                               T.C. Memo. 2013-96


                         UNITED STATES TAX COURT



                JOHN E. MCALLISTER, JR., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 19412-09.                           Filed April 8, 2013.



      John E. McAllister, Jr., pro se.

      Mark J. Tober, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      MORRISON, Judge: The respondent issued a notice of deficiency

determining a $26,696 deficiency in the petitioner’s federal income tax and a

$5,339 accuracy-related penalty under section 6662(a) for tax year 2007. Unless

otherwise indicated, all section references are to the Internal Revenue Code as in
                                           -2-

[*2] effect for the 2007 tax year. The respondent is referred to as the IRS; the

petitioner is referred to as McAllister.

      The issues for decision are:

      (1)    Did McAllister receive unreported compensation income of $78,849

             during the 2007 tax year, or in the alternative, did McAllister receive

             $78,849 of unreported cancellation-of-debt income (before application

             of the insolvency exception of section 108(a)(3))? We hold that

             McAllister did not receive $78,849 of unreported compensation

             income. However, we hold that McAllister received $78,849 of

             unreported cancellation-of-debt income (before application of the

             insolvency exception of section 108(a)(3)).

      (2)    What portion of the $78,849 of unreported cancellation-of-debt income

             is excludable from McAllister’s income because he was insolvent? We

             hold that $22,641.42 is excludable from McAllister’s income.

      (3)    Is McAllister liable for an accuracy-related penalty under section-

             6662(a)? We hold that he is not.
                                         -3-

[*3]                             FINDINGS OF FACT

       McAllister timely filed a petition with the Tax Court disputing the

determinations of the IRS. At the time of filing, McAllister resided in North

Carolina.

       In 2005 McAllister worked as an employee for Suncoast Roofers Supply.

During this time he borrowed money from Suncoast Roofers Supply as follows:

                        Date                        Amount
                  Feb. 21, 2005                    $11,480.00
                  Oct. 21, 2005                     29,869.07
                  Nov. 16, 2005                      2,500.00
                  Dec. 2, 2005                       9,000.00
                  Dec. 19, 2005                     26,000.00
                    Total                           78,849.07

Suncoast Roofers and McAllister executed a promissory note for each of the

advances. Pursuant to the loan arrangements, McAllister was to repay the loans

from bonuses earned through incentive plans as part of his compensation. Suncoast

Roofers agreed to pay McAllister the amounts of any tax liabilities from the earning

of bonuses. The loans had no repayment date and required no interest payments.

McAllister made no repayments of the loans.
                                         -4-

[*4] In 2007 Suncoast Roofers ran into financial difficulties. By August 2007

McAllister was no longer its employee. Suncoast Roofers was sold to Suncoast

Acquisition Corp. McAllister timely filed Form 1040, U.S. Individual Income Tax

Return, for 2007 in March 2008. In May 2008 Suncoast Acquisition Corp. issued

McAllister a Form 1099-MISC, Miscellaneous Income, showing the amount of the

loans and characterizing the amount as nonemployee compensation paid in 2007.

On his Form 1040 McAllister did not report as income the $78,849.07 that was later

reported to him on the Form 1099-MISC. On May 11, 2009, the IRS issued the

notice of deficiency.

                                      OPINION

1.    Did McAllister receive unreported compensation income of $78,849 during
      the 2007 tax year, or in the alternative, did McAllister receive $78,849 of
      unreported cancellation-of-debt income (before application of the insolvency
      exception of section 108(a)(1)(B))?

      The taxpayer bears the burden of proving by a preponderance of the

evidence that the IRS’s determinations in the notice of deficiency are incorrect.

Tax Ct. R. Pract. & Proc. 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933);

Bronstein v. Commissioner, 138 T.C. 382, 385 (2012). Under section 7491(a), if

the taxpayer produces credible evidence with respect to any factual issue relevant to

ascertaining the taxpayer’s liability for tax and meets other requirements, the
                                         -5-

[*5] burden of proof rests on the IRS as to that factual issue. Our conclusions here

are based on the preponderance of the evidence, and thus the allocation of the

burden of proof is immaterial. See Martin Ice Cream Co. v. Commissioner, 110

T.C. 189, 210 n.16 (1998).

      Gross income includes all income from whatever source derived. Sec. 61(a).

Gross income includes compensation for services. Sec. 61(a)(1). Gross income

also generally includes income from the cancellation of debt. Sec. 61(a)(12); United

States v. Kirby Lumber Co., 284 U.S. 1, 3 (1931).

