McLauchlan v. Commissioner ( 2014 )

Case: 12-60657 Document: 00512551524 Page: 1 Date Filed: 03/06/2014
IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
United States Court of Appeals
Fifth Circuit
FILED
No. 12-60657 March 6, 2014
Lyle W. Cayce
PETER A. MCLAUCHLAN, Clerk
Petitioner - Appellant
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent - Appellee
Appeal from the Decision
of the United States Tax Court
Case No. 14996-09
Before OWEN, SOUTHWICK, and GRAVES, Circuit Judges.
PER CURIAM:*
Peter A. McLauchlan appeals the tax court’s order sustaining the IRS’s
determination of a deficiency in McLauchlan’s income tax liability for the years
2005, 2006, and 2007 and assessing accuracy-related penalties for each year.
He argues the tax court erred in determining that expenses he claimed as
unreimbursed partnership expenses on his individual tax return were not
* Pursuant to 5TH CIR. R. 47.5, the court has determined that this opinion should not
be published and is not precedent except under the limited circumstances set forth in 5TH
CIR. R. 47.5.4.
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properly deductible. He also disputes his liability for accuracy-related
penalties. We AFFIRM.
FACTUAL AND PROCEDURAL BACKGROUND
This appeal presents the question of when a partner in a partnership
may deduct expenses of the partnership on his individual tax return. The
events leading to this appeal began in 2008 when the IRS started its audit of
McLauchlan’s tax returns for 2005, 2006, and 2007. On April 23, 2009, the IRS
issued a notice of deficiency to McLauchlan in which it determined deficiencies
in his income tax liability for those three years and imposed accuracy-related
penalties for each year. The notice of deficiency disallowed income deductions
McLauchlan had claimed for legal and professional fees, contributions to
pensions and profit sharing plans, and home mortgage interest payments,
among other things. In June 2009, McLauchlan filed a petition in the United
States Tax Court for redetermination of the deficiency for all three years. The
IRS filed an answer requesting that the calculation of deficiency be approved.
In July 2010, the IRS filed an amended answer asserting increased
deficiencies and penalties for 2005 and 2006. The IRS filed this amended
answer after discovering McLauchlan was a partner during 2005 and 2006 at
a law firm (that the parties call “AR”) structured as a partnership for tax
purposes. McLauchlan had reported income from the partnership on Schedule
C, which is used for reporting “Profit or Loss from Business,” as well as
deductions for business expenses for those years. In support of its claim for
increased deficiencies, the IRS argued McLauchlan was not entitled to claim
Schedule C profits and losses arising from his partnership at AR. Thus, he
was not entitled to the business expense deductions claimed on Schedule C.
McLauchlan conceded that, due to being a partner at AR, the expenses could
not be deducted on Schedule C. He countered that the disallowed Schedule C
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expenses were properly deductible as unreimbursed partnership expenses on
Schedule E, which reports “Supplemental Income and Loss.”
As a result of concessions by both parties, the only remaining issues at
trial were: (1) the deficiencies asserted in the amended answer resulting from
McLauchlan’s claimed Schedule C business expenses, (2) the penalties
asserted in the original notice of deficiency, and (3) the additional penalties
resulting from the deficiencies in the amended answer. The tax court first
considered whether McLauchlan was entitled, as a partner, to claim the
disallowed Schedule C deductions as unreimbursed partnership expenses on
Schedule E. Next, the tax court considered whether McLauchlan was liable
for any accuracy-related penalties. The tax court’s decision rejected all of
McLauchlan’s business expense deductions, with the exception of depreciation
expenses and charitable deductions deemed to be deductible flow-through
partnership expenses. 1 The tax court reasoned that these claimed deductions
either did not constitute unreimbursed partnership expenses or were not
properly substantiated. The tax court also assessed accuracy-related
penalties. McLauchlan timely appealed.
DISCUSSION
“We review Tax Court decisions in the same manner in which we review
civil actions decided by the district courts.” Branum v. Comm’r, 17 F.3d 805,
807 (5th Cir. 1994). Accordingly, factual findings are reviewed for clear error,
whereas conclusions of law are reviewed de novo. Id. at 807-08.
