Hennessey v. Comm'r , 93 T.C.M. 1259 ( 2007 )

T.C. Memo. 2007-131
UNITED STATES TAX COURT
GERARD AND AUDREY KATHLEEN HENNESSEY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1032-01. Filed May 24, 2007.
W. Thomas Finley, Tammy S. Wood, and M. Seth Sosolik,
for petitioners.
Kathryn F. Patterson, Abbey B. Garber, and Adam L. Flick,
for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
NIMS, Judge: This matter is before the Court on
petitioners’ motion for award of reasonable administrative and
litigation costs, filed pursuant to section 7430 and Rules 230
through 233, and request for a hearing. Unless otherwise
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indicated, section references are to sections of the Internal
Revenue Code in effect at all relevant times hereunder.
References to section 7430 are to the version of that section in
effect at the time the petition was filed. However, costs
incurred on or before January 18, 1999, are subject to section
7430 as amended by the Taxpayer Relief Act of 1997, Pub. L. 105-
34, secs. 1285, 1453, 111 Stat. 1038, 1055. Costs incurred after
January 18, 1999, are subject to section 7430 as amended by the
Internal Revenue Service Restructuring and Reform Act of 1998
(RRA 1998), Pub. L. 105-206, sec. 3101, 112 Stat. 727.
Rule references are to the Tax Court Rules of Practice and
Procedure.
Pursuant to section 7443A and Rules 180 and 183, this matter
was assigned to and heard by Special Trial Judge Lewis R.
Carluzzo. His recommended findings of fact and conclusions of
law were filed and served upon the parties by Order of July 5,
2005.
By the abovementioned Order, the parties were also given
until August 31, 2005, to make specific written objections to the
Special Trial Judge’s recommended findings of fact and
conclusions of law. In response thereto, respondent filed a
timely Notice of No Objection. Petitioners timely filed 26 pages
of Objections to Recommendations (Objections).
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Rule 183(d) provides that due regard shall be given to the
circumstance that the Special Trial Judge had the opportunity to
evaluate the credibility of witnesses, and the findings of fact
recommended by the Special Trial Judge shall be presumed to be
correct.
We have duly considered petitioners’ Objections and are not
convinced thereby that the Special Trial Judge’s meticulous and
exhaustive recommendations are in any substantive way incorrect
or incomplete. We therefore conclude that they should be adopted
as the report of the Court. We have made no changes to the
recommended findings of fact and conclusions of law, except to
relocate a footnote into the text and renumber the remaining
footnotes, change several headings, insert an explanatory
parenthetical sentence, and modify certain introductory
provisions. The recommended findings of fact and conclusions of
law of Special Trial Judge Lewis R. Carluzzo, as so modified, are
hereinafter set forth as the report of the Court.
After concessions by respondent,1 the issues for decision
are as follows: (1) Whether respondent’s positions in the
administrative and court proceedings are substantially justified;
(2) whether petitioners unreasonably protracted the
1
Respondent concedes that petitioners: (1) Exhausted their
administrative remedies, see sec. 7430(b)(1); (2) substantially
prevailed, see sec. 7430(c)(4)(A)(i); and (3) satisfy the
applicable net worth requirement, see sec. 7430(c)(4)(A)(ii).
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administrative and court proceedings; and (3) whether the
administrative and litigation costs claimed by petitioners are
reasonable.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
Petitioners are husband and wife. They resided in Richardson,
Texas, at the time that the petition was filed in this case.
References to petitioner are to Audrey Kathleen Hennessey.
In 1982, petitioners formed Beacon Telephone Systems,
Inc. (Beacon), a Texas corporation that was an S corporation
for all years relevant here. See secs. 1361(a) and 1362.
Petitioners have been the sole shareholders of Beacon since its
incorporation. According to petitioners, Beacon’s business
involves the manufacture and installation of telephone systems
that control building access. During the years in issue,
Beacon’s clients were located in Lubbock, Texas.
Petitioner was a professor at Texas Tech University (the
University) in Lubbock, Texas, during all periods relevant here.
During her 19-year tenure at the University, petitioner directed
research at the University’s Institute for Studies in
Organizational Automation (the Institute).
In 1982, petitioner started an unincorporated consulting
business, Industrial Scientific & Office Automation (ISOA
Consulting), which shared the same acronym as the Institute.
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In 1994, petitioner and Dr. Youling Lin (also a professor at
the University) formed ISOA, Inc., a Texas corporation that was
also an S corporation for some of the years in issue. Petitioner
and Dr. Youling Lin each owned 50 percent of ISOA, Inc.
Initially, ISOA, Inc., conducted business in Lubbock, Texas. In
1995, ISOA, Inc., moved the corporation’s business operations to
Richardson, Texas. In addition to ISOA, Inc., petitioner
continued to operate ISOA Consulting.
As part of an arrangement with the University, ISOA, Inc.,
licensed intellectual property developed at the Institute to
various third-party entities. In turn, ISOA, Inc., distributed a
portion of the licensing fees received to the University and to
student-inventors as royalty payments. In October 1996, ISOA,
Inc., entered into a final royalty fee agreement with the
University as to the distribution of the licensing fees received
by ISOA, Inc. The licensing agreement between ISOA, Inc., and
the University provided that ISOA, Inc., would retain 30 percent
of the net licensing fees received, the University would receive
15 percent, student-inventors would receive 50 percent, and a
corporate co-inventor would receive 5 percent. Additionally, per
the terms of the licensing agreement, ISOA, Inc., could be
obligated to refund any licensing fees to the third party if the
patents were not approved for the licensed intellectual property.
ISOA, Inc., used amounts from the licensing fees to pay various
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expenses (for example, the cost of filing a patent application)
before any royalties were paid.
According to petitioner, she typically traveled on
approximately 150 trips per year as part of her duties with the
University, ISOA Consulting, and ISOA, Inc. She testified that
University professors could be reimbursed for employment-related
travel expenses only to the extent of $1,000 per year.2 Grants
obtained by petitioner on behalf of the University also provided
for some paid travel expenses. According to petitioner, any
remaining travel expenses were paid by petitioners.
The University’s policy required that petitioner provide an
expense report for each trip regardless of whether her travel
expenses were ultimately reimbursed. According to petitioner:
(1) Original travel receipts were attached to the expense reports
submitted to the University; (2) a travel reimbursement check
from the University was usually received within 5 or 6 months
after submitting an expense report; and (3) the reimbursement
check did not always identify the specific travel expenses for
which petitioner was being reimbursed. Petitioner did not keep
records of what travel was reimbursed by the University, nor did
2
This testimony appears to be inconsistent with the
reimbursement evidence from the University, as well as the
amounts reported by petitioners as reimbursements on their tax
returns and “general ledgers”.
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petitioner reconcile the amounts actually reimbursed by the
University with the amounts submitted on the expense reports.
Petitioner also claimed to have paid the travel expenses of
students not employed by the University who provided assistance
on her trips. Petitioner included the students’ travel expenses
on her expense reports submitted to the University.3 According
to petitioners, Mr. Hennessey often accompanied petitioner on her
business trips. For instance, Mr. Hennessey accompanied
petitioner on her claimed business trips to the United Kingdom,
Singapore, Brazil, and Italy. Petitioners testified that they
would often conduct business related to the University, ISOA
Consulting, Beacon, and/or ISOA, Inc., on a single trip.
Petitioners’ claimed business travels also included personal
pleasure, for example a trip to their son’s wedding in Maryland
and to petitioner’s mother in Alaska.
According to petitioners, many of their air travel expenses
were paid with discounted tickets provided by their daughter, an
airline employee. Additionally, petitioners claimed to have
received significant discounts on car rentals and hotels.
Petitioners testified that they either repaid their daughter in
3
In addition, petitioner claimed to have often advanced the
travel expenses of students employed by the University who
traveled with her. These expenses were submitted to the
University, and the reimbursement checks were endorsed by the
students to petitioner. In addition, petitioner also testified
that such reimbursements by the University could take “up to a
year or a year and a half”.
