t c memo united_states tax_court siemer milling company petitioner v commissioner of internal revenue respondent docket no filed date michael g goller amy l barnes sara stellpflug rapkin and benjamin b genzer for petitioner jonathan e behrens and nathan m swingley for respondent memorandum findings_of_fact and opinion buch judge siemer milling co siemer is based in illinois and is engaged in the business of milling and selling wheat flour during tax years ending date and siemer conducted activities for which it claimed credits for increasing research activities under sec_41 the primary question before the court is whether siemer has proven that the expenses from those activities are qualified_research_expenses under the code it has not findings_of_fact siemer has been in the wheat milling business since the 1950s during the years in issue siemer owned and operated two mills one in illinois and one in kentucky siemer employed millers maintenance personnel lab technicians lab supervisors a research_and_development manager research_and_development staff and others during the years in issue siemer did not have any employees with the title engineer or geneticist during the years in issue nor did siemer employ anyone who held a degree in computer science or chemical and mechanical engineering during the years in issue i credit studies cliftonlarsonallen llp cla has long served as siemer’s accounting firm cla has prepared siemer’s returns for more than two decades and as a result is familiar with siemer’s business for the years in issue cla prepared siemer’s returns as well as credit studies certified audits and financial statements 1all section references are to the internal_revenue_code code in effect for the years in issue and all rule references are to the tax_court rules_of_practice and procedure unless otherwise indicated in david north a cla accountant informed siemer that it might qualify for tax_credits related to increasing research expenditures under sec_41 at that time mr north had spent several years preparing credit studies for companies in several industries on the basis of advice from mr north and cla siemer engaged cla to prepare credit studies siemer claimed credits under sec_41 on its returns for several years from the early 2000s through the years in issue since cla has prepared credit studies for siemer cla had open access to all of siemer’s books_and_records while it prepared the credit studies and returns the credit studies were prepared on the basis of a combination of interviews conducted with siemer employees and documents provided by siemer to cla vernon tegeler siemer’s current vice president of production was particularly involved in the preparation of siemer’s credit studies he was interviewed for the credit studies for both years in issue he provided estimates of the amount of time spent on research projects collected contemporaneous documents and ensured that cla interviewed appropriate siemer employees for the credit studies he oversaw the preparation of the credit studies for siemer cla also interviewed several other siemer employees including sunil maheshwari the director of siemer specialty ingredients rosemary gibbons the research_and_development manager brent boem the head miller dave brumleve the chief financial officer jane summer the administrative production assistant joyce stock the vice president of finance carl schwinke the vice president of grain merchandising and marianne tegeler a laboratory supervisor as part of preparing the credit studies cla prepared a calculation of siemer’s fixed-base percentage before the credit studies siemer reported a fixed-base percentage of according to siemer cla used as a safe_harbor at a time when it did not intend to calculate a research_credit for a taxpayer once siemer engaged cla to conduct the credit studies in siemer filed amended returns claiming a fixed-base percentage of in making this calculation cla used data estimates gathered through interviews of employees because siemer could not find the relevant records siemer and cla used estimates from mr tegeler to determine the number of hours spent on research_and_experimentation during the base years in later years the estimates were refined when siemer retrieved wage information from forms w-2 wage and tax statement and more documentation regarding expenses 2the fixed-base percentage is part of the formula used by the code to compare prior and current research expenditures the credit is allowed only to a company that can show an increase in its research expenditures the credit studies contain wage information for the years in issue and contemporaneous documentation of the research activities for each year the contemporaneous documentation includes a range of items such as narratives of particular experiments sample test orders recipes used in testing flour products and lab results many of the documents are not dated and the authors and sources of the materials are not known siemer identified four projects for the tax_year ending date the flour heat-treatment project the pulsewave project the wheat hybrids project and the ozone project siemer identified five projects for the tax_year ending date the littleford day project the whole wheat flour project the hydration project a continuation of the previous year’s flour heat-treatment project and a second pulsewave project as a general matter siemer routinely conducted lab tests whenever it engaged in new product development for example it conducted testing to identify the right wheat source to be milled and the right adjustments to the milling system ii research projects all of the projects were conducted in connection with siemer’s trade_or_business siemer is in the business of milling and selling flour and all of the projects are related to the production and sale of flour a flour heat-treatment project siemer conducted the flour heat-treatment project to develop processes to produce cake flour without the use of chlorine low-microorganism and low-bacteria flour without the use of chemicals and all-natural replacements for modified starches the flour heat-treatment project took place in both years in issue this project included heating flour for differing times and with various methods and testing the flour to measure its composition functional characteristics and level of bacteria and other microbiological material siemer installed its heat-treatment facilities in b pulsewave project siemer conducted the pulsewave project in both tax years in issue a pulsewave machine operates on the principle of resonance disintegration according to marketing materials the pulsewave machine reduces the particle size of various materials by the application of the physics of resonance shock waves and vortex-generated shearing forces as opposed to the crushing and grinding processes of conventional milling methods siemer conducted initial testing with a pulsewave machine in date at the pulsewave facility siemer entered into an agreement to lease its own pulsewave machine from the manufacturer pulsewave llc on date the machine was placed in service in date at that time the pulsewave machine was a new technology for the milling industry and siemer was the only miller using the pulsewave machine during the years in issue during the tax_year ending date siemer conducted the pulsewave project to determine whether it could increase the speed at which the pulsewave machine operated as a result of their testing pulsewave llc made physical modifications to the pulsewave machine siemer claimed that the pulsewave machine was able to operate at only big_number rotations per minute rpm but data provided by pulsewave llc to siemer from includes tests of milling applications with speeds of up to big_number rpm and wheat milling tests run at speeds of up to big_number rpm during the tax_year ending date siemer was also unsure of the effect of processing different materials with the pulsewave machine including different grains and flour that had already been milled to address these uncertainties siemer used the pulsewave machine to process different types of grain and varied load sizes additionally siemer experimented with processing in the pulsewave machine flour that had already been milled through conventional means during the tax_year ending date siemer conducted the pulsewave project to determine whether it could adjust the moisture level in finished flour keep the oil packet in the wheat kernel intact during milling and produce an ultrafine wheat flour and an ultrafine bran flour using the pulsewave machine siemer also sought to discover how the speed rotation and flow rate affected the milling process siemer tested these variables and analyzed each sample it produced as part of the project siemer tested the finished product’s composition as well as its performance in baking tests c wheat hybrids project siemer’s wheat hybrids project tested new varieties of wheat to determine whether they could be used in current or new products it conducted the wheat hybrids project in the tax_year ending date siemer collected new varieties from breeders milled them and tested the composition and product yield of each sample siemer shared the results of the testing with the wheat breeders and its customers siemer conducted these tests because it was unsure which wheat hybrids would meet the needs of its customers d ozone project ozone is a highly unstable form of oxygen that can be used to disinfect food products siemer conducted the ozone project during the tax_year ending may siemer’s ozone project was an effort to introduce ozone into the milling process to produce a low-microorganism flour for applications that may not include baking the final product before testing siemer was unsure how introducing ozone into the milling process would affect the composition bacterial content and flavor of the flour ozone was introduced into the milling process at various stages including at the beginning of the process during cleaning and tempering before milling and during the crushing or milling of the grain samples of wheat at each stage of the process were tested and compared with untreated grain the treated flour was then tested to determine composition bacteria level and flavor e littleford day project littleford day is a company that performed testing for siemer during the tax_year ending date siemer wanted to be able to produce toasted wheat flours and bran flours but was unable to do so with its existing heat-treatment facilities the purpose of the littleford day project was to find a system that could be incorporated into siemer’s existing milling facilities to toast wheat and bran to produce toasted products to conduct the littleford day project siemer provided flour grain and bran samples to littleford day littleford day heat treated or toasted the samples using varying times and temperatures either littleford day or siemer conducted compositional analyses of the resulting products and tested the products’ functional characteristics one of the variables that siemer sought to control was the moisture level in the