In Touch Props., LLC v. Comm'r ( 2007 )

T.C. Memo. 2007-105
UNITED STATES TAX COURT
IN TOUCH PROPERTIES, LLC, DAVID ENGLAND, TAX MATTERS PARTNER,
Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
Docket No. 9809-05. Filed April 30, 2007.
Eugene P. de Verges, for petitioner.
Gary L. Bloom, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
MARVEL, Judge: Respondent issued a Notice of Final
Partnership Administrative Adjustment (FPAA) for 2000 pursuant to
-2-
section 62231 to the Tax Matters Partner (TMP) of In Touch
Properties, LLC (In Touch), a limited liability company
classified as a partnership for Federal income tax purposes.2 In
the FPAA, respondent disallowed deductions claimed by In Touch
for professional fees, marketing expenses, consulting fees, and
amortized startup expenditures; determined that the members’ at-
risk amount under section 465 must be reduced by $176,818;
determined that the total capital contributed to In Touch as of
December 31, 2000, was $50,000; and determined that a
computational adjustment to net earnings (loss) from self-
employment must be made. A petition for a readjustment of
partnership items was filed on behalf of In Touch. Because the
petition did not identify a TMP or reflect that it was filed by
the TMP, we ordered In Touch to identify its TMP. On June 13,
2005, we received and filed a Notice of Identification of Tax
Matters Partner, which identified David England as the TMP. We
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable year in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
2
Although In Touch had fewer than 10 members during 2000,
it did not meet the definition of a small partnership under sec.
6231(a)(1)(B) because one of its members was a passthrough
entity. See sec. 6231(a)(1)(B)(i); sec. 301.6231(a)(1)-1(a)(2),
Proced. & Admin. Regs. Consequently, In Touch is an entity
subject to the partnership audit and litigation procedures of
secs. 6221-6231.
-3-
shall refer to Mr. England in his capacity as In Touch’s TMP as
petitioner.
The parties tried and briefed the following issues:
(1) Whether consulting fees, marketing expenses,
professional fees, and startup expenditures claimed by In Touch
on its 2000 return were properly accrued in 2000 and/or
adequately substantiated;
(2) whether promissory notes contributed to In Touch by
its members are properly included in calculating the members’
bases in In Touch; and
(3) whether promissory notes contributed to In Touch by its
members are properly included in calculating each member’s at-
risk amount under section 465(a).
For reasons explained, infra, we decide only issue (1) in
this opinion.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulations of the parties are incorporated herein by this
reference.
Background
In Touch is an Oklahoma limited liability company (LLC) that
was organized and formed by Lloyd Gilbert, Mark Hanna, and David
-4-
England on January 6, 2000.3 In Touch’s stated business
objective is to create, protect, and develop the value of
licensing agreements associated with the “ALPHA Critters”. The
ALPHA Critters are cartoon characters of each letter of the
alphabet designed to provide parents and educators a unique and
entertaining alternative to the traditional methods of teaching
children how to read. In Touch commenced the active conduct of
its business on June 1, 2000. At all relevant times, In Touch
used the accrual method of accounting for Federal income tax
purposes.
In Touch timely filed its 2000 Form 1065, U.S. Return of
Partnership Income, in October 2001, pursuant to two extensions
of time to file. On its return, In Touch claimed deductions
totaling $277,560, including $160,000 for consulting fees,
$22,990 for marketing expenses, $59,615 for professional fees,
and a $15,711 amortization deduction.4 In Touch’s 2000 Form 1065
3
Its principal place of business was in Tulsa, Okla., when
the petition in this case was filed.
4
In Touch elected, under sec. 195(b), to amortize startup
expenditures totaling $134,664 for a period of 60 months
beginning in June 2000. The startup expenditures that In Touch
claimed on its 2000 partnership return consisted of marketing
expenses of $17,423, rent of $15,000, printing costs of $111,
bank charges of $20, meals and entertainment of $277, and
consulting fees of $101,833.
-5-
showed a net loss of $276,560,5 which was allocated to its
members as follows:
Partner Share of loss
Lloyd Gilbert $30,000
David England 121,560
Mark Hanna -0-
Jim Coates 25,000
Abraham Joseph 50,000
Reebud Resources 50,000
Total 276,560
Disputed Adjustments
On July 24, 2002, respondent commenced an examination of In
Touch’s 2000 partnership return by mailing both an appointment
letter and an Information Document Request (IDR) to petitioner.
