 1999 return (Mr. Kopty's letter dated May 27, 2000, which was sent on June 6, 2000, and his transmittal letter dated October 4, 2000). We also agree that Mr. Kopty engaged in correspondence with Norwest and J.D. Edwards & Co. during 2000 regarding the distribution from the ESOP. That correspondence shows that Mr. Kopty was unhappy about the fact that his shares of J.D. Edwards & Co. stock were not sent until July 30, 1998, and were unregistered shares that could not be immediately sold. According to one of petitioner's letters to J.D. Edwards & Co., the "ESOP shares were supposed to have been received in April 'clear for sales' from J.D. Edwards." During the delay, the value of the shares decreased from $467,766.10, the value on July 15, 1998, to $336,022.08, the value of the shares on November 16, 1998, when they were sold. Petitioner was concerned by the fact that the Form 1099-R which he received from the ESOP was based upon the value of the shares on July 15, 1998, and showed the taxable amount of such distribution to be $42,695.14. When Mr. Kopty stated in his letter to the Internal Revenue Service dated May 27, 2000: "also we would like to request from you any suggestions that will help us resolve this matter", he was referring to this valuation issue. Similarly, petitioner's letter dated October 4, 2000, transmitting petitioners' 1998 tax return to the Internal Revenue Service, refers to the same error in the Form 1099-R. Petitioners' letter states: "under the circumstances I would like you to consider all of the above points while reviewing this situation and confirm to me your finding." Petitioner's letter was again asking the Internal Revenue Service to review the Form 1099-R issued by the ESOP on which petitioner's shares of J.D. Edwards & Co. stock were valued as of July 15, 1998, in the amount of $467,766.10, whereas the net proceeds from the sale of the stock on November 16, 1998, were $336,022.08.



In none of petitioner's correspondence with the Internal Revenue Service does he raise a question about the validity of the rollover of J.D. Edwards & Co. stock into his IRA or the Forms 1099-R issued to report the distributions from the IRA in 1999 and 2000. In fact, petitioners' opening brief states that they did not become aware "that the ESOP rollover was invalid in 1998 due to the 60 days rollover rule" until the audit of their 1999 and 2000 returns which took place between April and September of 2004. We reject any suggestion that petitioners raised with respondent, before the audit of their returns, an issue concerning the validity of the rollover contribution of J.D. Edwards & Co. stock to Mr. Kopty's IRA. In conclusion, we find that petitioners have not shown that there was reasonable cause for the understatement of tax required to be shown on their 1999 return or that they acted in good faith with respect thereto.




Computational Errors


In their posttrial brief, petitioners allege three "computational errors" for the first time in these proceedings. The first computational error involves the amount of the net operating loss for taxable 2000 that can be carried back to 1999. According to petitioners, respondent miscalculated the net operating loss by basing the calculation on adjusted gross income of -$5,522, rather than on -$15,522, the correct amount.



Petitioners failed to raise this issue in their petition, and it is not before the Court. We do not consider an issue that has not been pleaded. See, e.g., Frentz v. Commissioner, 44 T.C. 485, 491 (1965), affd. 375 F.2d (6th Cir. 1967); Sicanoff Vegetable Oil Corp. v. Commissioner, 27 T.C. 1056, 1066 (1957) (and the cases cited thereon), revd. on other grounds 251 F.2d 764 (7th Cir. 1958). This is particularly true in a case like this where the issue cannot be considered without surprise and prejudice to the other party. See Estate of Mandels v. Commissioner, 64 T.C. 61, 73 (1975). Furthermore, we note that the difference of $10,000, about which petitioners complain, is due to the inclusion in gross income of the distributions of $10,000 from Mr. Kopty's IRA during the year.



The second so-called computational error alleged by petitioners involves deductions for moving expenses under section 217(a). Apparently, during the audit of petitioners' returns, petitioners submitted a letter in which they claimed moving expenses in the amount of $5,770 for 1999 and $1,950 for 2000. In the notice of deficiency, respondent did not determine that petitioners were allowed moving expenses. Petitioners ask the Court "to order the moving expense correction."



Petitioners did not raise this matter in their petition. This is a new issue that was raised for the first time after trial. As stated above, we do not consider an issue that has not been pleaded. See, e.g., Frentz v. Commissioner, supra; Sicanoff Vegetable Oil Corp. v. Commissioner, supra. This is particularly true in a case like this where the issue cannot be considered without surprise and prejudice to the other party. See Estate of Mandels v. Commissioner, supra. Accordingly, we will not consider it.



Finally, petitioners argue that interest on underpayments under section 6601(a) should be computed from the date when the tax return was due, taking into consideration extensions of time to file, rather than from the original due date of the return. Petitioners ask the Court to rule that interest on any underpayment for taxable 1999 should begin on December 15, 2000, rather than on April 15, 2000.



Petitioners are correct when they state in their brief that this issue is not properly before the Court at this time. Moreover, we note that, pursuant to section 6601(a), interest begins to run on "the last date prescribed for payment" of the tax and, pursuant to section 6151(a), an extension of time for filing an income tax return does not extend the time for paying the tax due.



Based upon the foregoing,



Decision will be entered for respondent.