Nicholson v. Commissioner

MEMORANDUM OPINION

HALPERN, Judge: Respondent, by two notices of deficiency dated June 21, 1988, determined deficiencies in, and additions to, petitioners' Federal income tax as follows:

Unless otherwise noted, all section references are to the Internal Revenue Code in effect for the taxable years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.

The issues remaining for decision are as follows:

(1) Whether petitioners had unreported income in 1980; (2) whether petitioners had additional interest income in 1980 and 1981; (3) whether petitioners are entitled to claimed deductions in connection with the dental clinics for 1980 and 1981; (4) whether petitioners are entitled to claimed deductions in connection with petitioner Charles Nicholson's oral surgeon activity for 1980 and 1981; (5) whether petitioners are entitled to claimed Schedule C deductions in connection with their leasing activity for 1980 and 1981; (6) whether petitioners are entitled to a net operating loss carryback deduction claimed on an amended return for 1977; (7) *186 whether petitioners may on brief raise various new issues; (8) whether petitioners are liable for the additions to tax for each year at issue; and (9) whether petitioner Linda S. Nicholson is an innocent spouse.

Background

Some of the facts have been stipulated and are so found. The stipulation of facts filed by the parties and attached exhibits are incorporated herein by this reference. Petitioners jointly filed all tax returns at issue in this case. Petitioners Charles S. and Linda S. Nicholson, now divorced, lived in Bakersfield, California, and Danville, California, respectively, at the time their separate petitions herein were filed. Respondent's motion to consolidate was granted on March 15, 1990. For convenience, the term petitioner, in the singular, hereinafter will refer to petitioner Charles S. Nicholson.

I. Dentist Activity

A. Background

Petitioner has been licensed to practice dentistry and oral surgery by the Board of Dental Examiners of the State of California since January 1, 1969. In 1973, petitioner acquired a practice in Pleasant Hill, California. In approximately 1976, petitioner opened another office in Antioch, California. Both offices*187 were owned and operated by Charles S. Nicholson III, D.D.S., Inc. (CSN), a California corporation, incorporated in 1974 or 1975, of which petitioner was the sole shareholder.

B. The New Clinics

In approximately 1978, while operating both the Pleasant Hill and Antioch offices, petitioner considered purchasing and expanding dental clinics to provide specialist services to large groups of clients. Petitioner discussed the matter with a broker of dental practices, Tom Fitterer. At that time, Fitterer was the partner, along with a dentist named Dennis Demsky, in a partnership (DEMFIT) owning dental clinics in San Leandro and Fresno, California. DEMFIT, either at that time or earlier, had leased the San Leandro and Fresno dental clinics to Dental Group Management, Inc., a management company owned by Dennis Gerber. ¹ Under the terms of those leases, Gerber leased the San Leandro and Fresno dental clinics (including the real property and all dental equipment) from DEMFIT and was to manage those dental clinics, as will be discussed shortly.

*188 Gerber had entered into arrangements with dental practice owners who would practice in the dental clinic on "turnkey" bases with Gerber. Under the turnkey arrangements, Gerber would bill for the dentists' services, collect the money, hire and fire assistants, do the marketing, promotion, and advertising, and perform all other services required to sustain the dental practices. In exchange, Gerber would keep 66.7 percent of the gross production (billings) as compensation for his efforts, paying each dental practice owner 33.3 percent of the practice's gross production. Independent dentists, called "associates", worked for the dental practice owners. According to the agreements between the associates and the dental practice owners, such owners were to pay their associates 25 of their 33.3 percent of the practice's gross production (which is equivalent to 75 percent of the amount received by the dental practice owner from the management company), retaining 8.3 percent of the practice's gross production.

Thus, at the time petitioner considered purchasing the San Leandro and Fresno dental clinics, the following key players were involved: (1) The owner of the San Leandro and Fresno*189 dental clinics (DEMFIT), which leased those clinics to Gerber; (2) Gerber, who leased the San Leandro and Fresno dental clinics from DEMFIT, and "sublet" space therein to the dental practice owners; (3) the dental practice owners, who "sublet" space in the dental clinics from Gerber and employed associate dentists; and (4) the associate dentists, who worked for dental practice owners.