final toasted wheat flours and bran flours f whole wheat flour project siemer conducted the whole wheat flour project during the tax_year ending date it conducted this project in an effort to produce an ultrafine whole wheat flour product siemer attempted to use pearling machines to strip the bran layer from the flour later the ground bran was reintroduced into the flour during the milling process after processing the whole wheat flour siemer conducted tests to determine the amount of bacteria in the flour as well as other characteristics of the flour before conducting this project siemer was unsure of how to produce an ultrafine whole wheat flour it did not know whether pearling machines which had been used to process other types of grains would be helpful in processing wheat what size loads should be used how to incorporate the bran layer back into the flour and what affect this processing technique would have on the composition of the final product g hydration project siemer wanted to find a method to maintain a consistent level of moisture in flour because that consistency is important to its customers during the milling process evaporation causes the flour to lose more moisture than is optimal factors such as the time of year ambient temperature and humidity affect the moisture level in the finished flour siemer conducted the hydration project during the tax_year ending date in conducting this project siemer hoped to improve its milling process by developing a method to reintroduce moisture into its flour products without increasing mold and bacteria growth siemer experimented with a machine that reintroduced moisture to the finished flour after milling to control bacteria and mold growth siemer also introduced ozone into the water used to hydrate the flour siemer measured the moisture levels in the flour before and after processing and the amount of bacteria in the flour as well as the level of bacteria in the finished flour iii returns for the years in issue on its returns for the tax years ending date and siemer claimed credits for increasing research_and_experimentation expenditures under sec_41 siemer’s returns for both years were timely filed and included forms credit_for_increasing_research_activities for the tax_year ending may it claimed a credit of dollar_figure for increasing research activities for the tax_year ending date siemer claimed a credit of dollar_figure for increasing research expenses iv notice_of_deficiency petition and answer on date the commissioner issued a notice_of_deficiency to siemer disallowing the credits for both years the notice states that siemer had not proven that its expenses qualify for research_credit as a result the commissioner disallowed all credits for each year the commissioner also determined that siemer was not entitled to bonus_depreciation deductions that siemer must capitalize repair costs incurred in that siemer must use a longer depreciation schedule than reported on certain assets and that as a result of adjustments made to taxable_income siemer’s credit under sec_199 was increased siemer filed a timely petition for a redetermination of deficiencies for the tax years ending date and in the petition siemer argues that the commissioner erred in making all of the determinations in the date notice_of_deficiency 3at trial and on brief siemer did not present evidence or argument regarding any of the other adjustments the parties stipulated the correctness of the continued the commissioner filed an answer denying that the determinations were in error and a first amendment to answer asserting accuracy-related_penalties under sec_6662 for both years the commissioner argues that siemer’s underpayments as shown in the notice_of_deficiency are subject_to accuracy-related_penalties because they are attributable to both a substantial_understatement_of_income_tax as defined under sec_6662 and to negligence or disregard of rules or regulations as defined by sec_6662 v trial at the opening of trial the court received the parties’ first stipulation of facts the parties offered documents for admission to the record as a part of that stipulation the commissioner raised hearsay objections to of documents offered into evidence when the court asked siemer how it intended to use the documents to which the commissioner had raised hearsay objections continued commissioner’s adjustments to siemer’s income the commissioner conceded that siemer was entitled to deductions for bonus_depreciation totaling dollar_figure and dollar_figure for the tax years ending date and respectively to the extent that the commissioner has not conceded any issue and the commissioner and siemer did not come to an agreement on these issues before trial we find that siemer has waived any argument regarding them and find them to be conceded see rule sec_149 sec_151 see also eg 117_tc_117 n siemer responded that it did not plan to use the documents for the truth of the matter asserted the court ultimately determined that the documents would be admitted subject_to the hearsay objections ie not for the truth of the matter asserted but gave the parties the opportunity to revisit any document to rebut a hearsay objection the credit studies for both years in issue were admitted to the record subject_to the commissioner’s hearsay objections during trial the parties revisited the wage summaries included in the credit studies those wage summaries were admitted as summary exhibits the parties did not revisit the rest of the credit studies for the years in issue and as a result they remained admitted subject_to the hearsay objections at trial siemer offered mr tegeler as both a fact witness and an expert witness mr tegeler submitted an expert report as his expert testimony and gave oral testimony as a fact witness mr tegeler’s expert report was accepted into the record mr tegeler has worked for siemer since he began his career in the sanitation department over the course of several decades he rose through siemer’s ranks becoming head miller plant manager and finally vice president for production during his career mr tegeler has served in several leadership positions for the international association of operative millers including technical committee member and international president he has traveled the world touring mills given several presentations on milling processes and received awards in recognition of his accomplishments as a miller mr tegeler’s expert report focuses on the uncertainties that siemer sought to address with each of its research projects at trial he testified about the fixed-base percentage calculations the types of activities siemer employees conducted as a part of the projects and results of the activities mr tegeler was the only witness that either party called that had participated in the projects in both years a significant portion of mr tegeler’s work hours was dedicated to the research projects for which siemer claimed credits siemer also called dave brumleve siemer’s chief financial officer to testify mr brumleve has worked for siemer for over years he began in the accounting department in and worked his way up from to mr brumleve was siemer’s controller in he was promoted to chief financial officer a position he held during the years in issue at trial mr brumleve testified that he relied on cla’s expertise when he signed the returns for the years in issue as siemer’s agent siemer did not call any of its other employees to testify siemer called three of cla’s employees to testify jeff taylor dave north and mike meidel mr taylor is a certified_public_accountant cpa and was the principal author of the credit studies for the years in issue mr north supervised mr taylor in his preparation of the credit studies for the years in issue mr north also prepared the base_year calculations mr meidel is a cpa and was part of the team at cla that prepared siemer’s returns for the years in issue and he signed the returns as preparer the commissioner called two witnesses at trial trevor ziegler and jacob bramm mr ziegler is a former cla employee who participated in preparing the credit study for the tax_year ending date mr bramm is a current cla employee he was one of the cla employees who prepared the credit study for the tax_year ending date the commissioner did not call an expert witness to rebut mr tegeler vi motion to reopen the record on date the commissioner filed a motion to reopen the record in that motion he argued that the court should admit an email as written supervisory approval of the penalties asserted in the first amendment to answer siemer objected to the motion it argued that the email offered as evidence of written supervisory approval was hearsay and should not be admitted to the record opinion there are two questions before the court the first is whether siemer has proven that it qualifies for credits under sec_41 for the tax years ending date and the second is whether siemer is liable for accuracy-related_penalties under sec_6662 a subsidiary issue to this is whether the commissioner’s motion to reopen the record should be granted we will take each in turn i burden_of_proof generally the commissioner’s determinations in a notice_of_deficiency are presumed correct and taxpayers bear the burden of proving otherwise the commissioner bears the burden_of_proof however on any new_matter increases in deficiency or affirmative defenses pleaded in his answer the commissioner filed a first amendment to answer asserting accuracy-related_penalties under sec_6662 the commissioner therefore bears the burden_of_proof with respect to those penalties in limited situations the burden may shift to the commissioner under sec_7491 siemer did not argue that the burden should shift and we find 4rule a 290_us_111 5rule a 112_tc_183 ndollar_figure that the facts do not suggest that it should accordingly the burden on all items at issue other than the penalties asserted in the first amendment to answer is on siemer ii qualified_research_expenses under sec_41 sec_41 provides a credit equal to the sum of of the excess of qualified_research_expenses for the taxable_year over the base_amount qualified_research_expenses are defined as the sum of in-house_research_expenses and contract_research_expenses that are paid_or_incurred by a taxpayer in a taxable_year in carrying_on_a_trade_or_business in-house_research_expenses are defined as i any wages paid_or_incurred to an employee for qualified_services performed by such employee ii any amount_paid or incurred for supplies used in the conduct of qualified_research and iii any amount_paid or incurred to another person for the right to use computers in the conduct of qualified_research qualified_services consist of engaging in qualified_research or engaging in the direct supervision or direct support of qualified_research sec_41 sec_41 sec_41 there are four tests that an activity or project must meet to constitute qualified_research the four tests are the sec_174 test the technological information test the business_component test and the process_of_experimentation test in addition to the four tests