Martha G. Smith & George S. Lakner v. Commissioner ( 2018 )

T.C. Memo. 2018-127
UNITED STATES TAX COURT
MARTHA G. SMITH AND GEORGE S. LAKNER, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 8847-12, 25714-12 Filed August 13, 2018.
12293-14.
Edward J. Leyden, for petitioners.
Rachel L. Rollins and Jeffrey E. Gold, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LAUBER, Judge: With respect to petitioners’ Federal income tax for
2007-2011, the Internal Revenue Service (IRS or respondent) determined
1
Cases of the following petitioners are consolidated herewith: Martha G.
Smith and George S. Lakner, docket No. 25714-12; and George S. Lakner and
Martha G. Smith, docket No. 12293-14.
-2-
[*2] deficiencies in tax, additions to tax under section 6651(a)(1), and penalties
under sections 6662(a) and 6663(a),2 as follows:
Addition to tax Penalties
Year Deficiency sec. 6651(a)(1) Sec. 6662(a) Sec. 6663(a)
2007 $27,339 $5,621 $5,468 -0-
2008 106,999 25,472 -0- $80,249
2009 16,148 2,836 3,230 -0-
2010 313,914 15,448 -0- 235,210
2011 163,468 17,762 -0- 122,601
After various concessions (discussed below), the issues for decision are
whether petitioners for various years: (1) received unreported income; (2) are
entitled to deductions claimed on Schedules A, Itemized Deductions, in amounts
greater than respondent has allowed; (3) are entitled to deductions claimed on
Schedules C, Profit or Loss From Business, in amounts greater than respondent
has allowed; (4) are entitled to losses claimed on Schedules E, Supplemental
Income and Loss; (5) are entitled to deductions for net operating losses (NOLs);
(6) are liable for late-filing additions to tax under section 6651(a)(1); and (7) are
2
All statutory references are to the Internal Revenue Code (Code) in effect
for the years at issue, and all Rule references are to the Tax Court Rules of Prac-
tice and Procedure. We round all monetary amounts to the nearest dollar.
-3-
[*3] liable for accuracy-related penalties.3 With minor exceptions, we will sustain
respondent’s determinations.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulations of
fact and the attached exhibits are incorporated by this reference. Petitioners, who
are husband and wife, resided in Washington, D.C., when they filed their petitions.
A. Background
Petitioner George S. Lakner is a distinguished doctor and psychiatrist. He
has held teaching positions at Columbia University, Harvard University, and
George Washington University. Before he began teaching, he had a long career in
the U.S. Army, during which he was stationed at various military installations in
the United States and overseas. He has worked with the National Guard, the Vet-
erans Administration (VA), and the National Institutes of Health, all in his capa-
city as a psychiatrist.
Dr. Lakner joined the Army in 1976 and rose through the ranks to become a
colonel. From 1999 to 2001 he was employed by the VA Medical Center in Loma
Linda, California. During that employment he raised concerns with his superiors
3
In the notice of deficiency for 2008, 2010, and 2011, the IRS asserted, as
alternatives to the fraud penalties, accuracy-related penalties under section
6662(a).
-4-
[*4] that veterans with mental health problems were receiving inadequate care. In
November 2001 the VA terminated his employment.
In January 2002 Dr. Lakner filed a Complaint of Employment Discrimina-
tion with the Equal Employment Opportunity Commission (EEOC), and the fol-
lowing month he filed an amended EEOC complaint. In both complaints he al-
leged that he had been the victim of discrimination on the basis of religion, nation-
al origin, age, and/or disability. In the alternative he alleged that he had been fired
as a reprisal for protected activity in which he had engaged. The record is unclear
as to the status of his complaint between 2002 and 2010.
After leaving the VA, Dr. Lakner was deployed to Bosnia, where he was
severely injured by a roadside bomb in 2003. While recovering from his wounds
he was deployed to Kosovo. He alleges that in Kosovo he was confined for sever-
al months in military installations because the Army believed that the VA’s termi-
nation of his employment rendered his continued military service unlawful.
After returning to the United States Dr. Lakner went on inactive status in
2006 and retired from the Army in 2008. Around that time he started a medical
consulting practice that he operated during the years at issue. The record is un-
clear as to the exact nature of his consulting practice.
-5-
[*5] In January 2010 the EEOC held a hearing on Dr. Lakner’s complaints. Dur-
ing this hearing his attorney represented that the sole issue for adjudication was
whether Dr. Lakner’s employment had been unlawfully terminated by the VA. Dr.
Lakner testified that he had filed his complaint because he believed the VA had
discriminated against him for being Jewish. The hearing transcript contains no
reference to any physical sickness or injury suffered by Dr. Lakner.
In January 2010 Dr. Lakner reached a settlement with the VA. Under this
settlement he received a lump-sum payment of $328,000, representing pecuniary
and nonpecuniary damages; $172,000 for attorneys’ fees; and $178,552 for ac-
crued annual leave. The VA reported the latter amount to him on a Form W-2,
Wage and Tax Statement.
Petitioner Martha G. Smith was a licensed property manager during 2007-
2011. She was employed by Realtor Cathie Gill, Inc., where she supervised the
firm’s property management services. She also worked as an independent proper-
ty manager. During some or all of these years petitioners owned, jointly or indi-
vidually, as many as six rental properties: four in Washington, D.C., one in Cali-
fornia, and one in Connecticut. Ms. Smith managed these rental properties.
-6-
[*6] B. Petitioners’ Tax Returns
Petitioners jointly filed a delinquent Form 1040, U.S. Individual Income
Tax Return, for each year at issue. They included in each return a Schedule C. On
each Schedule C they reported income and expenses for Dr. Lakner’s medical
consulting business and Ms. Smith’s rental real estate activity, without identifying
which items related to which business.