On September 9, 2002, respondent issued a second IDR to
petitioner. Among other things, the IDRs requested documentation
to substantiate the consulting fees, marketing expenses,
professional fees, and startup expenditures claimed on In Touch’s
2000 return.
With respect to the consulting fees, respondent requested
invoices and other documentation substantiating payment dates and
detailing the services provided to In Touch. In response, In
Touch produced Letters of Understanding (Letters) dated November
10, 2000, with respect to Beverly Stool, Jeff Giddings, and Gene
5
In Touch reported total income of $1,000 and total
deductions of $277,560 on its 2000 partnership return.
-6-
Longcrier (the consultants). The Letters were not signed by the
consultants.6 The Letters purported to summarize the terms of a
consulting/employment arrangement with In Touch, including the
amount of compensation and benefits to be paid to the
consultants. Each Letter contained the following statement:
“Payments will be deferred until adequate funding can be
obtained.”7 In Touch provided no other documents to respondent
to substantiate the consulting fees claimed as ordinary and
necessary business expenses and/or as startup expenditures.
With respect to marketing expenses, respondent requested
receipts and invoices, the business purpose of these expenses,
and proof of payment. The only documentation produced by
In Touch in response to this request was a typed list of expenses
without any accompanying receipts or invoices.
With respect to professional fees, respondent requested
detailed invoices for professional services rendered, the dates
of service, and canceled checks or receipts to prove payment. In
Touch submitted typed summaries of the professional fees that
failed to list the date and type of services provided.
6
The record contains no evidence that the Letters were ever
delivered to the consultants.
7
As of the trial date, In Touch had not paid the consulting
fees it accrued as deductible expenses and/or startup
expenditures.
-7-
On March 7, 2005, respondent sent petitioner an FPAA
determining adjustments to the above expenses. In the FPAA,
respondent determined that In Touch had overstated its deductions
for consulting fees, marketing expenses, professional fees, and
amortization.8 Respondent also determined that the at-risk
amounts of In Touch’s members must be reduced and that the
capital contributed by In Touch’s members as of December 31,
2000, was $50,000.
Tax Court Litigation
On May 27, 2005, petitioner filed his petition for
readjustment of partnership items. A trial was held in Oklahoma
City, Oklahoma, on March 9, 2006.
Petitioner, who was a member of In Touch during 2000, was
the only witness who testified at trial on In Touch’s behalf.
Petitioner, over respondent’s objection, attempted to introduce
copies of seven promissory notes, each dated December 31, 2000.9
The promissory notes were as follows:
8
Respondent allowed In Touch’s startup costs of $11,408,
consisting of meals and entertainment of $277, bank charges of
$20, printing costs of $111, and rent of $11,000. Respondent
recomputed In Touch’s allowable amortization expense deduction
for 2000 ($11,408 x 7/60 = $1,331).
9
Petitioner also introduced a promissory note (Exh. 17-P)
that he had executed in favor of In Touch. Respondent did not
object to this exhibit.
-8-
Exhibit No. Obligor Obligee Amount
12-P In Touch Beverly Stool $80,000
13-P In Touch Jeff Giddings 60,000
14-P In Touch Gene Longcrier 48,000
15-P In Touch Curzon, Cumbey 33,615
16-P In Touch Eugene de Verges 15,000
18-P Lloyd Gilbert In Touch 30,000
19-P James Coates In Touch 25,000
Although we initially deferred ruling on the admissibility
of the promissory notes, respondent’s counsel withdrew his
objection to Exhibits 12-P, 13-P, and 14-P after he introduced
the original promissory notes as Exhibits 22-R, 21-R, and 20-R,
respectively. In his posttrial brief, respondent conceded that,
under Federal Rule of Evidence 901(a), petitioner properly
authenticated the remaining promissory notes containing the
signatures of James Coates and Lloyd Gilbert. Consequently, we
admit Exhibits 15-P, 16-P, 18-P, and 19-P.
Petitioner introduced three of the promissory notes,
Exhibits 12-P, 13-P, and 14-P, to substantiate the consulting
fees deducted and amortized as startup costs on In Touch’s 2000
return and in support of his contention that the fees in question
were properly accrued in 2000. However, petitioner never
delivered the promissory notes to the consultants and did not
introduce any evidence to describe the dates, nature, and amounts
of the services allegedly provided by the three consultants who
were the obligees of the notes.
-9-
Petitioner introduced two promissory notes, Exhibits 15-P
and 16-P, to substantiate the professional fees deducted on In
Touch’s 2000 return and in support of his contention that the
fees in question were properly accrued and deducted in 2000.
