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years EAPC existed, including 2001. EAPC has never paid wages or
a salary to Mrs. Arnold. Petitioners treated amounts EAPC
distributed to Mrs. Arnold as loans from EAPC. Mrs. Arnold
signed a promissory note in the amount of the balance due at the
end of each year. EAPC did not withhold payroll taxes on any
payments to Mrs. Arnold.
E. Petitioners’ Income Tax Returns
Mr. Arnold prepared the income tax returns for petitioners,
Western, EAPC, and Pacific. Western reported its income and
expenses on the basis of a taxable year ending November 30 for
the years ending in 1994-2000. EAPC reported $65,509 of income
from trade or business activities for the fiscal year ended
January 31, 2001.
Petitioners’ tax years ended on December 31. On their
individual income tax returns for 1999, 2000, and 2001,
petitioners deducted nonpassive S corporation losses from Western
of $10,093 for 1999, $10,579 for 2000, and $14,544 for 2001.
Petitioners reported $65,509 of income from EAPC on the Schedule
E attached to their Form 1040 for 2001.
On their Form 1040 for 2001, petitioners reported on
Schedule E, Part I, Income from Rental Real Estate and Royalties,
income from “leased payroll” of $17,995. Petitioners deducted in
Part I of Schedule E a total of $28,067, consisting of $3,200 for
repairs and improvements, $10,471 for interest expense, and
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