      It is undisputed that Suncoast Roofers loaned McAllister $78,849.07 in 2005.

The IRS contends that in 2007 Suncoast Roofers awarded McAllister a bonus of

$78,849.07 that he used to repay the $78,849.07 in loans. Thus, the IRS contends,

McAllister must include $78,849.07 in income as compensation. McAllister takes

the position that he did not receive a constructive bonus in 2007 and that either (1)

the loans were not canceled because he still intends to pay them back, or (2)

alternatively, even if the loans were canceled in 2007 he was insolvent.

      McAllister credibly testified that Suncoast Roofers did not inform him of a

bonus (constructive or otherwise) of $78,849.07 in 2007. By August 2007

McAllister was no longer an employee of Suncoast Roofers. Suncoast Roofers
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[*6] experienced financial difficulties during 2007 leading to its eventual sale.

Therefore, we reject the IRS’s contention that McAllister earned a $78,849.07

constructive bonus in 2007.

      However, we find the loans totaling $78,849.07 were canceled in 2007.

Suncoast Roofers was acquired by another company, Suncoast Acquisition Corp.,

which never contacted McAllister about paying back the loans. The Form 1099-

MISC, we find, memorialized Suncoast Acquisition Corp.’s decision to forgive the

McAllister debt that it acquired from Suncoast Roofers. The Form 1099-MISC

improperly1 classified the amount of the forgiven debt as nonemployee

compensation income of $78,849.07. We find this was a bookkeeping error rather

than a reflection that McAllister had been awarded a bonus. We find that by the end

of 2007 it was clear that McAllister would not have to repay the debt. Therefore,

McAllister had $78,849.07 in cancellation-of-debt income in 2007. Cozzi v.

Commissioner, 88 T.C. 435, 445 (1987) (“The moment it becomes clear that a debt

will never have to be paid, such debt must be viewed as having been discharged.”).




      1
      The proper form to issue when canceling debt is a Form 1099-C,
Cancellation of Debt.
                                          -7-

[*7] 2.      What portion of the $78,849 of unreported cancellation-of-debt
             income is excludable from McAllister’s income because he was
             insolvent?

      Section 108(a)(1)(B) excludes discharge of indebtedness income from gross

income if the discharge occurs when the taxpayer is insolvent. The amount of

income excluded under section 108(a)(1)(B) cannot exceed the amount by which the

taxpayer is insolvent. Sec. 108(a)(3). The amount by which the taxpayer is

insolvent is defined as the excess of the taxpayer’s liabilities over the fair market

value of the taxpayer’s assets. Sec. 108(d)(3). Whether a taxpayer is insolvent and

by what amount is “determined on the basis of the taxpayer’s assets and liabilities

immediately before the discharge.” Id.

      McAllister claims that his assets and liabilities at the end of 2007 were as

follows:

                         Assets                         Amount
                 Bank accounts                            $2,667.07
                 Savings account                           2,000.66
                 Real estate FL                          130,000.00
                 Real estate NC                          175,000.00
                 Automobile                               22,000.00
                  Total                                  331,667.73
                                         -8-

                        [*8] Liabilities              Amount
                 Home Depot account                      4,879.00
                 Mortgages                             363,068.15
                 State taxes                             1,485.00
                 Automobile loan                        19,897.00
                   Total                               389,329.15
                     Amount of insolvency               57,661.42

      Insolvency is a question of fact. See Toledano v. Commissioner, 362 F.2d

243, 245 (5th Cir. 1966), aff’g T.C. Memo. 1963-200; Smith v. Commissioner, 249

F.2d 218, 220, 221 (5th Cir. 1957), aff’g T.C. Memo. 1955-183; Estate of Phillips

v. Commissioner, 246 F.2d 209, 213-214 (5th Cir. 1957), rev’g T.C. Memo. 1955-

139; 14A Jacob Mertens, Law of Federal Income Taxation, sec. 54.5 (2013).

McAllister has the burden of proving his claim that he was insolvent. See Tax Ct.

R. Pract. & Proc. 142(a). At trial McAllister provided credible testimony that his

assets and liabilities were what he claimed they were, except that there is legitimate

doubt about the exact values he placed on the North Carolina and Florida real

estate. We consider the appropriate value of each of these properties in turn.