However, petitioner did not introduce any evidence to describe
the dates, nature, and amount of the services allegedly provided
by the obligees of the promissory notes.
Petitioner introduced three promissory notes, Exhibits 17-P,
18-P, and 19-P, to substantiate alleged additional capital
contributions and at-risk amounts by three of In Touch’s members:
petitioner, Lloyd Gilbert, and James Coates. The total principal
amount of the three notes coincides precisely with the three
members’ distributive shares of the net loss claimed by In Touch
on its 2000 return. Petitioner testified that he executed his
note on December 31, 2000, as a guaranty of In Touch’s
obligations to the consultants and professionals to whom In Touch
allegedly owed payment as of December 31, 2000. However,
petitioner did not introduce any evidence regarding the purpose
of the Gilbert and Coates promissory notes.
OPINION
I. Burden of Proof
The Commissioner’s determinations are generally presumed to
be correct, and the taxpayer must prove by a preponderance of
-10-
evidence that those determinations are erroneous. Rule
142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
However, a taxpayer can shift the burden of proof to the
Commissioner under section 7491(a) if the taxpayer satisfies the
requirements of section 7491(a)(2).10
Because the record does not support a finding that In Touch
or its TMP maintained required records and substantiated the
items claimed on its 2000 return, we conclude that petitioner did
not satisfy the requirements of section 7491(a). Therefore, the
burden of proof remains with petitioner on all issues.
II. Accrual of Consulting Fees
Section 461(a) states that a deduction must be taken in the
proper taxable year under the taxpayer’s method of accounting.
Accrual method taxpayers generally become entitled to a deduction
when all the events have occurred to establish the fact of the
liability and the amount of such liability can be determined with
reasonable accuracy. Sec. 461(h)(4); sec. 1.461-1(a)(2), Income
Tax Regs. To be properly accruable under the “all events test”,
10
Under sec. 7491(a)(2), a taxpayer must prove: (1) The
taxpayer has complied with the Code’s substantiation
requirements; (2) the taxpayer has maintained all required
records; and (3) the taxpayer has cooperated with reasonable
requests by the Commissioner for witnesses, information,
documents, meetings, and interviews.
-11-
(1) a liability must be binding and enforceable, (2) the
liability must not be contingent on a future event, (3) the
liability must be certain as to amount, and (4) the debtor must
have a reasonable belief that the liability will be paid. United
Control Corp. v. Commissioner, 38 T.C. 957, 967 (1962). In
addition, section 461(h)(1) provides that in determining whether
an amount has been incurred with respect to any item during a
taxable year, “the all events test shall not be treated as met
any earlier than when economic performance with respect to such
item occurs.” See also Restore, Inc. v. Commissioner, T.C. Memo.
1997-571 n.5, affd. without published opinion 174 F.3d 203 (11th
Cir. 1999).
Respondent argues that the consulting fees deducted by In
Touch as business expenses and/or included as startup
expenditures in calculating its amortization deduction were not
properly accruable because a contingency existed as to their
payment. In Putoma Corp. v. Commissioner, 66 T.C. 652, 659-663
(1976), affd. 601 F.2d 734 (5th Cir. 1979), a corporation’s
obligation to pay compensation to its shareholder-employees was
not properly accruable because payment of the salaries depended
upon the future profits of the company. The obligation to pay
salaries was not fixed since payment was contingent on the
availability of funds. Id. at 663.
-12-
Petitioner acknowledges that the Letters defer payment until
adequate funding can be obtained. Petitioner argues, however,
that the Letters represent only outlines of employment contracts
that In Touch might execute in the future and do not represent a
complete statement of the rights and obligations between the
consultants and In Touch. Moreover, petitioner contends that the
Letters do not refer to any consulting work performed before the
finalization of an employment agreement and that no contingency
or deferral exists as to liabilities due for past services.
Petitioner argues that the consultants invoiced In Touch for the
services they rendered, and In Touch responded by issuing
promissory notes as payment. These notes, petitioner believes,
clearly reflect that the amounts claimed are fixed and
immediately payable.
Petitioner’s arguments are not supported by the record. In
Touch did not have the necessary funds to pay the consultants.
According to the only consultant who testified at trial, a
representative of In Touch told him that he would be paid once In
Touch was financially capable of doing so. In reliance on this
statement, the consultant did not send any invoices to In Touch
for the service he rendered. The consultant also testified that
he did not receive the executed original of In Touch’s promissory
-13-
note, which allegedly was executed to guarantee payment of the
consultant’s fees.
