T.C. Memo. 2004-196

UNITED STATES TAX COURT

AMARO A. TAIBO, Petitioner v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 17416-02. Filed August 31, 2004.

Steven T. Barta, for petitioner.

Jonathan J. Ono, for respondent.

MEMORANDUM OPINION

SWIFT, Judge: The sole issue for decision is whether

petitioner for 2000 is liable for an accuracy-related penalty

under section 6662(a) in the amount of $10,828.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.
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Background

The facts of this case were submitted fully stipulated under

Rule 122 and are so found.

Since 1991, petitioner has resided on Johnston Island, an

unincorporated U.S. Territory located approximately 700 nautical

miles southwest of Hawaii where petitioner has been employed as

an electrical engineer by Raytheon Demilitarization Co. or its

successor (Raytheon).

On April 30, 1991, petitioner signed an employment agreement

with Raytheon, which stated, among other things, that “Johnston

Island is not tax exempt; therefore, standard tax obligations

apply.”

For each of the years 1991 through 1996, on his Federal

income tax returns, the record herein does not indicate whether

petitioner treated the wages he received from Raytheon as taxable

or as nontaxable income.

On his timely filed 1997 joint Federal income tax return,

petitioner treated the $143,013 in Raytheon wages that he

received in 1997 as taxable income, and petitioner paid the

$44,629 in taxes relating thereto.

On his timely filed 1998 individual Federal income tax

return, petitioner treated the $156,741 in Raytheon wages that he

received in 1998 as nontaxable income, and petitioner did not pay

the Federal income taxes relating thereto.
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1 Sec. 1.931-1, Income Tax Regs., provides in part as

follows:

§ 1.931-1. Citizens of the United States and domestic

corporations deriving income from sources within a

possession of the United States.--(a) Definitions.--(1) As

used in section 931 and this section, the term “possession

of the United States” includes * * * Johnston Island * * *.

(2) As used in section 931 and this section, the

term “United States” includes only the States, the

Territories of Alaska and Hawaii, and the District of

Columbia.

(b) General rule--(1) Qualifications. In the case of a

citizen of the United States or a domestic corporation

satisfying * * * [certain] conditions, gross income means

only gross income from sources within the United States

* * *.

On July 6, 1999, a petition was filed in this Court by a

Raytheon employee who worked on Johnston Island (first Raytheon

employee) in which petition the taxability of wages earned by

U.S. citizens on Johnston Island was challenged. Specking v.

Commissioner, docket No. 12010-99. A regulation, which stated

that Johnston Island constituted a U.S. possession for purposes

of excluding from taxable income wages earned by U.S. citizens on

Johnston Island, formed the basis for the claim of nontaxability. 

See sec. 1.931-1, Income Tax Regs.1 In subsequent similar cases

filed by Johnston Island employees, infra, other employees also

rely on this same regulation.

On July 12, 1999, another petition was filed in this Court

by another Raytheon employee who worked on Johnston Island

(second Raytheon employee) in which petition the taxability of
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2 The record herein does not indicate whether petitioner

ever filed a refund suit in Federal district court with regard to

his disallowed 1997 claim for refund.

wages earned on Johnston Island also was challenged. Umbach v.

Commissioner, docket No. 12348-99.

On July 30, 1999, petitioner filed an amended 1997 joint

Federal income tax return on which petitioner treated the

$143,013 in Raytheon wages that he received in 1997 as nontaxable

income and on which petitioner claimed a refund of the $44,629 in

taxes that he paid relating thereto.

On August 31, 1999, yet another petition was filed in this

Court by another Raytheon employee who worked on Johnston Island

(third Raytheon employee) in which petition the taxability of

wages earned on Johnston Island again was challenged. Haessly v.

Commissioner, docket No. 14496-99.

On September 28, 1999, respondent mailed to petitioner a

notice informing petitioner that respondent was formally

disallowing petitioner’s claim for refund of the $44,629 in taxes

petitioner paid on his Raytheon wages earned in 1997. 

Respondent’s letter stated that “The Tax Reform Act of 1986 [Pub.