1. 2007 Return
For 2007 petitioners reported negative adjusted gross income (AGI) of
$67,106. On their Schedule C they reported gross receipts of $58,400 and total
expenses of $130,213, for a net loss of $71,813. The reported expenses were as
follows:
Item Amount
Commissions/fees $2,247
Insurance (other than health) 9,001
Legal/professional services 31,369
Office supplies 862
Travel 2,389
Meals/entertainment 1,035
Utilities 4,441
Other 78,869
Total 130,213
For 2007 petitioners claimed on Schedule A the following deductions:
medical expenses of $4,023, State and local taxes of $22,731, and home mortgage
interest of $31,011. They also claimed an NOL deduction of $85,258.
-7-
[*7] 2. 2008 Return
For 2008 petitioners reported negative AGI of $136,685. On their Sched-
ule C they reported gross receipts of $77,200 and total expenses of $191,350, for a
net loss of $114,150. The reported expenses were as follows:
Item Amount
Commissions/fees $4,162
Insurance (other than health) 9,900
Legal/professional services 43,362
Office supplies 1,247
Travel 2,257
Meals/entertainment 864
Utilities 4,762
Other 124,796
Total 191,350
For 2008 petitioners claimed on Schedule A the following deductions:
medical expenses of $5,720, State and local taxes of $34,210, and home mortgage
interest of $58,246. They also claimed an NOL deduction of $99,383.
3. 2009 Return
For 2009 petitioners reported negative AGI of $193,471. On their Sched-
ule C they reported gross receipts of $66,617 and total expenses of $176,121, for a
net loss of $109,504. The reported expenses were as follows:
Item Amount
Commissions/fees $2,911
Insurance (other than health) 12,026
Legal/professional services 40,561
-8-
[*8] Office supplies 1,440
Travel 1,999
Meals/entertainment 845
Utilities 4,021
Other 112,318
Total 176,121
For 2009 petitioners claimed on Schedule A the following deductions:
medical expenses of $5,703, State and local taxes of $27,136, and home mortgage
interest of $35,181. They also claimed an NOL deduction of $162,030.
4. 2010 Return
For 2010 petitioners reported negative AGI of $226,693. On their Sched-
ule C they reported gross receipts of $83,350 and total expenses of $166,544, for a
net loss of $83,194. The reported expenses were as follows:
Item Amount
Insurance (other than health) $7,902
Legal/professional services 637
Office supplies 2,640
Travel 1,324
Meals/entertainment 597
Utilities 3,753
Other 149,691
Total 166,544
For 2010 petitioners claimed on Schedule A the following deductions:
medical expenses of $4,187, State and local taxes of $23,504, home mortgage in-
terest of $39,144, and unreimbursed employee expenses of $700. They also
claimed an NOL deduction of $219,855.
-9-
[*9] 5. 2011 Return
For 2011 petitioners reported negative AGI of $81,344. On their Schedule
C they reported gross receipts of $20,748 and total expenses of $103,554, for a net
loss of $82,806. The reported expenses were as follows:
Item Amount
Commissions/fees $1,900
Insurance (other than health) 1,763
Office supplies 4,101
Meals/entertainment 1,593
Other 94,197
Total 103,554
For 2011 petitioners claimed on Schedule A the following deductions:
medical expenses of $4,397, State and local taxes of $37,803, and home mortgage
interest of $8,514. They claimed an NOL deduction of $250,773 and reported on
Schedule E a real estate net loss of $25,000.
6. IRS Examination
The IRS selected petitioners’ 2007-2011 returns for examination. On the
basis of a bank deposits analysis the IRS determined that petitioners had omitted
rental income from all of their rental properties for 2008 and 2010; had omitted
gross receipts from Dr. Lakner’s medical consulting business for 2008 and 2010;
and had omitted a taxable settlement payment from the VA for 2010. The IRS did
- 10 -
[*10] not perform a bank deposits analysis for the other years but determined that
petitioners had omitted specific items of gross income for 2007, 2009, and 2011.
The IRS disallowed for lack of substantiation some of the deductions
claimed on petitioners’ Schedules A and all of the deductions claimed on their
Schedules C. After making various computational adjustments that are not at
issue here,4 the IRS determined the deficiencies set forth supra p. 2. The IRS also
determined late-filing additions to tax for all five years; accuracy-related penalties
for 2007 and 2009; fraud penalties for 2008, 2010, and 2011; and accuracy-related
penalties as alternatives to the fraud penalties for the latter three years.
The IRS issued petitioners three timely notices of deficiency--one for 2007,
one for 2009, and the third for 2008, 2010, and 2011--setting forth the deficien-
cies, additions to tax, and penalties noted above. Petitioners timely petitioned this
Court for redetermination. We consolidated the three cases for purposes of trial,
briefing, and opinion. The cases were partially tried in September 2013, and a
further trial was held in December 2016.
4
The IRS made computational adjustments to the taxable portions of peti-
tioners’ Social Security income for all years, itemized deductions for 2008-2011,
and personal exemptions for 2008. We leave these adjustments to the parties’
Rule 155 computations.
- 11 -
[*11] OPINION
I. Burden of Proof
The IRS’ determinations in a notice of deficiency are generally presumed
correct, and taxpayers bear the burden of proving them erroneous. Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933). For the presumption of correctness
to attach to a deficiency determination of unreported income, the Commissioner
must generally establish a “minimal evidentiary showing” connecting the taxpayer
with the income-producing activity, see Blohm v. Commissioner, 994 F.2d 1542,
1548-1549 (11th Cir. 1993), aff’g T.C. Memo. 1991-636, or demonstrate that the
taxpayer actually received unreported income, see Edwards v. Commissioner, 680
F.2d 1268, 1270 (9th Cir. 1982). Once the Commissioner makes the required
threshold showing, the burden of proof shifts to the taxpayer to prove by a prepon-
derance of the evidence that the Commissioner’s determinations are arbitrary or
erroneous. Helvering v. Taylor, 293 U.S. 507, 515 (1935); Tokarski v. Commis-
sioner, 87 T.C. 74 (1986).
To satisfy his burden of production regarding unreported income for 2008
and 2010, respondent introduced bank records obtained during the IRS audit.
These records establish that petitioners received unreported income from Dr. Lak-
ner’s medical consulting business and from Ms. Smith’s rental real estate activity.