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cash or paid her various expenses.4 Petitioners did not maintain
any receipts or other documentary evidence with respect to the
amounts paid to, or on behalf of, their daughter.
I. Federal Income Tax Returns
A. Petitioners’ Individual Tax Returns
Some time prior to the end of 1993, petitioners sent to the
Internal Revenue Service (IRS) a joint Form 1040, U.S. Individual
Income Tax Return, for 1992. That document had “Estimated”
written on the top of the first page (1992 “Estimated” return).
Petitioners testified that they prepared and sent the 1992
“Estimated” return in that manner because they were not in
possession of all their supporting documents and therefore were
not able to determine the exact amounts to be reported on the
return.
On or about August 12, 1994, petitioners sent to the IRS an
unsigned Form 1040 for the 1993 taxable year. Petitioners had
written “Estimated” on the top of the first page of the unsigned
1993 return (1993 “Estimated” return). The 1993 “Estimated”
return did not have any attached schedules or forms.
Petitioners claimed that they were unable to file a final
tax return for either 1992 or 1993 prior to the end of 1994 due
to time restraints from their various work responsibilities,
4
For example, on their 1994 return, petitioners deducted
$17,874 for payments made to, or on behalf of, their daughter.
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which included the incorporation of ISOA, Inc., and petitioner’s
competing work and travel demands, as well as a family crisis.
On December 18, 1994, after being contacted by the IRS,
petitioners sent a reply letter to the IRS which stated that
they planned to have their 1992 and 1993 returns completed by
January 15, 1995. Petitioners testified that their work
responsibilities, as well as personal concerns, prevented them
from completing their 1992 and 1993 returns by their self-imposed
January 15, 1995, deadline.
On or about March 1, 1995, respondent received a second Form
1040 for the 1992 taxable year which again had “Estimated”
written on the top of the first page.
On or about October 1, 1996, petitioners submitted an
unsigned Form 1040 to the IRS for the taxable year 1993 (1993
unsigned return).
On December 30, 1996, petitioners filed a Form 1040 for the
1993 taxable year (1993 return). On the 1993 return, among other
items, petitioners: (1) Reported a net operating loss (NOL)
carryforward deduction from 1992 of $18,347; (2) claimed a
deduction for travel expenses of $13,016 on Form 2106, Employee
Business Expenses; and (3) deducted $17,293 of travel expenses on
the Schedule C, Profit or Loss From Business, for ISOA
Consulting.
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On or about March 1, 1997, petitioners submitted an
additional Form 1040 to the IRS for the 1993 taxable year with
“Amended” written on the first page, as well as on several of the
pages attached to the return (1993 “Amended” return).
Petitioners reported a deduction for travel expenses of $29,978
on Form 2106. Petitioners also deducted $21,594 for travel
expenses on the Schedule C for ISOA Consulting.
Petitioners reported adjusted gross income on the four 1993
returns submitted to the IRS as follows:
Adjusted
Return gross income
1993 “Estimated” return $54,300
1993 Unsigned return 68,349
1993 Return 32,937
1993 “Amended” return 19,442
With the exception of the 1993 “Estimated” return which had no
schedules or forms attached, each of the 1993 tax returns sent by
petitioners to the IRS had double deducted expenses such as
mortgage interest and real estate taxes.
On the Schedules C for ISOA Consulting, which were attached
to the 1993 returns, petitioners reported the following amounts:5
1993 1993 1993
“Unsigned” return Filed return “Amended” return
Gross Income $27,953 $17,936 $9,576
Total Expenses (35,659) (40,707) (46,674)
Net Loss (7,706) (22,771) (37,098)
5
There was no Schedule C attached to the 1993 “Estimated”
return.
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On December 30, 1996, petitioners filed with the IRS a Form
1040 for the 1994 taxable year (1994 return). On the 1994
return, petitioners reported negative adjusted gross income of
$11,364 and an NOL carryforward of $51,284. Petitioners reported
deductions for travel expenses of $9,258 and $24,847 on Form 2106
and Schedule C, respectively. On the Schedule C for ISOA
Consulting, petitioners included “Royalties paid” of $46,200 as
part of the cost of goods sold. Petitioners also claimed
multiple deductions for some of the same expenses on the 1994
return.
In August 1997, petitioners sent to the IRS a second Form
1040 for the taxable year 1994 with the word “Revised” written at
the top of the first page, as well as on several attached pages
(1994 “Revised” return). On the 1994 “Revised” return,
petitioners reported deductions for travel expenses of $5,101 and
$29,533 on Form 2106 and Schedule C, respectively.
On the Schedules C for ISOA Consulting attached to the 1994
returns sent to respondent, petitioners reported the following
amounts:
1994 1994
Return1 “Revised” return
Gross income ($2,692) $13,055
Total expenses (42,272) (34,939)
2
Net loss (44,964) (20,344)
1 As noted by petitioners on both the Schedule C and Schedule E, Supplemental Income
and Loss, attached to the 1994 return, these amounts included petitioners’ portion
of the gross receipts and expenses from ISOA, Inc.
2 This amount is a mathematical error and should have been $21,884.
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On December 30, 1996, petitioners filed with the IRS a Form
1040 for the 1995 taxable year (1995 return). On the 1995
return, petitioners reported adjusted gross income of $25,439 and
an NOL carryforward of $50,132. Petitioners claimed deductions
for travel expenses of $9,428 and $21,565 on Form 2106 and
Schedule C, respectively. Petitioners again claimed multiple
deductions for some of the same expenses.
On or about March 14, 1997, respondent received a second
Form 1040 from petitioners for the taxable year 1995 with
“Amended” written at the top of the first page (1995 “Amended”
return). On the 1995 “Amended” return, petitioners reported
adjusted gross income of $6,395. Petitioners also reported
deductions for travel expenses of $14,586 on both the Form 2106
and Schedule C.
On or about August 18, 1997, respondent received a Form 1040
from petitioners for the 1996 taxable year. On the 1996 return,
petitioners reported adjusted gross income of $16,529 and an NOL
carryforward of $36,157. On a Schedule A, Itemized Deductions,
petitioners claimed a deduction for “Job travel: accom. in
Dallas” in the amount of $59,479. Petitioners also claimed a
deduction for travel expenses on Form 2106 of $36,714. On the
Schedule C for ISOA Consulting attached to the 1996 return,
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petitioners reported gross income of $38,220 and total expenses
of $38,220. On the 1996 return, petitioners claimed multiple
deductions for some of the same expenses.
B. Beacon’s Tax Returns
On or about August 12, 1994, Beacon submitted an “Estimated”
Form 1120S, U.S. Income Tax Return for an S Corporation, for the
taxable year 1993 (Beacon’s 1993 “Estimated” return) along with
petitioners’ 1993 “Estimated” return. Beacon’s 1993 “Estimated”
return reflected that Beacon was on the cash receipts and
disbursements method of accounting (cash basis) for Federal
income tax purposes.6
On or about March 4, 1997, Beacon filed with the IRS a
second Form 1120S for the taxable year 1993 (Beacon’s 1993
return). Beacon’s 1993 return reported total income and total
deductions of $13,691 and $24,248, respectively, for a loss of
$10,557. Beacon’s total deductions included travel expenses of
$13,717.
Along with petitioners’ 1994 “Estimated” return, Beacon
submitted for the taxable year 1994 a Form 1120S with “Estimated”
written on the top of the first page (Beacon’s 1994 “Estimated”
return). Beacon’s 1994 “Estimated” return reported total income
and total deductions of $5,000 and $2,710, respectively.
6
At all relevant times during the years in issue, Beacon
used the cash basis method of accounting for Federal income tax
purposes.
