Khalaf v. Dept. of Rev. ( 2020 )

No. 1 February 5, 2020 1
IN THE OREGON TAX COURT
REGULAR DIVISION
Rami KHALAF (Khalaf Motors),
Plaintiff,
v.
DEPARTMENT OF REVENUE,
Defendant.
(TC 5347)
At trial, taxpayer, as owner of a dune buggy export business, claimed deduc-
tions for various business expenses and an adjustment to his cost of goods sold
(COGS). Taxpayer claimed a deduction for freight expenses under IRC sec-
tion 162(a) and an adjustment for a supercharger as COGS. The court held that
taxpayer satisfied his burden of proof by providing sufficient documentation
to show these deductions were allowable by a preponderance of the evidence.
Taxpayer also claimed deductions for travel expenses, but the court determined
that these did not satisfy the higher documentation standard under IRC sec-
tion 274(d). Finally, taxpayer claimed a dune buggy was a depreciable business
asset, but the court held that his actions—keeping the mileage low and attempts
to sell—showed that the dune buggy was held as a demonstrator. Therefore, the
court held that taxpayer did not satisfy his burden of proof for the deduction of
the travel expenses and the dune buggy.
Trial was held in the courtroom of the Oregon Tax Court
on May 2, 2019.
Plaintiff Rami Khalaf argued the cause pro se.
James C. Strong, Assistant Attorney General, Depart-
ment of Justice, Salem, argued the cause for Defendant
Department of Revenue.
Decision for Defendant rendered February 5, 2020.
ROBERT T. MANICKE, Judge.
I. INTRODUCTION
This personal income tax matter is before the court
after trial. The tax year at issue is 2013. Plaintiff Rami
Khalaf (taxpayer) asserts that he is entitled to deductions for
various business expenses and an adjustment to his cost of
goods sold (COGS). Defendant Department of Revenue (the
department) asserts that taxpayer is not entitled to these
deductions nor is he entitled to an adjustment for COGS.
2 Khalaf v. Dept. of Rev.
II. FACTS
During 2013, taxpayer operated a sole proprietor-
ship under the assumed business name “Khalaf Motors.” At
trial, taxpayer described his business as “facilitating” sales
between customers in the United Arab Emirates (UAE) and
“suppliers” of various consumer goods located in the United
States. According to taxpayer, a typical transaction would
begin when a UAE customer contacted taxpayer, either by
phone, email, or online messenger, with a request that tax-
payer locate goods available for purchase from suppliers in
the United States. Once taxpayer located the customer’s
desired item in the United States, taxpayer would negoti-
ate the purchase price and logistics, including the cost of
international shipping to the customer located in the UAE.
Taxpayer would then arrange for the customer to wire the
total cost, including taxpayer’s fee, to taxpayer’s domes-
tic bank account. Upon receiving confirmation that the
funds had been deposited in his account, taxpayer would
secure the desired item and arrange shipping to the cus-
tomer in the UAE. Taxpayer would then wire the purchase
price to the supplier, who in turn would release the item
to taxpayer. Taxpayer would then arrange with a shipper
for pick-up of the item at the supplier’s location for deliv-
ery to the closest international port, usually within a day
or two after the item had been released to taxpayer. In a
few cases where the port was not ready to receive the ship-
ment, taxpayer would arrange to store the item at a nearby
warehouse or at his residence in Beaverton until the port
was ready to receive the item and load it into the shipping
container.
Taxpayer claimed a total of $39,007 on Line 27a
on Schedule C of his 2013 federal income tax return under
the heading “Other expenses,” including certain freight and
travel expenses. Taxpayer also elected to expense $7,820 on
Line 13 on Schedule C of his 2013 federal income tax return,
in the category of “Depreciation and section 179 expense
deduction,” for purchase of a dune buggy (the Dune Buggy).
Taxpayer also claimed the total amount of $208,343 as
COGS on Line 42 on Schedule C of his 2013 federal income
tax return.
Cite as 24 OTR 1 (2020) 3
The department audited taxpayer’s 2013 Oregon
income tax return and proposed adjustments to taxpay-
er’s deductions and COGS, resulting in a net tax owed of
$3,090 and a penalty of $618 for “substantial understate-
ment of income.” The department explained its adjust-
ments in a notice of deficiency (Deficiency Notice), mailed
to taxpayer on December 16, 2016. The Deficiency Notice
stated that the department had accepted certain amounts
claimed as “Other expenses” (cell phone/calling cards, lodg-
ing, and auto rental) once taxpayer supplied additional
evidence that the expenses were incurred in his business.
The department disallowed taxpayer’s deductions for travel
expenses taxpayer claimed to have incurred during 2013
because taxpayer failed to substantiate both that he paid
the travel expenses in 2013 and that these travel expenses
were primarily incurred by taxpayer for a business pur-
pose. See IRC § 274(d).1 The department also disallowed
taxpayer’s “Section 179” expense deduction of $7,820 for
2013 payments taxpayer made for the Dune Buggy, which
taxpayer had purchased in October 2012 and placed in ser-
vice in 2013. The department asserted that taxpayer held
the Dune Buggy as a floor/demonstration model, and as a
result, the department considered the Dune Buggy inven-
tory and not a depreciable business asset that taxpayer
could elect to expense pursuant to IRC section 179. See IRC
§ 167(a) (allowing a depreciation deduction for property used
in a taxpayer’s trade or business or for the production of
income); Treas Reg § 1.167(a)-2 (depreciation not applicable
to inventories or stock in trade). Consequently, the depart-
ment added the $19,902 cost of the Dune Buggy to tax-
payer’s 2013 beginning inventory.2 Lastly, the department
declined to accept, for COGS purposes, a $6,000 receipt
for a “supercharger” (the Supercharger) that taxpayer
claimed to have sold to a customer in the UAE. The depart-
ment cited lack of substantiation and unknown business
1
The court’s references to the Oregon Revised Statutes (ORS) are to the 2013
edition; references to the Internal Revenue Code (IRC, or the “Code”) are to the
IRC as in effect and operative for the 2013 calendar year.
