Chong v. Comm'r ( 2007 )

T.C. Memo. 2007-12
UNITED STATES TAX COURT
YUNG AND ANITA F. CHONG, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 19581-04. Filed January 17, 2007.
Yung and Anita F. Chong, pro sese.
Rebecca Duewer-Grenville, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HOLMES, Judge: Yung Chong gave money to his brother to help
open a business in Beijing. He had another business in this
country, and he and his wife, Anita, claimed large deductions on
their 1998 tax return for losses from both. The Commissioner
disallowed almost all of them due to a near complete lack of
records. The Chongs blame this in part on a catastrophe suffered
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when a labor dispute at the Chong brothers’ store in Beijing
turned ugly--the store was ransacked and looted, and his brother
had to skedaddle out of China.
FINDINGS OF FACT
Yung Chong works full time as a driver for Federal Express,
but he has a strong entrepreneurial spirit that impels him to
seek out business opportunities. His brother, Lok Chong, shares
his spirit, and they began to collaborate in 1993 when Lok found
a market in China for leftover chicken parts and Yung found a way
to buy those chicken parts from large chicken producers in the
United States. The Chong brothers did quite well for several
years until those they called the “big boys” began selling
directly to China. The Chongs’ chicken parts business dried up
and a few years passed while Lok and Yung looked for a new
opportunity.
Lok, who is an Australian citizen, moved to Beijing in 1997
and spotted an opportunity to import Western food for the growing
expatriate population there. Lok took the leftover money from
the chicken venture, Yung supplied some additional capital,1 and
Gourmet Down Under was born. Gourmet Down Under specialized in
importing and distributing Australian dairy products, but also
sold American beef and even some authentic Mexican food. Lok
1
Available records do not show how much Yung Chong
contributed to the venture over the years, but the parties agreed
that he had contributed at least $88,500 by the end of 1998.
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opened his shop next to the U.S. embassy, and at first the store
did well. But then, in 1999, Lok discovered that several of his
employees were importing yogurt from France in direct competition
with Gourmet Down Under. Even worse, they were using company
facilities, storage, delivery trucks, and business contacts to do
so. Lok fired five employees. Unfortunately, he fired them
during Chinese New Year--which, as he credibly testified, is a
big taboo in Chinese culture.
Retribution was swift: the storefront was torched, the
office was ransacked, and the bank account was drained.
Everything was destroyed, including the business records. Lok
filed a police report with the Beijing Public Security Bureau,
but made no effort to reconstruct the store’s daily business
records from prior years. The only documentation from the 1998
tax year was a general profit and loss statement and a balance
sheet, both of which Lok sent to Yung in early 1999. There were
no records to support the revenue and expenses that Yung and his
wife reported on their 1998 return, or to prove Yung’s percentage
ownership of the business during the year. The only thing that
can be determined about Yung’s interest, and even that by
testimony alone, is that he owned one-third of the business by
the end of 1998.
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Back in the United States, Yung was working at his regular
full-time job as well as industriously developing ways to make
money on the side. The main focus of his efforts was NuSkin, a
multilevel marketing company. Yung acted as an independent
contractor for NuSkin, incurring various business expenses such
as gas, car maintenance and insurance, tolls, and business meals.
By his own testimony, Yung was very frugal in his day-to-day
expenses: he scheduled his business meetings to avoid paying
multiple tolls; he bought “a few” used cars rather than a new car
and got special deals from a mechanic when he needed those cars
repaired; and he treated his prospective clients to meals at only
inexpensive restaurants. Yung kept receipts for many of his
expenses but, as with Gourmet Down Under, he did not have the
sort of systematic records of income and expenses customarily
kept by businessmen.
In April 1999, Yung filed a joint tax return with his wife,
Anita. They did not use a professional preparer, and claimed
more than $40,000 in partnership losses and thousands more in
self-employment expenses. The effect on their tax bill was
dramatic--if allowed, the losses would completely eliminate their
combined taxable income. The Commissioner sent the Chongs a
notice of deficiency, denying each of the claimed deductions,
stating “it has not been established that the expenses were
incurred and paid during the taxable year.” The Commissioner
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also added a 20-percent penalty under section 6662(a)2 for
negligence or disregard of the rules and regulations or,
alternatively, for substantially understating the amount of
income tax due.