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On or about June 30, 1997, Beacon submitted a second Form
1120S for the taxable year 1994 with “Amended” written on the top
of the first page (Beacon’s 1994 “Amended” return). On Beacon’s
1994 “Amended” return, Beacon reported total income and total
deductions of $4,936 and $17,760, respectively, for a loss of
$12,824. The total deductions included travel expenses of
$9,887.
On or about March 14, 1997, Beacon submitted a 1995 Form
1120S with “Amended” written on the top of the first page
(Beacon’s 1995 “Amended” return).7 On Beacon’s 1995 “Amended”
return, Beacon reported total income and total deductions of
$6,454 and $14,870, respectively, for a loss of $8,416. The
total deductions for 1995 included travel expenses of $5,615.
Beacon filed a Form 1120S for the taxable year 1996. On the
1996 Form 1120S, Beacon reported total income and total
deductions of $10,564 and $12,540, respectively, for a loss of
$1,976. For 1996, Beacon deducted travel expenses of $6,572.
C. ISOA, Inc.’s Tax Returns
On or about July 10, 1995, respondent received ISOA, Inc.’s
Form 1120S for the 1994 taxable year (ISOA, Inc.’s 1994 return).
ISOA, Inc.’s 1994 return was prepared on the cash basis method of
accounting. ISOA, Inc., reported gross profit of $18,749 and
7
Based on the record, there is no indication that Beacon
submitted any other 1995 return prior to Beacon’s 1995 “Amended”
return.
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total deductions of $10,384 for 1994. ISOA, Inc.’s total
deductions included travel expenses of $8,228.
On or about September 23, 1996, respondent received a 1995
Form 1120S (ISOA, Inc.’s 1995 return) prepared by Edward Chui
(Mr. Chui), the corporation’s certified public accountant. ISOA,
Inc.’s 1995 return was prepared on the cash basis method of
accounting. The 1995 Form 1120S reported total income of
$191,383 and total deductions of $170,679, for ordinary income of
$20,704. Deductions included “Royalties Paid To Investors” of
$104,860 and travel expenses of $21,069. On a balance sheet
attached to ISOA, Inc.’s 1995 return, the corporation listed
“Advances From Others” of $195,000 under “Other Current
Liabilities”. On the Statement of Assets, Liability & Equity for
the taxable year ending December 31, 1995, ISOA Inc. also
reported a current liability for “Unearned Income (Escrow)” of
$195,000.
On August 16, 1996, ISOA, Inc., terminated its S corporation
election and was thereafter a C corporation.
On or about September 13, 1996, respondent received an
amended 1994 Form 1120S for ISOA, Inc., for the taxable period
beginning August 18, 1994, and ending December 31, 1994, (ISOA
Inc.’s 1994 amended return) prepared by Mr. Chui. ISOA, Inc.’s
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1994 amended return was prepared on the cash basis method of
accounting. ISOA, Inc.’s 1994 amended Form 1120S reflected
ordinary income of $12,894.
On or about March 19, 1997, respondent received from ISOA,
Inc., a Form 1120S for the taxable year beginning January 1,
1996, and ending August 15, 1996. ISOA, Inc.’s 1996 return was
prepared on the cash basis method of accounting. ISOA, Inc.’s
1996 Form 1120S reported taxable income of zero and total
deductions of $69,937, for a loss of $69,937. The total
deductions included travel expenses of $22,856.
On or about March 19, 1997, respondent received ISOA, Inc.’s
Form 1120, U.S. Corporation Income Tax Return, for the taxable
year beginning August 16, 1996, and ending December 31, 1996.
The 1996 Form 1120 reflected that the return was prepared on the
accrual method of accounting. On the 1996 Form 1120, ISOA, Inc.,
reported total income of $446,454 and total deductions of
$482,825, for a loss of $36,371. On the balance sheet attached
to the Form 1120, ISOA, Inc., listed under “Other Current
Liabilities” ending balances for “Royalty Payable” and “Deferred
And Unearned Income” of $185,500 and $195,000, respectively.
II. Respondent’s Examinations
On June 12, 1996, respondent notified petitioners by letter
that their 1992 individual tax return had been selected for
examination in respondent’s Lubbock office. Revenue Agent Susan
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Sutton (Agent Sutton) was responsible for the examination of
petitioners’ 1992 taxable year. As part of the initial
examination for 1992, Agent Sutton requested that petitioners
provide, among other items, their 1991 through 1993 tax returns.
Respondent also scheduled an appointment in August to meet with
petitioners and discuss the examination.
Petitioners engaged Carolyn Stephenson (Ms. Stephenson), a
certified public accountant, to represent them during their
examination. Ms. Stephenson did not prepare petitioners’ 1992
return, nor did she request to see petitioners’ 1992 return.
In their initial discussion Ms. Stephenson advised Agent
Sutton that some of petitioners’ documents had been lost or
misplaced. Agent Sutton allowed petitioners until August 21,
1996, to gather the documents originally requested.
On July 9, 1996, Agent Sutton issued to petitioners an
Information Document Request (IDR) which requested, in part, that
petitioners provide by August 21, 1996, their individual tax
returns for the 1991 through 1995 taxable years, as well as
Beacon’s tax returns for the taxable years 1991 through 1995. In
addition, the IDR requested “books, records, invoices, receipts,
statements, and any other data to verify” income and expenses
with respect to petitioners’ 1992 tax year. At petitioners’
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request for additional time to gather the documentation, Agent
Sutton extended the time for petitioners’ response to October 1,
1996.
On or about October 1, 1996, petitioners provided Ms.
Stephenson with a box of documentation related to petitioners’
travel activities. This documentation also included petitioners’
1992 return.
On October 1, 1996, Ms. Stephenson met with Agent Sutton and
provided her some documents, including bank statements and charge
card statements, to review with respect to petitioners’ 1992
taxable year. Ms. Stephenson also informed Agent Sutton that
petitioners had been unable to collect some of the requested
documents, including travel receipts and reimbursement
documentation from the University. The meeting between Ms.
Stephenson and Agent Sutton lasted approximately 1 hour.
On October 3, 1996, Agent Sutton issued an IDR which
requested, in part, the “items requested in the original
appointment letter that has [sic] not yet been provided.” The
IDR also requested, in part, all tax returns from petitioners and
Beacon for the taxable years 1991 through 1995 and ISOA, Inc.,
for the taxable years since its incorporation. In addition,
Agent Sutton requested supporting documentation with respect to a
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number of petitioners’ claimed expenses. Ms. Stephenson notified
Agent Sutton that the requested information would be provided by
the middle of November.
On November 15, 1996, Agent Sutton issued an IDR and
requested, among other items, substantiation of the income and
expenses with respect to petitioners’ 1993 through 1995 taxable
years, Beacon’s 1992 through 1995 taxable years, and “any other
entities which [petitioners] control or own” for the taxable
years 1992 through 1995. The IDR requested that this information
be provided by December 5, 1996.
In December 1996, Agent Sutton spent 2 days at Ms.
Stephenson’s office reviewing the documentation made available by
petitioners. On December 30, 1996, during respondent’s
examination, petitioners filed the 1993 return, 1994 return, and
1995 return.
On January 2, 1997, respondent notified petitioners by
letter that their individual returns for the taxable years 1993
through 1995 were also under examination, as well as Beacon’s tax
returns for the 1992 through 1995 taxable years and ISOA Inc.’s
tax returns for the 1994 and 1995 taxable years.
By letter dated January 17, 1997, petitioners requested that
the examination of the taxable years 1993 through 1995 be
transferred to respondent’s Dallas, Texas, office.
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On January 23, 1997, Agent Sutton issued an IDR which again
requested, in part, copies of Beacon’s and ISOA, Inc.’s tax
returns for the taxable years in issue, as well as the general
ledgers which support all of the tax returns under examination.
Petitioners requested additional time to comply with the IDR
because of the large volume of documents in petitioners’
possession and the need to review each adjustment on their
“general ledgers”. On February 20, 1997, petitioners requested
additional time in order to reconstruct some records and to put
the 1994 and 1995 taxable years in a general ledger format.