DEMFIT provided petitioner with revenue and profit projections for the clinics. The San Leandro clinic, which had recently been established, purportedly was producing receipts of approximately $ 25,000 a month and purportedly was projected to produce receipts of approximately $ 100,000 a month in the following 6 to 9 months. The Fresno clinic purportedly already was producing receipts of $ 100,000 a month. ² It was also anticipated that the general dental practices would generate work for the providers of specialized services, such as periodontists, orthodontists, and endodontists.

*190 C. Purchase of the San Leandro Clinic

On or about September 7, 1979, petitioner purchased the San Leandro real property and clinic from DEMFIT, for $ 400,000, which he borrowed from Hibernia Bank (Hibernia) in order to finance that purchase. That loan was secured by two mortgages on the property acquired. Ultimately, that loan went into default and Hibernia foreclosed on its deeds of trust.

D. Purchase of the Fresno Clinic

On or about May 2, 1980, petitioner purchased the Fresno real property and clinic from DEMFIT for $ 550,000. The terms of that deal are outlined in a document entitled "Master Sales Agreement". That agreement, dated April 18, 1980, states that the lease, whereby Gerber had leased the Fresno clinic from DEMFIT and managed that clinic, had previously been terminated by DEMFIT.

E. Operation of the Dental Clinics

As part of his respective decisions to purchase the San Leandro and Fresno dental clinics, petitioner decided to lease the two clinics to Gerber, who would continue to manage those clinics, just as he had managed them for DEMFIT. On or about July 24, 1979, petitioner and Gerber executed a "building lease" relating to the San Leandro*191 clinic. Under that lease, Gerber was to pay petitioner a guaranteed monthly rent of $ 4,846 plus 5 percent of Gerber's gross receipts, beginning in approximately September 1979. Later (on a date not indicated by the record), petitioner and Gerber entered into a similar arrangement with respect to the Fresno clinic. Under that lease, Gerber was to pay petitioner a monthly rent of between $ 12,000 and $ 14,000, beginning in May 1980.

Petitioner's wholly owned corporation, CSN, was to be a dental practice owner, and petitioner, individually, was to be an associate dentist with CSN (perhaps along with other associates). ³ Accordingly, the key players at this point were to be as follows: (1) Petitioner, individually, as owner and lessor of the dental clinics; (2) Gerber, as lessee of the clinics, managing the clinics and "subleasing" them to dental practice owners; (3) dental practice owners, including petitioner's corporation, CSN, "subleasing" space in the dental clinics and hiring associate dentists; and (4) associate dentists, including petitioner, individually, working for dental practice owners.

*192 In order to devote adequate time to this enterprise, petitioner sold his practices in Antioch and Pleasant Hill. Petitioner spent a significant amount of time traveling, meeting with, and soliciting prospective dentists to work with CSN at the dental clinics.

The dental clinics were not successful. Much of this failure apparently is attributable to the practice owners' and associate dentists being paid on the basis of production, as opposed to actual collections. Overall, the enterprise was undercapitalized, and Gerber had difficulty paying bills and making payroll. Accordingly, petitioner, as an individual, lent substantial sums of money to Gerber, in the hope that a sufficient injection of capital into the dental practices would permit the enterprise to succeed. That did not happen.

F. Gerber's Default and Bankruptcy

Gerber never fully repaid his loans to petitioner. Petitioner's 1980 loans to Gerber, totaling $ 561,000, were secured (to some degree) by various accounts receivable. There was a prior security interest on those accounts receivable, however, in favor of United California Bank (UCB). In late summer or fall 1980, Gerber had defaulted on various obligations*193 to petitioner, who, unwilling to further forgo payment, negotiated with UCB and foreclosed on certain of the accounts receivable. Petitioner collected $ 33,021.21 and $ 31,599.06 (for a total of $ 64,620.27) from those accounts receivable between November 5, 1980, and December 3, 1981, respectively.