- 12 -
[*12] And they establish that Dr. Lakner in 2010 received from the VA a check for
$328,000. Respondent has therefore made whatever “minimal evidentiary show-
ing” he might be required to make. His determinations of unreported income are
thus entitled to the general presumption of correctness. See Powerstein v. Com-
missioner, T.C. Memo. 2011-271, 102 T.C.M. 497, 506.
Petitioners thus bear the burden of proving by a preponderance of the evi-
dence that respondent’s determinations of unreported income are arbitrary or er-
roneous. See Williams v. Commissioner, 999 F.2d 760, 763 (4th Cir. 1993) (citing
Helvering v. Taylor, 293 U.S. at 515), aff’g T.C. Memo. 1992-153; Tokarski, 87
T.C. at 77. Petitioners likewise bear the burden of proving their entitlement to
deductions allowed by the Code and of substantiating the amounts of claimed
deductions. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); sec.
1.6001-1(a), Income Tax Regs. Petitioners do not contend, and they could not
plausibly contend, that the burden of proof as to any issue of fact should shift to
respondent under section 7491(a).
II. Unreported Income
Section 61(a) defines gross income as “all income from whatever source
derived,” including income derived from business. Exclusions from gross income
are narrowly construed. Commissioner v. Schleier, 515 U.S. 323, 328 (1995);
- 13 -
[*13] Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429-430 (1955);
Helvering v. Clifford, 309 U.S. 331, 334 (1940). A taxpayer must maintain books
and records establishing the amount of his or her gross income. See sec. 6001.
When a taxpayer does not keep accurate books and records, the IRS may de-
termine his or her income “under such method as, in the opinion of the Secretary,
does clearly reflect income.” Sec. 446(b); see Petzoldt v. Commissioner, 92 T.C.
661, 693 (1989). And where the taxpayer has unexplained bank deposits, the IRS
may employ the bank deposits method to estimate income. Estate of Hague v.
Commissioner, 132 F.2d 775 (2d Cir. 1943), aff’g 45 B.T.A. 104 (1941); Estate of
Mason v. Commissioner, 64 T.C. 651, 657 (1975), aff’d, 566 F.2d 2 (6th Cir.
1977). The IRS has great latitude in reconstructing a taxpayer’s income, and the
reconstruction “need only be reasonable in light of all surrounding facts and cir-
cumstances.” Petzoldt, 92 T.C. at 687.
Bank deposits are prima facie evidence of income. The bank deposits meth-
od starts with the presumption that all money deposited into a taxpayer’s bank ac-
count during a given period constitutes taxable income. Price v. United States,
335 F.2d 671, 677 (5th Cir. 1964). This presumption is rebutted to the extent the
deposits are shown to include nontaxable amounts, and “the Government must
take into account any non-taxable source * * * of which it has knowledge.” Ibid.;
- 14 -
[*14] DiLeo v. Commissioner, 96 T.C. 858, 868 (1991), aff’d, 959 F.2d 16 (2d
Cir. 1992).
After the IRS reconstructs a taxpayer’s income and determines a deficiency,
the taxpayer bears the burden of proving that the IRS’ implementation of the bank
deposits method was unfair or inaccurate. See Clayton v. Commissioner, 102 T.C.
632, 645-646 (1994); DiLeo, 96 T.C. at 871-872. The taxpayer may do so by
showing (among other things) that certain deposits came from nontaxable sources.
See Clayton, 102 T.C. at 645. Nontaxable sources include funds attributable to
interaccount bank transfers and returned checks as well as “loans, gifts, inherit-
ances, or assets on hand at the beginning of the taxable period.” Burgo v. Com-
missioner, 69 T.C. 729, 743 n.14 (1978) (quoting Troncelliti v. Commissioner,
T.C. Memo. 1971-72).
A. Unreported Income for 2008 and 2010
Finding that petitioners lacked adequate books and records for 2008 and
2010, the revenue agent (RA) employed the bank deposits method to reconstruct
their income for those years. After obtaining petitioners’ bank statements by is-
suing summonses to their banks, the RA used the statements (which are part of the
record) to prepare schedules listing all deposits. After eliminating nontaxable re-
ceipts of which he was aware, and further reducing the total bank deposits by the
- 15 -
[*15] income petitioners reported on their returns, the RA prepared and provided
to petitioners schedules that determined unreported income. The RA determined
that this unreported income was attributable to Dr. Lakner’s medical consulting
business, Ms. Smith’s rental real estate activity, the VA settlement payment, and a
separate litigation settlement of an insurance claim.
Petitioners do not challenge the RA’s use of the bank deposits method or his
determination that their consulting and rental income was taxable. Rather, they
contend that he misapplied the bank deposits method by: (1) failing to exclude the
VA settlement payment, (2) failing to exclude other allegedly nontaxable amounts,
and (3) mischaracterizing certain receipts as rental income.
1. VA Settlement Payment
Petitioners assert that at least part of the VA settlement payment they re-
ceived in 2010 was nontaxable because it represented damages for the physical in-
jury Dr. Lakner sustained in Bosnia in 2003. Proceeds from litigation settlements
constitute gross income unless the taxpayer proves that the proceeds fall within a
specific statutory exclusion. Schleier, 515 U.S. at 328-337; Save v. Commission-
er, T.C. Memo. 2009-209, 98 T.C.M. 218, 218. The exclusion from gross
income upon which petitioners rely appears in section 104(a)(2). It provides that
gross income does not include damages received “on account of personal physical
- 16 -
[*16] injuries or physical sickness.” For this purpose, “emotional distress shall
not be treated as a physical injury or physical sickness.” Sec. 104(a) (penultimate
sentence).
When damages are received under a settlement agreement, the nature of the
claim that was the actual basis for the settlement determines whether the damages
are excludable under section 104(a)(2). United States v. Burke, 504 U.S. 229, 237
(1992). “The nature of the claim” is typically determined by reference to the terms
of the agreement. See Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir.