for qualified_research sec_41 also explicitly excludes the following activities from the definition of qualified_research research after commercial production adaptation of existing business components to a particular customer’s needs and duplication of existing business components surveys and studies including efficiency surveys market research routine data collection and quality control testing are also excludeddollar_figure a the sec_174 test under the sec_174 test the expenditures_for research must be eligible for treatment as expenses under section dollar_figure sec_174 provides alternative methods_of_accounting for ‘research or experimental expenditures’ that taxpayers would otherwise capitalize sec_1_174-2 income_tax regs defines sec_41 sec_41 sec_41 12union carbide corp subs v commissioner tcmemo_2009_50 97_tcm_1207 quoting sec_1_174-1 income_tax regs aff’d continued research or experimental expenditures as expenditures incurred in connection with the taxpayer’s trade_or_business which represent research_and_development costs in the experimental or laboratory sense the treasury regulations also define research_and_development costs in the experimental or laboratory sense expenditures represent research_and_development costs in the experimental or laboratory sense if they are for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product uncertainty exists if the information available to the taxpayer does not establish the capability or method for developing or improving the product or the appropriate design of the product whether a taxpayer faces uncertainty is an objective test and is dependant on the information available to the taxpayerdollar_figure similar to sec_41 sec_1_174-2 income_tax regs explicitly excludes t he ordinary testing or inspection of materials or products for quality control from research or experimental expenditures continued 697_f3d_104 2d cir sec_1_174-2 income_tax regs 14union carbide corp subs v commissioner t c m cch pincite citing 41_tc_582 aff’d 357_f2d_209 5th cir additionally expenditures are qualified only to the extent that the amount thereof is reasonable under the circumstances as we held in union carbide corp subs b ecause sec_174 refers to research_and_experimental_expenditures not research and experimental activities we interpret sec_41 as requiring only that qualified_research activities constitute research_and_development within the meaning of sec_174 consequently we consider whether the cost associated with the research and experimental activities may be treated as expenses under sec_174 at the heart of the sec_174 test is whether the costs were incurred in connection with the taxpayer’s trade_or_business and whether the activities were intended to discover information that would eliminate uncertainty concerning the development or improvement of a product sec_174 16union carbide corp subs v commissioner t c m cch pincite 17union carbide corp subs v commissioner t c m cch pincite citing 110_tc_454 sec_1_174-2 income_tax regs b technological information test under sec_41 for an activity to be qualified_research it must be undertaken for the purpose of discovering technological information under the regulations information is technological if the process_of_experimentation used to discover such information fundamentally relies on principles of the physical or biological sciences engineering or computer science c business_component test the business_component test requires that the research be undertaken with the purpose of discovering information the application of which is intended to be useful in the development of a new or improved business_component of the taxpayer dollar_figure a business_component is any product process computer_software technique formula or invention which is to be-- i held_for_sale lease or license or ii used by the taxpayer in a trade_or_business of the taxpayer sec_1_41-4 income_tax regs sec_41 sec_41 d process_of_experimentation test research is qualified_research only if substantially_all of the activities constitute elements of a process_of_experimentation for a purpose described in sec_41dollar_figure the substantially_all requirement means that percent or more of a taxpayer’s research activities measured on a cost or other consistently applied reasonable basis constitute elements of a process_of_experimentation for a purpose described in sec_41 the test is applied separately to each of the taxpayer’s business componentsdollar_figure the regulations define a process_of_experimentation as a process designed to evaluate one or more alternatives to achieve a result where the capability or the method of achieving that result or the appropriate design of that result i sec_22sec d c sec_1_41-4 income_tax regs sec_41 sec_1_41-4 income_tax regs in some situations sec_1_41-4 income_tax regs allows us to consider the subsets of a business_component when the requirements are not met at the business components level while siemer recites this rule it does not attempt to argue the application of it to its own business components since we find siemer would not qualify for the credit regardless of our application of this shrinking-back_rule we do not attempt to apply it on siemer’s behalf uncertain as of the beginning of the taxpayer’s research activities we have previously held that the uncertainty under the process_of_experimentation test is essentially the same uncertainty as is required by the sec_174 test dollar_figure in addition to the uncertainty requirement under the sec_174 test the process_of_experimentation test requires that the taxpayer have a more structured method of discovering information than sec_174 requiresdollar_figure we have previously explained that the project must involve a methodical plan involving a series of trials to test a hypothesis analyze the data refine the hypothesis and retest the hypothesis so that it constitutes experimentation in the scientific sense for example the regulations explain that the evaluation of products available from vendors is not a process_of_experimentation in sec_1 a example income_tax regs a taxpayer wishes to upgrade their warehouse management software the taxpayer evaluates several products available in the marketplace to determine which best meets its needs the sec_1_41-4 income_tax regs 26union carbide corp subs v commissioner t c m cch pincite 27union carbide corp subs v commissioner t c m cch pincite 28union carbide corp subs v commissioner t c m cch pincite sec_1_41-4 example income_tax regs example concludes the taxpayer’s activities in evaluating software products are not qualified_research because evaluating available products is not experimentation the final part of this test requires the activities be for a qualified purpose as described in sec_41dollar_figure qualified purposes include research related to i a new or improved function ii performance or iii reliability or quality of a business componentdollar_figure but research related to style taste cosmetic or seasonal design factors is not conducted for a qualified purposedollar_figure e the base_amount to qualify for credits under sec_41 a taxpayer must show that it paid_or_incurred qualified_research_expenses for the taxable_year exceeding the base amountdollar_figure the base_amount is equal to the product of the fixed-base percentage and the average annual gross_receipts of the taxpayer for the taxable years preceding the taxable_year for which the credit is being determined dollar_figure t he sec_41 sec_41 sec_41 sec_41 sec_41 fixed-base percentage is the percentage which the aggregate qualified_research_expenses of the taxpayer for taxable years beginning after date and before date is of the aggregate gross_receipts of the taxpayer for such taxable years the base_amount cannot be less than percent of the qualified_research_expenses for the credit_year iii the commissioner’s arguments regarding the sec_41 tests the commissioner argues that siemer has not met its burden with respect to any of the tests under sec_41 for any of the research projects undertaken during the years in issue there are several arguments that the commissioner makes with respect to all of the projects those arguments are described below the commissioner’s arguments that are specific to a particular project that we find pertinent are described with the analysis of the particular project and test a sec_174 test the commissioner argues that siemer did not face uncertainty with respect to any of its projects and therefore fails the sec_174 test as support for this argument he observes that many of the projects spanned several years he posits that siemer could not face the same uncertainty for more than one year thi sec_35sec c a sec_41 argument is unpersuasive siemer could have faced the same uncertainties for several years in a row not all uncertainties are neatly resolved within the confines of a single taxable_year there is no requirement under the statute or regulations that the taxpayer face different uncertainty each year only that the taxpayer face uncertainty concerning the development or improvement of a product in the year for which he wishes to claim the creditdollar_figure b technological information test the commissioner argues that because siemer does not employ anyone with the title of engineer or anyone with an engineering degree siemer did not have anyone on staff who could have performed research that relied on principles of engineering the commissioner makes the same argument with respect to computer science and the physical and biological sciences the commissioner also observes that siemer called only one witness with direct knowledge of the research activities and did not call any other witness to testify as to the principles of the physical or biological sciences engineering or computer science that it relied on from this observation the commissioner argues that the court should draw an adverse inference finding that testimony of sec_1_174-2 income_tax regs siemer’s other employees would have shown that siemer did not rely on principles of the physical or biological sciences engineering or computer science this argument is unpersuasive nothing requires a taxpayer to employ or contract with someone with a specialized degree to prove that research relied on the physical or biological sciences engineering or computer science while the degrees held by those conducting the research for which a credit is claimed may be a factor in determining whether the technological information test is satisfied no specific set of degrees is required additionally we note that the commissioner could have also called any of siemer’s employees to testify and we do not apply an adverse inference it is true that where a party who bears the burden_of_proof fails to introduce evidence within its control that if true would be favorable to it the failure to introduce that evidence can give rise to a presumption that the evidence would be unfavorabledollar_figure but where both parties have equal access to the evidence we do not apply an adverse inferencedollar_figure the commissioner could