Additionally, Ms. Stephenson notified Agent Sutton and claimed
that during this time petitioner’s work demands were also
“overwhelming to her.”
By letter dated February 10, 1997, respondent denied
petitioners’ request to transfer the examination to respondent’s
Dallas, Texas, office.
On March 10, 1997, Agent Sutton received from petitioner
what have been referred to by petitioners as “general ledgers”.
On March 14, 1997, Agent Sutton received revised general ledgers
for 1994 and 1995. (We have not undertaken to evaluate the so-
called general ledgers as to whether they fall within a normal
definition of “general ledger”. See Webster’s Third New
International Dictionary (1986), which defines general ledger as
follows: “the principal and controlling ledger of a business
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enterprise containing individual or controlling accounts for all
assets, liabilities, net worth items, revenue, and expenses”.)
The general ledgers provided to Agent Sutton list dates, amounts,
and types of expenses, but generally did not identify the
business purpose of the listed expense or provide any supporting
documentation. Petitioners provided Agent Sutton with revised
versions of the general ledgers several times as petitioners
continued to sort through their information. Additionally,
petitioners claimed that they were unable to provide supporting
documentation to Agent Sutton along with the “general ledgers”
because this information was located in Dallas. Ms. Stephenson
added that any such documents by themselves would not have been
helpful without input from petitioner, whom she claimed was busy
with work and travel at this time.
The examination of petitioners’ “general ledgers” raised
additional concerns with Agent Sutton. Many of the amounts on
the “general ledgers” provided by petitioners did not reconcile
to corresponding deductions on any of the numerous tax returns
provided by petitioners during the examination. Ms. Stephenson
noted that even with the final amounts on the “general ledgers”,
Agent Sutton might not “find the exact number on the tax return.”
In addition, some expenses listed on the “general ledgers”
included amounts which had been reimbursed by the University.
For example, one “general ledger” indicated that the
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reimbursements from the University to petitioner had been equally
split between petitioner’s employee business expenses at the
University and ISOA, Inc. Additionally, the amount of
petitioner’s travel expenses at the University on a general
ledger for 1993 did not equal the travel expenses claimed on the
1993 Form 2106. The “general ledgers” also indicated that
petitioners often claimed per diem expenses as well as hotel and
meal expenses for the same travel. There were also personal
expenses, including women’s clothing and car rental expenses for
petitioners’ son, which were included on the “general ledgers”
and deducted by petitioners on their tax returns under
examination.
During the examination, Agent Sutton was also provided with
a draft audit report prepared by the University. The draft audit
report raised questions regarding irregularities with respect to
petitioner’s expense reimbursements from the University.
On May 29, 1997, after examining the information provided to
that date, Agent Sutton issued an IDR to petitioners with more
than 300 questions and document requests. This again included,
in part, requests for substantiation for the claimed business
expense deductions, as well as an explanation of the $195,000 of
“Advances From Others” with respect to ISOA, Inc.’s 1995 return.8
8
Throughout the proceeding, the parties refer to this as
the “deferred income” issue. We do likewise.
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In a June 3, 1997, letter to Agent Sutton, Ms. Stephenson
requested that a sampling technique be used with respect to the
requested documents since petitioners would have to review over
24,000 documents in response to the latest IDR. Agent Sutton
denied petitioners’ request to sample the expenses listed on the
returns and the related substantiation because there were too
many discrepancies in the returns and submitted documentation to
warrant sampling petitioners’ records. However, Agent Sutton
informed Ms. Stephenson that petitioners should provide only the
information and documentation that was possible without
disrupting their professional lives or spending excessive sums of
money.
On June 30, 1997, petitioners sent their response to the
latest IDR to Agent Sutton. For example, petitioners’ response
to a request for hotel receipts was “Samples are attached”.
However, respondent did not receive any such receipts attached to
the IDR. In describing the $195,000 of licensing fees received
by ISOA, Inc., in 1995 but not reported in the corporation’s
taxable income, petitioners stated that this amount was “held
for $1.5 million buyout of intellectual property from [the
University] within 5 years. Funds can be used to offset approved
costs of licensing intellectual property per [ISOA, Inc./the
University] agreement. [ISOA, Inc.] must show reasonable progress
each year toward accumulation of the $1.5 million”.
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On August 25, 1997, Agent Sutton prepared and sent a
Referral Report of Potential Criminal Fraud Cases to the Criminal
Investigation Division (CID) of the IRS with respect to
petitioners, Beacon, and ISOA, Inc., for the taxable years under
examination (the criminal fraud referral). The criminal fraud
referral for petitioners and Beacon was based, in part, on the
substantial overstatement of deductions with respect to income
and the overall incompleteness of documentation provided by
petitioners at that point in the examination. With respect to
ISOA, Inc., the criminal fraud referral was based largely on the
$195,000 of “deferred income” from licensing fees that was
omitted from income and classified by ISOA, Inc., as “Advanced
Royalties” on the 1995 return. Special Agent Mike Metzler of the
CID informed petitioners that their individual returns for the
taxable years at issue were under a criminal fraud investigation.
On January 20, 1998, Agent Sutton issued a Revenue Agent’s
Report (RAR) with respect to petitioners’ 1992 taxable year (1992
RAR). The 1992 RAR proposed an income tax deficiency of $14,750
and total penalties of $14,604. The 1992 RAR, in part,
disallowed all of petitioners’ claimed Schedule C deductions on
the basis that ISOA Consulting was not a trade or business and
that the claimed expenses were either nondeductible personal
expenses or that they had been deducted by petitioners elsewhere
on the 1992 return.
- 25 -
On February 2, 1998, the criminal fraud investigation was
closed without a recommendation for prosecution.
On February 13, 1998, respondent issued a notice of
deficiency to petitioners with respect to their 1992 taxable
year.
On March 10, 1998, Agent Sutton informed petitioners that
the examination was expanding to include the 1996 taxable year
with respect to petitioners, Beacon, and ISOA, Inc. At that
time, Agent Sutton issued an IDR with respect to the 1996 tax
returns for petitioners, Beacon, and ISOA, Inc.9
On August 12, 1998, Agent Sutton issued separate proposed
RARs for petitioners, Beacon, and ISOA, Inc., with respect to the
remaining taxable years under examination. Agent Sutton offered
to have a conference with petitioners and Ms. Stephenson on
August 25, 1998, to discuss the proposed adjustments. Agent
Sutton stated that the proposed RARs were meant to let
petitioners “know what the proposed adjustments were and provide
[Ms. Stephenson] and the taxpayers time to talk to me or provide
more books and records.”
On August 24, 1998, after the proposed RARs had been issued,
Ms. Stephenson notified Agent Sutton that petitioners did not
9
The request included the tax returns for ISOA, Inc., for
the taxable year 1996 ending on August 15 and December 31.
- 26 -
agree with the adjustments in the proposed RARs sent on August
12, 1998, and requested that the returns under examination be
reviewed by respondent’s Appeals Office.
On August 27, 1998, respondent issued to petitioners a 30-
day letter for their 1993 through 1995 individual taxable years
and a 30-day letter for their 1996 individual taxable year.
Respondent proposed deficiencies, additions to tax, and penalties
as follows:10
Additions to tax Penalty
Year Deficiency sec. 6651(a)(1) sec. 6663
1993 $25,046 $2,866 $18,785
1994 31,754 8,019 23,815
1995 74,895 11,277 56,171
1996 33,656 --- 25,242
Respondent, in part, disallowed a number of claimed business
expense deductions claimed by petitioners for lack of
substantiation and business purpose. Respondent also asserted
that several of petitioners’ claimed business expense deductions
were either reimbursed by the University, personal in nature, or
deducted multiple times among petitioners, Beacon, and ISOA, Inc.
