Wakefield v. Commissioner of Internal Revenue, 010715 FEDTAX, 15383-09

Docket Nº:15383-09
Opinion Judge:WHERRY, Judge
Attorney:Steven R. Mather, for petitioners. Halvor R. Melom, for respondent.
Case Date:January 07, 2015
Court:United States Tax Court

T.C.Memo. 2015-4




No. 15383-09

United States Tax Court

January 7, 2015

R determined deficiencies in income tax for Ps' 2002, 2003, and 2004 taxable years arising from Ps' failure to report income they received in connection with an ESOP and an S corporation, R's disallowance of deductions for passthrough losses from Ps' wholly owned partnership, and related computational adjustments. Before trial the parties settled outstanding issues other than Ps' entitlement to deductions for passthrough losses from their partnership, and they agreed to try the case as if Ps had directly claimed on their individual returns the deductions underlying the passthrough losses.

Held: The stipulation of settled issues does not authorize Ps to deduct expenses reported by the S corporation and a related C corporation or a $100, 000 passthrough loss for 2002 from the partnership.

Held, further, R properly disallowed all deductions for passthrough losses from the partnership for 2002, 2003, and 2004.

Held, further, Ps failed to substantiate most of the expenses underlying the partnership's losses for 2002, 2003, and 2004, and those expenses are therefore not deductible. Ps may deduct expenses as conceded by R and certain expenses that have been adequately substantiated.

Held, further, Ps are liable for penalties under I.R.C. sec. 6662(a) as to any underpayments resulting from R's disallowance of deductions for passthrough losses from the partnership, to the extent Ps may not deduct the underlying expenses directly.

Steven R. Mather, for petitioners.

Halvor R. Melom, for respondent.



Respondent determined deficiencies and penalties for 2002, 2003, and 2004, as follows:



Penalty sec. 6662(a)


$355, 871

$71, 174.20


47, 901

9, 580.20


21, 289

4, 257.80

After filing of a stipulation of facts, a supplemental stipulation of facts, a stipulation of settled issues (SOSI), and a stipulation, the facts of which are agreed to by the parties and by this reference incorporated herein, as well as subsequent concessions, the issues remaining for decision are:

(1)whether the SOSI authorizes petitioners to deduct: (a) expenses and/or losses reported by corporate entities Capital Equity Resources, Inc. (Capital Equity), and/or Great Western Sierra Holdings, Inc. (Great Western), for 2002 and 2003; and/or (b) a $100, 000 passthrough loss from their wholly owned general partnership Wakefield Business Enterprises Partnership (WBE) for 2002;

(2) whether petitioners may otherwise deduct passthrough losses from WBE of $161, 085, $46, 433, and $57, 464 for tax years 2002, 2003, and 2004, respectively;

(3) whether petitioners may alternatively deduct any or all expenses reported by WBE for tax years 2002, 2003, and 2004 on Schedules A, Itemized Deductions, for those tax years; and

(4) whether petitioners are liable for section 6662(a) accuracy-related penalties for tax years 2002, 2003, and 2004 with respect to any deficiencies resulting from the disallowance of deductions for passthrough losses from WBE, to the extent they may not directly deduct the expenses underlying those losses.1



Petitioners Kennison and Mary Wakefield filed a Form 1040, U.S. Individual Income Tax Return, for each of the tax years 2002, 2003, and 2004 as married persons filing jointly. Petitioners lived in California when they filed their petition.

At all times during 2002 through 2004 Mr. Wakefield worked as a stockbroker. He did so as an employee, first of Prudential Financial and then of Wachovia after it acquired Prudential Financial.2 Mr. Wakefield received a small salary from Prudential, but his earnings derived principally from commissions on investment products purchased by clients whose business he brought to the firm. Before joining the securities industry Mr. Wakefield earned a degree in business administration and marketing at the University of Southern California (USC) and attended two years of law school at the University of San Fernando Valley. As of 2002 he had 30 years of experience in the securities industry.

On petitioners' tax returns for 2002, 2003, and 2004 Mrs. Wakefield reported her occupation as "interior design" and reported income and expenses from a residential building refurbishment business on attached Schedules C, Profit or Loss From Business. In 2002 she also received wage income from Ralph's Grocery Co.

