Holland v. Comm'r of Internal Revenue

• Decision Date: 25 September 1978
• Docket Number: Docket No. 4275-76.
• Citation: 70 T.C. 1046
• Parties: JOHN C. HOLLAND and MARIE HOLLAND, PETITIONERS v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

70 T.C. 1046

JOHN C. HOLLAND and MARIE HOLLAND, PETITIONERS

v.COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 4275-76.

United States Tax Court

Filed September 25, 1978.

Held, for purposes of computing the maximum tax on earned income under sec. 1348, I.R.C. 1954, the 30-percent limitation on the amount of earned income from business in which capital is a material income-producing factor, as provided in sec. 911(b), to which sec. 1348(b)(1) refers for a definition of earned income, applies to net profits of a business within the United States. Held, further, respondent not barred from assessing deficiency by either sec. 7121, I.R.C. 1954, or collateral estoppel by virtue of taxpayers' execution of Form 4549 (consent to immediate assessment). John M. Carter, for the petitioners.

John S. Ball, for the respondent.

OPINION

DRENNEN, Judge:

Respondent determined deficiencies in petitioners' 1972 and 1973 income taxes in the amounts of $2,776.26 and $19,948.38, respectively. Other adjustments in the statutory notice not having been placed in issue, the remaining question is whether petitioner-husband may include 100 percent of net profits from his unincorporated maintenance contracting business in “earned income” in computing his tax liabilities under the maximum tax provisions of section 1348. Resolution of this question turns upon two subissues:

(1) Whether respondent is bound by an audit report issued by an agent of respondent prior to the statutory notice of deficiency;

(2) If not, whether the 30-percent limitation on the amount of earned income from business in which capital is a material income-producing factor under sections 1348(b)(1) and 911(b), I.R.C. 1954,¹ applies to net profits of a business within the United States.

This case was submitted fully stipulated under Rule 122, Tax Court Rules of Practice and Procedure. The stipulation of facts with the exhibits attached are incorporated herein by this reference. The pertinent facts are as follows:

John C. Holland and Marie Holland, husband and wife, resided in Chesapeake, Va., when they filed their petition. Marie Holland is a petitioner only because the couple filed joint returns; references to “petitioner” alone will be to John C. Holland.

Petitioners timely filed joint income tax returns for 1972 and 1973 with the Internal Revenue Service Center, Memphis, Tenn.

During 1972 and 1973 petitioner operated an unincorporated maintenance contracting business. His business consisted principally of collecting and disposing of trash, garbage, and scrap material. A substantial portion of petitioner's business was derived by contracting with the Government to provide trash and garbage collection service at various naval installations in the general vicinity of Norfolk, Va.

The net profit from petitioner's business, as reflected on the returns and after making adjustments for business-related items shown in the notice of deficiency and not contested by petitioners, was $175,243.59 in 1972 and $246,987.24 in 1973.

Petitioner invested in equipment, machinery, and other assets for use in his business. The income from petitioner's business could be earned only through the use of these assets. Petitioner's cost basis in depreciable property used in his business amounted to more than $172,000 in 1972 and more than $305,000 in 1973.

In addition to office equipment, petitioner's depreciable assets used in the business generally consisted of trucks, bulldozers, dumpsters, cranes, and various other items of “heavy” and light equipment and machinery.

Petitioner employed approximately 65 people in his business during the periods in question.

Petitioner, generally speaking, occupied a managerial position in his business as opposed to actually operating a piece of equipment or machinery on a daily basis.

Petitioners computed their 1972 and 1973 tax liabilities pursuant to the maximum tax on earned income provisions of section 1348. In their maximum tax computations, petitioners included in “earned income” all of the net profit from the maintenance contracting business.