On August 27, 1998, respondent issued separate 30-day
letters to Beacon and ISOA, Inc., with respect to the
corporations’ taxable years under examination. The 30-day letter
10
Respondent and petitioners resolved the issues that arose
during the examination of petitioners’ 1992 individual tax return
with no additional tax or penalties due.
- 27 -
sent to ISOA, Inc., stated, in part, that the company had failed
to report $195,000 of income in 1995 which had been erroneously
classified by petitioners as “deferred income”. Specifically,
Agent Sutton noted that ISOA, Inc., received the $195,000 in
licensing fees from the company’s clients with no restrictions on
the use of the funds and that the licensing fees had been
deposited in the company’s bank account like all other receipts
by the company.
By letter dated October 28, 1998, Anthony Rebollo (Mr.
Rebollo), an attorney hired by petitioners, protested the 30-day
letters issued to petitioners, Beacon, and ISOA, Inc., and
requested an Appeals conference to discuss respondent’s proposed
adjustments made with respect to all of the tax returns under
examination. Mr. Rebollo also noted, in part, that “the
taxpayers’ records are voluminous and, with respect to some
issues, can be difficult and time consuming to analyze” and that
petitioners’ “extremely hectic schedule requiring extensive
travel and a great deal of stress” had “contributed to some of
the problems” in petitioners’ case.
In November 1998, petitioners were notified that their case
had been transferred to respondent’s Appeals Office. Appeals
Officer Estevan Medina (Appeals Officer Medina) was assigned to
review petitioners’ 1993 through 1996 taxable years. By letter
dated March 11, 1999, Appeals Officer Medina informed Ms.
- 28 -
Stephenson as to the general scope and course of the Appeals
review process with respect to petitioners. Appeals Officer
Medina also informed Ms. Stephenson as to the categories of
expenses with respect to petitioners, Beacon, and ISOA, Inc.,
that would be examined. Appeals Officer Medina further noted
that the examiner would initially apply a sampling technique to
review petitioners’ substantiation. Ms. Stephenson was
subsequently informed by Appeals Officer Medina that any
settlement with respect to petitioners’ 1992 taxable year was
irrelevant because each year stands on its own and that each
issue raised during the original audit had to be addressed at
Appeals.
After discussing petitioners’ case with Appeals Officer
Medina, Ms. Stephenson notified petitioners by letter as to
the nature of the Appeals Office review. Specifically, Ms.
Stephenson informed petitioner that if the sampling process did
not yield sufficient results then the examiner might deny a
deduction in whole or in part, or “she will have to look at every
item of deduction”.
Revenue Agent Jean Wharton (Agent Wharton) was assigned to
examine petitioners’ records during the Appeals Office review.
Petitioners did not support Appeals Officer Medina’s suggestion
to add a second revenue agent to expedite the Appeals
examination.
- 29 -
From May to September 1999, Agent Wharton spent 14 days at
petitioners’ residence reviewing records and documentation with
respect to the 1993 through 1996 taxable years. This included
more than 20 boxes of travel documentation from petitioners and
their related entities. This documentation included, among other
items, restaurant receipts, hotel receipts, and business cards.
During Appeals consideration, Agent Wharton often did
not receive adequate documentation from petitioners and Ms.
Stephenson in response to questions raised during her
examination. For example, in some cases the only substantiation
Agent Wharton received with respect to the business purpose of
certain travel expenses was business cards.
During her review, Agent Wharton noted that she had several
versions of “general ledgers” and that none completely reconciled
to any of the returns in respondent’s possession. For example,
Agent Wharton determined that in 1995, petitioner frequently
traveled from Lubbock, Texas, to Richardson, Texas, on day trips
with no overnight stays. However, in addition to the actual
travel expenses, petitioner claimed per diem expenses for at
least 100 days. Petitioner also claimed a per diem expense for
time in Hawaii while she waited to have a visa approved for a
trip to Australia. During her review, Agent Wharton found that
petitioners deducted $59,479 on their 1996 Schedule A for “Job
travel: accom. in Dallas”. Petitioners’ 1996 general ledger
- 30 -
indicated that this amount included petitioners’ mortgage
payments, car loan payments, and payments for home furnishings.
Agent Wharton also determined that a majority of shipping
expenses were for items shipped to family members for which there
was no clear business purpose.
On January 12, 2000, Appeals Officer Medina met with
petitioners, Ms. Stephenson, and Mr. Rebollo to discuss Agent
Wharton’s review and the adjustments he was willing to concede in
order to facilitate a possible settlement. Petitioners rejected
the settlement proposal. Subsequent settlement proposals by Ms.
Stephenson were rejected by Appeals Officer Medina.
By letter to Mr. Rebollo dated January 28, 2000, Appeals
Officer Medina again explained the results of Agent Wharton’s
examination and respondent’s position with respect to the
proposed adjustments.
In April 2000, petitioners engaged new counsel, W. Thomas
Finley (Mr. Finley) to represent them in their dispute. After an
April 28, 2000, meeting, Mr. Finley agreed to provide Appeals
Officer Medina additional substantiation prior to any decision by
the Appeals Office.
On June 20, 2000, Mr. Finley sent a new settlement proposal
to Appeals Officer Medina, along with additional substantiation
and spreadsheets prepared by Ms. Stephenson. In a letter to
Appeals Officer Medina dated August 1, 2000, Ms. Stephenson
- 31 -
provided a summary of petitioners’ positions with respect to the
issues of the latest settlement proposal. With respect to the
deferred income issue, Ms. Stephenson stated that this amount was
“the accumulation of royalties owed to inventors” and that ISOA,
Inc., was “merely a conduit for distributing these royalty
payments to the inventors.” Ms. Stephenson for the first time
also claimed that ISOA, Inc.’s 1995 return erroneously indicated
that the corporation was on the cash basis method of accounting.
In addition, Ms. Stephenson stated that ISOA, Inc., was an
accrual basis taxpayer and that the proper accounting treatment
of the “deferred income” would have been “to recognize the
royalty income when received and set up a corresponding payable
to the inventors for the same amount.”
By letter to Ms. Stephenson dated August 11, 2000, Appeals
Officer Medina rejected petitioners’ June 2000 settlement
proposal.
III. The Notice of Deficiency
On October 19, 2000, respondent issued to petitioners a
notice of deficiency for their 1993 through 1996 individual
taxable years. The notice of deficiency also included
adjustments with respect to Beacon for the taxable years 1993
through 1996 and ISOA, Inc., for the taxable years 1995 and
- 32 -
1996.11 In the notice, respondent asserted, in part, that
numerous business expenditures claimed by petitioners, Beacon,
and ISOA, Inc., had not been adequately substantiated and did not
have a business purpose. Respondent also determined that Beacon
and ISOA, Inc., had failed to properly include certain amounts in
income. Specifically, respondent determined that ISOA, Inc.,
failed to properly include the $195,000 of “deferred income” in
the corporation’s 1995 taxable income. The notice of deficiency
determined deficiencies, additions to tax, and accuracy-related
penalties, as follows:12
Additions to tax Penalty
Year Deficiency sec. 6651(a)(1) sec. 6662
1993 $23,733 $2,538 $4,747
1994 28,514 7,209 5,703
1995 75,089 11,306 15,018
1996 28,307 --- 5,661
IV. The Petition and Proceedings to Date
On January 17, 2001, petitioners timely filed a petition
with the Court. Petitioners placed all of the amounts in the
notice of deficiency in dispute. Petitioners alleged, among
other things, that the claimed business expense deductions with
respect to petitioners’ business activities had been adequately
11
The adjustments with respect to ISOA, Inc., for the
taxable year 1996 were for the corporation’s taxable year ending
Aug. 15, 1996.
12
The sec. 6663 fraud penalty was conceded as a result of
Appeals Office consideration.
- 33 -
substantiated and were ordinary and necessary business expenses.
The petition further alleged that Beacon and ISOA, Inc., did not
fail to properly report any items of taxable income.