L. 99-514, sec. 1272, 100 Stat. 2085 (TRA 1986)] amended IRC 931. 

Therefore, income from sources within the Johnston Islands does

not qualify for the possession exclusion.”2

On December 21, 1999, after an audit of petitioner’s 1998

Federal income tax return, respondent mailed to petitioner a
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letter notifying petitioner that the $156,741 in Raytheon wages

that petitioner received in 1998 constituted taxable income with

respect to which $41,898 in taxes was due. Attached to the

letter was Form 886-A, Explanation of Items, which stated:

Since your home is not in a foreign country, but a territory

of the United States, your earned income is not excludable

under Internal Revenue Code 911. See 1.911-2([g]) & (h) for

the United States and foreign country defined. Also, since

you are not a bona fide resident of a specified possession

“as defined in Internal Revenue Code 931(c)”, you do not

qualify for the possession exclusion.

In early 2000, petitioner paid to respondent $49,285,

reflecting the full $41,898 tax deficiency for 1998 determined by

respondent, including interest, and no formal notice of

deficiency for 1998 was ever mailed to petitioner. With respect

to 1998, respondent did not impose a penalty against petitioner

relating to the treatment on petitioner’s 1998 Federal income tax

return of his Raytheon wages as nontaxable income. 

On February 28, 2000, a complaint was filed in Federal

district court by a fourth Raytheon employee who worked on

Johnston Island in which complaint the taxability of wages earned

on Johnston Island was challenged. Farrell v. United States, No.

CV 00-00164SOM-KSC.

The record herein does not include a copy of petitioner’s

1999 Federal income tax return, apparently filed in April of

2000, and the record herein does not indicate whether petitioner
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3 All references herein to sec. 931 are to sec. 931 as

amended by the Tax Reform Act of 1986, Pub. L. 99-514, sec. 1272,

100 Stat. 2593 (TRA 1986), and all references to former sec. 931

are to such section prior to amendment by TRA 1986.

treated thereon his Raytheon wages received in 1999 as taxable or

as nontaxable income.

On February 12, 2001, the District Court for the District of

Hawaii decided Farrell v. United States, 87 AFTR 2d 1159, 2001-1

USTC par. 50,279 (D. Haw. 2001), and held that Johnston Island

does not constitute a foreign country for purposes of section 911

and does not constitute a specified possession for purposes of

section 931.3 Therefore, the District Court, in spite of the

conflicting regulation, which listed Johnston Island as a

possession, concluded that wages earned on Johnston Island

constituted taxable income. Thereafter, the taxpayer in Farrell

filed a timely appeal to the Court of Appeals for the Ninth

Circuit of the District Court’s decision.

On his electronically filed 2000 individual Federal income

tax return, filed on approximately March 4, 2001, petitioner

treated the $185,048 in Raytheon wages that he received in 2000

as nontaxable income, and petitioner did not pay any Federal

income taxes relating thereto.

Petitioner’s retained copy of his electronically filed 2000

Federal income tax return, which is in evidence herein, reflected
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4 A partial copy of petitioner’s electronically filed 2000

Federal income tax return as printed out by respondent discloses

only the information in the first five numbered items in the

above list regarding petitioner’s wages earned on Johnston Island

and does not reflect the information in the last two abovenumbered items.

the following information regarding the wages petitioner received

in 2000 relating to his work on Johnston Island:

(1) The amount -- $185,048;

(2) Their character -- petitioner’s wages from Raytheon;

(3) Raytheon’s treatment of the wages -- as petitioner’s

wages and as taxable income to petitioner;

(4) The fact that $50,109 in taxes were withheld by

Raytheon with regard thereto;

(5) The fact that petitioner on his Federal income tax

return was claiming an offsetting reduction to the full

$185,048 in disclosed wages and a refund of the $50,109

in withheld taxes relating thereto;

(6) The fact that petitioner worked on Johnston Island and

that petitioner’s Federal income tax return treated

Johnston Island as a “possession”; and

(7) The basis on which petitioner was relying for his

treatment of his Johnston Island wages as nontaxable

income, namely sec. 1.931-1(a) and (b)(i) and (ii),

Income Tax Regs.4

On March 5, 2001, a fourth petition was filed in this Court

by a fifth Raytheon employee who worked on Johnston Island in

which petition the taxability of wages earned on Johnston Island

was challenged. Jones v. Commissioner, docket No. 2970-01.
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On August 28, 2001, we decided Specking v. Commissioner,

117 T.C. 95 (2001), affd. sub nom. Haessly v. Commissioner, 68

Fed. Appx. 44 (9th Cir. 2003), affd. sub nom. Umbach v.