The record supports an inference that none of the promissory
notes allegedly executed on behalf of In Touch in favor of the
consultants was ever delivered to the consultants. Petitioner
produced the original promissory notes in response to a subpoena
duces tecum issued by respondent before trial. It is reasonable
to conclude from the fact that petitioner had the original
promissory notes in his possession that the original promissory
notes allegedly executed for the benefit of the consultants were
never delivered to the consultants. Under Oklahoma State law,
delivery is an essential element to complete the legal transfer
of a negotiable instrument such as a promissory note. Harber v.
Lincoln, 51 P.2d 967, 969 (Okla. 1935).11 Because petitioner
failed to prove that In Touch delivered the promissory notes to
their intended recipients, petitioner has failed to prove that
11
Both execution and delivery are prerequisites to the
validity of a note. Luker v. Kells, 411 P.2d 511, 515 (Okla.
1966). Under Oklahoma law, the issuance of an instrument is
defined as “the first delivery of an instrument by the maker or
drawer, whether to a holder or nonholder, for the purpose of
giving rights on the instrument to any person.” Okla. Stat. Ann.
tit. 12A, sec. 3-105(a) (West 1998). Delivery is deemed to occur
upon a “voluntary transfer of possession.” Okla. Stat. Ann. tit.
12A, sec. 1-201(14) (West 2004).
-14-
the promissory notes were valid negotiable instruments under
State law.
Finally, petitioner failed to produce credible evidence to
prove the nature and extent of the consulting services provided
to In Touch during 2000 or to prove that the economic performance
requirement of section 461(h)(1) was satisfied with respect to
the consulting fees claimed by In Touch on its 2000 return.
Consequently, we hold that petitioner failed to demonstrate that
respondent’s disallowance of In Touch’s claimed consulting fees
was erroneous, and we sustain respondent’s determination.
III. Substantiation of Expenses
Deductions are a matter of legislative grace, and the
taxpayer must clearly demonstrate entitlement to any deductions
claimed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).
A taxpayer is obligated to keep records sufficient to allow the
Commissioner to establish the correct amount of the taxpayer’s
deductions. Sec. 6001; sec. 1.6001-1(a), Income Tax Regs. A
taxpayer must produce those records upon request for inspection
by authorized internal revenue officers or employees. Sec.
7602(a); sec. 1.6001-1(e), Income Tax Regs. If upon examination
the Commissioner disallows a business expense deduction, the
taxpayer bears the burden of introducing evidence to substantiate
the claimed deduction. Rule 142(a); see also Wilson v.
-15-
Commissioner, T.C. Memo. 2001-301; Joseph v. Commissioner, T.C.
Memo. 1997-447. If the taxpayer claims a deduction but cannot
fully substantiate it, we may estimate the allowable amount if
there is sufficient evidence in the record to provide a basis for
the estimate. Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d
Cir. 1930); see also Vanicek v. Commissioner, 85 T.C. 731, 742-
743 (1985).
Petitioner failed to substantiate the business expenses and
startup expenditures disallowed by respondent. At trial,
petitioner introduced only a brief summary of expenses and two
promissory notes purportedly issued as payment for professional
services. None of those documents established the dates,
description, or business purpose of the expenses. The evidence
offered was completely inadequate to substantiate petitioner’s
claimed expenses as required by section 6001 and related
regulations.
The complete absence of credible evidence in the record also
precludes us from estimating petitioner’s expenses under Cohan.
Petitioner did not offer testimony or documents to describe the
nature and amount of the startup expenditures and business
expenses that In Touch allegedly incurred during 2000, nor did
petitioner offer the Court any credible explanation for In
-16-
Touch’s failure to produce invoices, receipts, checks, or other
business records during the audit or at trial.
We sustain respondent’s determinations disallowing
petitioner’s deductions for professional fees, marketing
expenses, and amortization.
IV. Other Issues
Petitioner raised, and the parties briefed, two additional
issues: (1) Whether In Touch’s members had sufficient bases to
deduct their distributive share of In Touch’s 2000 net loss and
(2) whether property in the form of promissory notes contributed
to In Touch was “at risk” under section 465(a). Neither party
disputed that these issues involved partnership items that we
could properly decide in this partnership-level proceeding.