1 At the beginning of its opinion, the tax court held that McLauchlan’s deductions on
Schedule C for depreciation expenses in 2006 as well as charitable deductions for 2005 and
2006 were allowable as flow-through partnership items under I.R.C. § 702. In its brief, the
Government brings to our attention that, through oversight, the deductions the tax court
allowed for depreciation and charitable contributions were not calculated in the
Government’s Rule 155 computation (adopted by the tax court) of deficiencies and penalties
owed by McLauchlan. The Government asks for remand for the sole purpose of entering
corrected deficiency and penalty amounts giving McLauchlan credit for those deductions.
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I. Burden of proof
McLauchlan argues that the tax court erred in its allocation of the
burden of proof. “The allocation of the burden of proof is a legal issue reviewed
de novo.” Whitehouse Hotel Ltd. P’ship v. Comm’r, 615 F.3d 321, 332 (5th Cir.
2010). When the Commissioner asserts new matters in an amended answer,
the burden of proof shifts to the Commissioner as to those new matters. TAX
CT Rule 142(a). Because the only remaining issues at trial were deficiencies
raised by the Commissioner in its amended answer, McLauchlan argues that
the tax court committed error by refusing to hold the Commissioner to the
burden of proving McLauchlan was not entitled to deduct the unreimbursed
partnership expenses. He claims the tax court effectively allocated the burden
to him in violation of Rule 142(a).
The tax court recognized the requirement that the Commissioner has the
burden of proof for new matters under Rule 142(a). The tax court concluded,
however, that resolution of the burden of proof issue was unnecessary because
its determination of whether the expenses were deductible was based on a
preponderance of the evidence standard, making the burden of proof
immaterial.
The tax court’s decision to disregard the burden of proof in its reliance
on a preponderance standard was not error. The need to resolve a burden of
proof issue is obviated when both parties have offered some evidence and the
tax court’s determination relies on the weight of the evidence. See Whitehouse,
615 F.3d at 332 (citing Blodgett v. Comm’r, 394 F.3d 1030, 1039 (8th Cir.
2005)). Here, both parties presented some evidence on the issue of the
deductibility of McLauchlan’s claimed partnership expenses. The tax court did
not err in determining that the party supported by the weight of the evidence
would prevail regardless of which party bore the burden of proof. See Blodgett,
394 F.3d at 1039.
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II. Deduction of expenses on Schedule E
We turn now to the question of whether the expenses at issue are
deductible on Schedule E as unreimbursed partnership expenses. Generally,
a partner may not deduct the expenses of the partnership on his individual
return, even if the expenses were incurred by the partner in furtherance of
partnership business. Cropland Chem. Corp. v. Comm’r, 75 T.C. 288, 295
(1980), affd., 665 F.2d 1050 (7th Cir. 1981) (unpublished table decision). The
exception to this rule is where “under a partnership agreement, a partner has
been required to pay certain partnership expenses out of his own funds, he is
entitled to deduct the amount thereof from his individual gross income.” Klein
v. Comm’r, 25 T.C. 1045, 1052 acq., 1956-2 C.B. 4 (1956).