The Chongs were California residents when they petitioned
this Court, and there was a short trial in San Francisco.
OPINION
I. Partnership Loss
In early 1999, Lok Chong sent his brother a profit-and-loss
statement for Gourmet Down Under. Lok didn’t send a Schedule K-
1, nor did he provide any records to verify the business purpose
of the many expenses shown on the statement. This statement
showed a total partnership loss of over $120,000 for the year,
about $40,000 of which was attributed to Yung. Yung claimed his
loss on his Schedule C as an “other expense,” but has since
conceded that it should have been reported as a partnership loss
on Schedule E.
There are four questions which must be answered before we
can determine whether Yung was entitled to a partnership loss:
(1) did a partnership exist; (2) if there was a partnership, what
was Yung’s distributive share; (3) what was the partnership’s
2
All section references are to the Internal Revenue Code in
effect for 1998. Rule references are to the Tax Court Rules of
Practice and Procedure.
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total loss; and (4) how much of that loss, if any, can Yung
claim.
A. Did the partnership exist?
Section 761(a) defines a partnership to include
“unincorporated organization through or by means of which any
business, financial operation, or venture is carried on, and
which is not, within the meaning of this title, a corporation or
a trust or estate.”
The Commissioner concedes that the Chong brothers had a
partnership that began in 1993 when they started importing
chicken parts into China from the United States. We find that
the brothers continued to seek out new ventures for their China
enterprise even after the chicken parts business ended--and
because a partnership continues until “no part of any business,
financial operation, or venture of the partnership continues to
be carried on by any of its partners,” sec. 708(a) and (b)(1)(A),
Lok and Yung continued to be partners at least until 1999 when
Lok escaped the destruction of Gourmet Down Under. Exactly how
long the partnership continued after Gourmet Down Under cratered
doesn’t matter. The only relevant issue is whether the
partnership was valid and continuing at the end of the 1998 tax
year. We find that it was.
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B. What was Yung’s distributive share?
A distributive share is the portion of a partnership’s
income and losses which flows through to an individual partner.
Normally, each partner’s distributive share is set out in a
partnership agreement. Sec. 704(a). When a partnership
agreement is silent, each partner’s distributive share is
determined by his interest in the partnership. Sec. 704(b)(1).
A partner’s interest is determined by looking at “all facts and
circumstances relating to the economic arrangement of the
partners.” Sec. 1.704-1(b)(3)(i), Income Tax Regs. There is a
presumption that each partner has a per capita share in the
partnership, but this may be rebutted by facts and circumstances
showing a different arrangement. Id.
Based on the testimony of both Lok and Yung, and the profit
and loss statement for 1998, we find that Yung had a one-third
interest in the partnership at the end of 1998. However, it is
somewhat unclear whether he held a one-third interest for the
entire tax year, or just at the end. Yung testified that he
contributed $10,000 during 1998, but then in the answering brief
accepted respondent’s statement that he didn’t make any capital
contributions after 1995. A partner’s distributive share must
take into account the various partnership interests throughout
the year as well as the length of time each interest was held,
sec. 706(d), but we do not find Yung’s assertion that he made an
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additional contribution (unsupported by any check or money order
receipt) in 1998 to be credible. We therefore find that he had a
one-third interest in the partnership throughout the year.
C. What were the partnership’s total losses?
Just like individuals, partnerships must keep records to
support claims of income, deductions, credits, etc. See sec.
1.6001-1(a), Income Tax Regs. Such records must show a
sufficient business connection for any deductions. Gorman v.
Commissioner, T.C. Memo. 1986-344. When it is evident that there
were business-related expenses but the taxpayer is unable to
produce records, we do have the authority to estimate, Cohan v.
Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930), but have to
have something on which to base our estimate. Williams v. United
States, 245 F.2d 559, 560 (5th Cir. 1957). Section 274(d)
further limits our discretion by adding requirements for
substantiating certain kinds of expenses--a burden we can’t lift
by relying on the Cohan rule. Sanford v. Commissioner, 50 T.C.
823, 827-828 (1968), affd. per curiam 412 F.2d 201 (2d Cir.
1969).
This is a real problem for the Chongs, because Yung himself
had no first-hand knowledge of the partnership’s income and
expenses. And Lok’s bookkeeping was very informal--he admitted
that he fed his family by withdrawing inventory from the store,
and he failed to produce a single receipt, deposit slip, or check
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book in support of the summary profit-and-loss statement. Even
by the end of the trial, the only record that either brother
produced to prove any item of the partnership’s income and
expenses for the 1998 tax year remained that same profit-and-loss
statement. Lok claims, and we believe, that he paid Chinese
taxes on the partnership income, but Yung didn’t submit any
Chinese tax returns--or any other records for that matter--into
evidence.
We do find that the primary reason there is so little in the
way of documentation is that all the records were destroyed in
1999. The Chong brothers--particularly Lok, since he was the
onsite manager of Gourmet Down Under--should have tried to
salvage or reconstruct what records he could. See, e.g., Cox v.
Commissioner, T.C. Memo. 1980-244. This sort of “reasonable
reconstruction” is always a good practice, and it is required for
expenses (like the travel expenses that the partnership claimed)
subject to section 274's limitations. Sec. 1.274-5T(c)(5),
Temporary Income Tax Regs., 50 Fed. Reg. 46022 (Nov. 6, 1985);
see Seckel v. Commissioner, T.C. Memo. 1974-170. We have not
seen any evidence of any such reconstruction by either Yung or
Lok; we therefore are unable to apply such a defense to this
case. The lack of records--compounded by the absence of any
testimony by Lok about any specific items of income or loss--
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leads us to find that the partnership has not proven its actual
losses for the 1998 tax year.
D. How much of a loss, if any, can Yung claim?
Even if we could determine the partnership’s total losses,
Yung would still only be able to claim his share of such losses
to the extent of his adjusted basis. Sec. 704(d); Sennett v.
Commissioner, 80 T.C. 825 (1983), affd. 752 F.2d 428 (9th Cir.
1985). Adjusted basis is essentially the partner’s contribution
to the partnership increased by his distributive share of
partnership income and decreased by cash distributions and his
share of partnership losses. Sec. 705(a). A partner’s
distributive share of income or losses automatically flows
through to him. See sec. 702(a); sec. 1.702-1(a), Income Tax
Regs. But his adjusted basis can’t go below zero; if his
distributive share of partnership losses is greater than his
available adjusted basis, the excess loss can’t be claimed in
that year but must instead be carried forward until he once again
has adjusted basis available to offset the loss. See sec. 1.704-
1(d)(1), Income Tax Regs.
To determine Yung’s adjusted basis in the Chong brothers’
partnership at the end of 1998, we must know how much he
contributed to the partnership and his annual distributive share
of partnership income and/or losses since the partnership began.
Both Yung and Lok credibly testified that there had never been a
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cash distribution made to Yung, so we needn’t concern ourselves
with that portion of the adjusted basis equation. And the
Commissioner has conceded that Yung contributed at least $88,500
to the partnership since 1993. However, even if we take that as
a starting point to determine his adjusted basis, we have no
record of Yung’s distributive share of income or losses in the
partnership during the previous five years. A line item on the
1998 balance sheet shows “losses carried forward,” which implies
Yung was unable to claim prior losses due to a zero adjusted
basis. But the Court probed the Chong brothers on their
understanding of partnership tax law and finds that this item on
the statement is, more likely than not, Lok’s estimate of prior
losses that should have been claimed but weren’t.
It is simply impossible to state with any certainty what
Yung’s adjusted basis was. It is therefore impossible for us to
say how much of any potential loss Yung could have claimed in
1998. Because we are unable to determine how much loss Yung
could potentially have claimed, we sustain the Commissioner’s
disallowance of the partnership loss on this alternate ground as
well.