Petitioner determined at about that time that legal action against Gerber (in addition to said foreclosure on certain accounts receivable) would have been futile because Gerber simply had no money. On February 17, 1982, Gerber, doing business as "Dental Group Services", filed a voluntary petition in the United States Bankruptcy Court for the Eastern District of California (the Bankruptcy Court). That petition lists total assets of $ 10,150 and total liabilities of $ 1,483,176.50. Petitioner is listed therein as a secured creditor in the amount of $ 711,720, with regard to various promissory notes made in 1980. Gerber was released from all dischargeable debts by order of the Bankruptcy Court, dated July 28, 1982, and the bankruptcy trustee filed a "Trustee's Report of No Distribution", dated October 27, 1982, reporting that there was no property available for distribution from the*194 bankruptcy estate.

On March 2, 1981, the corporate powers of Dental Group Management, Inc., through which Gerber did business, were suspended by the Secretary of the State of California. On May 3, 1982, the corporate powers of Dental Group Services, through which Gerber did business, were suspended by the Secretary of the State of California.

On August 28, 1980, after Gerber's involvement with the dental clinics had been terminated, petitioner caused the incorporation of Dental Management Associates, Inc. (DMA). DMA was to substitute for Gerber as lessee and manager of the dental clinics, on the same terms as had been agreed to with Gerber. Petitioner was the sole shareholder of DMA. The various roles played at this point by petitioner, both individually and through his corporations, can be summarized as follows: (1) Owner and lessor of the properties, individually; (2) lessee/manager (and sublessor), through DMA; (3) dental practice owner (and sublessee), through CSN; and (4) associate dentist, individually.

CSN's gross revenue for its taxable year ended June 30, 1980, was $ 166,124. For that taxable period, CSN deductions included expenses of $ 124,169 paid or payable to*195 petitioner; ⁴ however, petitioner reported no income therefrom for his taxable years 1980 and 1981.

II. XYZ Enterprises

During 1980 and 1981, petitioners were engaged as lessors in a leasing activity under the name "XYZ Enterprises" (XYZ), which activity they reported on Schedule C of their tax returns for those years. XYZ was owned and operated by petitioners as individuals. On September 20, 1979, petitioners filed a "Fictitious Business Name Statement" for XYZ. In*196 September 1979, XYZ purchased a Porsche automobile for $ 31,731 cash plus a finance charge of $ 10,241.80 (at a total nominal cost of $ 41,972.80). In approximately June 1980, XYZ entered into a lease with Dance Ergetics, Inc. (Dance Ergetics), a dance aerobic business owned by petitioner Linda S. Nicholson, under which lease, after making total rental payments of $ 30,683.52 over 3 years, Dance Ergetics would have the option of purchasing the Porsche for $ 1,917.72. Thus, the total nominal price would be $ 32,601.24. The lease states the price of the Porsche as being $ 26,000.

In her notice of deficiency, respondent disallowed the following adjustments with respect to XYZ:

III. Net Operating Loss Carryback and Tax Refunds

Based upon the net operating losses reported on their 1980 and 1981 returns, petitioners filed amended returns for 1977 and 1978 (which year is not here at issue) to carry back those reported losses. As a result, petitioners received a refund check in the amount of $ 34,380.56 for 1977. Petitioner Linda S. Nicholson, in*197 connection with her divorce from petitioner Charles S. Nicholson, received the entire proceeds of that check.

Discussion

I. Income Adjustments

A. Unreported Income in 1980

Normally, in this Court, a taxpayer bears the burden of proving respondent's determination to be incorrect. Rule 142(a). That burden placed upon the taxpayer is sometimes described as giving a "presumption of correctness" to respondent. In certain circumstances, however, the burden of going forward with the evidence will be placed upon respondent (depriving her of what is termed the presumption of correctness). Petitioners make two arguments for stripping respondent of her presumption of correctness and, instead, placing upon her the burden of going forward with the evidence.