1965), aff’g T.C. Memo. 1964-33; Robinson v. Commissioner, 102 T.C. 116, 126
(1994), aff’d in part, rev’d in part, and remanded on another issue, 70 F.3d 34 (5th
Cir. 1995). If the settlement agreement does not explicitly state which claims the
payment was made to settle, “the intent of the payor * * * is critical.” Longoria v.
Commissioner, T.C. Memo. 2009-162, 98 T.C.M. 11, 15; see George v.
Commissioner, T.C. Memo. 2016-156, 112 T.C.M. 239, 240.
The intent of the payor may be determined by considering all relevant facts,
including the amount paid, the circumstances leading to the settlement, and the al-
legations in the injured party’s complaint. Green v. Commissioner, 507 F.3d 857,
868 (5th Cir. 2007), aff’g T.C. Memo. 2005-250; Bent v. Commissioner, 87 T.C.
236, 245 (1986), aff’d, 835 F.2d 67 (3d Cir. 1987). “[T]he nature of underlying
- 17 -
[*17] claims cannot be determined from a general release that is broad and
inclusive.” Ahmed v. Commissioner, T.C. Memo. 2011-295, 102 T.C.M.
607, 608, aff’d, 498 F. App’x 919 (11th Cir. 2012).
In his EEOC complaints Dr. Lakner alleged that the VA had terminated his
employment because of his Jewish ancestry and religion and as reprisal for his
advocacy on behalf of veterans with psychological illness. His original and
amended complaints were filed in 2002. They did not mention (nor could they
possibly have mentioned) the injury he sustained in 2003.
The EEOC hearing was held in 2010. During that hearing Dr. Lakner’s at-
torney stated that the sole issue for adjudication was whether Dr. Lakner’s em-
ployment with the VA had been unlawfully terminated in 2001. Neither his com-
plaint nor the hearing transcript contains any reference to physical injury or physi-
cal sickness.
The settlement agreement between Dr. Lakner and the VA states that it re-
solves all matters he had raised in his complaint. The VA agreed to pay $328,000
in pecuniary and nonpecuniary damages, make a lump-sum payment for accrued
annual leave, and pay Dr. Lakner’s attorney’s fees. There is no mention of any
physical injury he had suffered. In exchange for the VA’s payments, Dr. Lakner
agreed to “withdraw, in their entirety, all discrimination complaints.” Apart from
- 18 -
[*18] Dr. Lakner’s testimony at trial, there is no evidence that the EEOC settle-
ment payment represented compensation for the injuries he sustained in Bosnia.
Dr. Lakner contends that the injury he sustained in Bosnia was exacerbated
by his alleged confinement in Kosovo and that the VA settlement agreement had
“linkage” to those events. But in deciding whether a settlement payment is ex-
cludable under section 104(a)(2), the crucial question is whether the settlement
amount was actually paid to redress a physical injury. See Molina v. Commission-
er, T.C. Memo. 2013-226, 106 T.C.M. 371, 373. Dr. Lakner alleged no
physical injury in his EEOC complaints, and the settlement agreement clearly
states that the VA settled the case in consideration of his agreement to withdraw
“all discrimination complaints” he had made. Giving primacy to the terms of the
settlement agreement and to “the intent of the payor,” Longoria, 98 T.C.M. (CCH)
at 15, we find that the VA intended to settle, and did settle, Dr. Lakner’s claims of
discrimination based on religion, national origin, and reprisal.5 We accordingly
5
Dr. Lakner also agreed to waive “his right to pursue future causes of action
against the Agency based on facts in existence as of the date of * * * this Agree-
ment.” We have found such general, prospective waivers inadequate to show that
a settlement payment was made for a physical injury. See Devine v. Commission-
er, T.C. Memo. 2017-111, 113 T.C.M. 1496, 1499. In any event, even if
petitioners could show that some portion of the $328,000 settlement was attri-
butable to physical injury, they have offered no evidentiary basis for calculating
that portion and would thus fail to meet their burden of proof.
- 19 -
[*19] hold that the $328,000 VA settlement payment was not received “on account
of personal physical injuries or physical sickness” and is therefore not excludable
from gross income under section 104(a)(2).
2. Other Income for 2008 and 2010
During 2008 and 2010 petitioners maintained 10 to 12 personal bank ac-
counts into which they made deposits. When performing his bank deposits analy-
sis, the RA subtracted from petitioners’ total deposits for 2008 and 2010 non-
taxable transfers of $216,357 and $523,795, respectively. These calculations
yielded net taxable deposits of $305,327 and $885,684, respectively. From these
sums he subtracted the gross income petitioners had reported on their 2008 and
2010 tax returns, i.e., $179,405 and $186,420, respectively. This yielded net un-
reported income of $125,922 for 2008 and $699,264 for 2010. Using information
in the bank records, the RA allocated this unreported income into three categories
(the $328,000 VA settlement payment is included in the Schedule C total for
2010):
Item 2008 2010
Litigation settlement proceeds -0- $275,000
Medical consulting (Schedule C) $92,887 334,175
Rental real estate (Schedule E) 33,035 90,089
Total 125,922 699,264
- 20 -
[*20] The litigation proceeds of $275,000 reflected an insurance settlement peti-
tioners received in 2010 following a casualty loss to one of their rental homes.
This loss was caused by a neighbor who did unauthorized work on his property,
resulting in a landslide that damaged the retaining wall on petitioners’ property.
Respondent conceded in his post-trial brief that these insurance proceeds were ex-
cludable from gross income and hence that the $275,000 was a nontaxable deposit.
Petitioners’ unreported income for 2010, including the VA settlement payment, is
thus reduced to $424,264.
Petitioners have supplied no credible evidence that would justify eliminat-
ing any other bank deposits as nontaxable items. Petitioners have stipulated that
they did not receive any gifts or inheritances during these years. Contrary to their
contention, the RA correctly accounted for interaccount transfers of $158,443 for
2008 and $76,122 for 2010. Petitioners assert that a $719 check that Dr. Lakner
received from the VA in 2008 was excludable from gross income under section
104, but they provided no credible evidence that the VA made this payment on
account of disability, physical injury, or physical sickness.