Commissioner, 357 F.3d 1108 (10th Cir. 2003), representing a

consolidated group of cases involving three of the above

petitions filed in the Tax Court. In our decision in Specking v.

Commissioner, supra, we held that Johnston Island does not

constitute a foreign country for purposes of section 911 and does

not constitute a specified possession for purposes of section

931. We concluded that section 931 applies to income earned on

Johnston Island for years beginning after December 31, 1986, and,

therefore, that wages earned on Johnston Island constituted

taxable income.

Three months after Specking was decided by this Court, on

November 13, 2001, in response to a letter request from a

Raytheon employee on Johnston Island, respondent mailed to the

employee a letter and a copy of section 1.931-1, Income Tax

Regs., in which letter such regulation was described as “current

as of October 24, 2001”, and in which regulation Johnston Island

was listed as a possession.

On November 30, 2001, after an audit of petitioner’s 2000

Federal income tax return, respondent mailed to petitioner a

letter notifying petitioner that the $185,048 in Raytheon wages

that petitioner received in 2000 constituted taxable income with

respect to which $54,139 in taxes was due. This letter stated
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that Johnston Island was not a specified possession for purposes

of the income exclusion allowed under section 931. Respondent

did not assert any penalty relating thereto.

A month thereafter, on December 28, 2001, petitioner mailed

to respondent a personal check in the amount of $57,709,

reflecting payment of the full $54,139 tax deficiency for 2000

determined by respondent, including interest. In an e-mail sent

to respondent on the same day, petitioner reserved his right to

file a claim for refund if the pending litigation regarding the

taxability of Johnston Island wages was eventually resolved in

the taxpayers’ favor.

On February 26, 2002, respondent mailed to petitioner

another letter relating to petitioner’s 2000 Federal income tax

return in which letter respondent proposed against petitioner for

2000 a $10,828 accuracy-related penalty under section 6662(a)

relating to petitioner’s claim that his $185,048 in 2000 wages

constituted nontaxable income.

On May 9, 2002, each of the three taxpayers in Specking v.

Commissioner, supra, filed appeals of our decision therein, two

to the Court of Appeals for the Tenth Circuit and one to the

Court of Appeals for the Ninth Circuit.

On June 4, 2002, a fifth petition was filed in this Court by

a sixth Raytheon employee who worked on Johnston Island in which

petition the taxability of wages earned on Johnston Island was

challenged. Hautzinger v. Commissioner, docket No. 9501-02.
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On August 23, 2002, respondent mailed a notice of deficiency

to petitioner with respect to the $10,828 accuracy-related

penalty for 2000 which petitioner had not yet paid.

On November 7, 2002, petitioner became the sixth Raytheon

employee to file a petition in this Court in which petition

petitioner challenges not the taxability of his Johnston Island

wages but only the imposition by respondent of the $10,828

accuracy-related penalty.

On December 24, 2002, the Court of Appeals for the Ninth

Circuit in Farrell v. United States, 313 F.3d 1214 (9th Cir.

2002), affirmed the District Court’s decision in Farrell v.

United States, 87 AFTR 2d 1159, 2001-1 USTC par. 50,279 (D. Haw.

2001). The Court of Appeals held that Johnston Island does not

constitute a foreign country for purposes of section 911 and does

not constitute a specified possession for purposes of section

931. In addition, the Court of Appeals held that section 931

controls over the conflicting regulation at section 1.931-1,

Income Tax Regs. Therefore, the Court of Appeals concluded that

wages earned on Johnston Island by U.S. citizens constituted

taxable income.

On January 14, 2003, we decided Jones v. Commissioner, T.C.

Memo. 2003-14, involving the fourth petition filed in the Tax

Court involving Johnston Island wages. In our decision in Jones,

we held that Johnston Island does not constitute a foreign

country for purposes of section 911 and that Johnston Island does
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not constitute a specified possession for purposes of section

931. We also held that section 931 controls over the conflicting

regulation at section 1.931-1, Income Tax Regs., and that, for

years beginning after December 31, 1986, section 931 applies to

income earned by U.S. citizens on Johnston Island, making the

wages taxable income.