On March 8, 2001, Mary Kay McIlyar (Ms. McIlyar), the
District Counsel attorney to whom the case was assigned, filed an
answer to the petition which denied all of petitioners’
assignments of error.
Ms. McIlyar met with Agent Wharton, Ms. Stephenson, and Mr.
Finley to discuss petitioners’ case. At this meeting, it was
decided that petitioners would provide “mockup” tax returns which
would include only the amounts that could be adequately
substantiated by petitioners. These “mockup” tax returns would
not be filed with the IRS.
Years after petitioners’ filed returns, “Estimated” returns,
“Revised” returns, and “Amended” returns, Ms. Stephenson prepared
the “mockup” tax returns along with “general ledgers” to support
the amounts on these returns. Between June and September of
2001, Mr. Finley provided Ms. McIlyar with the “mockup” returns
for the entities and taxable years in issue. Many of the amounts
on the “mockup” tax returns differed from the amounts on the tax
returns petitioners had previously submitted to the IRS. Revenue
Agent Richard Laakso (Agent Laakso) was assigned to examine the
“mockup” returns and the “general ledgers” prepared by Ms.
Stephenson. Agent Laakso selected a limited number of entries
- 34 -
from the most recent “general ledgers” to verify the amounts on
the “mockup” tax returns. During his review of the “mockup” tax
returns, Agent Laakso occasionally needed to request additional
substantiation. After reviewing the “mockup” tax returns, Agent
Laakso discussed settlement proposals for each taxable year in
issue with Ms. Stephenson. The settlement proposals reached
between Agent Laakso and Ms. Stephenson were then submitted to
Ms. McIlyar and Mr. Finley to negotiate any possible final
settlements.
On December 5, 2001, Mr. Finley sent respondent a separate
settlement offer for each of the years 1993 through 1996 with
total tax liabilities for each year as follows:
Total
Year tax liability
1993 $5,000
1994 5,450
1995 7,700
1996 1,750
On February 11, 2002, the settlement offers for 1993 and
1994 were accepted by Ms. McIlyar in the amounts proposed by Mr.
Finley.
On February 19, 2002, Ms. McIlyar proposed settlements for
the 1995 and 1996 taxable years as follows:
Total Penalty
Year tax liability sec. 6662(a)
1995 $12,921 ---
1996 7,330 $1,466
- 35 -
On April 12, 2002, a stipulated decision document was signed
and submitted to the Court reflecting the following settlement:
Penalty
Year Deficiency sec. 6662(a)
1993 $5,000 ---
1994 5,450 ---
1995 12,921 ---
1996 7,330 $1,466
On May 14, 2002, petitioners filed their motion for an
award of costs.13 Accordingly, on May 14, 2002, the stipulated
decision was vacated, recharacterized, and filed as a stipulation
of settlement. On June 26, 2002, petitioners filed an amended
motion for costs.
On August 26, 2002, respondent filed an objection to
petitioners’ amended motion for an award of costs. According to
respondent’s objection: (1) The positions maintained by
respondent in the administrative and court proceedings were
substantially justified; (2) petitioners unreasonably protracted
both the administrative and court proceedings; (3) petitioners
did not incur any costs in connection with either the
administrative or court proceedings; and (4) the administrative
and litigation costs claimed by petitioners were unreasonable in
amount.
13
Respondent’s counsel agreed to the settlement unaware of
petitioners’ intention to file the motion here under
consideration after the stipulated decision had been entered.
- 36 -
On April 30, 2003, petitioners filed a reply. Pursuant to
petitioners’ request, an evidentiary hearing was conducted on
petitioners’ motion in Dallas, Texas.
OPINION
Administrative costs incurred in connection with an
administrative proceeding may be awarded under section 7430(a)
only if a taxpayer: (1) Is the prevailing party, and (2) did
not unreasonably protract the administrative proceeding. Sec.
7430(a) and (b)(3).14 Similarly, litigation costs incurred in
connection with a court proceeding may be awarded only if a
taxpayer: (1) Is the prevailing party; (2) has exhausted his or
her administrative remedies within the IRS; and (3) did not
unreasonably protract the court proceeding. Sec. 7430(a) and
(b)(1), (3).
A taxpayer must satisfy each requirement in order to be
entitled to an award of administrative or litigation costs under
section 7430. Sec. 7430(a)(1) and (2), (c)(1) and (2); Rule
232(e).
To be a “prevailing party”, the taxpayer must: (1)
Substantially prevail with respect to either the amount in
14
Administrative costs include only the costs incurred on
or after the earlier of: (1) The date of receipt by the taxpayer
of the decision by the Appeals Office; (2) the date of the notice
of deficiency; or (3) the date on which the first letter of
proposed deficiency which allows the taxpayer an opportunity for
administrative review in the IRS Appeals Office is sent. Sec.
7430(c)(2).
- 37 -
controversy or the most significant issue or set of issues
presented; and (2) satisfy the applicable net worth requirement.
Sec. 7430(c)(4)(A). Respondent concedes that petitioners have
satisfied the requirements of section 7430(c)(4)(A). According
to respondent, however, petitioners are not prevailing parties
within the meaning of section 7430 because respondent’s positions
in the administrative and court proceedings were substantially
justified. Sec. 7430(c)(4)(B)(i).
In general, the Commissioner’s position is substantially
justified if, based on all of the facts and circumstances and the
legal precedents relating to the case, the Commissioner acted
reasonably. Pierce v. Underwood, 487 U.S. 552 (1988); Sher v.
Commissioner, 89 T.C. 79, 84 (1987), affd. 861 F.2d 131 (5th Cir.
1988). In other words, to be substantially justified, the
Commissioner’s position must have a reasonable basis in both law
and fact. Pierce v. Underwood, supra; Rickel v. Commissioner,
900 F.2d 655, 665 (3d Cir. 1990), affg. in part and revg. in part
on other grounds 92 T.C. 510 (1989). A position is substantially
justified if the position is “justified to a degree that could
satisfy a reasonable person.” Pierce v. Underwood, supra at 565
(construing similar language in the Equal Access to Justice Act).
Thus, the Commissioner’s position may be incorrect but
nevertheless be substantially justified “‘if a reasonable person
- 38 -
could think it correct’”. Maggie Mgmt. Co. v. Commissioner, 108
T.C. 430, 443 (1997) (quoting Pierce v. Underwood, supra at 566
n.2).
The relevant inquiry is “whether * * * [the Commissioner]
knew or should have known that * * * [his] position was invalid
at the onset”. Nalle v. Commissioner, 55 F.3d 189, 191 (5th Cir.
1995), affg. T.C. Memo. 1994-182. We look to whether the
Commissioner’s position was reasonable given the available facts
and circumstances at the time that the Commissioner took his
position. Maggie Mgmt. Co. v. Commissioner, supra at 443;
DeVenney v. Commissioner, 85 T.C. 927, 930 (1985). In deciding
whether the Commissioner’s position was substantially justified,
a significant factor is whether, on or before the date the
Commissioner assumed the position, the taxpayer provided “all
relevant information under the taxpayer’s control and relevant
legal arguments supporting the taxpayer’s position to the
appropriate Internal Revenue Service personnel.”15 Sec.
301.7430-5(c)(1), Proced. & Admin. Regs.
The fact that the Commissioner eventually concedes or loses
a case does not establish that his position was unreasonable.
15
“Appropriate Internal Revenue Service personnel” are
those employees who are reviewing the taxpayer’s information or
arguments, or employees who, in the normal course of procedure
and administration, would transfer the information or arguments
to the reviewing employees. Sec. 301.7430-5(c)(1), Proced. &
Admin. Regs.
- 39 -
Estate of Perry v. Commissioner, 931 F.2d 1044, 1046 (5th Cir.
1991); Sokol v. Commissioner, 92 T.C. 760, 767 (1989). However,
the Commissioner’s concession is a factor to be considered.