There is likewise no factual basis for petitioners’ assertion that the RA erred
in characterizing certain bank deposits as rental income. Each deposit that the RA
characterized as rent corresponded to a check that named one or both petitioners as
- 21 -
[*21] payees and either (1) bore the notation “rent” on the memo line or (2) show-
ed an address matching the address of one of petitioners’ rental properties. Peti-
tioners assert that the RA double-counted certain deposits by treating them as rent,
but they have supplied no evidentiary support for that assertion.
In sum, we find that petitioners have failed to carry their burden of showing
error in the RA’s bank deposits analysis for 2008 or 2010, apart from the errone-
ous inclusion of the $275,000 insurance settlement as conceded by respondent.
We accordingly find that petitioners had unreported income of $125,922 for 2008
and $424,264 for 2010, allocable between Schedule C and Schedule E as shown
on the table above. See supra p. 19.
B. Unreported Income for 2007, 2009, and 2011
For 2007 petitioners concede that they failed to report taxable interest in-
come of $34,357. For 2011 respondent concedes that a $28,735 distribution peti-
tioners received from an IRA account was not includable in gross income. We
thus sustain respondent’s determination of unreported income for 2007, but not for
2011.
For 2007 and 2009 petitioners contend that the RA erred in allocating in-
come between Schedule C and Schedule E. For both years petitioners lumped to-
gether, on a single Schedule C, the income and expenses connected with Dr. Lak-
- 22 -
[*22] ner’s medical consulting business and the income and expenses connected
with Ms. Smith’s rental real estate activity. The latter amounts should have been
reported on Schedule E. Given the disarray in petitioners’ recordkeeping, untang-
ling the two streams of income and expenses was no easy task. Using information
in petitioners’ bank records, the RA determined that $58,400 of Schedule C gross
receipts for 2007 and $66,617 of Schedule C gross receipts for 2009 should be re-
characterized as rental income and transferred to Schedule E. Petitioners have not
shown that this determination was arbitrary or erroneous.
III. Schedule A Deductions
For 2008 petitioners claimed a deduction of $58,246 for home mortgage
interest expense. The IRS reduced the allowable deduction to $35,669, determin-
ing that petitioners had failed to substantiate the remainder. Petitioners introduced
no credible evidence to support a deduction larger than the IRS has allowed.
For 2008, 2010, and 2011 petitioners deducted State and local taxes of
$34,210, $23,504, and $37,803, respectively. The IRS in the notice of deficiency
disallowed these deductions in their entirety. In his post-trial brief respondent
conceded that petitioners are entitled to State tax deductions of $4,197 for 2008,
$4,120 for 2010, and $32,390 for 2011. Petitioners introduced no credible evi-
- 23 -
[*23] dence to substantiate deductions for State taxes in amounts larger than
respondent has conceded.6
IV. Schedule C Deductions
Deductions are a matter of legislative grace. The taxpayer bears the burden
of proving that reported business expenses were actually incurred and were “ordi-
nary and necessary.” Sec. 162(a); Rule 142(a); INDOPCO, Inc., 503 U.S. at 83.
The taxpayer also bears the burden of substantiating expenses underlying his
claimed deductions by keeping and producing records sufficient to enable the IRS
to determine his correct tax liability. Sec. 1.6001-1(a), (e), Income Tax Regs. The
failure to keep and present such records counts heavily against a taxpayer’s at-
tempted proof. Rogers v. Commissioner, T.C. Memo. 2014-141, 108 T.C.M.
(CCH) 39, 43. In certain circumstances the Court may approximate the amount of
an expense if the taxpayer proves that it was incurred but cannot substantiate the
exact amount. Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). But
the taxpayer must provide some basis for such an estimate. Vanicek v. Commis-
sioner, 85 T.C. 731, 742-743 (1985).
6
Petitioners contend that “there is a substantial possibility” that their disal-
lowed Schedule A expense deductions were attributable to their rental properties.
As noted in the text, they supplied no credible evidence to substantiate the
expenses, regardless of the schedule on which they might properly be reportable.
- 24 -
[*24] Section 274(d) imposes strict substantiation requirements for deductions
claimed for expenses of traveling (including meals and lodging while away from
home), gifts, and entertainment. No such deduction is allowed unless the taxpayer
substantiates, by adequate records or by sufficient evidence corroborating his own
statements, the amount, time and place, and business purpose for each expendi-
ture. Sec. 274(d); sec. 1.274-5T(a), (b), and (c), Temporary Income Tax Regs., 50
Fed. Reg. 46014-46017 (Nov. 6, 1985). A court may not apply the Cohan rule to
approximate expenses covered by section 274(d). Sanford v. Commissioner, 50
T.C. 823, 827-828 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969).
For 2007-2011 petitioners claimed deductions on Schedule C in the respec-
tive amounts of $130,213, $191,350, $176,121, $166,544, and $103,554. With
minor exceptions, the IRS disallowed these deductions for lack of substantiation
or because they constituted “personal, living, or family expenses.” See sec.
262(a). We sustain these determinations subject to certain concessions by re-
spondent as noted below.7
7
Petitioners lumped together on their Schedules C expenses allegedly in-
curred both in Dr. Lakner’s medical consulting business and in the rental real es-
tate activity. To the extent that petitioners have substantiated expenses properly
reportable on Schedule E rather than Schedule C, we have noted that in the text
below.
- 25 -
[*25] A. 2007 and 2009
To substantiate their expenses for 2007 and 2009, petitioners provided at
trial numerous receipts and invoices, order confirmation emails, canceled checks,
bank statements, and handwritten summaries. Because these documents were
highly disorganized, we instructed petitioners to attach to their post-trial briefs
spreadsheets linking each claimed deduction to specific substantiating documents
in the record. The spreadsheets petitioners supplied did not do this in a helpful or
plausible way. We will briefly address each category of expenses petitioners
claim to have paid:
• Meals, Entertainment, and Business Gifts: Petitioners claimed deductions
for grocery shopping, airline and car rental expenses, dining out at numerous res-
taurants, and alleged business gifts in the form of wine, desserts, flowers, and gift
cards. These expenses are subject to the strict substantiation requirements of
section 274(d). See Sanford, 50 T.C. at 827; sec. 1.274-5T(a), Temporary Income
Tax Regs. Petitioners did not satisfy these requirements because they failed to
supply any credible evidence establishing the time, place, and/or business purpose
for these expenditures.