On June 16, 2003, the Court of Appeals for the Ninth Circuit

decided Haessly v. Commissioner, 68 Fed. Appx. 44 (9th Cir.

2003), affg. Specking v. Commissioner, 117 T.C. 95 (2001), and

held that Johnston Island does not constitute a foreign country

for purposes of section 911 and, following its opinion in Farrell

v. United States, supra, that Johnston Island does not constitute

a specified possession for purposes of section 931. The Court of

Appeals affirmed our opinion in Specking v. Commissioner, supra,

and concluded that wages earned on Johnston Island constituted

taxable income.

On June 24, 2003, the taxpayer in Jones v. Commissioner,

T.C. Memo. 2003-14, filed an appeal of our decision therein to

the Court of Appeals for the Eleventh Circuit, which appeal is

still pending.

In the above deficiency determinations by respondent, and in

the above court opinions regarding the taxability of Johnston

Island wages by the District Court, the Tax Court, and the Courts

of Appeals, no penalties were asserted against the taxpayers, and

none was imposed by the courts.
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On August 8, 2003, we decided Hautzinger v. Commissioner,

T.C. Memo. 2003-236, involving the fifth petition filed in the

Tax Court involving Johnston Island wages. In our decision in

Hautzinger, consistent with the above court opinions, we held

that Johnston Island does not constitute a specified possession

for purposes of section 931 and that section 931 controls over

the conflicting regulation at section 1.931-1, Income Tax Regs. 

Therefore, we concluded that wages earned on Johnston Island

constituted taxable income.

In addition, however, in Hautzinger, we decided that the

taxpayer was negligent in falsely reporting on his Federal income

tax return that his Raytheon wages were earned by him on American

Samoa, a specified possession for purposes of section 931, and

not on Johnston Island, where the wages in fact were earned. 

Because of such false reporting of the source of the wages, we

sustained respondent’s determination of a section 6662(a)

accuracy-related penalty. The taxpayer in Hautzinger did not

file an appeal of our decision.

On December 11, 2003, the Court of Appeals for the Tenth

Circuit in Umbach v. Commissioner, 357 F.3d 1108 (10th Cir.

2003), affg. Specking v. Commissioner, 117 T.C. 95 (2001),

representing the consolidated cases of Umbach v. Commissioner,

supra, and Specking v. Commissioner, supra, affirmed our decision

in Specking. The Court of Appeals held that Johnston Island does

not constitute a foreign country for purposes of section 911 and
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does not constitute a specified possession for purposes of

section 931. The Court of Appeals held that section 931 applies

to income earned on Johnston Island, noting its agreement with

the decision of the Court of Appeals for the Ninth Circuit in

Farrell v. United States, 313 F.3d at 1219, and that the wages

earned by U.S. citizens on Johnston Island constituted taxable

income. In Umbach v. Commissioner, supra, with regard to the

taxpayer’s treatment of his Johnston Island wages as nontaxable

income, no penalty was asserted by respondent and none was

imposed by the Court of Appeals for the Tenth Circuit.

Discussion

Under section 6662, an accuracy-related penalty is to be

added to the portion of an underpayment of tax attributable to

negligence, to a disregard of rules or regulations, or to a

substantial understatement of income tax.

Generally, for purposes of the accuracy-related penalty,

negligence includes a failure to make a reasonable attempt to

comply with the tax laws. Sec. 6662(c). Negligence is indicated

where a taxpayer fails to make a reasonable attempt to ascertain

the correctness of the claimed tax treatment of an item, does not

have a reasonable basis for such tax treatment, and does not act

with reasonable cause and in good faith with respect to such tax

treatment. Secs. 1.6662-3(b)(1)(ii), 1.6662-3(b)(3), 1.6664-

4(a), Income Tax Regs.
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A substantial understatement of income tax is defined as an

understatement constituting the greater of 10 percent of the tax

required to be shown on a Federal income tax return or $5,000. 