2
Because taxpayer had not reported that he sold the Dune Buggy as of
December 31, 2013, the department added that same amount to taxpayer’s end-
ing inventory as well. Taxpayer requests the court allow a depreciation expense
of “$20,250” for the cost of the Dune Buggy “along with other parts and labor[.]”
4 Khalaf v. Dept. of Rev.
purpose, asserting that taxpayer had failed to include a
customer invoice or documentation to support taxpayer’s
assertion that he had installed the Supercharger on a vehi-
cle taxpayer shipped to a customer soon after buying the
Supercharger.
Taxpayer requested and received a conference
with the department regarding taxpayer’s deductions for
the freight payment, travel expenses, and depreciation on
the Dune Buggy, as well as his request that the cost of the
Supercharger be included in his COGS for 2013. The depart-
ment allowed some items at conference, resulting in a reduc-
tion of net tax due and a reduced penalty. Taxpayer appealed
to the Magistrate Division from the notice of assessment that
accompanied the conference decision letter. Following trial,
the magistrate issued a decision in favor of the department,
and taxpayer timely appealed to the Regular Division.
Unlike the audit, the department’s conference,
and the Magistrate Division trial in this matter, proceed-
ings in the Regular Division are governed by formal pro-
cedural rules, including the statutory rules of evidence,
which often complicate matters considerably, especially for
self-represented nonattorney taxpayers. See ORS 40.015(2)
(Oregon Evidence Code applicable); ORS 305.425(3) (“All
hearings and proceedings before the tax court judge shall
be in accordance with the rules of practice and procedure
promulgated by the court, which shall conform, as far as
practical to the rules of equity practice and procedure in this
state.”). Among other things, those rules require each party
to present its exhibits to the court and give the other party
a chance to raise any objections, such as objections on the
grounds of hearsay. The court then must decide whether to
admit each exhibit for use during the trial. In this case, the
status of the evidence is as follows: taxpayer’s Exhibits 1 and
4; taxpayer’s Exhibit 2, pages 1-16, 19-20, and 23; taxpayer’s
Exhibit 5 pages 4-7, 11-12; taxpayer’s Exhibit 6, pages 1-3;
and taxpayer’s Exhibit 7, pages 1-4, 6-8 were admitted into
evidence at trial without objection. Taxpayer’s Exhibit 2 con-
tained additional pages that were disregarded at trial at the
request of taxpayer. The department stipulated to the dates
of travel provided on plane tickets submitted in taxpayer’s
Exhibit 4. The department also stipulated to the fact that
Cite as 24 OTR 1 (2020) 5
taxpayer wired money to his sisters, Ruba Khalaf and Reem
Khalaf, for payment of the apartment and vehicle rental in
the UAE. The department’s Exhibits A to D were admitted
into evidence without objection.3 The department objected to
several pages in taxpayer’s exhibits on grounds of relevance,
hearsay, and lack of foundation, which the court took under
advisement.4 The court will address the department’s objec-
tions in the relevant sections below.
III. ISSUES
(1) May taxpayer deduct the cost of a vehicle freight
charge as a business expense under IRC section 162?
(2) May taxpayer include the cost of the Supercharger
in his cost of goods sold for 2013?
(3) Do the special substantiation rules under IRC sec-
tion 274 prevent taxpayer from deducting the rental
costs of an apartment and vehicle in the UAE as
travel expenses?
(4) May taxpayer deduct part of the cost of the Dune
Buggy as an expense under IRC section 179?
IV. ANALYSIS
This case involves proof of business expenses and
costs. At a minimum, all taxpayers have the burden of prov-
ing that they are entitled to the deductions and other items
they list on their tax returns, and the law requires them to
keep records sufficient to establish the amounts they claim.
IRC § 6001; Treas Reg § 1.6001-1(a). For certain kinds of
items, including business travel, Congress long ago decided
to impose, in addition, detailed and specific recordkeeping
requirements in order to curb abuse.5 The court observed
taxpayer’s testimony at trial and does not question taxpayer’s
3
The department included Exhibits E to H on its list of exhibits exchanged
before trial but did not offer them into evidence.
4
At trial, taxpayer acknowledged that his pretrial memorandum memo is
not itself evidence, but rather a summary of evidence that taxpayer intended to
present at trial. Taxpayer did not formally offer his pretrial memorandum into
evidence during trial.
5
As discussed below, this case involves federal substantiation requirements,
which Oregon incorporates in its personal income tax law. See, e.g., ORS 316.007;
ORS 316.012.
6 Khalaf v. Dept. of Rev.
good faith and sincerity with respect to the items still in
dispute after the department’s concessions and allowances
during the audit and conference processes. The court must
resolve these issues by applying the rules governing proof
and recordkeeping to taxpayer’s facts.
The court first notes an overarching concern that
taxpayer expressed, namely that the department fails to
understand the nature of his business. (“Comprehending
the nature of ‘locating’ goods in the USA for customers who
live abroad has been the main obstacle for the [department]
auditors * * *.”) Taxpayer testified that he considers himself
a “broker” who provides a specific “service,” “locating” and
matching up his foreign customers with items available
from “suppliers” in the United States, as a side occupation
to his regular employment. Taxpayer resists the notion
that he deals in “inventory,” as he does not generally buy
merchandise in advance, hoping to find a buyer for it, but
instead buys specific merchandise only after receiving ear-
marked funds from a customer who wants that particular
item.
The court does not doubt that taxpayer’s custom-
ers primarily are attracted by his ability to understand
and find exactly what they want. And it is not surprising
that taxpayer might wish for simpler tax treatment, such as
might be enjoyed by a consultant who earns a straightfor-
ward fee for services and never buys or sells merchandise.
However, taxpayer filed his return as a seller of goods. He
claimed $208,343 in “cost of goods sold,” an amount that
offset more than 90 percent of his gross receipts of $227,461.
This manner of reporting is consistent with the evidence:
to illustrate his pattern of exporting all-terrain vehicles
during the period 2009 to 2013, taxpayer provided receipts
of numerous transactions, all of which show Khalaf Motors
(or another business name at the same address) as the pur-
chaser. Taxpayer made no attempt to present evidence sup-
porting tax treatment fundamentally different from what
he claimed on his return. See generally Boris I. Bittker &
Lawrence Lokken, Federal Taxation of Income, Estates &
Gifts ¶ 40.1 (3rd ed 2019) (identifying six factors that courts
use to determine whether a sale has occurred, including
parties’ treatment of the transaction).