have subpoenaed any of the 38134_tc_1 citing 6_tc_1158 aff’d 162_f2d_513 10th cir supplemented by t c memo 39jordan v commissioner t c pincite citing 469_f2d_1183 9th cir aff’g in part on this issue rev’g in part continued individuals that he says siemer should have called to testify thus both parties had access to the potential witnesses we decline to apply an adverse inference the commissioner also argues that siemer has not identified the principles of the physical or biological sciences engineering or computer science on which it relieddollar_figure as a general matter this argument is persuasive but for the projects where siemer has demonstrated that it sought to reduce the amount of bacteria in the flour siemer relied on principles of biology c business_component test the commissioner argues that all of siemer’s projects for the years in issue fail the business_component test he contends that siemer has been inconsistent in its description of business components to which each project relates as evidence the commissioner notes that when asked whether the business components related to processes or products mr tegeler stated that they were all processes but on brief siemer describes them as either process improvements product improvements or some combination of both the commissioner also argues that continued t c 40see sec_1_41-4 income_tax regs because the credit studies for the years in issue claim a greater number of business components than siemer has claimed at trial siemer’s current representations are untrustworthy this argument is unpersuasive at trial mr tegeler described the projects as processes that we worked with to develop products this description is not at odds with siemer’s representation on brief that each of the projects is either process improvements product improvements or some combination of both while inconsistency in the record may weigh against a party’s credibility we find that this particular turn of phrase does not bar siemer from meeting its burden with respect to the business_component test on each of the projects presented at trial the commissioner argues that because several of the projects spanned several years the business components to which they relate were not new during the years in issue we also find this argument unpersuasive like uncertainties under the sec_174 test the development or improvement of a business_component can span more than one tax_year d process_of_experimentation test the commissioner argues that siemer has not shown that it engaged in a process_of_experimentation with respect to any of the projects during the years in issue according to the commissioner the record is devoid of evidence that petitioner formulated or tested hypotheses or engaged in modeling simulation or systematic trial and error nor is there any evidence that petitioner evaluated alternatives during the years in issue this argument is compelling while siemer states that it engaged in a process_of_experimentation there is little in the record to support this assertion even the credit studies for the years in issue which were admitted to the record subject_to the commissioner’s hearsay objections included very little evidence of siemer’s asserted process_of_experimentation had siemer been able to rely on the credit studies for the truth of the matter asserted that would not have been enough to establish that siemer had engaged in a process_of_experimentation the commissioner also argues that siemer has not proven that substantially_all of the activities for which it claimed credits were a part of a process_of_experimentation on brief the commissioner argues that siemer makes conclusory statements regarding compliance with the substantially_all requirement of the process_of_experimentation test this argument is persuasive because siemer has not shown that it engaged in a process_of_experimentation it also cannot show that substantially_all of the activities for which it claimed the credits were part of a process_of_experimentation consequently where siemer has not shown that it engaged in a process_of_experimentation to begin with it has also not met the substantially_all requirement of this test iv application of the sec_41 tests siemer failed to establish that any of its projects met all four tests necessary for a project to constitute qualified_research we address each project in turn a flour heat-treatment project siemer did not establish that the flour heat-treatment project met the process_of_experimentation test the record does not establish that siemer had a methodical plan involving a series of trials to test a hypothesis analyze the data refine the hypothesis and retest the hypothesis so that it constitutes experimentation in the scientific sense while the record establishes that siemer set out to develop three new products with the use of its flour heat- treatment facility it is not clear how it set out to do that and whether that process was a true process_of_experimentation siemer did not establish that it satisfied the process_of_experimentation test with respect to the flour heat-treatment project 41see union carbide corp subs v commissioner t c m cch pincite b pulsewave project tax_year ending date siemer did not establish that it satisfied the sec_174 test because it failed to prove that it faced uncertainty with respect to the speed at which the pulsewave machine could run it argues that it wanted to run the machine at big_number rpm but would lose a coupling on the drive if it ran the machine past big_number rpm siemer’s activities were not research_and_experimentation but more akin to mechanical maintenance the record is clear that as of testing on wheat samples had been conducted at up to big_number rpm and testing on nonwheat products had been conducted at speeds of up to big_number rpm siemer also did not explain how its improvements to the machine would help it develop or improve a product siemer did not establish that its activities with the pulsewave machine meet the technological information test siemer argues that the pulsewave project meets this test because the experimentation siemer conducted to discover information relied on principles of engineering and the physical and biological sciences but siemer did not establish the principles on which its research activities relied siemer again cites the example of changing the pulsewave machine so that it could run at faster speeds but the machine was already designed to run at speeds up to big_number rpm and siemer’s adjustments to the machine such as replacing the bearings did not constitute experimentation siemer also did not establish that it met the process_of_experimentation test with respect to the pulsewave project neither the documents in the record nor the testimony offered at trial proves that siemer had a methodical plan involving a series of trials to test a hypothesis analyze the data refine the hypothesis and retest the hypothesis so that it constitutes experimentation in the scientific sense tax_year ending date for the tax_year ending date on the basis of the information in the record siemer’s pulsewave project fails the technological information test siemer’s example of its reliance on principles of the physical or biological sciences engineering or computer science is the application of resonance disintegration to separate a wheat kernel along its natural growth pattern on brief siemer states that this required reliance on principles of physics and biology but it does not elaborate on this conclusory statement the record does not establish what principles of engineering biochemistry or biology siemer relied on 42see union carbide corp subs v commissioner t c m cch pincite or how it relied on any particular principle in conducting experimentation consequently siemer has not met its burden with respect to the pulsewave project as with the tax_year ending date siemer also did not establish that it met the process_of_experimentation test with respect to the pulsewave project for neither the documents in the record nor the testimony offered at trial proves that siemer had a methodical plan involving a series of trials to test a hypothesis analyze the data refine the hypothesis and retest the hypothesis so that it constitutes experimentation in the scientific sense c wheat hybrids project siemer fails the business_component test because it did not establish what business_component it sought to develop with its wheat hybrids project rather than develop a new product or process or improve an existing product or process siemer was simply determining what was available from wheat breeders and growers without an identifiable product or process that siemer was attempting to develop or improve siemer fails the business_component test with respect to its wheat hybrids project 43see union carbide corp subs v commissioner t c m cch pincite siemer also did not establish that its activities with respect to the wheat hybrids project pass the process_of_experimentation test although siemer faced uncertainty with respect to whether the wheat hybrids that it tested would be sufficient for current or new products it did not establish that it engaged in a process_of_experimentation with respect to the wheat hybrids siemer did not establish that it had a methodical plan involving a series of trials to test a hypothesis analyze the data refine the hypothesis and retest the hypothesis so that it constitutes experimentation in the scientific sense siemer tested the products available to it from its producers although it provided feedback to breeders siemer itself was not a breeder there is little information in the record of siemer’s involvement with the development of wheat hybrids or the quality or quantity of information collected and provided to breeders siemer’s testing with respect to the wheat hybrids project is more akin to evaluating available products on the market as described in sec_1_41-4 example income_tax regs rather than a true process_of_experimentation siemer’s evaluation of which wheat products to select compares to the 44see union carbide corp subs v commissioner t c m cch pincite hypothetical taxpayer’s evaluation of software products accordingly the wheat hybrids project fails the process_of_experimentation test d ozone project siemer did not establish that the ozone project met the process_of_experimentation test siemer argues that it meets this test because it engaged in a process designed to evaluate alternatives with respect to inserting ozone into the milling process it explains the steps in its process but does not expand on what theory it may have been testing or how it refined its process based on data collected siemer did not establish that it had a methodical plan involving a series of trials to test a hypothesis analyze the data refine the hypothesis and retest the hypothesis so that it constitutes experimentation in the scientific sense without more in the record to establish that siemer had a methodical plan that constituted a process_of_experimentation the ozone project fails the process_of_experimentation test e littleford