Three “Income Tax Audit Changes” forms were issued by an agent of respondent prior to issuance of the statutory notice of deficiency. The proposed deficiencies in these audit reports were as follows:

+----------------------------------+
                ¦  ¦           ¦1972     ¦1973     ¦
                +--+-----------+---------+---------¦
                ¦  ¦           ¦         ¦         ¦
                +--+-----------+---------+---------¦
                ¦1.¦Form 4549  ¦$791.06  ¦$2,468.23¦
                +--+-----------+---------+---------¦
                ¦2.¦Form 4549-A¦14,212.94¦26,489.90¦
                +----------------------------------+
                

   (First corrected report)
                3. Form 4549                2,776.26 19,948.37
                

 (Second corrected report)
                

In the first Form 4549 the inclusion of all the net profits of petitioner's business in earned income for maximum tax purposes was not challenged. In the corrected audit reports, however, respondent treated only 30 percent of the net profits of petitioner's business as earned income.²

Petitioners are contesting only the computation of their tax liability as determined in the statutory notices of deficiency. In determining petitioner's earned income for use in the maximum tax computation, respondent determined that capital was a material income-producing factor and limited petitioner's earned income to 30 percent of the net profits of his business for the years in question pursuant to sections 1348(b)(1) and 911(b). The 1972 and 1973 tax liabilities were recomputed by income averaging—-the most favorable method available to petitioners as a result of the 30-percent limitation.³

The first argument made by petitioners is that respondent should be bound by the first audit report. In that report, Form 4549, the inclusion in earned income of all the net profits of petitioner's business for maximum tax purposes was not challenged.

No authority is cited by petitioners in support of this contention, and in view of Hudock v. Commissioner, 65 T.C. 351, 362-363 (1975), this argument requires little discussion. In Hudock we rejected petitioners' claims that execution of a Form 4549 by petitioners and a revenue agent constituted a closing agreement under section 7121⁴ or operated to invoke the doctrine of equitable estoppel against respondent's assessment of the deficiency at issue. We reasoned that a Form 4549 does not constitute an agreement by the Secretary to anything, much less a final closing agreement, and that execution of the Form 4549 and a payment pursuant thereto did not establish or give rise to the doctrine of equitable estoppel. Our analysis there applies with equal force here.

The substantive issue deals with the definition of earned income for maximum tax purposes. In 1972 and 1973, section 1348(a) provided for a 50-percent maximum tax rate on earned taxable income. Pursuant to section 1348 (b)(2) “earned taxable income” was generally the same proportion of total taxable income as earned net income was of adjusted gross income, reduced by certain tax preference income. For this purpose “earned net income” meant earned income reduced by certain related deductions. “Earned income” thus was the key term in the maximum tax computation.

“Earned income” in turn was defined by section 1348 (b)(1) to mean—-

any income which is earned income within the meaning of section 401(c)(2)(C) or section 911(b), except that such term does not include any distribution to which section 72(m)(5), 72(n), 402(a)(2), or 403(a)(2)(A) applies or any deferred compensation within the meaning of section 404.* * *

Section 401(c)(2)(C) defines earned income to include income from disposition of certain property by an individual whose personal efforts created the property. Section 911(b) defines “earned income” as follows:

(b) DEFINITION OF EARNED INCOME. —-For purposes of this section, the term “earned income” means wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered, but does not include that part of the compensation derived by the taxpayer for personal services rendered by him to a corporation which represents a distribution of earnings or profits rather than a reasonable allowance as compensation for the personal services actually rendered. In the case of a taxpayer engaged in a trade or business in which both personal services and capital are material income-producing factors, under regulations prescribed by the Secretary or his delegate, a reasonable allowance as compensation for the personal services rendered by the taxpayer, not in excess of 30 percent of his share of the net profits of such trade or business, shall be considered as earned income.

Consequently, by reference to section 911(b), “earned income” for purposes of applying the maximum tax under section 1348 is statutorily limited to 30 percent of net profits derived by a taxpayer engaged in an unincorporated trade or business in any case in which both personal services and capital are material income-producing factors.

That capital was a material income-producing factor in petitioner...