Cite as 24 OTR 1 (2020) 7
Two of the four issues in this case (the freight
expenses and the Supercharger) are disputes about the basic
recordkeeping requirements that apply simply because tax-
payer is a seller of goods. The court resolves these two issues
in favor of taxpayer, because his evidence, although imper-
fect, is adequate. A third issue (travel expenses) involves
the much more demanding recordkeeping requirements in
IRC section 274(d). Those special rules require a taxpayer
to maintain records that are detailed and contemporaneous
with the travel, and particular scrutiny applies to transac-
tions involving family members. The court denies the travel
expense deductions because taxpayer failed to keep and
produce adequate contemporaneous records to substanti-
ate the expenses. Some of taxpayer’s desired evidence also
was inadmissible under the hearsay rules. Regarding the
final issue (cost of the Dune Buggy), the court concludes that
taxpayer held the Dune Buggy not as a depreciable asset
for use in his business, but as inventory that he temporar-
ily pulled for “demonstration” purposes, a common practice
among vehicle dealers. Although taxpayer does not see him-
self as a dealer with inventory, the department’s treatment
of the Dune Buggy fits squarely within a line of federal tax
cases.
A. Burden of Proof
When the department denies a deduction and a tax-
payer appeals, the taxpayer bears the burden of showing by
a preponderance of the evidence that the deduction is allow-
able. ORS 305.427; DeGroat v. Dept. of Rev., 23 OTR 254,
257 (2019). A “preponderance” of the evidence means “the
greater weight of evidence, the more convincing evidence.”
Feves v. Dept. of Rev., 4 OTR 302, 312 (1971). Oregon courts
have concluded that when the law places the burden of proof
on the taxpayer, it is the responsibility of the taxpayer to put
forward “sufficient evidence which will weigh more in the
mind of the trier of fact than the * * * weight of the evidence
adduced by the [department] * * *.” Sproul v. Commission, 1
OTR 31, 65 (1962), rev’d on other grounds, Sproul v. State
Tax Com., 234 Or 567, 382 P2d 99 (1963). The “preponder-
ance of evidence” standard requires (1) a taxpayer to provide
the court with facts supporting the taxpayer’s position; and
(2) that those facts outweigh the department’s evidence. See
8 Khalaf v. Dept. of Rev.
Dept. of Rev. v. Bahr I, 20 OTR 434, 448 (2012) (stating that
when the evidence in the record does not favor either side,
“the court must find against the party bearing the burden
of proof”). “[I]f the evidence is inconclusive or unpersuasive,
the taxpayer will have failed to meet his burden of proof
* * *.” Reed v. Dept. of Rev., 310 Or 260, 265, 798 P2d 235(1990).
B. Taxpayer’s Deduction for Freight Expenses
Taxpayer seeks to deduct $1,000 for a cash payment
to a freight company for delivery of a Toyota Tundra from a
seller in Arizona to taxpayer’s residence in Beaverton. (testi-
mony of Khalaf at 11:54:00). The department disallowed the
payment at conference because “[n]o charges were totaled on
the bill of lading” and because taxpayer’s bank statements
“only show three cash withdraws of $200 from September 27th
to October 4th.”
Section 162 of the Internal Revenue Code allows
a taxpayer to deduct from gross income “all the ordinary
and necessary expenses paid or incurred during the taxable
year in carrying on any trade or business[.]” IRC § 162(a).
Taxpayer must keep adequate records to establish both the
amount the taxpayer paid and the business purpose of any
deduction. IRC § 6001; Treas Reg § 1.6001-1(a); see, e.g.,
Lyseng v. Comm’r, 102 TCM (CCH) 280, 2011 WL 4389644at *3 (US Tax Ct) (“In general, taxpayers must substan-
tiate claimed deductions with evidence such as invoices
or receipts that establish that the expenses were actually
incurred[.]”). The term “ ‘expense,’ when used to determine
tax deductions, means money spent; disbursing of money; a
drain on one’s finances; or the incurring in the tax year of
an obligation to pay.” National Can Corp. v. United States,
520 F Supp 567, 579 (ND Ill 1981), aff’d, 687 F2d 1107 (7th
Cir 1982). “Whether an expense is deductible under section
162 is a question of fact to be decided on the basis of all the
relevant facts and circumstances.” Adams v. Comm’r, 105
TCM (CCH) 1029, 2013 WL 135103 at *9 (US Tax Ct) (citing
Commissioner v. Heininger, 320 US 467, 473-75, 64 S Ct 249,
88 L Ed 171 (1943)). The department does not contest that
the freight charge, if proved, was an ordinary and necessary
business expense.
Cite as 24 OTR 1 (2020) 9
At trial, taxpayer credibly testified that he had
arranged for shipment of the Toyota Tundra to his residence
in Beaverton because the port of export in Washington was
not ready to receive the Tundra for shipment to taxpayer’s
customer in the UAE. Taxpayer testified that the $1,000
expense represents a $950 freight charge and an additional
$50 that taxpayer paid the driver for a tip.
Taxpayer submitted a bill of lading from KT Auto
Transport dated October 4, 2013.6 That bill of lading shows
KT Auto Transport picked up a 2014 Toyota Tundra from
a Toyota dealership (Right Toyota) in Arizona and deliv-
ered it to taxpayer at his residence in Beaverton, Oregon
on October 7, 2013. The bill of lading is signed by taxpayer.
Taxpayer also produced a separate shipping manifest from
KT Auto Transport. That shipping manifest shows that
KT Auto Transport picked up a Toyota Tundra from Right
Toyota in Arizona on either October 7, 2013, or October 8,
2013, and delivered it to taxpayer’s residence in Beaverton,
Oregon, between October 10, 2013 and October 12, 2013.
The shipping manifest shows the total length of the trip
between pick-up and drop-off was 1,354 miles. Taxpayer
also submitted an invoice from Accelerated Services LLC
Auto Transporters showing a payment to Right Toyota of
$950 with respect to a Toyota Tundra. The invoice is dated
October 9, 2013.7 Each document refers to the same vehicle
identification number.