      North Carolina

      McAllister testified that he purchased the property in North Carolina for

$191,020 in December 2006 but that by the end of 2007 its value had declined to

$175,000. He based the $175,000 estimate on a sale of a property in the same

neighborhood in January 2007. The IRS contends that the value of the North
                                        -9-

[*9] Carolina property was $201,650, which was the property’s assessed value for

local property tax purposes in January 2008.

      We find that the value of McAllister’s property was $191,020 at the end of

2007. This is the price at which McAllister had bought the property a year before.

We do not rely on the January 2007 sale of another property. The sale took place

only a month after the purchase of McAllister’s property, and we doubt that the

property was comparable to McAllister’s property. We do not rely on the assessed

value of McAllister’s property for local property tax purposes. “[A] value placed

upon property for the purpose of local taxation, unsupported by other evidence,

cannot be accepted as determinative of fair market value for Federal income tax

purposes in the absence of evidence of the method used in arriving at that

valuation.” Pierce v. Commissioner, 61 T.C. 424, 431 n.6 (1974). The IRS did not

provide any information on the method the local government used to assess the

property. Thus, we cannot rely on this valuation.

      Florida

      McAllister credibly testified that he purchased the property in Florida in

March 2005 for $149,000. He testified that its value by the end of 2007 was

$130,000 based on its assessed value for local property tax purposes. He did not
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[*10] explain the method by which the assessed value was determined. We find

that the value of the property at the end of 2007 was $149,000.

      Conclusion

      In summary, we find that McAllister’s liabilities at the end of 2007 exceeded

his assets by $22,641.42.

                           Assets                    Amount
                   Bank accounts                     $2,667.07
                   Savings account                    2,000.66
                   Real estate FL                   149,000.00
                   Real estate NC                   191,020.00
                   Automobile                        22,000.00
                    Total                           366,687.73

                            Liabilities
                   Home Depot account                 4,879.00
                   Mortgages                        363,068.15
                   State taxes                        1,485.00
                   Automobile loan                   19,897.00
                    Total                           389,329.15
                      Amount of insolvency           22,641.42

      The amount of income excluded under the insolvency exception of section

108(a)(1)(B) is limited to the amount of the insolvency. Sec. 108(a)(3). Of the

$78,849.07 of cancellation-of-debt income, $22,641.42 is excludable from

McAllister’s income. The remaining amount--$56,207.65--is included in income.
                                         - 11 -

[*11] 3.     Is McAllister liable for the accuracy-related penalty pursuant to section
             6662(a)?

      Section 6662(a) and (b)(2) impose a penalty equal to 20% of the part of an

underpayment attributable to a substantial understatement of income tax. Generally,

an “understatement” is the excess of tax required to be shown on the return over the

tax shown on the return. Sec. 6662(d)(2)(A); sec. 1.6662-4(b)(2), Income Tax

Regs. An understatement of income tax is substantial if it exceeds the greater of

10% of the tax required to be shown on the return or $5,000. Sec. 6662(d)(1)(A);

sec. 1.6662-4(b)(1), Income Tax Regs.

      The IRS has the burden of producing evidence that a taxpayer is liable for

penalties. Sec. 7491(c). The IRS satisfies its burden by producing “sufficient

evidence indicating that it is appropriate to impose the relevant penalty.” Higbee v.

Commissioner, 116 T.C. 438, 446 (2001). Once the IRS satisfies its burden of

production, the taxpayer has the burden of persuading the fact finder that he or she

is not liable for additions or penalties. Id. at 446-447.

      In this case, the IRS has satisfied its burden of production if the Rule 155

computations show a substantial understatement of income tax.

      McAllister did not report cancellation-of-indebtedness income, resulting in

an underpayment of tax. The section 6662 penalty is not imposed on an
                                        - 12 -

[*12] underpayment if the taxpayer (i) had a reasonable cause for and (ii) acted in

good faith regarding the underpayment. See sec. 6664(c)(1); sec. 1.6664-4(a),

Income Tax Regs. The taxpayer bears the burdens of both production and proof as

to whether this exception applies. See Higbee v. Commissioner, 116 T.C. at 446

(stating that the IRS “need not introduce evidence regarding reasonable cause,

substantial authority, or similar provisions”). On the basis of our review of the

record, McAllister had reasonable cause for, and acted in good faith with respect to

the underpayment. Accordingly, he is not liable for the section 6662(a)

accuracy-related penalty.


                                                 Decision will be entered

                                        under Rule 155.
