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Transupport, Inc. v. Commissioner of Internal Revenue

United States Court of Appeals, First Circuit

February 14, 2018

TRANSUPPORT, INC., Petitioner, Appellant,

          APPEAL FROM THE UNITED STATES TAX COURT [Hon. Mary Ann Cohen, U.S. Tax Court Judge]

          Michael S. Lewis, with whom Rath, Young and Pignatelli, P.C. was on brief, for appellant.

          Anthony T. Sheehan, with whom David A. Hubbert, Acting Assistant Attorney General, and Richard Farber, Attorney, Tax Division, Department of Justice, were on brief, for appellee.

          Before Lynch, Stahl, and Barron, Circuit Judges.

          LYNCH, Circuit Judge.

         Transupport, Inc. appeals from the Tax Court's decision upholding the Commissioner's notice of deficiency, which, for tax years 2006 through 2008, reduced Transupport's cost of goods sold, reduced deductions it took for compensation paid to four employee-shareholders, and assessed a 20% accuracy-related penalty. See Transupport, Inc. v. Comm'r (Transupport II), 112 T.C.M (CCH) 580, 2016 WL 6900913 (2016). This is the Tax Court's second opinion in this case. The first addressed whether Transupport committed fraud. See Transupport, Inc. v. Comm'r (Transupport I), 110 T.C.M. (CCH) 268, 2015 WL 5729787 (2015). We affirm the Tax Court's decision in Transupport II, as to which this appeal is taken.

         I. Background A. Transupport's Business

         Transupport is a wholesaler of engines and engine parts used in military vehicles. Transupport II, 2016 WL 6900913, at *1. The portion of its business that is relevant to this dispute involved buying parts in bulk lots from the U.S. Government and reselling them. Id. Harold Foote ("Foote") founded Transupport in 1972 and served as its president and chief executive officer. Id. Foote's sons, William ("W. Foote"), Kenneth, Richard, and Jeffrey ("J. Foote"), were Transupport's only other full-time employees. Id. Foote owned almost all of Transupport's stock in 1999, but transferred Transupport's nonvoting common stock to his sons in equal portions in 2005. Id. at *2.

         At all relevant times, Elaine Thompson, a certified public accountant, served as Transupport's outside accountant. Id. Thompson prepared Transupport's tax returns based on handwritten summaries of the company's financials, which were usually prepared by J. Foote. Id. Thompson did not audit or verify the summaries. Id.

         B. Cost of Goods Sold

         A taxpayer's income from selling goods is calculated by taking the income generated by selling goods and subtracting the amount that the taxpayer paid for those goods, which is also known as the "cost of goods sold." Treas. Reg. § 1.61-3(a) (as amended in 1992). The cost of goods sold for a given tax year only includes the cost of the goods that the taxpayer sold in that tax year. See id. Given this constraint, the cost of goods sold for a given tax year usually equals the beginning inventory (at cost) plus inventory purchases and inventory costs, minus the ending inventory (at cost). Huffman v. Comm'r, 126 T.C. 322, 324 (2006).

         Transupport used the gross profit method to determine its cost of goods sold. See Transupport II, 2016 WL 6900913, at *2. So, instead of calculating the cost of goods sold by tracking changes in its inventory, Transupport selected a percent profit that it claimed to make on the sale of goods and used that figure to generate its cost of goods sold as well as estimates of its beginning and ending inventory. Id. Transupport allegedly used a percent profit consistent with industry standards. See Transupport I, 2015 WL 5729787, at *6. Transupport's cost of goods sold "varied without explanation" from year to year, and Transupport kept no records indicating how it selected its gross profit percentage. Id.

         Transupport was audited by the IRS in 1984, and "the examining agent was aware that petitioner did not maintain a physical inventory of the unsold parts in its warehouse and backed into the closing inventory, reported in its returns, by using a percentage of sales as costs of goods sold." Transupport II, 2016 WL 6900913, at *2. The IRS expressed disapproval of Transupport's methodology, but did not meaningfully adjust Transupport's cost of goods sold for the years under audit. Id. Transupport was audited again in 1992. Id. The IRS was again aware of Transupport's practice of not taking a physical inventory, and again the IRS auditor did not require changes. Id.

         Transupport continued its use of the gross profit method after the 1992 audit. Its gross profit percentage changed each year, but remained between 39.3% and 31% from 1999 through 2008. Id. It reported a cost of goods sold of $6, 951, 132 in 2006; $6, 365, 543 in 2007; and $7, 519, 086 in 2008, based on gross profit percentages of 33.4%, 39.3%, and 37%, respectively. Id.

          C. Reasonable Compensation

         Foote's sons were officers of Transupport, but "performed various and overlapping tasks for the company, including tasks that might have been performed by lower level employees." Id. at *1. Transupport paid each of Foote's sons $575, 000 in 2006, $675, 000 in 2007, and $720, 000 in 2008. Id. at *3. Foote made the compensation decisions alone, without consulting his accountant. Id. "The only apparent factors considered in determining annual compensation were reduction of reported taxable income, equal treatment of each son, and share ownership." Id. Transupport did not pay dividends in the years at issue. See id.

         D. IRS ...

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