1. New Matter

In the notice of deficiency, respondent determined that petitioners received unreported income of $ 387,055 with respect to 1980. The notice of deficiency does not state the specific basis of that determination. ⁵*199 Respondent's amendment to answer and brief, however, demonstrate that her determination was based on a source and application of funds analysis. Subsequent to the trial, on brief, respondent*198 formally abandoned that theory, relying instead on other theories first raised by respondent in her amendment to answer. Specifically, respondent's new theories and arguments concern: (1) Unreported income, actually or constructively received (individually), as an associate of CSN; (2) unreported income, actually or constructively received, as a dental practice owner; (3) unreported rent income, actually or constructively received, (individually) as the lessor of the dental clinics; (4) unreported income from pension plan withdrawals; and (5) unreported interest income. On account of respondent's new theories, petitioners contend that respondent has raised a "new matter", within the meaning of Rule 142(a), and therefore ought to bear the burden of proof. ⁶

We disagree. None of respondent's new theories are inconsistent with respondent's notice of deficiency, which says nothing more than that petitioners had unreported income of $ 387,055 in 1980, which is taxable to them inasmuch as they have failed to establish the applicability of any exclusion. We have repeatedly stated that a theory will not constitute a new matter, within the meaning of Rule 142(a), if it is consistent with the theory (or theories) advanced by respondent in the notice of deficiency. E.g., Achiro v. Commissioner, 77 T.C. 881, 890 (1981) ("The assertion of a new theory which merely clarifies or develops the original determination without being inconsistent or increasing the amount of the *200 deficiency is not a new matter requiring the shifting of the burden of proof."). Accordingly, where, as here, the theory advanced by respondent in her notice of deficiency is broadly worded, respondent is at liberty to advance in her answer (or amended answer) any argument consistent with that broad theory, without assuming the burden of proof under the new matter doctrine. Spangler v. Commissioner, 32 T.C. 782, 793 (1959), affd. 278 F.2d 665 (4th Cir. 1960). All of respondent's new theories deal with unreported income and therefore are consistent with respondent's extremely broad notice of deficiency, which, as discussed, does no more than charge petitioners with unreported income to which no exclusion applies. Accordingly, we find that respondent's new arguments do not constitute new matters under Rule 142(a).

Nevertheless, to the extent that respondent has sought an increased deficiency, she must bear the burden of proof. Rule 142(a). As noted, respondent's notice of deficiency determined unreported income for 1980 in the amount of $ 387,055. Respondent's present determination of unreported income for that year, however, *201 totals $ 413,299.09 (exceeding the determination appearing in her deficiency notice). All other things remaining equal, respondent's determination of increased unreported income would result in an increased deficiency. Accordingly, respondent must bear the burden of proof to that extent. Rule 142(a). In this case, however, we need not independently consider whether respondent has sustained her burden of proving an increased deficiency, because it is clear that she cannot. As we will discuss, petitioners have sustained their burden of proof to an extent sufficient to disprove (by a preponderance of the evidence) any increased deficiency determined by respondent, as well as a portion of the original determination. Accordingly, we need not consider the point further.

2. Arbitrariness

Under Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979), revg. 67 T.C. 672 (1977), to which we defer in accordance with the doctrine of Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971), respondent must come forward with a minimal evidentiary*202 foundation in support of her determination of unreported income. ⁷*203 If she fails to do so, her determination will be deemed arbitrary and, consequently, she will lose her presumption of correctness and will be forced to go forward with the evidence. Weimerskirch v. Commissioner, supra.Petitioners argue that respondent has failed to come forward with the requisite minimal evidentiary foundation, that her determination therefore is arbitrary, and that consequently she must bear the burden of going forward with the evidence. For reasons that will be explained below, we disagree with petitioners. Respondent has adduced a sufficient evidentiary foundation to render her determination nonarbitrary; ⁸ the burden of going forward, therefore, will remain squarely upon petitioners.

3. Unreported Income in 1980

Respondent has determined that petitioners had unreported income in 1980 as follows:

a. Associate Income From CSN

Respondent has determined that petitioners actually or constructively received $ 124,593 of associate income from CSN in 1980. CSN, in accordance with its agreements with Gerber and DMA, was to receive 33.3 percent of the dental practices' gross billings. In turn, in accordance with its agreement with petitioner, individually (CSN's only associate), CSN was to remit to petitioner 25 percent of the practices' gross billings. In other words, CSN was to remit to petitioner 75 percent of any amounts received by it from Gerber and DMA as compensation*204 for petitioner's services as an associate dentist (25 percent / 33.3 percent = 75 percent). CSN's gross revenue for the fiscal year July 1, 1979, through June 30, 1980, was $ 166,124. Petitioner therefore was entitled to 75 percent of that figure, $ 124,593, for that period of time. In fact, CSN reported certain expenses totaling very nearly that amount ($ 124,169) on its corporate tax return for its tax year ended June 30, 1980, which expenses we have already concluded were paid or payable to petitioner. Respondent thus argues that an associate's fee of $ 124,593 was paid by CSN to petitioner, either actually or constructively, in 1980.