Taxpayer made considerable effort to reconstruct
this transaction in order to meet his burden of proof.8 The
court finds that the bill of lading, shipping manifest, and
6
Taxpayer testified that two trucking companies were involved in hauling
the Toyota Tundra from the Toyota dealership in Arizona to his residence in
Beaverton: “Accelerated Services” and “KT Auto Transport.”
7
Taxpayer offered several other documents (“Corvette Documents”) in sup-
port of the $1,000 freight expense. The department objected to the Corvette
Documents on grounds of hearsay, relevance, and lack of foundation. According
to the department, the Corvette Documents relate to a different transaction
involving two Corvettes, an expense the department allowed. Taxpayer testified
that he sought to introduce the Corvette Documents for comparison purposes,
presumably to highlight an inconsistency in the department’s audit methodology.
The court sustains the department’s objection to the Corvette Documents.
8
The court notes that the fact that taxpayer made this payment in cash
makes it harder for him to prove the payment.
10 Khalaf v. Dept. of Rev.
invoice together provide a contemporaneous record of the
shipping charge. The court finds those documents, com-
bined with taxpayer’s testimony that he paid the driver
upon receiving the Toyota Tundra, to be sufficient evidence
that taxpayer paid the $1,000 freight expense for delivery of
the Toyota Tundra in 2013. See National Can Corp., 520 F
Supp at 579 (“[T]here can be an expense which will qualify
as a tax deduction where all other requirements are satis-
fied, if there is payment in kind or in the equivalent of cash.”
(Citations omitted.)). The court concludes that taxpayer has
carried his burden of proof by showing sufficient records to
support treatment of the payment as a business expense
pursuant to IRC section 162(a). The court allows taxpayer’s
$1,000 deduction for payment of the freight expenses.9
C. Adjustment to Gross Income for Cost of Goods Sold
(Supercharger)
Taxpayer seeks a $6,000 increase to COGS for his
purchase of the Supercharger that was shipped to taxpay-
er’s customer in the UAE during 2013. The department dis-
allowed the adjustment to COGS because taxpayer could
not produce the original invoice documenting taxpayer’s
purchase of the Supercharger in 2013. Taxpayer admitted
he had lost the original receipt showing proof of purchase of
the Supercharger.
An individual taxpayer computes his or her net
profit or loss from doing business as a sole proprietor on
9
The court does not apply the special rules for “listed property.” Under IRC
section 274(d)(4) any deduction claimed with respect to a passenger automobile
is disallowed unless the taxpayer substantiates specified elements of the auto-
mobile’s use by adequate records or by sufficient evidence corroborating the
taxpayer’s own statement. Id. (identifying specific substantiation requirements
for “listed property,” including passenger automobiles); Temp Treas Reg § 1.274-
5T(b)(6) (additional requirements to deduct the cost of an automobile used in a
business). Whether the Toyota Tundra is “listed property” was not briefed by the
parties nor was it advanced by the department at any prior stage of taxpayer’s
appeal, presumably because taxpayer did not use the Toyota Tundra as a means
of transportation at any point during 2013. See, e.g., Ghadiri-Asli v. Comm’r, 118
TCM (CCH) 355, 2019 WL 5423725 *13 n 11 (US Tax Ct) (citing IRC § 280F(d)(4)
(“Listed property includes passenger automobiles, any other property used as a
means of transportation, and property generally used for purposes of entertain-
ment, recreation, or amusement.” (Emphasis added.))). Because the issue was nei-
ther briefed nor argued, the court does not decide whether the “listed property”
requirements apply.
Cite as 24 OTR 1 (2020) 11
the taxpayer’s Schedule C (IRS Form 1040) by subtracting
the COGS, along with ordinary and necessary business
expenses, from the gross receipts earned that year. See
IRC § 61; Treas Reg § 1.61-3(a); Velinsky v. Comm’r, 71 TCM
(CCH) 2766, 1996 WL 173544 at *3 (US Tax Ct) (“cost of
goods sold is taken into account in computing gross income
and is not an item of deduction”). “It is a taxpayer’s respon-
sibility to maintain adequate books and records sufficient to
substantiate all items on the tax return, including the cost
of goods sold.” Said v. Comm’r, 85 TCM (CCH) 1353, 2003
WL 21205252 at *3 (US Tax Ct), aff’d, 112 F Appx 608 (9th
Cir 2004) (citing IRC § 6001). Any amount claimed as a cost
of goods sold must be substantiated. Azimzadeh v. Comm’r,
TCM 2013-169, 2013 WL 3811481 at *5 (US Tax Ct).
Taxpayer testified that he purchased the
Supercharger at the request of a customer in the UAE.
Taxpayer also testified that he shipped the Supercharger
to the UAE in the same overseas container as a Toyota
Tundra. Taxpayer offered a copy of a credit card receipt
from Toyota of Gladstone for $6,000, dated March 1, 2013,
and a shipping invoice from International TLC, Inc., dated
November 13, 2013, for a container shipment from Tacoma,
Washington, to the UAE.10
“It is well established that courts permit a taxpayer
to substantiate deductions through secondary evidence where
the underlying documents have been unintentionally lost or
destroyed.” Davis v. Comm’r, 92 TCM (CCH) 514, 2006 WL
3780743 at *4 (US Tax Ct) (citations omitted). However, even
when a taxpayer loses an invoice, the taxpayer still bears
the burden of proving through sufficient secondary evidence
10
Taxpayer sought to introduce a copy of an email from Dave Ruppert,
Service Manager at Toyota of Gladstone, dated December 22, 2017, in order to
show that a “quote” for parts from December 22, 2017, was, in effect, a replace-
ment for the lost invoice. The department objected to this email on the grounds
of hearsay and lack of foundation. As will be explained further below, the rule
against hearsay bars the admission of out-of-court statements introduced for the
truth of the matter asserted in that statement. OEC 802. The court concludes
that this email is inadmissible hearsay because Dave Ruppert did not appear
at trial and taxpayer sought to introduce the statement Dave Ruppert made in
his email for its truth. The court sustains the department’s objection. Although
the department did not object to admitting the quote itself, the quote carries no
weight because taxpayer cannot use the email to explain it.