II. Schedule C Deductions
In addition to full-time employment and his interest in the
partnership with his brother, Yung also pursued a multilevel
marketing business with NuSkin. He reported this business on his
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1998 Schedule C, and it showed nearly $10,000 in income that was
almost entirely offset by expenses. We agree with Yung that it
“is just common sense” that he would incur expenses in earning an
income from his side business. And the Commissioner doesn’t
dispute many of Yung’s expenses--he disallowed only those
deductions that are subject to the limitations of section
274(d).3
To claim a deduction for any item described in section
274(d), a taxpayer must substantiate his deduction with “adequate
records,” such as a logbook or diary, or “sufficient evidence
corroborating the taxpayer’s own statement,” such as the
statement of the person(s) entertained. Sec. 274(d); sec. 1.274-
5T(c)(2)(i) and (3)(i), Temporary Income Tax Regs., 50 Fed. Red.
46017, 46020 (Nov. 6, 1985). These substantiation records must
explain: (A) the amount of the expense; (B) the time and place
the expense was incurred; (C) the business purpose of the
expense; and, where applicable, (D) the business relationship to
the taxpayer of the person(s) entertained. Sec. 274(d). Yung
didn’t meet these standards for any of the disallowed deductions-
-not even breaking down any of his categories of expense into
3
These include the deductions for repair and maintenance on
Yung’s cars: Section 1.274-5T(b)(6)(i)(A), Temporary Income Tax
Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985), specifically lists “the
cost of maintenance and repairs” as one of the “expenditure[s]
with respect to an item of listed property” covered by section
274(d)(4).
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individual items. He is therefore not entitled to the disputed
Schedule C deductions.
III. Penalty Under Section 6662(a)
The final issue is whether the Chongs are liable for a 20-
percent accuracy-related penalty under section 6662(a) for
neglecting or disregarding the tax rules and regulations, or for
substantially understating their income tax. The Chongs have the
burden of proving that the Commissioner’s imposition of this
penalty was in error. See Rule 142(a). They can do this by
showing that, under all the facts and circumstances, they acted
with reasonable cause and in good faith. Sec. 6664(c)(1); sec.
1.6664-4(b)(1), Income Tax Regs.
With regard to the partnership loss, we find that the Chongs
did have reasonable cause to claim the loss and acted in good
faith. Partnership tax law is a deceptively complex area. A
reasonable and prudent person with their background and
experience wouldn’t necessarily know to ask about such things as
adjusted basis and distributive shares. In fact, if such a
person received a balance sheet and profit-and-loss statement
like Yung did, it is much more likely that he would rely on the
totals provided in those papers. This is especially true in this
case, where Lok was a trained accountant (albeit not one trained
in U.S. accounting rules) who was in control of all the
partnership’s records.
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On the other hand, we find that the Chongs did not act
reasonably and prudently in taking the disallowed Schedule C
deductions. Section 274(d)’s substantiation rules are not
complex, nor are they so little known as to be a trap for the
average taxpayer. The Chongs could have done any number of
things to discover what was needed to claim the business
deductions. They could have contacted a professional tax
preparer or, if they didn’t want to spend money on professional
assistance, they could have contacted the IRS directly for
advice. The IRS annually publishes an up-to-date version of
Publication 463--Travel, Entertainment, Gift, and Car Expenses.
This publication outlines in detail the various business expense
deductions which are available and the records required to
substantiate them. The fact that Yung didn’t try to keep any
sort of ledger or even keep all of his receipts re-enforces our
conclusion that the Chongs did not act reasonably. We find that
the Chongs were negligent, and disregarded the rules and
regulations, in claiming their disallowed Schedule C deductions.
CONCLUSION
The Chongs are not entitled to their claimed deductions for
either the partnership loss or the Schedule C business expenses,
and the Commissioner was correct in imposing an accuracy-related
penalty under section 6662(a) for their disallowed Schedule C
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deductions. However, the Chongs are not liable for a penalty
under that section for claiming a partnership loss.
Decision will be entered
under Rule 155.