In deriving a formula for determining whether McLauchlan was entitled
to deduct any of the claimed expenses, the tax court identified this limited
exception governing deduction of partnership expenses, examined AR’s
partnership agreement, and heard testimony as to any routine at AR whereby
partners expend their own funds on partnership business. The court noted
there were substantiation requirements for certain expenses, particularly the
automobile expenses, which would have to be met in order for those expenses
to be deductible. The tax court then delineated the expenses at issue and
proceeded to analyze whether the remaining expenses were unreimbursed
partnership expenses, and if so, whether any of the expenses were nevertheless
disallowable for lack of proper substantiation. 2
The tax court categorized and listed the expenses at issue as well as the amount for
2
each year in question. The list of expenses as provided by the tax court included: Advertising;
car and truck; professional organizations and continuing legal education fees; contract labor;
depreciation and Section 179; automobile and home insurance; interest; office; vehicle lease
and rental; repairs and maintenance of automobiles and other; supplies; automobile taxes
and licenses and state bar membership license; travel, meals and entertainment; utilities;
wages; and charitable contributions. As we noted earlier, the court began its opinion by
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a. Unreimbursed partnership expenses
The first element examined by the tax court was whether McLauchlan
“was required to pay” any of the expenses at issue per either the partnership
agreement or routine practice equal to an agreement. Id. at 1052. 3 The AR
partnership agreement expressly provided that expenses partners incurred for
“business meals, automobiles, travel and entertainment, conventions,
continuing legal education seminars and professional organizations” — termed
“indirect expenses” by the tax court — would be borne by the partner unless
approved for reimbursement by the managing partner. The testimony did not
demonstrate that AR had a routine practice requiring partners to pay any AR
expenses outside the terms of the partnership agreement, contrary to
McLauchlan’s assertions. Accordingly, expenses McLauchlan claimed as
deductions beyond those identified in the partnership agreement, such as for
advertising, contract labor, home insurance, interest, office supplies, utilities,
and wages, were expenses McLauchlan chose to incur, rather than ones called
for by AR’s partnership agreement. They therefore were not deductible on
McLauchlan’s individual tax return. See id.
Having identified the expenses McLauchlan was required by AR’s
partnership agreement to incur, the tax court went on to determine, with the
exception of the automobile expenses, whether those required expenses were
holding that deduction of the depreciation expense for 2006 as well as the charitable
deductions for 2005 and 2006 would be allowed.
3 The rule in Klein states that a partner must be “required to pay certain expense[s]
out of [the partner’s] own funds” in order to deduct the same on his individual return. 25
T.C. 1052 (emphasis added). We maintain the terminology of the tax court and begin with
whether expenses are “required.” That is not to say the partnership agreement must read as
a mandate demanding partners incur certain expenses in order for those to be deductible.
Rather, it must be clear that the expenses were identified in some manner as ones the
partners had agreed they would incur or by routine practice understood as necessary for
partners to incur in the business of the partnership.
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reimbursable by the partnership. 4 The AR partnership agreement specifically
provided that the following were reimbursable if approved by a managing
partner: expenses partners incurred for reasonable travel, client maintenance
and development expenses, interoffice travel involving an automobile,
automobile lease and rental expenses for client travel, business meals and
entertainment, and continuing legal education. The court also determined that
expenses for state bar membership and professional organizations were
reimbursable as a matter of routine practice. AR’s chief financial officer during
the relevant years testified that AR had a fairly liberal reimbursement policy.
The tax court concluded that reasonableness was the determinative criterion
for reimbursement of AR expenses.
All of the expenses the tax court identified as indirect expenses that
McLauchlan was required to incur were also found to be reimbursable by either
AR’s written policy or routine practice. The tax court concluded, therefore, that
McLauchlan was not required ultimately to bear any of these expenses. See
Wallendal v. Comm’r, 31 T.C. 1249, 1252 (1959) (providing for deduction when
“expenses shall be borne by particular partners out of their own funds”).
Moreover, the court noted that McLauchlan failed to present any evidence of
specific expenses for which AR had denied him reimbursement. The tax court
concluded McLauchlan was not required to pay, without reimbursement, any
of the claimed expenses at issue and thus they were not properly deductible as
unreimbursed partnership expenses. See id.
McLauchlan urges that partners at AR were expected to self-fund
various business expenses without reimbursement, including expenses for
4 The court declined to assess whether the automobile expenses were reimbursable
because it alternatively found that those expenses were not properly substantiated, and
therefore not deductible. We will address the automobile expenses and substantiation
requirement separately in Section II.b.
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cellular phones, office furniture, advertising, computers, home office, and a
number of other expenditures. The tax court declined to credit McLauchlan’s
vague and general testimony regarding expenses he was allegedly expected to
incur as a partner without reimbursement. It concluded it was self-serving,
unverified, and undocumented and therefore the court was not required to
accept it. See Shea v. Comm’r, 112 T.C. 183, 189 (1999). McLauchlan also
disputes the concept that expenses are deductible only if AR required him to
incur them. He argues that all of his expenses should be deductible because
they were partnership-related expenses for the benefit of the partnership. This
argument ignores the general rule that a partner may not deduct expenses of
the partnership on his individual return, even if they are incurred in
furtherance of partnership business. Cropland Chem. Corp., 75 T.C. 295.