12 Khalaf v. Dept. of Rev.
that he actually paid for the items and that he actually sold
them in the course of his business. See id. Having observed
taxpayer’s testimony at trial, the court finds it credible with
respect to his sale of the Supercharger to a customer in the
UAE. See Freeman v. Comm’r, 98 TCM (CCH) 236, 2009 WL
2958663 at *6 (US Tax Ct) (citing Boyd v. Comm’r, 122 TC
305, 320-21, 2004 WL 886993 (US Tax Ct) (“If documenta-
tion is unavailable, we may accept the taxpayer’s credible
testimony to substantiate the deduction.”). In addition, tax-
payer reconstructed the amount of the Supercharger expense
through contemporaneous evidence of a $6,000 payment
to Toyota of Gladstone and by providing a shipping invoice
showing that a 2014 Toyota Tundra was shipped alongside
a box of auto parts to the UAE on November 13, 2013. The
court finds taxpayer’s evidence and testimony to be sufficient
secondary evidence of his Supercharger expense. See Davis,
2006 WL 3780743 at *5 (allowing claimed amounts as deduc-
tions where original documents were lost but taxpayer pre-
sented credible reconstructions of their expenses). The court
concludes that taxpayer has met his evidentiary burden and
is entitled to include the $6,000 cost of the Supercharger in
his 2013 COGS.
D. Foreign Lodging and Vehicle Rental Expense
Taxpayer seeks to deduct as a business travel
expense the cost of an apartment and vehicle he rented in
the UAE. The department disallowed taxpayer’s deduction
because it determined taxpayer had not met the substantia-
tion requirements of IRC section 274 for travel expenses.
The Internal Revenue Code generally allows tax-
payers to deduct the cost of lodging and vehicle rental as
travel expenses to the extent incurred in the ordinary course
of business. IRC § 162(a)(2). In addition to meeting the gen-
eral substantiation requirements under IRC section 6001,
taxpayers seeking to deduct the cost of lodging and vehicle
rental as travel expenses must meet the strict substantia-
tion requirements of IRC section 274(d) for the deduction to
be allowable. See, e.g., Griggs v. Comm’r, 96 TCM (CCH) 248,
2008 WL 4643010 at *5 (US Tax Ct). A taxpayer must sub-
stantiate by adequate records, or by sufficient evidence cor-
roborating the taxpayer’s own testimony, the amount of the
Cite as 24 OTR 1 (2020) 13
expense, as well as the time, place, and business purpose
of the taxpayer’s expenditure or use of the property. IRC
§ 274(d); Temp Treas Reg § 1.274-5T(b). The elements that
must be substantiated to deduct the business use of a pas-
senger automobile, such as the vehicle taxpayer drove in the
UAE, are: “(i) the amount of the expenditure; (ii) the mile-
age for each business use of the automobile and the total
mileage for all uses of the automobile during the taxable
period; (iii) the date of the business use; and (iv) the busi-
ness purpose of the use of the automobile.” Adler v. Comm’r,
99 TCM (CCH) 1181, 2010 WL 934267 at *11 (US Tax Ct),
aff’d, 443 F Appx 736 (3rd Cir 2011) (citing Temp Treas Reg
§ 1.274-5T(b)(6)). Finally, in addition to satisfying the sub-
stantiation requirements in IRC section 274(d), a taxpayer
who travels outside the United States must comply with IRC
section 274(c), which requires a taxpayer to track much more
precisely—and to document—the time the taxpayer spends
on business vs. nonbusiness activity and allows deductions
only to the extent the expenses are specifically allocable to
business activity.11 See Treas Reg § 1.274-4; see also Temp
Treas Reg § 1.274-5T(c)(1).
Taxpayer credibly testified that during 2013 he trav-
eled to the UAE for business purposes, which required him
to rent an apartment and a vehicle. He also testified that he
used the apartment to meet with potential customers in the
UAE. Taxpayer explained that the apartment was leased
to his sister, Reem Khalaf, a resident of the UAE, and the
vehicle was owned by taxpayer’s other sister, Ruba Khalaf,
11
The more rigorous tracking and expense allocation rules under IRC section
274(c) apply when the trip exceeds one week and the amount of time attributed
to nonbusiness activities is more than 25 percent of the total time of the trip.
See Treas Reg §§ 1.274-4(c) - (d) (rules for determining the length of the trip and
the amount of time attributable to nonbusiness activities). Taxpayer told the
court that he understood IRC section 274(c) to mean that if a taxpayer’s foreign
trip lasts less than seven days, the IRS considers the taxpayer to have made the
trip “entirely for business.” See IRS Pub 463 (2018) at 7 (“Your trip is considered
entirely for business if you were outside the United States for a week or less
* * *.”). Taxpayer misunderstands the law. By keeping a foreign trip to a week or
less, a taxpayer avoids only the overlay of allocation rules in IRC section 274(c).
The general rules of substantiation for all travel expenses continue to apply. See,
e.g., Helguero-Balcells v. Comm’r, TC Summ Op 2012-31, 2012 WL 1165336 at
*4 (US Tax Ct) (“In addition to the strict substantiation requirements of section
274(d), foreign travel expenses, if otherwise deductible, are subject to the alloca-
tion requirements of section 274(c).” (Citations omitted; emphases added.)).
14 Khalaf v. Dept. of Rev.
also a resident of the UAE.12 Taxpayer offered signed and
translated statements of Reem Khalaf and Ruba Khalaf as
proof that he paid them for his use of the apartment and
the vehicle during his visit to the UAE, and that his use of
both properties was for a business purpose. The department
objected to taxpayer’s sisters’ statements as inadmissible
hearsay.