Business Entities

Before 2002 Mr. Wakefield met A. Blair Stover, Jr., a principal at the accounting firm Grant Thornton, which had been providing accounting services to petitioners.3 After reviewing Mr. Wakefield's financial situation, Mr. Stover recommended that Mr. Wakefield form various business entities, including Nevada corporations and an ESOP. Mr. Wakefield engaged Grant Thornton to form the entities for him because he understood that doing so "would help * * * [him] in * * * [his] taxes as far as what * * * [his] tax obligations would be."

Mr. Stover and his team formed the following entities (business entities) for Mr. Wakefield: (1) Great Western, an S corporation that reported Mr. Wakefield as its president and an ESOP as its sole shareholder on its 2001, 2002, and 2003 tax returns; (2) Capital Equity, a C corporation with a fiscal taxable year ending on October 31 that reported Mr. Wakefield as its sole shareholder, president, or owner on its 2002 and 2003 tax returns; and (3) WBE, a 50-50 partnership between petitioners of which Mr. Wakefield served as the designated tax matters partner.

Forming these entities enabled petitioners to participate in a management S corporation/ESOP transaction designed to reduce ordinary taxable income by the alleged payment to a newly created S corporation, Great Western, of alleged management fees that were reported by Great Western as income and passed through to the tax-exempt ESOP. The transaction also involved purported fee payments and expenses allocated between Capital Equity and WBE. In 2010 Mr. Stover was permanently enjoined from promoting various tax-shelter schemes, including the "ESOP/S" and "parallel C" structures. See supra note 3.

When Mr. Stover and several other individuals, including Angela Parker and Kelly Webb, decamped from Grant Thornton to another accounting firm, Kruse Mennillo, LLP (Kruse Menillo), Mr. Wakefield followed them and thereafter used Kruse Mennillo for tax preparation and other services. Ms. Parker and/or Ms. Webb prepared petitioners' and the business entities' tax returns for 2002, 2003, and 2004. They prepared the returns using business and personal expense summaries that Mr. Wakefield created. Mr. Wakefield signed the returns as presented to him by Kruse Mennillo.

Petitioners claimed deductions for passthrough losses from WBE on Schedules E, Supplemental Income and Loss, of their 2002 through 2004 tax returns. WBE reported income, deductions, and ordinary losses on Forms 1065, U.S. Return of Partnership Income, for tax years 2002, 2003, and 2004.4 WBE conducted no business activity and incurred no expenses during those tax years.5]

The Notice of Deficiency

Respondent mailed a notice of deficiency to petitioners on March 23, 2009. On an enclosed Form 5278, Statement - Income Tax Changes, respondent identified the following adjustments to petitioners' income for tax years 2002, 2003, and 2004:

Adjustment Source




(1) Other income

$270, 000 ---

(2) Tax benefit from ESOP

29, 800

$98, 000

(3) Recapture of ESOP tax benefit

450, 686


(4) Pass through losses from WBE

161, 085

46, 433

$57, 464

(5) Itemized deductions

27, 347

4, 333

1, 724

(6) Exemptions

5, 280

5, 490

Total adjustments

944, 198

154, 256

59, 188

The notice also determined section 6662(a) penalties with respect to the resulting deficiencies. Petitioners petitioned this Court on June 22, 2009, disputing the deficiencies and their liability for the penalties.

Settled Issues and Concessions

In the SOSI, the parties intended to settle all issues related to petitioners' participation in the management S corporation/ESOP transaction in taxable years 2001, 2002, and 2003 by attributing to them individually the taxable income that Great Western reported as having passed through to the ESOP. The SOSI thus resolved adjustments (1) through (3) above by providing that "petitioners received, but did not report, ordinary income" of $426, 313 for 2002 and $84, 837 for 2003. The amount petitioners were obliged to report for 2002, $426, 313, represents the net amount of taxable income they avoided reporting for taxable years 2001 and 2002 because of their use of Great Western in conjunction with the ESOP. The amount petitioners were obliged to report for 2003, $84, 837, represents the amount of taxable income petitioners avoided reporting for taxable year 2003 because of their use of Great Western in conjunction with the ESOP. Respondent, in turn, conceded the deficiencies he had determined with respect to Capital Equity and Great Western.

The parties further agreed in the SOSI that petitioners are liable for accuracy-related penalties under section 6662(a) equal to 10% of $190 of unreported income for 2002 and 10% of $84, 837 of unreported income for 2003. The SOSI identified two issues as outstanding: petitioners' entitlement to deductions for passthrough losses from WBE for all three tax years at issue and their liability for section 6662(a) penalties with respect to any underpayments...

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