• Professional Services: Petitioners claimed deductions for legal fees, ap-
praisal fees, and accounting fees. Such expenses are deductible on Schedule C
- 26 -
[*26] only if incurred in connection with the taxpayer’s trade or business. Kenton
v. Commissioner, T.C. Memo. 2006-13; Test v. Commissioner, T.C. Memo. 2000-
362, aff’d, 49 F. App’x 96 (9th Cir. 2002). As purported substantiation petitioners
supplied canceled checks or invoices showing lawyers or other professionals as
payees. Petitioners have provided no evidence that would enable the Court to
determine whether the claimed payments had any connection with Dr. Lakner’s
consulting business or with Ms. Smith’s rental real estate activity. We therefore
sustain the disallowance of all deductions in this category.
• Professional and Licensing Fees: To substantiate these expenses petition-
ers offered canceled checks made out to the D.C. Treasurer and various medical
associations. We sustain disallowance of all deductions in this category because
petitioners have failed to prove that the canceled checks corresponded to ordinary
and necessary expenses of Dr. Lakner’s consulting business.
• Maintenance: Respondent has conceded that petitioners have substantia-
ted $100 of deductible maintenance expenses for 2007. The IRS properly disal-
lowed deductions for the other reported expenses in this category because they
were personal, were incurred outside the years at issue, or were not shown to have
any connection with Dr. Lakner’s consulting business or with petitioners’ rental
properties.
- 27 -
[*27] • Miscellaneous Property-Related Expenses: Petitioners submitted a large
stack of canceled checks, receipts, and invoices showing payments to numerous
utility companies, service companies, insurance companies, and retail stores (such
as Macy’s, Home Depot, and Bed Bath and Beyond). Petitioners do not contend
that any of these expenses was properly deductible on Schedule C. Respondent
has conceded that petitioners are entitled to a Schedule E deduction of $532 for
improvements to a rental property in 2009. We did not find credible petitioners’
testimony that any of the other reported expenses related to their rental properties
as opposed to their personal residence. Petitioners have not carried their burden of
proving that these expenses were properly deductible. See sec. 262; Tokarski, 87
T.C. at 77.
• Property Tax and Mortgage Interest: As purported substantiation for
Schedule C expenses in 2007 and 2009, petitioners’ spreadsheet listed real prop-
erty taxes and home mortgage interest that they had separately claimed as itemized
deductions on Schedule A. The IRS allowed all of the itemized deductions that
petitioners claimed for 2007 and 2009. Petitioners have failed to substantiate any
deductions for property taxes or interest beyond the amounts the IRS allowed as
itemized deductions.
- 28 -
[*28] • IRA Contributions: As purported substantiation for their Schedule C ex-
penses, petitioners’ spreadsheets listed IRA contributions of $2,000 for 2007 and
2009. Petitioners separately claimed on line 32 of their Form 1040 for each year,
and the IRS allowed, an IRA contribution deduction of $2,000. Petitioners have
failed to prove that they are entitled to IRA deductions larger than those respond-
ent has allowed.
• Charitable Contributions: As purported substantiation for their Schedule
C expenses, petitioners’ spreadsheet listed charitable contributions of $2,430 for
2007. Petitioners for 2007 separately claimed on Schedule A, and the IRS al-
lowed, a charitable contribution deduction of $2,100. Petitioners have failed to
prove that they are entitled to a charitable contribution deduction for 2007 in ex-
cess of the amount respondent allowed on Schedule A.
• Other Expenses: On their spreadsheet for 2007 petitioners listed an ex-
pense of $159 for “professional training.” Respondent conceded that petitioners
substantiated $40 of this expense. We find that they have not substantiated the re-
mainder.
- 29 -
[*29] B. 2008, 2010, and 2011
For 2008, 2010, and 2011, the IRS disallowed most of petitioners’ claimed
Schedule C expense deductions, determining that they had substantiated only the
following:
Item 2008 2010 2011
Travel $2,257 $1,324 -0-
Meals/entertainment 864 957 $1,593
Total 3,121 2,281 1,593
Petitioners have produced no invoices, bank statements, credit card state-
ments, or other credible documentation to substantiate the existence or amount of
any other Schedule C expenses. We reject their request that we estimate their
deductible expenses because they have provided no evidentiary basis on which we
could base such an estimate. See Norgaard v. Commissioner, 939 F.2d 874, 879
(9th Cir. 1991) (requiring the taxpayer to present credible evidence from which the
Court can make an estimate under the Cohan rule), aff’g in part, rev’g in part T.C.
Memo. 1989-390. We find that petitioners have not substantiated Schedule C
expenses for 2008, 2010, or 2011 in excess of the amounts respondent has
allowed.
- 30 -
[*30] V. Schedule E Loss
On their Schedule E for 2011 petitioners reported income of $13,045 from
two rental properties and negative income of $38,045 from three rental properties,
producing an alleged rental real estate loss of $25,000. They reported the full
amount of that loss on line 17 of their Form 1040. In the notice of deficiency the
IRS disallowed any deduction for that loss, stating: “Your rental loss was disal-
lowed because * * * you are not a real estate professional and your modified ad-
justed gross income is over $150,000.”
The Code allows an individual who actively participates in a rental real es-
tate activity to deduct against ordinary income up to $25,000 of losses from that
activity if AGI is less than $150,000. See sec. 469(i)(1), (2), and (3). Respondent
concedes that Ms. Smith actively participated in the rental real estate activity dur-
ing 2011. In light of the adjustments to income that we have sustained, however,
petitioners’ AGI for 2011 was substantially in excess of $150,000. Thus, assum-
ing arguendo that petitioners have substantiated their claimed real estate loss, they
cannot deduct any portion of it unless Ms. Smith during 2011 was a “real estate
professional,” i.e., a taxpayer engaged in a “real property business” within the
meaning of section 469(c)(7).