(1) Respondent's Determination Nonarbitrary

Initially, we note that respondent has met her burden of establishing a minimal evidentiary foundation under Weimerskirch v. Commissioner, supra. In our view, there is sufficient foundation for respondent to conclude: (1) That CSN had $ 166,124 of gross income, from the San Leandro and Fresno dental clinics, in its taxable year ended June 30, 1980; (2) that CSN had approximately the same gross income from such dental clinics in the 1980 calendar year; and (3) *205 that, in accordance with their agreement, CSN actually paid or made available 75 percent of such gross income ($ 166,124 X .75 = $ 124,593) as an associate's fee. We consider the reasonableness of each conclusion in turn.

First, inasmuch as (i) CSN's tax return for its taxable year ended June 30, 1980, does not specify the source of the $ 166,124, (ii) petitioner's tax return indicates the sale of at least one of his other two practices (Pleasant Hill and Antioch) as of July 1, 1979, and (iii) petitioner's testimony indicates that the two practices were sold together in 1979, we think respondent reasonably concludes that the $ 166,124 represents income from the San Leandro and Fresno dental clinics. ⁹

*206 Second, in the absence of any reason to believe that CSN's gross income (from the San Leandro and Fresno clinics) was lower in the 1980 calendar year than in the tax year ended June 30, 1980, we think respondent reasonably supposes those figures to be comparable. Accordingly, respondent's conclusion that CSN had $ 166,124 of gross income (from the San Leandro and Fresno clinics) in the 1980 calendar year is not arbitrary.

Third, inasmuch as the agreement between CSN and petitioner (individually), as dental practice owner and associate, respectively, provides that CSN would remit to petitioner 75 percent of its gross receipts from the San Leandro and Fresno dental clinics (received from Gerber and DMA), respondent needs nothing more to justify the conclusion that $ 124,593 (75 percent of $ 166,124) was either actually or constructively paid to petitioner in 1980. Moreover, CSN's claiming of very nearly that amount of expenses ($ 124,169), apparently paid or payable to petitioner (as discussed above) for its 1980 tax year, further justifies respondent's conclusion that such sum was paid. Respondent, therefore, has established a minimal evidentiary foundation for her determination*207 that petitioner actually or constructively received $ 124,593 from CSN in 1980. See Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979), revg. 67 T.C. 672 (1977). The burden of going forward with evidence to disprove respondent's determination remains upon petitioners.

(2) Petitioners' Attempt to Sustain Burden of Proof

Preliminarily, petitioners argue that CSN did not have $ 166,124 of gross income from the San Leandro and Fresno dental clinics in the 1980 calendar year (and that petitioner therefore did not receive 75 percent of that amount as an associate's fee). Petitioners assert that that amount was not earned from those clinics, but from the Pleasant Hill and Antioch practices. Moreover, petitioners argue, CSN's gross income for the tax year ended June 30, 1980, does not accurately reflect its gross income for the 1980 calendar year. Petitioners present no evidence, however, as to CSN's actual gross income for the 1980 calendar year, or as to what amount CSN received from the San Leandro and Fresno dental clinics, as opposed to other sources, during that year. Presumably, petitioners would have us *208 resolve those doubts against respondent. This, however, we cannot do. Petitioners bear the burden of disproving respondent's determination and, having failed to offer evidence in support of their contentions, fail to carry that burden. See Rule 142(a).