Powers v. Commissioner, 100 T.C. 457, 471 (1993), affd. in part,
revd. in part and remanded on another issue 43 F.3d 172 (5th Cir.
1995).
As relevant here, the position of the United States under
consideration with respect to the recovery of administrative
costs is the position taken by the Commissioner as of the date of
the notice of deficiency. Sec. 7430(c)(7)(B)(ii); Fla. Country
Clubs, Inc. v. Commissioner, 122 T.C. 73 (2004), affd. 404 F.3d
1291 (11th Cir. 2005). The position of the United States under
consideration with respect to the recovery of litigation costs is
the position taken by the Commissioner in the answer to the
petition. Bertolino v. Commissioner, 930 F.2d 759, 761 (9th Cir.
1991); Sher v. Commissioner, 861 F.2d at 134-135; see sec.
7430(c)(7)(A). Ordinarily, we consider the reasonableness of
each of these positions separately in order to account for a
change in the Commissioner’s position. Maggie Mgmt. Co. v.
Commissioner, supra at 442 (citing Huffman v. Commissioner, 978
F.2d 1139, 1144-1147 (9th Cir. 1992), affg. in part and revg. in
part on other grounds T.C. Memo. 1991-144). In the present case,
however, we need not follow this approach because respondent’s
- 40 -
position was essentially the same in the administrative and Court
proceedings. See Maggie Mgmt. Co. v. Commissioner, supra at 442.
The parties agree, more or less, that prior to the
settlement, the items at issue as a result of respondent’s
examination were primarily: (1) Petitioners’ claimed business
expense deductions; and (2) ISOA, Inc.’s “deferred income” in
1995 in the amount of $195,000. We have previously adopted an
issue-by-issue approach to the awarding of costs under section
7430, apportioning the requested award among the issues according
to whether the position of the United States was substantially
justified. Swanson v. Commissioner, 106 T.C. 76, 102 (1996);
O’Bryon v. Commissioner, T.C. Memo. 2000-379; see also Powers v.
Commissioner, 51 F.3d 34, 35 (5th Cir. 1995). We follow that
approach here and separately discuss whether respondent’s
position was substantially justified with respect to each of the
above issues.16
I. Business Expense Deductions
In the notice of deficiency, respondent disallowed various
business expense deductions claimed on petitioners’ individual
tax returns, as well as the tax returns of Beacon and ISOA, Inc.,
16
Much of petitioners’ presentation at the hearing
addressed the criminal referral and the proposed civil fraud
penalty. Although the civil fraud penalty was proposed in the
revenue agent’s report, it was neither included in the notice of
deficiency nor the answer. Consequently, the substantial
justification of respondent’s proposed imposition of the civil
fraud penalty is not considered here. See sec. 7430(c)(7).
- 41 -
because petitioners did not: (1) Adequately substantiate those
deductions; and/or (2) establish the business purpose for the
deductions.
We begin with a fundamental proposition of Federal income
taxation. Deductions are matters of legislative grace. New
Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Segel v.
Commissioner, 89 T.C. 816, 842 (1987). Taxpayers are required to
substantiate the claimed deductions by maintaining records
necessary to establish entitlement and the amount of the
deduction in question. Sec. 6001; Meneguzzo v. Commissioner,
43 T.C. 824, 831-832 (1965); sec. 1.6001-1(a), Income Tax Regs.;
see Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); Welch v. Helvering, 290 U.S. 111, 115 (1933); Segel v.
Commissioner, supra; Hradesky v. Commissioner, 65 T.C. 87, 90
(1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976). In
general, the burden to demonstrate entitlement to a claimed
deduction rests with the taxpayer. Rule 142(a); Underwood v.
Commissioner, 56 F.2d 67 (4th Cir. 1932), revg. 20 B.T.A. 1117
(1930).
Generally, section 162(a) allows “as a deduction all the
ordinary and necessary expenses paid or incurred during the
taxable year in carrying on any trade or business”, including a
taxpayer’s trade or business as an employee. See Primuth v.
Commissioner, 54 T.C. 374, 377-378 (1970). To support expenses
- 42 -
entitled to a section 162(a) deduction, a taxpayer must provide
evidence to establish a sufficient connection between the
deduction and his trade or business. Gorman v. Commissioner,
T.C. Memo. 1986-344.
Certain expenses that otherwise qualify for deduction under
section 162(a) require enhanced, more specified substantiation
under section 274. These include travel, food, and entertainment
expenses. For these items, taxpayers must show that an expense
was “directly related” to the business activity, and must provide
the business purpose, amount, and time and place of the
expenditure. Sec. 274(a); sec. 1.274-5T(b)(2), Temporary Income
Tax Regs. 50 Fed. Reg. 46014 (Nov. 6, 1985). In order to
substantiate these types of deductions by means of adequate
records, a taxpayer must maintain a diary, a log, or a similar
record, and documentary evidence that, in combination, are
sufficient to establish each element of each expenditure or use.
Sec. 1.274-5T(c)(2)(i), Temporary Income Tax Regs., 50 Fed. Reg.
46017 (Nov. 6, 1985).
If the allowance of a deduction claimed on a return is
challenged by respondent, respondent is not obliged to concede
the taxpayer’s entitlement to the deduction until adequate
substantiation for the deduction has been provided by the
- 43 -
taxpayer. See Huynh v. Commissioner, T.C. Memo. 2002-110;
Gealer v. Commissioner, T.C. Memo. 2001-180; O’Bryon v.
Commissioner, supra; Cooper v. Commissioner, T.C. Memo. 1999-6.
What constitutes adequate substantiation for challenged
deductions, of course, is fertile ground for disputes between a
taxpayer and respondent, and we recognize that the nature and
quantum of substantiation for a given deduction can vary with
the circumstances. Welch v. Helvering, supra. Guidance
published by respondent identifies generally how a deduction may
be substantiated, but notes that proof that an expenditure was
made or incurred does not necessarily establish that a taxpayer
is entitled to a deduction for that expenditure. Taxpayers are
advised to keep any other documents that may prove entitlement to
the deduction. See Rev. Proc. 92-71, 1992-2 C.B. 437.
Furthermore, a taxpayer’s self-serving declaration is generally
not a sufficient substitute for records. See Weiss v.
Commissioner, T.C. Memo. 1999-17.
Respondent’s position with respect to the disallowance of
deductions claimed on petitioners’ returns flows from the
examination of those returns, and it is clear that a taxpayer’s
return is hardly substantiation for items reported on that
return. See Seaboard Commercial Corp. v. Commissioner, 28 T.C.
1034, 1051 (1957); Halle v. Commissioner, 7 T.C. 245, 247 (1946),
affd. 175 F.2d 500 (2d Cir. 1949).
- 44 -
According to petitioners, their hectic work schedules
precluded them from filing timely individual tax returns for the
years 1993 through 1995. Petitioners’ 1993, 1994, and 1995
returns were not received by respondent until December 30, 1996,
and then each was followed by an “amended” or “revised” version.
In addition to filing multiple versions of untimely tax
returns, petitioners repeatedly failed to respond timely and
adequately to respondent’s numerous requests for information and
documentation during the examination. Petitioners attribute
these failures to their busy work and travel schedules.
Petitioners complain of respondent’s practice of issuing multiple
IDRs for the same information, but ignore their own behavior as
the reason for such multiple requests.
Nothing introduced at the hearing establishes that
respondent’s agents improperly or unreasonably failed to accept
adequate substantiation for the deductions in dispute. Many of
petitioners’ claimed business expense deductions were for travel
and entertainment. As previously noted, that type of expense is
subject to strict substantiation requirements to be allowed as a
deduction. As best as can be determined from the hearing record,
petitioners provided little substantiation with respect to much
of their travel and entertainment expense deductions. For
example, petitioners provided only business cards to substantiate
the business purpose of some claimed travel expenses.