- 31 -
[*31] Section 469(a) generally disallows a current deduction for a “passive activ-
ity loss” incurred by an individual. Section 469(c) defines “passive activity” to
include an activity involving a trade or business in which the taxpayer does not
“materially participate” and “any rental activity” regardless of whether the taxpay-
er materially participates. Sec. 469(c)(1), (2), (4). But section 469(c)(7) provides
that the rental real estate activity of a real estate professional is not per se passive.
See Kosonen v. Commissioner, T.C. Memo. 2000-107, 79 T.C.M. 1765,
1767; sec. 1.469-9(b)(6), (c)(1), Income Tax Regs. If a real estate professional
materially participates in a rental real estate activity, that activity is treated as non-
passive, and the section 469(a) disallowance does not apply. See Shiekh v. Com-
missioner, T.C. Memo. 2010-126, 99 T.C.M. 1526, 1528; Fowler v. Com-
missioner, T.C. Memo. 2002-223, 84 T.C.M. 281, 284; sec. 1.469-9(e)(1),
Income Tax Regs.
To qualify as a real estate professional, a taxpayer must (among other
things) “perform[] more than 750 hours of services during the taxable year in real
property trades or businesses in which * * * [she] materially participates.” Sec.
469(c)(7)(B)(ii). The taxpayer must satisfy the 750-hour requirement personally;
participation in the real estate activity by the taxpayer’s spouse is not attributed to
the taxpayer for this purpose. Oderio v. Commissioner, T.C. Memo. 2014-39, 107
- 32 -
[*32] T.C.M. (CCH) 1214, 1215; sec. 1.469-9(c)(4), Income Tax Regs. Moreover,
“personal services performed as an employee shall not be treated as performed in
real property trades or businesses” unless “such employee is a 5-percent owner
* * * in the employer.” Sec. 469(c)(7)(D)(ii).
During 2011 Ms. Smith was employed by Realtor Cathie Gill, Inc., where
she supervised the firm’s property management services. There is no evidence
that she held a 5% ownership interest (or any ownership interest) in that firm. Her
services rendered as an employee therefore do not count in determining whether
she met the 750-hour requirement.
Petitioners have produced no documentary evidence of any kind to substan-
tiate the number of hours that Ms. Smith or Dr. Lakner devoted to their rental
properties. Ms. Smith did not testify at trial. Dr. Lakner testified that his wife
spent 500 to 600 hours annually, and that he spent another 1,000 to 1,200 hours
annually, managing those properties. There was no documentary support for these
assertions, which were at best “ballpark guesstimates,” and we did not find Dr.
Lakner’s testimony credible. See Moss v. Commissioner, 135 T.C. 365, 369
(2010); Tokarski, 87 T.C. at 77. Finding as we do that neither petitioner was a real
- 33 -
[*33] estate professional during 2011, we sustain respondent’s disallowance of the
$25,000 Schedule E loss deduction petitioners claimed for that year.8
VI. NOLs
On line 21 of their 2007-2011 returns, captioned “Other Income,” petition-
ers claimed “net operating loss carryover[s]” in the following amounts:
Year NOL
2007 $85,258
2008 99,383
2009 162,030
2010 219,855
2011 250,773
Respondent disallowed these NOL deductions entirely, and properly so.
A taxpayer may generally deduct, as an NOL for a taxable year, an amount
equal to the sum of the NOL carryovers and carrybacks to that year. Sec. 172(a).
A taxpayer claiming an NOL deduction must file with his return “a concise state-
ment setting forth the amount of the * * * [NOL] deduction claimed and all mater-
ial and pertinent facts relative thereto, including a detailed schedule showing the
computation of the * * * [NOL] deduction.” Sec. 1.172-1(c), Income Tax Regs.
8
Petitioners did not claim any rental real estate losses on their returns for
2007-2010 and did not include a Schedule E in any of those returns. They have
not substantiated, for any of those years, rental real estate expenses in excess of
the Schedule E income that respondent has determined. Thus, they are not entitled
to any deductions for real estate losses for 2007, 2008, 2009, or 2010.
- 34 -
[*34] Petitioners bear the burden of establishing both the existence of NOLs for
prior years and the NOL amounts that may properly be carried forward to the years
at issue. See Rule 142(a); Keith v. Commissioner, 115 T.C. 605, 621 (2000).
The $85,258 NOL deduction petitioners claimed for 2007 allegedly repre-
sented the carryforward of losses petitioners had incurred in 2004-2006. Petition-
ers did not attach to their 2007 return the explanatory statement required by the
regulations. They offered no evidence that they had sustained bona fide losses
during 2004-2006, apart from submitting copies of the tax returns on which they
reported those losses. Merely claiming a loss does not substantiate it. See Coburn
v. Commissioner, T.C. Memo. 2014-113, 107 T.C.M. 1551, 1558 (“A tax-
payer’s return is merely a statement of the taxpayer’s position and cannot be used
to substantiate a deduction.”); see also Gould v. Commissioner, 139 T.C. 418, 447
(2012), aff’d, 552 F. App’x 250 (4th Cir. 2014).
The NOL carryforward deductions petitioners claimed for 2008-2011 re-
sulted from the $85,258 NOL carryforward from 2004-2006 (to which they were
not entitled) and the negative AGI they reported for 2007-2010 (in the aggregate
amount of $623,955). As a result of the adjustments we have sustained, requiring
inclusion of unreported income and disallowing petitioners’ claimed Schedule C
loss deductions, petitioners will have substantial positive AGI for each year at is-
- 35 -
[*35] sue. Because they have no operating losses to carry forward, the IRS
properly disallowed all of their claimed NOL deductions.
VII. Additions to Tax
Section 6651(a)(1) provides for an addition to tax of 5% of the tax required
to be shown on the return for each month or fraction thereof for which there is a
failure to file the return, not to exceed 25% in toto. The parties have stipulated
that petitioners’ 2007-2011 returns were filed late. Respondent has thus met his
burden of production under section 7491(c).