The court sustains the department’s objection. As
explained by the Oregon Supreme Court, “[h]earsay is a
‘statement, other than one made by the declarant while tes-
tifying at the trial or hearing, offered in evidence to prove
the truth of the matter asserted.’ ” State v. Bement, 363 Or
760, 765, 429 P3d 715 (2018) (quoting Oregon Evidence Code
(OEC) 801(3)). Taxpayer did not present Reem Khalaf or
Ruba Khalaf as a witness at trial to testify that taxpayer
had paid them for his use of the apartment and vehicle, and
that this use was for a business purpose. Consequently, the
court concludes that the signed statements contained in
taxpayer’s Exhibit 5, pages 2, 3, 9, and 10, are inadmissi-
ble hearsay because they are out-of-court statements which
taxpayer has submitted to the court for the truth of the mat-
ter asserted by those statements. See OEC 801(3). The court
also concludes that these statements do not fall within the
so-called “business records” exception to the rule against
hearsay, see OEC 803(6), because taxpayer did not establish
by admissible evidence that either statement was made by a
person under a business duty at the time to report taxpay-
er’s payment for use of the apartment or vehicle. See, e.g.,
Morgan v. Valley Property and Casualty Ins. Co., 289 Or App
454 (2017), adh’d to on recons, 290 Or App 595, rev den, 363
Or 390 (2018) (“For a business record to be admissible hear-
say, not only must the entrant be under a business duty to
record the event, but the informant must be under a con-
temporaneous business duty to report the occurrence to
the entrant as well.” (Citation omitted.)). Taxpayer stated
12
Taxpayer offered copies of documents that taxpayer identified as copies of
the underlying dwelling lease and vehicle purchase contract signed by his sisters.
The court admitted the documents without objection. Taxpayer testified that
because his U.S. citizenship prevents him from owning or leasing property in the
UAE, his signature does not appear on either document, but he represented that
his sisters had signed them (the lease is in Arabic and is not translated, and none
of the signatures are legible).
Cite as 24 OTR 1 (2020) 15
on cross-examination that neither of taxpayer’s sisters was
on the payroll of Khalaf Motors during 2013.13 As a result,
the court cannot consider the written statements of Ruba
Khalaf and Reem Khalaf in this case.14 Thus, even assum-
ing that the remainder of taxpayer’s Exhibit 5 establishes
that taxpayer’s sisters lease the apartment and own the
vehicle, taxpayer presented no admissible evidence of his
arrangement with his sisters.
The court looks to the remaining evidence to deter-
mine whether taxpayer substantiated his apartment and
vehicle rental expenses by adequate records or by suffi-
cient evidence corroborating his statements at trial. See
IRC § 274(d); see Temp Treas Reg § 1.274-5T(c)(1) (general
rules of substantiation for travel and vehicle expenses). To
substantiate travel expenses by “adequate records,” the tax-
payer must maintain “[a]n account book, diary, log, state-
ment of expense, trip sheet, or similar record” in which
each element of an expenditure is recorded “at or near the
time of the expenditure or use.” Temp Treas Reg § 1.274-
5T(c)(2)(ii); see, e.g., Reynolds v. Comm’r, 296 F3d 607, 616
(7th Cir 2002) (“Complete, contemporaneous records are the
preferred method of substantiation. Taxpayers who pursue
alternative methods will have to present evidence that is
13
Taxpayer explained that he considered his sisters to fall within the defini-
tion of “business associate” in IRS Publication 463. That definition of “business
associate” applies to travel expenses paid by a taxpayer on behalf of another
individual. See id. at 5. Taxpayer gave the court no evidence that either sister
traveled with taxpayer during 2013; nor does taxpayer seek to deduct expenses
incurred by either sister on his 2013 federal tax return.
14
Even if the sisters’ statements regarding taxpayer’s use were admissible,
the fact that taxpayer paid family members for his use of the apartment and vehi-
cle would create an additional evidentiary burden for taxpayer. As a general rule,
courts closely scrutinize transfers of property between family members to ensure
that each transaction was motivated by a bona fide business purpose and that
the transaction does not represent a nondeductible gift to the taxpayer or to the
taxpayer’s family. E.g., Estate of Reynolds v. Comm’r, 55 TC 172, 201 (1970) (“The
presumption is that a transfer between closely related parties is a gift.”); IRC
§ 274(b)(1) (“No deduction shall be allowed under section 162 * * * for any expense
for gifts made directly or indirectly to any individual * * *.”); Stern v. US, 436 F2d
1327, 1330 (1971) (quoting Treas Reg § 25.2512-8 (“[A] sale, exchange, or other
transfer of property made in the ordinary course of business (a transaction which
is bona fide, at arm’s length, and free from any donative intent), will be consid-
ered as made for an adequate and full consideration in money or money’s worth.”).
In this case, for example, taxpayer offered no evidence that he compensated his
sisters at fair rental value.
16 Khalaf v. Dept. of Rev.
equally credible and probative, which will be difficult.”).
Taxpayer produced a travel log15 detailing three trips to
the UAE.16 Importantly, taxpayer made no showing that he
recorded the information in the travel log contemporane-
ously with his trips to the UAE. See Temp Treas Reg § 1.274-
5T(c)(2)(ii)(A) (“[A]t or near the time of the expenditure”
means that “the elements of an expenditure or use are
recorded at a time when * * * the taxpayer has full present
knowledge of each element of the expenditure or use[.]”). The
court concludes that taxpayer’s travel log does not meet the
higher substantiation requirements for travel and vehicle
expenses under IRC section 274(d) because taxpayer did not
establish that he created the log contemporaneously with
his travel. See, e.g., Hillenga v. Dept. of Rev., 21 OTR 396,
413 (2014), rev’d in part on other grounds, 358 Or 178, 361
P3d 598 (2015) (taxpayer’s single-page summary of mile-
age and maintenance expenses did not meet substantiation
requirements of IRC section 274(d) in part because it did
not purport to be a contemporaneous record). Taxpayer sub-
mitted no additional evidence to substantiate the business
purpose of his use of the apartment in the UAE pursuant
to IRC section 274(d). Regarding his use of the vehicle, tax-
payer testified on cross-examination that he did not keep a
mileage log documenting his use of the vehicle in the UAE.
See Temp Treas Reg § 1.274-5T(b)(6)(i)(B) (requiring a tax-
payer to prove business use of an automobile based on an
appropriate measure, such as a mileage log).
