Transupport, Inc. v. Comm'r, T.C. Memo. 2016-216

• Decision Date: 23 November 2016
• Docket Number: Docket No. 12152-13.,T.C. Memo. 2016-216
• Parties: TRANSUPPORT, INCORPORATED, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

TRANSUPPORT, INCORPORATED, Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent^*

T.C. Memo. 2016-216
Docket No. 12152-13.

UNITED STATES TAX COURT

November 23, 2016

Michael S. Lewis and William F. J. Ardinger, for petitioner.

Carina J. Campobasso and Kimberly A. Kazda, for respondent.

SUPPLEMENTAL MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: In our prior opinion in this case, Transupport, Inc. v. Commissioner (Transupport I), T.C. Memo. 2015-179, we held that assessments of the deficiencies determined for 1999 through 2005 are barred by the statute of

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limitations because respondent failed to prove by clear and convincing evidence that underpayments for those years were due to fraudulent intent on the part of petitioner. After that opinion was issued, further trial was held to present expert opinion evidence on the remaining issues for the years for which assessment is not barred. The issues for determination in this opinion are whether amounts deducted for 2006 through 2008 for compensation paid to the four shareholding sons of petitioner's president, Harold Foote (Foote), were reasonable, whether respondent's determinations regarding petitioner's costs of goods sold during those years should be sustained, and whether petitioner is liable for the accuracy-related penalty prescribed by section 6662(a) for any of those years. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Because the background facts found in Transupport I are for the most part relevant to the issues addressed in this opinion, we incorporate certain of them verbatim from Transupport I and intersperse, where appropriate, additional findings based upon the expert evidence presented at the continued trial. Some additional facts have been stipulated, and these facts are incorporated in our

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findings by this reference. Petitioner's place of business was New Hampshire when the petition was filed.

Petitioner is a supplier and surplus dealer of aircraft engines and engine parts for use in military vehicles, including helicopters, airplanes, and tanks. It primarily purchased surplus parts from the Government in bulk lots that contained parts having little value as well as parts that petitioner wanted for its business. Petitioner bought the lots to acquire items that it expected to sell but also ended up with items that would not be sold. The costs of particular items were not specified as part of the purchase transactions.

Petitioner was also a distributor of parts. The distributorship line of business is referred to in the record as the Goodrich line. Distributorship purchases were of specific parts, and the individual item costs were traceable. The purchased distributorship items were susceptible of accurate inventory accounting, and some computer records were kept in later years; but an accurate inventory was never made part of petitioner's financial and tax reporting.

Petitioner was not a manufacturer. If aircraft engines required overhaul, petitioner sent the work out to be performed by others. The correct category for comparing petitioner's business with other businesses for purposes of determining reasonable compensation is wholesaler.

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Foote, its president and chief executive officer, founded petitioner in 1972. During the years in issue Foote and his four sons, William Foote (W. Foote), Kenneth Foote (K. Foote), Richard Foote (R. Foote), and Jeffrey Foote (J. Foote) were petitioner's only full-time employees and officers. None of petitioner's officers is an accountant. Each of the officers performed various and overlapping tasks for the company, including tasks that might have been performed by lower level employees. The officers performed no supervisory functions.

In 1999 Foote owned 98% of petitioner's stock. The other 2% was owned by Richard Smith, an unrelated person. As of December 31, 2004, petitioner had issued, and had outstanding, 1,000 shares of class A voting common stock and 9,000 shares of class B nonvoting common stock. On August 8, 2005, Foote transferred 2,250 shares of class B nonvoting common stock to each of his four sons. Accordingly, after this transfer, Foote owned 1,000 shares of class A voting common stock and his four sons each owned 2,250 shares of class B nonvoting common stock.

Starting in the mid-to-late 1970s, petitioner retained Elaine Thompson as its accountant, and she served as petitioner's outside accountant until she died in 2010. Thompson was a certified public accountant (C.P.A.), was a name partner

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in her firm, and was the first female president of the Connecticut Society of Certified Public Accountants.

Petitioner provided to Thompson handwritten summaries, usually prepared by J. Foote. Thompson, through her accounting firm, prepared compiled financial statements for petitioner for 1990 through 2008 that were based upon the summaries and upon financial information that petitioner maintained. The financial statements were not audited by Thompson or her firm, and the information on the summaries was never verified by Thompson or her firm. In a memorandum dated December 22, 2000, Thompson advised Foote that "any inventory increase creates more income".