We decline to decide the remaining issues identified in this
opinion for several reasons. The first is that respondent
determined in the FPAA that the bases of In Touch’s members and
their at-risk amounts as of December 31, 2000, were limited to
$50,000, the amount of capital contributed as of December 31,
2000. Because we have sustained respondent’s determination
disallowing the vast majority of In Touch’s deductions for 2000,
it no longer appears to be necessary for us to decide whether the
members had sufficient bases or at-risk amounts to claim their
distributive shares of In Touch’s adjusted net loss.
-17-
We also question whether determinations regarding the
members’ bases and at-risk amounts satisfy the definition of
partnership item. If they are not partnership items, we may not
decide issues involving them in a partnership-level proceeding.
Section 6221 provides that, except as otherwise provided in
subchapter C dealing with the tax treatment of partnership items,
the tax treatment of any partnership item must be determined at
the partnership level. Section 6226(a) authorizes a tax matters
partner to file a petition for readjustment of partnership items
within 90 days after the date on which an FPAA is mailed to the
tax matters partner. A partnership-level proceeding filed
pursuant to section 6226(a) permits a court to consider and
resolve partnership items and the proper allocation of such items
among the partners. Sec. 301.6226(f)-1T, Temporary Proced. &
Admin. Regs., 52 Fed. Reg. 6788 (Mar. 5, 1987).
Section 6231(a)(3) defines a “partnership item” as:
any item required to be taken into account for the
partnership’s taxable year under any provision of
subtitle A to the extent regulations prescribed by the
Secretary provide that, for purposes of this subtitle,
such item is more appropriately determined at the
partnership level than at the partner level.
In section 301.6231(a)(3)-1, Proced. & Admin. Regs., the
Commissioner has provided guidance that amplifies the definition
of partnership item contained in section 6231(a)(3). However,
-18-
section 301.6231(a)(3)-1, Proced. & Admin. Regs., does not
clearly answer the question of whether determinations regarding
contributions to a partnership’s capital and the effect of those
contributions on the partner’s basis and at-risk amounts are
partnership items. See the discussion of section 301.6231(a)(3)-
1, Proced. & Admin. Regs., in Hambrose Leasing 1984-5 Ltd. Pship.
v. Commissioner, 99 T.C. 298, 306-312 (1992).
In Hambrose Leasing, we interpreted section 301.6231(a)(3)-
1, Proced. & Admin. Regs., in the context of determining whether
individual partners were at risk under section 465(b)(4). After
carefully considering the provisions of section 301.6231(a)(3)-1,
Proced. & Admin. Regs., and the arguments of the parties therein,
we stated the following:
We conclude, based on the circumstances of this
case, that the determination of amounts at risk with
respect to partnership liabilities personally assumed
by individual partners is not a partnership item, but
is an affected item, which can be dealt with only in a
proceeding involving the partners and not in this
partnership level proceeding. Sec. 6226(f); N.C.F.
Energy Partners v. Commissioner, 89 T.C. 741, 743
(1987). We base this conclusion on the definition of
“partnership item” in section 6231 (“required to be
taken into account for the partnership’s taxable
year”), our interpretation of the pertinent
regulations, in light of the statute (an approach which
makes it unnecessary for us to rule on petitioners’
contention that the regulations are invalid), and the
application of the statute and regulations in the
decided cases. In short, the application of section
465 as such is not an issue appropriate for a
determination in a partnership level proceeding. See
-19-
Dial USA, Inc. v. Commissioner, 95 T.C. 5 n.5. [Id.
at 312; fn. ref. omitted.]
We have also considered a similar issue with respect to
contributions of property to a passthrough entity and the effect
of the contributions on the basis of individual members. In Dial
USA, Inc. v. Commissioner, 95 T.C. 1 (1990), we considered
whether a member’s basis in an S corporation is a “subchapter S
item” within the meaning of former section 6245.12 We
acknowledged that the partnership audit and litigation provisions
contained in sections 6221-6231 “were, in effect, grafted onto
the subchapter S audit and litigation provisions” by former
section 6244, id. at 3, and we held that a member’s basis in the
passthrough entity was not an item “required” to be taken into
account by the entity for the entity’s taxable year, id. at 5-6.
We conclude that it is not necessary or appropriate to
decide the basis and at-risk issues.
To reflect the foregoing,
An appropriate decision will
be entered.
12
The subch. S audit and litigation provisions were repealed
by the Small Business Job Protection Act of 1996, Pub. L. 104-
188, sec. 1307(c)(1), 110 Stat. 1781, applicable to tax years
beginning after Dec. 31, 1996.