Next, petitioners argue that, whatever amounts CSN may have owed petitioner, petitioner neither actually nor constructively received those amounts. With respect to actual receipt, petitioners argue that petitioner did not (actually) receive those funds. On the other hand, however, petitioners have on brief denied that CSN used the accrual method of accounting. Given the nature of CSN's business, and the lack of any evidence to the contrary, we think it logical to conclude that CSN used the cash method of accounting, recording expenses as made and receipts when on hand. Accepting that as so, CSN's claiming of deductions of $ 124,169 for amounts apparently owed to petitioner is evidence that such amounts actually were paid to petitioner during the tax year ended June 30, 1980. Petitioner has failed to demonstrate that those amounts were not in fact paid during that taxable year. Further, petitioner has failed to demonstrate*209 that such amounts were paid other than in the 1980 calendar year, which information petitioner, either individually or in his capacity as the sole shareholder of CSN, would have been able to adduce. Under these circumstances, we are unable to accord any weight to petitioner's testimony that he did not actually receive $ 124,593 from CSN in 1980 and sustain respondent's determination as to actual receipt.

a. CSN's Dental Practice Owner Income

Respondent has determined that petitioner actually or constructively received $ 41,531 as a dental practice owner in 1980. The practice owner was CSN, a corporation and taxable entity distinct from petitioner. Petitioner has denied receiving a distribution from CSN in that amount and we found such testimony to be credible. Assuming, arguendo, that petitioners have the burden of going forward as to this item, we find that petitioner's testimony is sufficient to sustain that burden. Because respondent has adduced no evidence contradicting petitioner's credible testimony, we find that petitioner did not actually receive $ 41,531 from CSN.

Next, we consider whether there was constructive receipt of the $ 41,531. That amount properly *210 belonged to CSN, a separate entity from petitioner, as its 8.3-percent fee for being the practice owner (33.3 percent - 25 percent = 8.3 percent) and petitioner, in his capacity as an individual, was not entitled to that sum. "The argument that the principle of constructive receipt comes into action with the mere possession of the power (as opposed to the right) to receive funds extends the principle to unwarranted limits and has been rejected by the courts on numerous occasions." Basila v. Commissioner, 36 T.C. 111, 117 (1961). Accordingly, even without considering CSN's financial condition, we find for petitioners as to constructive receipt of the $ 41,531.

Respondent also argues that that amount properly is allocable to petitioners under section 482. Section 482 authorizes the Commissioner to reallocate income or deductions among commonly controlled entities in order to prevent the evasion of taxes or clearly to reflect income. Further, "Transactions between one controlled taxpayer and another will be subject to special scrutiny to ascertain whether the common control is being used to reduce, avoid, or escape taxes." Sec. 1.482-1(c), Income Tax*211 Regs. We fail to see, however, why the $ 41,531 is not most clearly reflected as income to CSN and not petitioner. Under its agreements with the owner of the clinics (petitioner, individually) and its associate dentist (again, petitioner, individually), CSN, in its capacity as dental practice owner (after receiving 33.3 percent of gross billings and remitting 25 percent of gross billings to petitioner), was entitled to retain the remaining 8.3 percent of gross billings. Respondent, for no clearly articulated reason, would allocate that income to petitioner (individually). We agree with petitioners that such allocation would constitute an improper exercise of respondent's discretion under section 482. ¹⁰

b. Unreported Real Estate Rental Income From Gerber and DMA

*212 Respondent has determined that petitioner had $ 169,152 of unreported real estate rental income from Gerber and DMA in 1980.

(1) Is Respondent's Determination Arbitrary?

As stated above, Gerber initially managed the dental clinics and, subsequently, DMA was incorporated (on August 28, 1980) to manage the dental clinics on the same terms as Gerber had done. The leases under which petitioner rented the San Leandro property to Gerber and DMA entitled petitioner to a base monthly rental of $ 4,846 plus 5 percent of gross receipts. The San Leandro clinic was represented by DEMFIT as producing approximately $ 25,000 a month in gross revenue at the time of petitioner's purchase, which would come to a total monthly rental of $ 6,096 ($ 4,846 + $ 1,250). The leases under which petitioner rented the Fresno property entitled him to a monthly rental of between $ 12,000 and $ 14,000. ¹¹*213 Accordingly, respondent argues that petitioner actually or constructively received $ 169,152 from Gerber management companies and DMA in 1980. ¹²

We find that respondent's determination is not arbitrary within the meaning of Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979), revg.