Aside from his testimony and travel log, taxpay-
er’s only admissible evidence is the stipulated evidence that
15
Taxpayer introduced the travel log as part of a letter taxpayer sent to the
department’s auditor on November 10, 2016. The department objected to the let-
ter on the grounds that it was argumentative, assumed facts not in evidence, and
contained hearsay. The department’s objection to the travel log is overruled and
the travel log is admitted. Taxpayer testified that he produced the travel log. He
was also available at trial for cross-examination. The department’s objection to
the remainder of the letter in Exhibit 3, pages 1-7, is sustained. Taxpayer’s cor-
respondence with the department’s auditor is not relevant to this court’s de novo
proceeding. See ORS 305.425(1). As will be explained further, even if the court
were to consider taxpayer’s email, taxpayer’s evidence does not meet the higher
substantiation rules for travel expenses under IRC section 274(d).
16
The plane tickets submitted by taxpayer show that he traveled to the UAE
twice: from April 11 to May 13, 2013, and from August 7 to August 18, 2013.
Taxpayer submitted a third plane ticket showing a domestic flight from Portland,
Oregon, to Long Beach, California.
Cite as 24 OTR 1 (2020) 17
taxpayer paid his sisters by wire transfer and the copies
of the apartment lease and car purchase contract. For the
reasons explained, the court finds those records insufficient
under the higher substantiation requirements for lodging
and vehicle expenses in IRC section 274(d). See, e.g., Barmes
v. Comm’r, 12 F Appx 415, 418 (7th Cir 2001) (“[W]here the
taxpayer has failed to maintain adequate records, IRS reg-
ulations require a taxpayer to establish each element of the
deduction with a detailed personal statement corroborated
by other evidence.” (Internal citations omitted.)); Ghadiri-
Asli, 2019 WL 5423725 at *11 ([A] “taxpayer is not allowed a
deduction or credit on the basis of approximations or unsup-
ported testimony.”); Schladweiler v. Comm’r, 80 TCM (CCH)
681, 2000 WL 1690282 at *3 (US Tax Ct), aff’d, 28 F Appx
602 (8th Cir 2002) (“If a taxpayer does not substantiate the
travel expense as required by section 274(d), he is not enti-
tled to a deduction for the expense no matter how plausible
it may be that he paid the expense. For expenses covered
by section 274, the proposition is simple—a taxpayer who
cannot prove the expense loses the deduction.”). The court
concludes that taxpayer has not substantiated his expenses
for the apartment and vehicle rental in the UAE during
2013. The court denies taxpayer’s deduction for these travel
expenses.
E. Dune Buggy Expense
Taxpayer claimed a deduction for payment of $7,820
toward the cost of the Dune Buggy. The department chal-
lenged the deduction, claiming the Dune Buggy was inven-
tory, rather than a depreciable business asset, and that
its cost therefore was ineligible to be expensed under IRC
section 179.17
Section 167 of the Internal Revenue Code provides
that “a reasonable allowance for the exhaustion, wear and
tear, and obsolescence of property used in the trade or
17
The auditor disallowed the deduction based on evidence showing that
taxpayer used the Dune Buggy as inventory during 2013. At conference, how-
ever, the department asserted a different reason, stating “it is not reasonable to
buy such an expensive item for the primary purpose of advertising the item for
resale” and declaring that the Dune Buggy was not “an ordinary and necessary”
expense. The department did not assert the “ordinary and necessary” argument
at trial.
18 Khalaf v. Dept. of Rev.
business or of property held by the taxpayer for the produc-
tion of income shall be allowed as a depreciation deduction.”
IRC § 167(a); see Treas Reg § 1.167(a) - 1(a); see also Chapin
v. Dept. of Rev., 5 OTR 571, 574 (1974) (“The allowance of
depreciation for income tax purposes is intended to provide
a nontaxable fund to restore property used in producing
income at the end of the useful life, when its capacity to pro-
duce income has ceased.”). The type of property considered
depreciable generally includes assets used in a taxpayer’s
business that gradually wear out or become obsolete during
business use, such as manufacturing equipment, buildings,
office equipment, or vehicles used to transport employees for
business purposes. See, e.g., Hewlett-Packard Co. v. US, 71
F3d 398 (Fed Cir 1995) (holding that “rotable parts” used in
servicing customer computers are depreciable property, not
inventory). In recent years, as an economic stimulus tool,
Congress has, within limits, allowed taxpayers to deduct
the entire cost of certain depreciable business assets as an
expense in the taxable year in which the business asset is
placed into service in the taxpayer’s trade or business. IRC
§ 179(a). Taxpayer claimed the Dune Buggy payment of
$7,820 as such a “Section 179” expense for 2013.18
Critically, a taxpayer is not allowed to claim
depreciation deductions (or a Section 179 expense deduc-
tion) for property that is “inventory.”19 Federal courts have
defined “inventory” to mean “property that is held for sale.”
Galedrige Const., Inc. v. Comm’r, 73 TCM (CCH) 2838, 1997
WL 269574 at *8 (US Tax Ct) (citation omitted). When
determining whether a vehicle owned by a taxpayer is non-
depreciable inventory, or whether it is a depreciable business
18
As with travel expenses, the heightened substantiation requirements
under IRC section 274(d) also apply to depreciation or Section 179 deductions for
“listed property,” including all-terrain vehicles. See Singh v. Comm’r, 97 TCM
(CCH) 1146, 2009 WL 349745 at *1 (US Tax Ct) (considering “listed property”
requirements with respect to an applicable IRC section 179 deduction); see also
Benavides & Co., P.C. v. Comm’r, 118 TCM (CCH) 221, 2019 WL 4257012 at *9
(US Tax Ct) (taxpayer’s use of an all-terrain vehicle is “listed property” subject
to heightened substantiation requirements under IRC section 274(d) and IRC
section 280F(d)(4)(A)(iii)).
19
Section 1.167(a)-2 of the federal Treasury Regulations, which the depart-
ment asserts applies to taxpayer’s purchase of the Dune Buggy, provides that
no depreciation deduction may be taken with respect to “inventories” or stock in
trade.