day project siemer failed to establish that the littleford day project met the technological information test siemer again makes a conclusory statement that it 45see union carbide corp subs v commissioner t c m cch pincite meets the technological information test because it relied on principles of engineering and the physical and biological sciences it says an example is that it analyzed the effects of adjustments to heat blending speed and hold time in the machine on the flavor moisture and color of the resulting flour products siemer alleges it relied on principles of biochemistry food science and engineering but without more in the record to establish how siemer relied on principles in these fields the littleford day project fails the technological information test likewise siemer failed to establish that the littleford day project met the process_of_experimentation test siemer put forth as evidence the steps in its process but narrating the steps of its process does not establish that it engaged in testing of a hypothesis so that it constitutes experimentation in the scientific sense without more in the record to establish that siemer had a methodical plan that constituted a process_of_experimentation the littleford day project fails the process_of_experimentation test additionally if the project was undertaken to evaluate a product of a vendor it fails the process_of_experimentation testdollar_figure without more information in 46see union carbide corp subs v commissioner t c m cch pincite sec_1_41-4 example income_tax regs the record establishing that the research was not incurred simply to evaluate a vendor’s product the littleford day project does not meet the process_of_experimentation test f whole wheat flour project siemer failed to establish that the whole wheat flour project met the technological information test as an example of activities that might meet this test siemer offers that it shaved the bran layer from the wheat kernel and analyzed the resulting whole wheat flour samples for bacteria content and granulation relying upon principles of biology and engineering siemer does not explain what principles this testing relied on or how they were incorporated into its research siemer did not meet its burden to establish its process_of_experimentation meets the technological information test siemer also did not establish that the whole wheat flour project met the process_of_experimentation test there is insufficient evidence in the record to conclude that siemer had a methodical plan involving a series of trials to test a hypothesis analyze the data refine the hypothesis and retest the hypothesis so that it constitutes experimentation in the scientific sense siemer states that it 48see union carbide corp subs v commissioner t c m cch pincite ran tests it does not explain how those tests were part of a scientific process where a hypothesis was formed tested and retested siemer has not met its burden_of_proof as to the process_of_experimentation test with respect to the whole wheat flour project g hydration project as with several other projects siemer failed to establish that the hydration project met the process_of_experimentation test because all it did was recite the steps in its process it does not explain how its process is scientific we have insufficient evidence in the record to conclude that siemer had a methodical plan involving a series of trials to test a hypothesis analyze the data refine the hypothesis and retest the hypothesis so that it constitutes experimentation in the scientific sense siemer did not establish that it met the process_of_experimentation test with respect to the hydration project v base_year calculations the commissioner argues that siemer has not substantiated its fixed_base_percentage because siemer did not establish that any of its projects were 49see union carbide corp subs v commissioner t c m cch pincite qualified_research under sec_41 we do not need to reach the issue of the fixed_base_percentage vi the commissioner’s motion to reopen the record in his motion to reopen the record the commissioner requests that we reopen the record to allow him to submit evidence of supervisory approval of penalties as required by sec_6751 as discussed above the commissioner bears the burden_of_proof with respect to the penalties under sec_6662 because they are a new_matter raised in his first amendment to answer and not determined in the notice of deficiencydollar_figure without the evidence of supervisory approval the commissioner would not meet his burden with respect to the penalties asserted in this casedollar_figure we will not grant a motion to reopen the record unless among other requirements the evidence relied on is not merely cumulative or impeaching the evidence is material to the issues involved and the evidence probably would 50see rule a dynamo holdings ltd p’ship v commissioner t c __ __ slip op pincite date shea v commissioner t c pincite n 51see graev v commissioner 149_tc_485 supplementing and overruling in part 147_tc_460 change the outcome of the case siemer has met the requirements of a reasonable_cause and good_faith defense against penalties consequently reopening the record would not change the outcome regarding the applicability of penalties in this case as a result we will deny the commissioner’s motion to reopen the record vii sec_6662 accuracy-related_penalties sec_6662 and b and imposes a accuracy-related_penalty on any portion of an underpayment_of_tax that is due to negligence or disregard of rules or regulations or a substantial_understatement_of_income_tax negligence includes failure to reasonably attempt to comply with the code and disregard includes a careless reckless or intentional disregarddollar_figure a return position that has a reasonable basis is not attributable to negligencedollar_figure disregard of rules or regulations is careless if the taxpayer does not exercise reasonable diligence to determine the correctness of a return position that is contrary to the rule or 52114_tc_276 see also coleman v commissioner tcmemo_1989_248 57_tcm_493 aff’d without published opinion sub nom meisel v commissioner 991_f2d_795 6th cir sec_6662 116_tc_438 sec_1_6662-3 income_tax regs regulationdollar_figure an understatement of income_tax is substantial when it exceeds the greater of of the tax required to be shown on the return or dollar_figure or in the case of a corporation other than an s_corporation or a personal_holding_company if the amount exceeds the lesser_of of the tax required to be shown on the return or if greater dollar_figure or dollar_figure milliondollar_figure sec_6664 provides that n o penalty shall be imposed under sec_6662 if it is shown that there was a reasonable_cause and that the taxpayer acted in good_faith with respect to the underpayment reasonable reliance on a competent professional may show that a taxpayer acted with reasonable_cause and in good faithdollar_figure reliance is reasonable when the taxpayer meets each requirement of a three-prong test the adviser was a competent professional who had sufficient expertise to justify reliance the taxpayer provided necessary and accurate information to the adviser and the taxpayer actually relied in good_faith on the adviser’s judgement sec_1_6662-3 income_tax regs sec_6662 and b 57115_tc_43 aff’d 299_f3d_221 3d cir 58neonatology assocs p a v commissioner t c pincite siemer meets all three prongs of the test and reasonably relied in good_faith on the advice of cla and its employees cla is a competent adviser it is an accounting firm that has prepared siemer’s certified financial audits and income_tax returns for more than two decades and it has prepared credit studies for siemer for approximately a decade and a half it employs several accountants and staff that are specialists in preparing credit studies siemer also provided cla with necessary and accurate information while preparing siemer’s returns and the studies for the years in issue siemer gave cla open access to its records siemer also made its staff available for interviews there is nothing in the record to suggest that siemer held back any of its records from cla finally mr brumleve siemer’s chief financial officer testified that he relied on cla’s expertise there is nothing in the record to suggest that siemer did not rely in good_faith on cla’s expertise we find that siemer is not liable for the penalties under sec_6662 viii conclusion siemer has not shown that expenses for which it claimed research credits for the tax years ending date and were qualified_research_expenses consequently siemer is not entitled to the credits it claimed under sec_41 in claiming the credits however siemer acted with reasonable_cause and in good_faith when it relied on cla in its preparation of siemer’s returns and credit studies for the tax years ending date and siemer is not liable for penalties under sec_6662 an appropriate order will be issued denying respondent’s motion and decision will be entered under rule


t c memo united_states tax_court clayton w plotkin petitioner v commissioner of internal revenue respondent docket no filed date wayne a smith for petitioner charles b burnett and j robert cuatto for respondent memorandum findings_of_fact and opinion vasquez judge respondent determined a dollar_figure deficiency in petitioner’s federal_income_tax as well as a dollar_figure sec_6662 accuracy-related_penalty the first issue for decision is whether the amount which petitioner received as a 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 - - loan from his employer’s pension_plan constitutes a taxable_distribution under sec_72 if so we must determine whether petitioner is liable for the 10-percent additional tax under sec_72 by reason of such distribution as well as whether petitioner is liable for the sec_6662 accuracy- related penalty findings_of_fact certain facts have been stipulated and are so found the stipulation of facts and the exhibits are incorporated herein by this reference at the time the petition was filed petitioner resided in phoenix arizona petitioner is an attorney who practices primarily in the fields of civil litigation and domestic relations during the year at issue petitioner conducted his law practice through a professional_corporation clayton w plotkin p c the corporation petitioner was the corporation’s sole director officer and shareholder in the corporation adopted the clayton w plotkin p c money purchase plan the plan a pension_plan exempt from income_taxation pursuant to sec_401 and sec_501 after hiring an attorney to establish the plan petitioner hired e a edberg and associates edberg to administer the plan the plan was restated in amended in and ultimately terminated in - - in edberg prepared a loan policy for the plan which was adopted by petitioner as the sole member of the plan’s advisory committee pursuant to the policy a plan participant could apply for a loan in an amount not to exceed one-half of the participant’s nonforfeitable accrued_benefit the maximum aggregate dollar amount of loans outstanding to any one