- 45 -
Petitioners had no receipts for amounts deducted as travel
expenses that were allegedly paid to their daughter in exchange
for travel coupons. Many questions were raised by the revenue
agent regarding petitioner’s reimbursements for University-
related travel, but petitioners delayed responding to those
questions, or failed completely to do so, even though an
investigation by the University focused upon those
reimbursements.17
From their presentation at the hearing, it appears that
petitioners, for the most part, consider the “general ledgers”
provided to the examining agents as adequate substantiation for
the challenged deductions. Ignoring for the moment
inconsistencies from version to version, the “general ledgers”
provided little support for the challenged deductions. The
“general ledgers” lacked meaningful descriptions of the listed
expenditures or their business purpose, and, on an item by item
basis, the amounts reported on the “general ledgers” often did
not support the amounts reported on any of the returns submitted
by petitioners. Contrary to the significance that petitioners
attribute to the “general ledgers”, in many ways, those documents
actually support respondent’s requests for additional information
for certain deductions inasmuch as entries contained in the
17
Petitioner was given the opportunity at the hearing to be
recalled as a witness to explain the nature of the University’s
investigation, but she chose not to do so.
- 46 -
“general ledgers” suggest that petitioners improperly deducted:
(1) Personal items as business expenses; (2) actual travel
expenses in addition to per diem amounts; and (3) mortgage
payments, automobile payments, and home furnishings as “job
travel” expenses. Furthermore, the “general ledgers” were
continually revised during the examination of petitioners’
returns. This suggests that petitioners did not keep these
records contemporaneously with their expenditures or that entries
originally made were in some manner or another erroneous.
Respondent properly requested supporting documentation for
entries made in the “general ledgers”, but some requests were
ignored and many responses were delayed.
A taxpayer’s poorly detailed and noncontemporaneous records
are hardly proper substantiation for challenged deductions, and
secondary sources, such as petitioners’ “general ledgers”,
offered in support of a taxpayer’s business expense deductions
need not be accepted by respondent or this Court. See Krieger v.
Commissioner, T.C. Memo. 1993-347, affd. without published
opinion 64 F.3d 657 (4th Cir. 1995); Bard v. Commissioner, T.C.
Memo. 1990-431; Farguson v. Commissioner, T.C. Memo. 1983-615.
Under the circumstances, including the confusion no doubt
caused by the use of similar acronyms for different entities, we
find no fault with respondent’s refusal to accept the “general
ledgers” and other information provided by petitioners as
- 47 -
adequate substantiation for the business expense deductions
disallowed in the notice of deficiency. Taking into account
controlling legal precedent and based on the facts available to
respondent when the notice of deficiency was issued, as well as
when the answer was filed, we find that respondent’s position
that results from that refusal has a reasonable basis in law and
fact and therefore is substantially justified. See Maggie Mgmt.
Co. v. Commissioner, 108 T.C. 443.
Our conclusion on this point is not altered by the fact that
a settlement was achieved after “mock-up” tax returns that
differed from all of the returns previously submitted by
petitioners and additional substantiation were provided and
reviewed by respondent’s counsel. See Harrison v. Commissioner,
854 F.2d 263, 265 (7th Cir. 1988), affg. T.C. Memo. 1987-52;
Wickert v. Commissioner, 842 F.2d 1005 (8th Cir. 1988), affg.
T.C. Memo. 1986-277.
II. The “Deferred Income” Issue
In the notice of deficiency and in his answer, respondent
takes the position that $195,000 of licensing fees received by
ISOA, Inc., are includable in its income in the year received.
According to petitioners, respondent has failed to establish that
his position has a reasonable basis in law. Petitioners argue
that respondent’s position is, therefore, not substantially
justified.
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For the taxable years in issue, ISOA, Inc., was an S
corporation that prepared its tax returns on the cash basis
method of accounting. On its 1995 return, ISOA, Inc., treated
$195,000 of licensing fees received during the taxable year as
“Unearned Income (Escrow)”. Petitioners claimed that ISOA, Inc.,
did not include the $195,000 of licensing fees it received in
taxable income due to the fact that the royalties the corporation
owed would not ultimately be paid until a final agreement was
reached with the University. Therefore, petitioners argued, the
full amount of the licensing fees which ISOA, Inc., would retain
could not be determined at the time of receipt.
Once again, respondent’s position on this issue calls into
play fundamental principles of Federal income taxation. As a
general rule, a cash basis taxpayer recognizes income in the year
of receipt. Sec. 451(a); sec. 1.451-1(a), Income Tax Regs.
Exceptions to this general rule exist for amounts properly
characterized as deposits or amounts held in trust that might
have to be returned. See, e.g., Commissioner v. Indianapolis
Power & Light Co., 493 U.S. 203, 207-208 (1990); Johnson v.
Commissioner, 108 T.C. 448, 467-475 (1997), affd. in part, revd.
in part and remanded on another ground 184 F.3d 786 (8th Cir.
1999). Unless received under a claim of right, “a taxpayer need
not treat as income moneys * * * which were not his to keep, and
which he was required to transmit to someone else as a mere
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conduit.” Diamond v. Commissioner, 56 T.C. 530, 541 (1971),
affd. 492 F.2d 286 (7th Cir. 1974). Receipts subject to the
taxpayer’s claim of right are includable in the taxpayer’s income
in the year of receipt. N. Am. Oil Consol. v. Burnet, 286 U.S.
417, 424 (1932). A taxpayer has a claim of right to income if
the taxpayer: (1) Receives the income; (2) has control over the
utilization and disposition of the income; and (3) asserts a
“claim of right” or entitlement to the income. Id. at 424.
Over the course of the examination, petitioners maintained
several different positions with respect to ISOA, Inc.’s
treatment of the licensing fees as “deferred income”. In 1997,
petitioners’ original position with respect to the “deferred
income” was that the amount was being “held for payment of $1.5
million buyout of intellectual property” from the University.
Later, in August 2000, petitioners maintained the position that
the “deferred income” represented accumulated royalties owed to
the inventors of the underlying intellectual property. At trial,
Ms. Stephenson also testified that the licensing fees were
treated as “deferred income” because they were subject to being
refunded to the licensees. We also note that, on August 1, 2000,
just prior to respondent’s notice of deficiency sent on October
19, 2000, Ms. Stephenson stated that ISOA, Inc., was actually an
accrual basis taxpayer and that the proper accounting treatment
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of the “deferred income” would have been “to recognize the
royalty income when received and set up a corresponding payable
to the inventors for the same amount.”
Given petitioners’ explanations, it was reasonable for
respondent to take the position that ISOA, Inc., was not merely a
conduit and that the $195,000 received by the corporation in 1995
was includable in taxable income in the year received. There was
no question that the licensing fees were received by ISOA, Inc.,
in 1995 and deposited into the corporation’s bank account. ISOA,
Inc., had control over the utilization and disposition of these
licensing fees and, in fact, paid related expenses from these
licensing fees. There is no indication in the record that the
licensing fees were ever deposited or segregated into any
separate account. While ISOA, Inc., may have had an unfixed
obligation to pay royalties to the inventors, the licensing fees
were not required to be held until that time.
Accordingly, it was reasonable for respondent to take the
position that ISOA, Inc., had dominion and control over the
licensing fees and that such amounts were not held by the
corporation merely as an agent or conduit. We find that
respondent’s position that the $195,000 of “deferred income”
should have been included in ISOA, Inc.’s 1995 taxable income was
a reasonable application of the law given the available facts and
circumstances at the time that respondent took his position.
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Because respondent’s positions in the administrative and
court proceedings were substantially justified, we need not
decide whether petitioners unreasonably protracted the
proceedings, or whether the administrative and litigation costs
claimed by petitioners are reasonable.
We find that respondent’s positions on the disputed issues
were substantially justified. Therefore, we hold that
petitioners are not prevailing parties within the meaning of
section 7430 and are not entitled to an award of administrative
and litigation costs.
To reflect the foregoing,
An appropriate order
and decision will be entered.