Petitioner filed Form 1120, U.S. Corporation Income Tax Return, for each of the years in issue. Thompson prepared petitioner's Forms 1120 using the same financial information that petitioner provided in connection with preparation of petitioner's compiled financial statements.

On petitioner's returns the inventory and cost of goods sold amounts were reported as follows:

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Year	Inventory; purchases	Ending; inventory	Cost of; goods sold	Cost of goods sold; as a % of sales
1990	$2,438,837	$349,036	$2,411,031	70.2
1991	2,411,063	504,265	2,293,132	69.0
1992	5,722,070	517,336	5,766,439	83.2
1993	2,992,018	575,808	2,989,565	71.5
1994	2,889,862	595,180	2,942,558	70.1
1995	5,735,674	698,584	5,715,005	79.6
1996	4,534,762	671,351	4,635,362	72.2
1997	8,442,613	700,851	8,466,177	80.5
1998	5,025,653	725,921	5,095,312	70.6
1999	4,582,833	731,783	4,619,035	68.0
2000	6,823,574	876,651	6,749,058	69.0
2001	5,653,767	1,488,289	5,086,870	63.5
2002	6,962,709	1,232,117	7,266,115	68.8
2003	5,523,832	1,553,889	5,264,284	64.4
2004	5,643,235	1,520,813	5,724,397	62.4
2005	5,401,471	1,389,847	5,603,004	68.1
2006	7,160,157	1,657,697	6,951,132	66.6
2007	6,510,873	1,867,257	6,365,543	60.7
2008	8,257,286	2,662,956	7,519,086	63.0

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Costs of goods sold reported as percentages of purchases ranged from 91% for 2008 to over 100% for 1999, 2002, 2004, and 2005.

The Internal Revenue Service (IRS) audited petitioner's Forms 1120 for 1982 and 1983 in 1984. The IRS audited petitioner's Forms 1120 for 1988, 1989, and 1990 in 1992. During each of the audits the examining agent was aware that petitioner did not maintain a physical inventory of the unsold parts in its warehouse and backed into the closing inventory, reported in its returns, by using a percentage of sales as costs of goods sold. The examining agent conducting the audit for 1990 was advised that some surplus items had been sold at amounts in excess of 100% gross profit, but he accepted petitioner's representation that, on the basis of Foote's experience in selling the surplus items, petitioner had averaged approximately a 30% gross profit margin. Although the examining agents in each audit informed Foote or petitioner's C.P.A. that petitioner should maintain a physical inventory, the costs of goods sold were adjusted only to reflect a minor change in the purchases that petitioner made in 1983.

In 2000, 2002, 2004, and 2005, petitioner obtained appraisal reports that presented a valuation analysis of the fair market value of petitioner's stock as of December 31, 1999, 2001, 2003, and 2004, respectively. The appraisal reports were obtained in relation to Foote's intent to make gifts of stock to his sons. After

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the first appraisal, Foote objected to the appraised value because the appraiser's value would make it harder for Foote to give petitioner's stock to his sons. Foote later gave his sons stock valued at the maximum allowed without gift tax liability and arranged for his sons to pay the balance of the purchase price over a period of years. Foote and W. Foote were familiar with the estate and gift tax consequences of such gifts. Foote was also familiar with the marginal income tax rates applicable to him and to his sons. Foote alone determined the compensation payable to his sons. He did not consult his accountant or anyone else in determining their compensation. The only apparent factors considered in determining annual compensation were reduction of reported taxable income, equal treatment of each son, and share ownership.

On its Forms 1120 for 1999 through 2008, petitioner deducted the following amounts as compensation:

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Officer	1999	2000	2001	2002	2003	2004	2005	2006	2007	2008
Foote	$478,528	$593,587	$538,213	$538,269	$428,291	$513,152	$213,194	$353,211	$478,993	$599,858
R. Foote	255,000	425,000	407,500	495,000	425,000	510,000	390,000	575,000	675,000	720,000
K. Foote	255,000	425,000	407,500	495,000	425,000	510,000	390,000	575,000	675,000	720,000
J. Foote	255,000	425,000	407,500	495,000	425,000	510,000	390,000	575,000	675,000	720,000
W. Foote	255,000	425,000	407,500	495,000	425,000	510,000	390,000	575,000	675,000	720,000
Others	-0-	-0-	-0-	-0-	-0-	-0-	-0-	5,952	8,366	6,323
Total	1,498,528	2,293,587	2,168,213

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