McLauchlan also challenges the tax court’s use of “unreimbursable” as
an element of deductibility. He contends the tax court’s analysis has expanded
the legal rule regarding deductibility of partnership expenses creating an
additional requirement that expenses not be reimbursable by the partnership.
He argues this additional requirement creates a rule that a partner must seek
reimbursement for every expense and document the denial of such a request
before claiming a deduction. McLauchlan again asserts that partners at AR
regularly incurred expenses that they did not submit for reimbursement and
that reimbursements were not unlimited or automatic. He argues he therefore
should be able to deduct his unreimbursed expenses regardless of whether they
were in fact reimbursable.
The requirement that an expense not be reimbursable by the partnership
in order to be deductible flows from the fact that partnership expenses may
only be deducted on an individual partner’s tax return if the partnership
agreement provides “such expenses shall be borne by particular partners out
of their own funds.” Wallendal, 31 T.C. 1252 (emphasis added). It follows
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that, if a partnership agreement provides for reimbursement of an expense, it
is not one a partner is required to bear out of his own funds. The tax court was
correct in its assessment that the agreement of the partners must require the
partner to “bear the . . . unreimbursed expenses out of his personal funds” in
order for the same to be deductible from his individual gross income. Klein, 25
T.C. 1052.
Additionally, if a partner has a right to reimbursement and does not elect
to pursue it, that partner should not be entitled to deduct the expenses. See
Occhipinti v. Comm’r, 28 T.C.M. 978 (1969), aff’d sub nom. Bayou Verret Land
Co. v. Comm’r, 450 F.2d 850 (5th Cir. 1971) (disallowing deductions for
partnership expenses if they were reimbursable by the partnership and
partner failed to seek reimbursement). To conclude otherwise would allow a
taxpayer to convert an expense of the partnership into one of his own simply
by failing to seek reimbursement. See Orvis v. Comm’r, 788 F.2d 1406, 1408
(9th Cir. 1986) (reasoning, in the context of deduction of necessary business
expenses, that a deduction is not allowed when an employee fails to seek
reimbursement for an employment expense when entitled to do so).
The AR partnership agreement specifically provided for expenses
McLauchlan was required to incur. Any additional expenses McLauchlan
chose to incur, such as those for advertising, contract labor, home office, or
supplies, are not deductible as partnership expenses. Further, AR’s
reimbursement practices show that the remainder of McLauchlan’s expenses,
ones he was required to incur, were all reimbursable per AR’s liberal
reimbursement policy. McLauchlan did not present evidence of specific
expenses he was required to incur without reimbursement. Because all of
McLauchlan’s claimed expenses either were reimbursable by the partnership,
or were not partnership expenses McLauchlan was required to incur, we affirm
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the tax court’s conclusion disallowing McLauchlan’s deductions. See Klein, 25
T.C. 1051-52.
b. Unsubstantiated expenses
As noted earlier, the tax court concluded it was unnecessary to evaluate
whether McLauchlan’s automobile expenses were reimbursable, even though
AR’s partnership agreement required him to incur them, because the tax court
found he could not meet the substantiation requirements for a deduction.
The tax code provides that in order to claim certain types of deductions,
including deductions related to passenger automobiles, a taxpayer must meet
strict substantiation requirements. I.R.C. §§ 274(d), 280F(d)(4)(A)(i).
McLauchlan’s claimed automobile deductions stem from his use of two
passenger automobiles subject to these requirements. In order to claim
deductions for his business use of an automobile, McLauchlan must
substantiate (1) the amount of each separate expenditure, (2) the mileage for
each business use and total mileage for all business use of the automobile, (3)
the date of the expenditure or use, and (4) the business purpose for the
expenditure or use. Temp. Treas. Reg. § 1.274-5T(b)(6).