Cite as 24 OTR 1 (2020) 19
asset, “it is not the nature of the property itself which is
determinative but rather the purpose for which the prop-
erty is held.” Latimer-Looney Chevrolet, Inc. v. Comm’r, 19
TC 120, 125 (1952) (emphasis added). For example, cases
involving whether a car held by a car dealer is inventory
or a depreciable business asset depend on the specific
facts. In Latimer-Looney Chevrolet, the United States Tax
Court held that certain cars removed from inventory were
depreciable property because they were used as company
cars for 8,000 to 12,000 miles before being eventually sold.
Id. at 125-26. On the other hand, a dealer that temporar-
ily withdraws certain vehicles from its inventory to use as
“demonstration” vehicles meant to stimulate future sales
cannot then claim depreciation deductions on those vehi-
cles unless the evidence clearly shows that the vehicles were
used for a business purpose other than sale to customers.
See Rev Rul 75-538, 1975-2 C.B. 35 (1975) (so stating); see
also Duval Motor Co. v. Comm’r, 264 F2d 548 (5th Cir 1959),
aff’g 28 TC 42 (1957); Luhring Motor Co., 42 TC 732 (1964);
R. E. Moorhead & Son, Inc., 40 TC 704 (1963). Because
taxpayer bears the burden of proof here, it is taxpayer’s
responsibility to convince the court, by a preponderance
of evidence, that he used the Dune Buggy as a depreciable
business asset, such as for strictly business transportation
purposes, and that he did not merely keep it for “demonstra-
tion” purposes and eventual sale.
As noted above, taxpayer offered copies of invoices
from 2009 to 2012 as evidence of his long-standing business
practice of selling dune buggies to customers overseas.20
Taxpayer explained that, unlike his prior purchases, he
bought the Dune Buggy using funds he borrowed from a
20
Taxpayer also offered copies of emails he exchanged with Paul Vai, the
department’s auditor, during 2016. The department objected to these emails on
the grounds of hearsay and relevance. In response, taxpayer explained that he
intended to show that he had introduced “evidence during the time of that audit
that did not make it into the deficiency letter.” The court sustains the depart-
ment’s objection. Not only did taxpayer fail to take Vai’s testimony on this point
during trial (making the emails inadmissible as hearsay), the de novo nature of
this court’s proceedings renders irrelevant any dispute over documents Vai did
or did not review on audit. See ORS 305.425(1). Even if the court were to consider
these emails, the totality of the evidence presented by taxpayer, including Vai’s
testimony, shows taxpayer used the Dune Buggy as inventory and not a business
asset during 2013.
20 Khalaf v. Dept. of Rev.
lender unrelated to himself or to the customer and paid for
upgrades on it using his own money, not money wired to
him from any prospective purchaser in the UAE. Taxpayer
testified that he “kept the mileage low” on the Dune Buggy
because he intended to use it as a prototype and demon-
stration unit to stimulate future purchases of dune bug-
gies. Taxpayer also testified that after realizing customer
demand for the Dune Buggy as modified had decreased
due to seasonal trends specific to the dune buggy industry,
he attempted to sell the Dune Buggy.21 The court finds no
evidence in the record that taxpayer used the Dune Buggy
for any other purpose than to promote his business of locat-
ing dune buggies for customers in the UAE. Cf. Dehaai v.
Comm’r, 56 TCM (CCH) 1549, 1989 WL 26380 (US Tax
Ct) (concluding that taxpayer was entitled to depreciation
expense deductions on two items of equipment because tax-
payer held the equipment as prototypes meant to secure
investment funding from large manufacturers and not as
inventory for sale to customers). The fact that taxpayer
chose to keep the mileage low and then attempted to sell
the Dune Buggy also indicates that taxpayer did not use the
Dune Buggy as a depreciable business asset but rather as
property held for sale to customers in the ordinary course
of his business. See, e.g., Sovereign v. Comm’r, 281 F2d 830,
834-35 (7th Cir 1960) (“Temporary use of property in a busi-
ness [as depreciable property] does not prevent its classifi-
cation as primarily held for sale to customers in the course
of business.”). The court finds that taxpayer has not shown
he used the Dune Buggy as a business asset. The court con-
cludes that taxpayer is not entitled to expense his $7,820
payment for the Dune Buggy.22 Now, therefore,
21
Taxpayer’s testimony is consistent with Vai’s testimony that taxpayer had
told him the Dune Buggy was bought as a “floor model” and that taxpayer later
attempted to sell the Dune Buggy online.
22
As an alternative, taxpayer asserted that he is entitled to deduct his pay-
ment for the Dune Buggy as “the cost of developing a new product” under IRC sec-
tion 174. Subject to stringent requirements, IRC section 174(a) generally allows a
taxpayer to deduct specified research and development expenditures incurred in
a taxable year. On the record presented, there is no evidence that taxpayer’s pur-
chase of the Dune Buggy constitutes “research and experimental expenditures”
within the meaning of section 174(a) because taxpayer testified at length that he
bought the Dune Buggy for promotional purposes. See Treas Reg § 1.174-2(6) (defin-
ing “experimental expenditures” as expressly excluding “expenditures for * * *
(v) Advertising or promotions”). In addition, Treas Reg section 1.174-3(b) provides:
Cite as 24 OTR 1 (2020) 21
V. CONCLUSION
IT IS THE OPINION OF THIS COURT that
Plaintiff has established by a preponderance of the evidence
that he is entitled to a deduction of $1,000 for the cost of
the freight shipment and that he is also entitled to a $6,000
adjustment to COGS for the cost of the Supercharger; and
IT IS THE OPINION OF THIS COURT that
Defendant’s denial of Plaintiff’s deductions for the costs
of the apartment and vehicle rental in the UAE, and his
Section 179 deduction for payment on the Dune Buggy, is
correct.
Counsel for Defendant is directed to submit an
appropriate form of judgment.
“If the taxpayer fails to adopt the method [described in section 174(a)] for the first
taxable year in which he incurs such expenditures, (i.e. research and experimen-
tal) he cannot do so in subsequent taxable years unless he obtains the consent
of the Commissioner under section 174(a)(2)(B) * * *.” The court concludes that
taxpayer is not entitled to an expense deduction for research and product devel-
opment under IRC section 174.