A taxpayer who files his return late is liable for the section 6651(a)(1) addi-
tion to tax unless he shows that his failure was due to reasonable cause and not
due to willful neglect. United States v. Boyle, 469 U.S. 241, 245 (1985). Petition-
ers first assert that Dr. Lakner’s deployment overseas constitutes reasonable cause
for their failure to file timely. But Dr. Lakner returned to the United States from
overseas deployment in 2006. Petitioners have offered no cogent explanation why
his overseas military service during 2006 and prior years rendered them unable to
file timely returns for 2007-2011, the first of which was not due for filing until
April 2008.
Alternatively, petitioners contend that “significant health problems” made it
impossible for them to file their returns on time. Petitioners introduced no cred-
- 36 -
[*36] ible evidence to support this assertion. They insisted throughout the trial
that they actively engaged in a medical consulting business and a rental real estate
activity during the tax years at issue. Their returns for each year were prepared by
a certified public accountant (CPA) at “Physicians’ Tax Service.” If ill health did
not prevent petitioners from managing their commercial affairs, we find no basis
for concluding that ill health prevented them from furnishing information timely to
their return preparer. See Poppe v. Commissioner, T.C. Memo. 2015-205, 110
T.C.M. 401, 406-407 (rejecting ill health defense where taxpayer as a se-
curities trader “engag[ed] in activities that required a high degree of concentration
and ability to analyze and organize information”); Hardin v. Commissioner, T.C.
Memo. 2012-162, 103 T.C.M. 1861, 1862-1863 (rejecting ill health de-
fense where taxpayer was able to manage his business affairs, including managing
two rental properties, selling one of them, and being employed full time).
In sum, we conclude that petitioners have failed to carry their burden of
proving that they had reasonable cause for failing to file their 2007-2011 returns
on time. We thus sustain the addition to tax under section 6651(a)(1) for each
year.
- 37 -
[*37] VIII. Penalties
In his post-trial brief respondent conceded that petitioners are not liable for
fraud penalties under section 6663, as the IRS had determined in the notice of de-
ficiency for 2008, 2010, and 2011. But respondent contends that petitioners are
liable for accuracy-related penalties under section 6662(a) for all five years. We
agree with that submission.
The Code imposes a 20% penalty on the portion of any underpayment of tax
attributable to “[n]egligence or disregard of rules and regulations” or “[a]ny sub-
stantial understatement of income tax.” Sec. 6662(a) and (b)(1) and (2). Negli-
gence includes “any failure to make a reasonable attempt to comply” with the in-
ternal revenue laws. Sec. 6662(c). An understatement of income tax is “substan-
tial” if it exceeds the greater of $5,000 or 10% of the tax required to be shown on
the return. Sec. 6662(d)(1)(A).
Under section 7491(c) respondent bears the burden of production with re-
spect to the liability of any individual for any penalty. See Higbee v. Commission-
er, 116 T.C. 438, 446 (2001). Respondent has satisfied his burden of production
as to negligence by showing that petitioners for each year failed to report all of
their taxable income and failed to maintain any meaningful books and records for
their business activities. See sec. 1.6662-3(b)(1), Income Tax Regs.
- 38 -
[*38] In Graev v. Commissioner, 149 T.C. __ (Dec. 20, 2017), supplementing and
overruling in part 147 T.C. 460 (2016), we held that respondent’s burden of pro-
duction under section 7491(c) also includes establishing compliance with section
6751(b). That section requires that penalties be “personally approved (in writing)
by the immediate supervisor of the individual making such determination.” See
Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), aff’g in part, rev’g in
part T.C. Memo. 2015-42.
For 2007 and 2009 the record includes copies of Civil Penalty Approval
Forms signed by the immediate supervisor of the revenue agent who examined
petitioners’ returns, approving imposition of section 6662(a) penalties against pe-
titioners for those years. For 2008, 2010, and 2011 the record includes copies of a
Civil Penalty Approval Form, signed by the immediate supervisor of the revenue
agent who examined petitioners’ returns, approving imposition of section 6663
fraud penalties and (in the alternative) section 6662(a) accuracy-related penalties
against petitioners for those years. We accordingly find that respondent has satis-
fied his burden of production to show compliance with section 6751(b).
No penalty is imposed with respect to any portion of an underpayment if the
taxpayer acted with reasonable cause and in good faith with respect thereto. See
sec. 6664(c)(1). The taxpayer generally bears the burden of proving reasonable
- 39 -
[*39] cause and good faith. Higbee, 116 T.C. at 446. Reasonable cause can be
shown by good-faith reliance on the advice of a qualified tax professional. Sec.
1.6664-4(b)(1), (c), Income Tax Regs. Whether the taxpayer actually relies on the
advice and whether such reliance is reasonable present questions of fact. Neona-
tology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98 (2000), aff’d, 299 F.3d 221(3d Cir. 2002); sec. 1.6664-4(c)(1), Income Tax Regs. For reliance to be reason-
able, the taxpayer must (among other things) have provided “necessary and accu-
rate information to the adviser.” Neonatology Assocs., P.A., 115 T.C. at 99.
Petitioners contend that they made a good-faith effort to determine their
Federal income tax liabilities correctly because they hired a CPA to prepare their
returns. Petitioners did not call the CPA to testify at trial. They offered no evi-
dence to show that he was a competent adviser or that they actually relied on him
in good faith.
All of the adjustments we have sustained in this case involve unreported
income and unsubstantiated deductions. Assuming arguendo that petitioners’
CPA was competent, it is obvious that petitioners did not supply him with all
“necessary and accurate information” needed to prepare their 2007-2011 returns
properly. Ibid. We conclude the “reasonable cause” exception does not apply and
that all of the underpayments (as redetermined) are attributable to negligence. Al-
- 40 -
[*40] ternatively, in the event the Rule 155 computations show that the various
understatements of income tax exceed the greater of $5,000 or 10% of the amounts
required to be shown on the respective returns, we conclude that those underpay-
ments are attributable to substantial understatements of income tax for which
reasonable cause has not been shown.
To reflect the foregoing,
Decisions will be entered under
Rule 155.