McLauchlan did not maintain records indicating the amount of business
use and total use, the dates of any business use, or the purpose of any business
use for the automobiles. We agree with the tax court’s determination and
conclude McLauchlan was not entitled to deduct the automobile expenses due
to his failure to meet the substantiation requirements of Section 274.
Having concluded McLauchlan was not entitled to any of the claimed
deductions for unreimbursed partnership expenses, we turn now to the tax
court’s assessment of accuracy-related penalties.
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III. Accuracy-related penalties
The determination of whether a taxpayer acted with reasonable cause
and in good faith in making a substantial understatement of tax liability on
his tax return is a factual issue we review for clear error. Srivistava v. Comm’r,
220 F.3d 353, 367 (5th Cir. 2000), overruled on other grounds by Comm’r v.
Banks, 543 U.S. 426 (2005). The Commissioner has the burden of production
and must come forward with sufficient evidence that it is appropriate to impose
a penalty. I.R.C. § 7491(c).
The Internal Revenue Code provides for imposition of an accuracy-
related penalty of twenty-percent on underpayments of tax attributable to,
among other things, negligence or disregard of rules or regulations, or any
substantial understatement of income tax. I.R.C. § 6662(a), (b)(1) and (b)(2).
A substantial understatement is an amount that exceeds the greater of ten-
percent of the tax required to be shown on the return, or $5,000. I.R.C.
§ 6662(d)(1)(A). A taxpayer is not liable for an accuracy-related penalty if the
taxpayer acted with reasonable cause and in good faith. I.R.C. § 6664(c)(1).
Whether a taxpayer acted with reasonable cause and in good faith depends on
the pertinent facts and circumstances, including the taxpayer’s efforts to
assess his proper tax liability; the knowledge, experience and education of the
taxpayer; and the reliance on the advice of a professional. Treas. Reg. § 6664-
4(b)(1).
Here, because ten percent of the tax McLauchlan was required to show
on his return is greater than the $5,000 threshold, we apply the ten-percent
standard to determine whether Mclauchlan’s underpayment rises to the level
of substantial. In both 2005 and 2006, McLauchlan’s underpayment amounts
far-exceeded the ten-percent threshold and are, therefore, “substantial” under
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Section 6662(d)(1)(A). 5 Evaluating whether McLauchlan could show he acted
with reasonable cause and good faith, the tax court found that McLauchlan
had been a well-educated practicing attorney for over twenty years, had failed
to seek the assistance of a tax professional, and had prepared his own federal
income tax returns for the years in issue. Additionally, the court concluded
McLauchlan had repeatedly disregarded the rules and regulations on reporting
income and claiming deductions, and failed to offer any persuasive evidence
that he acted with reasonable cause and in good faith. Accordingly, the tax
court did not clearly err in its determination that McLauchlan did not act with
reasonable cause and good faith. See Srivistava, 220 F.3d at 367.
As we noted earlier, the Government acknowledged that it failed to credit
McLauchlan for the deductions for depreciation in 2006 and charitable
deductions in 2005 and 2006 allowed by the tax court. We REMAND solely for
the re-computation of McLauchlan’s deficiencies and penalties, crediting
McLauchlan the overlooked deductions. Otherwise, we AFFIRM the
conclusions of the tax court disallowing the remainder of McLauchlan’s
claimed deductions for partnership expenses as well as the tax court’s
assessment of liability for the accuracy-related penalties.
AFFIRMED and REMANDED.
5 McLauchlan reported income tax liabilities on his returns in the amounts of $12,127
for 2005, $22,228 for 2006, and $378 for 2007. Deficiencies of income tax were determined in
the amounts of $46,600 for 2005, $58,285 for 2006, and $4,619 for 2007. Thus, the
underpayment amounts are substantial only for 2005 and 2006. Again, we note the
Government’s acknowledged error in computing the deficiencies due to failing to include
McLauchlan’s deductions for depreciation and charitable deductions. The Government
proffers that after crediting McLauchlan those deductions, the deficiencies for 2005 and 2006
will be in the amounts of $45,943.20 and $57,153, respectively; meaning the underpayment
amounts for those years will remain substantial for purposes of calculating any accuracy-
related penalties.
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