participant when aggregated with all participant loans from other employer qualified_plans could not exceed dollar_figure all loans were subject_to approval by the plan’s advisory committee in date petitioner’s nonforfeitable accrued_benefit in the plan was dollar_figure there is no evidence that he had previously borrowed from the plan with respect to loans the proceeds of which were to be used by a plan participant to acquire a dwelling that the participant would use as his principal_residence the loan policy permitted a repayment term of up to years with respect to all other loans the repayment term could not exceed years the loan policy specifically provided as follows participants should note the law treats the amount of any loan other than a home loan not repaid five years after the date of the loan as a taxable_distribution on the last day of the five year period or if sooner at the time the loan is in default lft the dollar_figure figure was required to be reduced by the excess of the participant’s highest outstanding loan balance during the 12-month_period ending on the date of the loan over the participant’s current outstanding loan balance on the loan date - - a participant extends a non-home loan having a five year or less repayment term beyond five years the balance of the loan at the time of the extension is a taxable_distribution to the participant during november of petitioner sought to borrow against his accrued_benefit under the plan pursuant to edberg’s recommendation petitioner authorized the loan transaction on behalf of the corporation’s board_of directors as well as the shareholders the minutes of the board and shareholders meeting held on date provide as follows the meeting was held because the pension_plan administrators edberg’s people indicate that there must be corporate approval in order for clayton w plotkin to borrow from the pension_plan according to annie at edberg’s office plotkin is able to borrow up to dollar_figure but he only wants to borrow dollar_figure the loan must be secured must be payable at least guarterly of principal and interest it can be amortized over any length but it must be paid off at five years with a balloon payment balance and interest should be prime plus one or two percent if there have been no other loans or changes plotkin can borrow again at the end of the five years in the amount needed to pay off the balance of the loan resolved that clayton w plotkin be allowed to borrow dollar_figure from the pension and that there be a note with a deed_of_trust secured to plotkin’s house the interest rate on the loan is to be with monthly payments of principal and interest of dollar_figure payments are to be due the lst day of the month and will be late if not received by the 15th day of the month payments start the loan payments will be based on a year payment with a balloon payment due when the loan is supposed to be paid off if he is able plotkin may borrow from the pension_plan to pay off the balance due but must meet the requirements at that time we will get a schedule - - from the cpa on the years with each year on it so that we will know the balance to be paid when the loan is supposed be paid off also on date petitioner executed a promissory note which he prepared evidencing the terms of the loan the note provided that petitioner was borrowing dollar_figure from the plan at an annual interest rate of percent with respect to repayment terms the note provided that petitioner was to make monthly payments at the rate of dollar_figure petitioner inadvertently omitted from the promissory note the term requiring a balloon payment at the end of years nonetheless at the time of signing the promissory note petitioner intended to repay the loan at the end of years through a balloon payment of the then outstanding principal balance in order that he would know the proper amount of the balloon payment petitioner requested the accounting firm of hill d’amore co ltd to prepare an amortization schedule for the loan the amortization schedule bearing the letterhead of petitioner’s accountant and dated date reflected the following items a loan date of date a loan balance of dollar_figure a nominal annual interest rate of percent respondent does not dispute petitioner’s assertion that at the time the promissory note was executed petitioner intended to satisfy the loan through a balloon payment at the end of years - - monthly payments of dollar_figure a 15-year term and a principal balance of dollar_figure at the end of the initial years of the loan the same accountant who prepared the amortization schedule prepared petitioner’s income_tax return the loan was secured_by petitioner’s principal_residence as evidenced by a deed_of_trust which petitioner prepared and executed in favor of the plan although the loan was secured_by petitioner’s residence petitioner did not use the proceeds of the loan to acquire his residence the plan was terminated during february of at that time petitioner satisfied the loan by recognizing as a distribution the outstanding balance on the promissory note petitioner reported the distribution together with an early distribution penalty on his income_tax return opinion a distributions from the plan sec_402 provides generally that distributions froma qualified_plan are taxable to the distributee in the taxable_year of the distributee in which distribution occurs pursuant to sec_72 sec_72 a provides the general_rule that proceeds of a loan from a qualified_employer_plan to a plan participant are treated as a taxable_distribution to the the first monthly payment reflected on the amortization was actually dollar_figure due on date _- _- participant in the year in which the loan proceeds are received see patrick v commissioner tcmemo_1998_30 affd 181_f3d_103 6th cir prince v commissioner tcmemo_1997_324 estate of gray v commissioner tcmemo_1995_421 sec_72 however provides an exception to this general_rule under this exception a loan is not treated as a taxable_distribution if the principal_amount of the loan when added to the outstanding balance of all other loans from the same plan does not exceed a specified limit see sec_72 a the loan by its terms must be repaid within years from the date of its inception or is made to finance the acquisition of a home which is the principal_residence of the participant see sec_72 b and the loan must have substantially level amortization with quarterly or more frequent payments required over the term of the loan see sec_72 c respondent argues that the loan at issue did not qualify for the exception provided by sec_72 accordingly respondent determined that distribution of the loan proceeds from the plan constituted a taxable_distribution pursuant to sec_72 a petitioner on the other hand contends that the loan satisfies each requirement of the sec_72 p exception repayment term we begin with the repayment term of petitioner’s loan in order for a loan to be excepted from being treated as a taxable_distribution under sec_72 a the loan generally must require by its terms repayment within years see sec_72 b with respect to repayment provisions the promissory note executed by petitioner called for monthly payments of dollar_figure at the percent rate of annual interest stated in the note satisfaction of the loan would not have occurred until the fifteenth year of the loan respondent points out that the loan by its terms did not require repayment within years accordingly respondent argues that the loan failed to satisfy sec_72 b petitioner concedes that the promissory note as drafted omitted the 5-year repayment provision petitioner testified that he intended the promissory note to contain a provision calling for a balloon payment at the end of the fifth year of the loan to satisfy the then outstanding principal balance and that the omission of such provision was a product of a drafting mistake on his part in support of his testimony petitioner while an exception exists for loans the proceeds of which are used to purchase a principal_residence see sec_72 p b the proceeds of the loan which petitioner took from the plan were not used by petitioner for this purpose accordingly the exception to the 5-year repayment term requirement does not apply in this case - notes that the loan policy adopted by the plan’s advisory committee did not permit a repayment term in excess of years under the circumstances the board minutes authorizing the loan required that the loan be paid off at the end of years through a balloon payment and petitioner instructed his accountant to provide him with an amortization of the loan so that he would know the proper amount of the necessary balloon payment petitioner therefore requests this court to treat the promissory note as if it had been reformed to explicitly include the 5-year balloon payment provision we need not resolve the issue of whether petitioner’s loan constitutes a taxable_distribution under sec_72 p a based on the failure of the loan to meet the 5-year repayment requirement of sec_72 b even if we were to find as petitioner reguests that the loan by its terms was required to be paid off in its fifth year through a balloon payment of the then outstanding principal balance the loan would fail to satisfy the requirements of sec_72 c we discuss this point below petitioner contends that a court of equity could have reformed the promissory note to comply with the intent of the parties citing boone v grier p 2d ariz app petitioner argues that formal reformation of the note was not necessary in this context because petitioner treated the note as so reformed in both his capacity as plan trustee and plan participant obligor -- - substantially level amortization in order for a loan to qualify for the sec_72 p exception to taxable_distribution treatment the loan must provide for substantially level amortization over its term see sec_72 c the substantially level amortization requirement under sec_72 c has been interpreted as requiring that payment of principal and interest be made in substantially level amounts over the term of the loan see estate of gray v commissioner tcmemo_1995_421 if we treat the promissory note as requiring a balloon payment in the fifth year then the promissory note would call for monthly payments of dollar_figure and a final balloon payment of dollar_figure the balloon payment is more than times larger than the regular monthly payment and more than percent of the initial principal balance from a textual standpoint these payments simply cannot be characterized as substantially level froma policy standpoint one of the stated purposes behind the enactment of sec_72 c was to prevent taxpayers from currently enjoying plan assets through the use of balloon payment loans the rules governing the tax treatment of loans from certain tax-favored plans are intended to limit the extent to which an employee may currently use assets held by a plan for nonretirement purposes and to ensure that loans are actually repaid within a reasonable period however there is concern that the present rules do not prevent an employee from effectively