Sec. 6662(d)(1)(A). An understatement is reduced by that portion

of the understatement which is attributable to either substantial

authority for the claimed tax treatment of the item or adequate

disclosure of and reasonable basis for the claimed tax treatment

of the item. Sec. 6662(d)(2)(B).

Under section 7491(c), respondent has the burden of

production with respect to any penalty. Once respondent meets

the burden of production, the taxpayer, however, continues to

have the burden of proof with respect to whether respondent’s

determination of the penalty is correct. Rule 142(a); Higbee v.

Commissioner, 116 T.C. 438 (2001).

Petitioner argues that, with respect to his 2000 Federal

income tax return and his treatment of Johnston Island wages

reported thereon as nontaxable income, his reliance on section

1.931-1, Income Tax Regs., was reasonable and the pending

litigation was in good faith. Petitioner argues that the

regulation and the pending litigation, combined with the

disclosure petitioner made on his 2000 individual Federal income

tax return, establish a reasonable basis for his tax treatment of

his Raytheon wages as nontaxable income.

Respondent seems to argue that the existence of section 931

(in which Johnston Island is not listed as a specified possession
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for purposes of excluding from taxable income wages earned

therein) precludes any reasonable reliance by petitioner on

section 1.931-1, Income Tax Regs. (in which regulation Johnston

Island was and is still listed as a possession of the United

States). Respondent contends that petitioner should have known

that his interpretation was “too good to be true”. Respondent

also contends that regardless of whether petitioner made an

adequate disclosure on his 2000 Federal income tax return of

facts relating to his Johnston Island wages, petitioner did not

have a reasonable basis for the nontaxable treatment thereof.

We believe that for 2000 imposition on petitioner of the

accuracy-related penalty with regard to the nontaxable treatment

of his Johnston Island wages is inappropriate.

Although the District Court case and all five Tax Court

cases regarding the taxability of Johnston Island wages have

since been decided in favor of respondent, the question of

whether petitioner had a reasonable basis for the nontaxability

of his Johnston Island wages is to be evaluated as of March 4,

2001, the day petitioner filed his 2000 individual Federal income

tax return. We note particularly respondent’s letter of

November 13, 2001, in which respondent continued to refer

Johnston Island employees to section 1.931-1, Income Tax Regs.,

and to describe the regulation as “current”. We also note

respondent’s failure, as of March 2001, to assert any accuracyrelated penalty against any of the taxpayers who were litigating
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the issue as to the taxability of Johnston Island wages. We do

not regard petitioner’s treatment on his 2000 individual Federal

income tax return of his Johnston Island wages as negligent.

We turn to the question of whether petitioner’s tax return

treatment of his Johnston Island wages constituted a substantial

understatement giving rise to the accuracy-related penalty. The

grounds on which a substantial understatement may be reduced

include tax treatments that are based on adequate disclosure and

a reasonable basis. Sec. 6662(d)(2)(B)(ii).

The disclosure made on petitioner’s 2000 Federal income tax

return, as reflected on petitioner’s retained copy of such

return, constitutes adequate disclosure for purposes of

section 6662(d)(2)(B)(ii). Respondent provides no explanation

for the incomplete nature of respondent’s printout of

petitioner’s 2000 individual Federal income tax return. In

deciding this disclosure issue, particularly in light of

respondent’s burden of production on this penalty, we believe it

appropriate to rely on the information reflected on petitioner’s

retained copy of his 2000 individual Federal income tax return. 

On the facts of this case, the disclosure issue is resolved in

favor of petitioner.

With regard to reasonable basis, we incorporate our

discussion above and conclude that petitioner, on his 2000

individual Federal income tax return, had a reasonable basis for
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his tax treatment of his Johnston Island wages as nontaxable income.

In Hautzinger v. Commissioner, T.C. Memo. 2003-236, decided

by this Court on August 8, 2003, respondent did assert and we did

sustain imposition of an accuracy-related penalty, but, as

stated, such penalty related to the false reporting by the

taxpayer that his wages were earned in American Samoa rather than

in Johnston Island, where the wages in fact were earned.

Petitioner herein is not liable for the section 6662(a)

accuracy-related penalty with respect to his tax understatement

relating to his Johnston Island wages.

To reflect the foregoing,

Decision will be entered

for petitioner.