maintaining a permanent outstanding dollar_figure loan balance through the use of balloon repayment obligations from third parties h rept pincite 1986_3_cb_1 s rept pincite 1986_3_cb_1 emphasis added accordingly we hold that the balloon payment provision which petitioner requests we incorporate into the promissory note would cause the loan to violate the requirements of sec_72 p c conclusion as to sec_72 if we were to interpret the promissory note according to its express provisions then petitioner’s loan would violate the year repayment reguirement of sec_72 b i if we incorporate into the promissory note a provision calling for a balloon payment at the end of the fifth year of the loan then the loan fails to provide for substantially level amortization as required by sec_72 c thus under either possible interpretation of the promissory note petitioner’s loan fails to gualify for the sec_72 exception the loan therefore constitutes a taxable_distribution pursuant to sec_72 p a b tax on barly distributions sec_72 provides for a 10-percent additional tax on early distributions from a qualified_pension plan see chapman v commissioner tcmemo_1997_147 sec_72 sets forth specific exemptions petitioner does not argue that any of the statutory exceptions applies to him accordingly we sustain respondent’s determination as to the sec_72 additional tax c accuracy-related_penalty pursuant to sec_6662 respondent determined an accuracy-related_penalty of percent of the amount of the underpayment attributable to a substantial_understatement of tax in the alternative respondent imposed the accuracy-related_penalty on the amount of the underpayment due to negligence or disregard of the rules and regulations respondent’s determinations are presumed to be correct and petitioner bears the burden of proving that the accuracy-related_penalty does not apply see rule a a substantial_understatement of tax is defined as an understatement_of_tax that exceeds the greater of percent of the tax required to be shown on the return or dollar_figure see sec_6662 d a the understatement is reduced to the extent the taxpayer has adequately disclosed his or her position and has a reasonable basis for the tax treatment of the item or has substantial_authority for the tax treatment of the item see sec_6662 b sec_6662 defines negligence as any failure to make a reasonable attempt to comply with the provisions of the internal_revenue_code and disregard as any careless reckless or intentional disregard whether applied based on a substantial_understatement of tax or negligence or disregard of the rules or regulations the accuracy-related_penalty is not imposed with respect to any portion of the underpayment as to which the taxpayer acted with reasonable_cause and in good_faith see sec_6664 the decision as to whether the taxpayer acted with reasonable_cause and in good_faith depends upon all the pertinent facts and circumstances see sec_1_6664-4 income_tax regs see also hickman v commissioner tcmemo_1997_545 relevant factors include the taxpayer’s efforts to assess his proper tax_liability including the taxpayer’s reasonable and good-faith reliance on the advice of a professional such as an accountant see jorgenson v commissioner tcmemo_2000_38 sec_1 b income_tax regs petitioner cites his intent to comply with sec_72 for the purpose of showing that he acted with reasonable_cause and good_faith in not reporting the loan as a taxable_distribution on his income_tax return petitioner hired a qualified_plan administrator on whose advice he relied at the time of entering into the loan the minutes of the board meeting that were prepared contemporaneously with the loan indicate that petitioner relied upon information from annie in edberg’s office for the proposition that he could amortize the loan over years as long as it was repaid with a balloon payment within years furthermore petitioner provided his accountant with the relevant loan documents as reflected in the amortization schedule prepared by petitioner’s accountant the accountant was aware that petitioner borrowed dollar_figure from the plan the payment of which was to be amortized over years the same accountant prepared petitioner’s income_tax return based on the record before us we find that petitioner acted with reasonable_cause and in good_faith in reporting his income_tax_liability accordingly the accuracy-related_penalty does not apply in reaching our holdings herein we have considered all arguments made by the parties and to the extent not mentioned above we find them to be irrelevant or without merit to reflect the foregoing decision will be entered under rule


third party communication none date of communication not applicable office_of_chief_counsel internal_revenue_service memorandum number release date cc ita b04 cmglendening postf-150853-13 uilc date date to mark a ericson attorney long island tax exempt government entities from donna welsh senior technician reviewer branch office of associate chief_counsel income_tax accounting subject treatment of the massachusetts senior circuit breaker credit for federal_income_tax purposes this chief_counsel_advice responds to your request for assistance this advice may not be used or cited as precedent issue what is the proper federal_income_tax treatment of the massachusetts senior circuit breaker credit the credit conclusions the amount of the credit that reduces a potential state_income_tax liability as part of computing how much state tax is due is not includable in federal gross_income and is not deductible for federal tax purposes the proper federal_income_tax treatment of the amount of the credit not used in a taxable_year to reduce an income_tax_liability that is the refundable portion of the credit depends on the tax situation of the taxpayer first a taxpayer who rents a residence and receives the refundable portion of the credit is not required to include that amount in gross_income under the general welfare postf-150853-13 exclusion next a taxpayer who owns a home and pays real_estate_taxes to a local_government and who does not itemize its deductions for federal_income_tax purposes does not include the refundable portion of the credit in gross_income in this situation the refundable portion is treated as a return_of_capital with no tax consequences lastly a taxpayer who owns a home and pays real_estate_taxes to a local_government and who itemizes its deductions for federal_income_tax purposes in a prior year must include the refundable portion of the credit in income except to the extent that the deduction did not reduce the tax imposed facts the state of massachusetts state provides a refundable_credit against state income taxes to certain eligible low-income state residents who paid real_estate_taxes or rent during the taxable_year alm gl ch k the credit offsets state_income_tax liability and the excess if any is refunded to the taxpayer alm gl ch k state enacted the credit to help low income senior citizens defray the cost of housing although the credit is based on property taxes imposed by and paid to local governments the state government is the entity that pays the credit the credit is allowable for senior homeowners and renters who meet certain income limits and other eligibility requirements to be eligible for the credit an individual must be an owner or tenant of residential property located in state be aged or older not be a dependent of another taxpayer and occupy the property as his principal_residence alm gl ch k the credit is allowable only to taxpayers whose state total income does not exceed dollar_figure as adjusted for inflation for a single individual dollar_figure as adjusted for inflation for a head_of_household individual and dollar_figure as adjusted for inflation for married individuals filing a joint_return additionally the assessed value of the taxpayer’s residence cannot exceed dollar_figure as adjusted for inflation alm gl ch k for purposes of the credit a taxpayer’s state total income is the sum of the taxpayer's state adjusted_gross_income increased by the following to the extent excluded or subtracted from adjusted_gross_income income and receipts from social_security retirement pension annuities cash but not in-kind public assistance and tax-exempt_interest and dividends alm gl ch k the amount of the credit depends on whether the taxpayer generally is a homeowner or renter for homeowners the amount of the credit is equal to the amount by which the real_estate_taxes paid during the taxable_year including water and sewer charges as applicable exceeds percent of the taxpayer’s total income for renters the amount of the credit is equal to the amount by which the rent constituting real_estate tax payment exceeds percent of the taxpayer’s total income rent constituting real postf-150853-13 estate_tax payment equal sec_25 percent of the rent that the taxpayer pays during the taxable_year under a good_faith rental agreement for the right of occupancy of the residence for both homeowners and renters the amount of the credit cannot exceed the lesser_of dollar_figure as adjusted for inflation or the amount of real_estate_taxes paid or the rent constituting real_estate tax payment alm gl ch k state real_property_taxes are assessed by and paid to local_government entities the state grants local governments the authority to assess and collect taxes alm gl ch sec_2 thus although local governments impose the real_estate tax and state makes the credit payment state has a degree of control_over the local governments such that the local governments are an integral part of state therefore state is not an unrelated third party reimbursing taxpayers for real_estate_taxes paid because the state is indistinguishable from the local governments law sec_61 of the internal_revenue_code code provides that except as otherwise provided in subtitle a gross_income means all income from whatever source derived see also sec_1_61-1 of the income_tax regulations gross_income is an undeniable accession to wealth clearly realized over which a taxpayer has complete dominion 348_us_426 1955_1_cb_207 although many state tax_credits are only used to reduce a state tax_liability some may also be refundable such as the credit the amount of a state tax_credit that reduces a potential tax_liability as part of computing how much tax is due to the state does not represent an accession to wealth therefore this amount is not includable in gross_income instead it will generally be reflected in a reduced federal deduction for state tax under sec_164 of the code 136_tc_341 aff’d sub nom esgar corp v commissioner u s app lexi sec_4261 10th cir generally a refundable state tax_credit is treated for federal_income_tax purposes as a reduction in the recipient’s state tax_liability and any excess over the state tax_liability is treated as a payment from the state and is includible in gross_income under sec_61 unless an exclusion applies governmental grants are includible in gross_income under sec_61 of the code unless excluded from gross_income by law see revrul_85_39 1985_1_cb_21 dividend payments alaska makes to all adult residents to encourage them to remain in the state and thereby reduce social economic and political instability are gross_income under sec_61 the internal_revenue_service service however has held that payments under legislatively provided social benefit programs for the promotion of the general welfare are not includible in an individual’s gross_income the general welfare exclusion in determining whether the general welfare exclusion applies to payments the service generally requires that the payments be made from a governmental fund be for postf-150853-13 the promotion of the general welfare ie on the basis of need rather than to all residents regardless of financial status health educational background or employment status and not be made for services that the recipient provides see revrul_98_19 1998_1_cb_840 revrul_74_205 1974_1_cb_20 sec_164 of the code provides in part a deduction for the state and local income and real_property_taxes paid_or_accrued during a taxable_year under the tax_benefit_rule the recovery_of taxes deducted in an earlier taxable_year is includible in gross_income except to the extent that the deduction did not reduce tax imposed the tax_benefit_rule includes two components an inclusionary part and an exclusionary part generally the inclusionary part of the tax_benefit_rule requires a taxpayer who received a tax_benefit from a deduction in an earlier year to recognize income in a later year if an event occurs that is fundamentally inconsistent with the premise on which the deduction was initially based 460_us_370 the exclusionary part of the tax_benefit_rule is codified in sec_111 of the code and allows a taxpayer to exclude an amount that did not previously provide a tax_benefit when it was deducted a taxpayer who receives a rebate of state taxes that the taxpayer did not previously deduct on a prior year’s federal_income_tax return is not required to include the rebate in gross_income because it is a return of a capital with no tax consequences see revrul_93_75 1993_2_cb_63 analysis the following examples illustrate the proper federal_income_tax treatment of the credit for taxpayers with different tax situations in each example the taxpayer meets the age requirements for the credit and does not have any state estimated_tax payments or withholding example a is an individual who receives dollar_figure in state total income for year a rents an apartment for year and pays dollar_figure in rent during year a does not pay any real_estate_taxes during year however percent of the rent is rent constituting real_estate_taxes paid for purposes of the credit thus the amount of a’s rent constituting real_estate_taxes paid is dollar_figure dollar_figure x big_number for year a’s maximum allowable credit_amount is dollar_figure big_number - big_number dollar_figure x dollar_figure state total income for year however a’s allowable credit is limited to dollar_figure a’s state_income_tax liability before the credit is dollar_figure for year therefore after the credit a’s state_income_tax liability is reduced to zero for year in year a receives the dollar_figure refundable portion of the credit in this case for year for federal tax purposes the dollar_figure portion of the credit that reduced a’s state_income_tax liability to zero is a reduction in a potential tax_liability not an item_of_income if a itemized her deductions her deduction for state_income_tax postf-150853-13 under sec_164 would be zero the dollar_figure refundable portion of the credit that a receives in year is not a rebate of rent paid_by the lessor and is an item_of_income however it is excluded from a’s gross_income under the general welfare exclusion because the credit is made from a governmental fund to individuals based on financial need and is not a payment for services example b is a single individual who receives dollar_figure in state total income for year b owns and uses a home as his principal_residence the assessed value of b’s principal_residence is dollar_figure and b pays dollar_figure in local real_estate_taxes in year thus b’s maximum allowable credit_amount is dollar_figure dollar_figure- dollar_figure dollar_figure x dollar_figure state total income for year however b’s allowable credit is limited to dollar_figure b’s state_income_tax liability before the credit is dollar_figure for year therefore after the credit b’s state_income_tax liability is reduced to zero for year in year b receives the dollar_figure refundable portion of the credit b did not deduct local real_estate_taxes on his federal_income_tax return for year in this case for year for federal tax purposes the dollar_figure portion of the credit that reduced b’s state_income_tax liability to zero is a reduction in a potential tax_liability not an item_of_income if b itemized his deductions his deduction for state_income_tax under sec_164 would be zero the dollar_figure refundable portion of the credit that b receives in year is a recovery_of the real_estate_taxes that b paid in year because the formula to calculate the credit is based on real_estate_taxes paid and is paid_by the state which is indistinguishable from the local governments however because b did not previously deduct the real_estate_taxes the dollar_figure refundable portion is not an item_of_gross_income and has no federal tax consequences example the facts are the same as example except that for federal_income_tax purposes c itemizes his deductions and deducts the dollar_figure real_estate_taxes paid in year under sec_164 of the code on his year federal_income_tax return the full dollar_figure deduction reduced c’s federal_income_tax in year in this case for year for federal tax purposes the dollar_figure portion of the credit that reduced c’s state_income_tax liability to zero is a reduction in a potential tax_liability not an item_of_income and is not includible in federal gross_income under the tax_benefit_rule however c’s deduction for state_income_tax under sec_164 is zero the dollar_figure refundable portion of the credit is treated as a recovery_of the real_estate_taxes that c paid in year which is fundamentally inconsistent with his prior deduction the inclusionary part of the tax_benefit_rule applies to the dollar_figure refundable portion and the general welfare exclusion does not apply to income includible under the tax_benefit_rule postf-150853-13 because c’s year deduction for local real_estate tax reduced c’s federal tax for year the dollar_figure that c receives in year is includable in federal gross_income in year and is reportable on line of form_1040 please call christina glendening at if you have any further questions _____________________________ donna welsh senior technician reviewer branch office of associate chief_counsel income_tax accounting


department of the treasury i n t e r n al r e v e n u e s e r v i c e w as h i n g t o n d c date offic e of c h ief c o u n sel number cc dom it a release date spr-117335-99 uil memorandum for director forms and publications division op fs fp from subject michael j montemurro senior technician reviewer branch technical coordination report from regional chief compliance officer cco ex bas northeast region the above-captioned technical coordination report dated date recommends that you revise the instructions to form 1099-b to state that a corporation directly making some purchases of its own stock is required to issue its shareholders a form 1099-b we have not evaluated the merits of the recommendation other than to consider its implementation under existing law your office has advised that a copy of this advisory memorandum will be provided to the field conclusion we advise you not to make the recommended changes to the instructions for form 1099-b the current instructions state that a corporation is a broker if it regularly stands ready to redeem its stock or retire its debt however if there are no facts that indicate otherwise a corporation that purchases odd-lot shares from its stockholders is not a broker in our opinion the instructions correctly summarize the proper interpretation of the law facts in the tax years and the taxpayer purchased outstanding shares of its stock from numerous shareholders a stock_transfer_agent handled the majority of these purchases and issued forms 1099-b however the corporation purchased some of its own stock directly from some of its shareholders the revenue_agent determined that the corporation was not required to issue forms 1099-b issue whether a corporation directly making purchases of its own stock is acting as a no opinion was requested and none is expressed regarding the agent’s conclusion that the corporation was not required to issue forms 1099-b spr-117335-99 broker in every situation and therefore under sec_6045 of the internal_revenue_code should be required to issue its shareholders forms 1099-b law and analysis sec_6045 which requires that every person doing business as a broker shall when required by the secretary make an information_return currently on the form 1099-b has been the law for roughly years having had its genesis in sec_1211 of the revenue act of for its first years the law required brokers to report profits and losses eighteen years ago the law was amended to require that brokers report the gross_proceeds from the transaction sec_311 of the tax equity and fiscal responsibility act of tefra pub_l_no 96_stat_600 reprinted pincite_2_cb_462 the tefra bill also clarifie d the definition of broker to explicitly include persons such as dealers barter exchanges and others who for consideration regularly act as middlemen with respect to property or services s rep no 97th cong 2d sess that amendment is codified in sec_6045 but congress has not otherwise defined the term broker revrul_86_21 1986_1_cb_349 copy attached first announced that a corporation purchasing odd-lot shares from its stockholders on an irregular basis is not a broker for purposes of sec_6045 of the code where as here there are no additional facts that indicate otherwise on the other hand a corporation is a broker for purposes of sec_6045 if it regularly stands ready to redeem its stock emphasis added the treasury_department concurred with this result and this interpretation of the scope of the broker reporting rules is codified in sec_1_6045-1 in the income_tax regulations effective date nprm intl-52-86 1988_1_cb_892 re-proposed and re-printed pincite_19_irb_26 finalized as t d 1997_44_irb_5 nothing in our subsequent research leads us to conclude that the broker reporting rules should be amended and the instructions to form 1099-b revised to the contrary should you have any questions please do not hesitate to call a kathie kiss of my staff at attachments 2however that was not the first time we had examined the scope of the broker reporting rules for example in the interpretative division of the office_of_chief_counsel indicated that the pre- tefra version of sec_6045 should not be used as a catch-all reporting vehicle information returns for interest_paid on bearer bonds gcm big_number i-278-81 date copy attached