WORLD OF SERVICE, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent; FEELIN' GREAT, INC., Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
After the parties' concessions, the issues remaining for our consideration are: (1) Whether petitioners have shown that they are entitled to various deductions in excess of the amounts allowed by respondent; and (2) whether petitioners are liable for additions to tax under sections 6653(a)(1) and (2) and 6661. *458
In the early 1980s, Great's business area covered the States of Florida, Georgia, and Alabama. By 1982, Great was operating (i.e., holding seminars) in about 26 States. Throughout the years in controversy, Service's principal place of business was in the Johnsons' residence. The Johnsons' residence, a three-bedroom condominium, contained 1,600 square feet of usable space, of which 320 square feet was used exclusively for Service's business purposes. In addition, the Johnsons' two-car garage contained 300 square feet, with an equal amount of attic storage area above the garage. Of the 600 total square feet of combined garage area, 400 square feet was used exclusively for business purposes. The Johnsons' residential telephone was listed in Service's name. Service's checks contained the Johnsons' residence address. During this period, Great had a separate principal place of business and office in a commercial location outside of the Johnsons' residence.
Service paid the Johnsons' residential mortgage payments of $ 5,043 and $ 5,400 during 1982 and 1983, respectively. Service deducted $ 1,443 and $ 1,800 on its 1982 and*461 1983 income tax returns for use of the Johnsons' residence. For those same years, the Johnsons reported $ 3,600 in income for Service's use of the residence, because the mortgage was paid by Service. Respondent determined that only 10 percent of the residence was used for business purposes and disallowed the mortgage and other deducted expenditures related to the condominium in excess of 10 percent.
Service also deducted $ 2,101, $ 2,178, and $ 5,018, and respondent disallowed $ 1,284, $ 1,362, and $ 3,403 for 1982, 1983, and 1984, respectively. These deductions were for utilities, trash removal, pest control, telephone, etc. The largest portion of these amounts was attributable to telephone expenses.
Service made the following expenditures, which were deducted in the tax year paid and were disallowed by respondent as being without a business purpose:
Petitioners bear the burden of proving that they are entitled to the deductions claimed, or of showing that respondent erred in the determination. Rule 142(a); New Colonial Ice Co. v. Helvering, 292 U.S. 435">292 U.S. 435, 440 (1934). In addition, petitioners are required to maintain adequate records to substantiate their claimed deductions. Sec. 6001. Petitioners were closely held corporations owned and operated by the Johnsons. The businesses marketed and promoted family seminars about "self-improvement", vitamins, nutritional products, health care, and exercise programs. There was a substantial amount of travel involved. Petitioners, for one reason or another, did not have complete documentation on numerous items. For example, a receipt that shows the purchase of gasoline might not indicate whether the expenditure was one for business or personal. Compounding these problems was the practice of causing petitioner corporations to pay both their business and the Johnsons' personal expenditures, which were accumulated and divided by estimations at yearend.
It was argued that petitioners' and the Johnsons' expenses were properly segregated and that the corporations did not deduct the Johnsons' personal items, which were "backed-out" and which the Johnsons reported as income. References were made to worksheets containing the segregations, but none were offered or received in our record.
Respondent raised the question of whether Service met the requirements*479 for both section 280A (business use of home) and the holding of Commissioner v. Soliman, 506 U.S. , 113 S. Ct. 701 (1993). However, we have found that Service's principal place of business was in the Johnsons' residence. Service is not an S corporation and, accordingly, it is unnecessary to analyze this matter under the standards of section 280A(c) (1)(A).
With respect to petitioners' claims for bad debts, section 166 permits a deduction for a debt that becomes worthless during the taxable year. Zimmerman v. United States, 318 F.2d 611">318 F.2d 611, 612 (9th Cir. 1963). Only a bona fide debt, arising from a "debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money", qualifies for a deduction under section 166. Sec. 1.166-1(c), Income Tax Regs. Whether a bona fide debtor-creditor relationship exists is a question of fact to be determined after consideration of all the facts and circumstances. Fisher v. Commissioner, 54 T.C. 905">54 T.C. 905, 909 (1970).
Although notes were executed in connection with the amounts given to various individuals, petitioners*480 have not shown that a genuine debtor-creditor relationship existed between Service and any of the alleged borrowers. In most instances, the loans were made through the corporation to friends or acquaintances of the Johnsons. When the amounts were not repaid, even though there was "evidence of indebtedness", Mr. Johnson did not want to pursue collection from friends. Under those circumstances, where the sole shareholder(s) of a corporation cause a corporation to give corporate funds to the shareholder's friend(s) from whom they would not seek formal collection, it is difficult to find that there was a true debtor-creditor relationship. Just as significantly, petitioners have failed to show that the advances were worthless during the years the bad debt deductions were claimed.
Respondent determined additions to tax under section 6653(a)(1) and (2) and section 6661 for each taxable year in issue. Section 6653(a)(1) provides for a 5-percent addition on the entire underpayment if any part of the underpayment is due to negligence or intentional disregard of rules or regulations. Section 6653(a)(2) provides for an additional amount equal to 50 percent of the interest payable with respect*481 to the portion of the underpayment attributable to negligence.
Negligence is the lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances. Neely v. Commissioner, 85 T.C. 934">85 T.C. 934, 937 (1985). Petitioners have the burden of showing that their underpayment was not due to negligence or intentional disregard of rules or regulations. Rule 142(a); Welch v. Helvering, 290 U.S. 111">290 U.S. 111 (1933); Bixby v. Commissioner, 58 T.C. 757">58 T.C. 757, 791-792 (1972).
Both petitioners failed to maintain adequate records. The failure to properly segregate personal and business expenditures and the method of yearend allocation further exacerbate the inadequacy of petitioners' records. It was the Johnsons' and petitioners' choice to mix personal and business records, and their failure or inability to properly show the division is of their own making and was clearly negligent. Stovall v. Commissioner, 762 F.2d 891">762 F.2d 891, 895 (11th Cir. 1985), affg. T.C. Memo. 1983-450; Crocker v. Commissioner, 92 T.C. 899">92 T.C. 899, 917 (1989).*482
Further, petitioners claimed, up until the eve of trial, amounts which had been conceded in prior proceedings. Claiming hundreds of thousands of dollars in net operating loss deductions, when those matters had been finally settled in earlier years' litigation, cannot be considered reasonable or what an ordinarily prudent person would do. Although petitioners' returns were prepared by accountants, the Johnsons made all judgments regarding personal or business decisions, and they labeled various amounts for inclusion in the corporate returns. We also note that Mr. Johnson has an associate's degree in tax and accounting.
Under these circumstances, petitioners have failed to show that respondent's determination was in error; hence, we find that petitioners are liable for additions to tax under section 6653(a)(1) and (2).
Respondent determined that petitioners are liable for an addition to tax under section 6661 for all taxable years in dispute. Section 6661(a) provides for an addition to tax in the amount of 25 percent of any underpayment attributable to a substantial understatement of income tax. An understatement is substantial if it exceeds the greater of 10 percent of the correct*483 tax or, in the case of a corporate taxpayer, $ 10,000.
If an item is not attributable to a tax shelter, then any understatement may be reduced by amounts attributable to items for which a taxpayer had substantial authority or which were adequately disclosed in the return (e.g., by attaching a statement thereto). Sec. 6661(b)(2)(B)(i) and (ii).
Petitioners have not shown that there was substantial authority for their tax treatment of any of the adjustments determined by respondent. In addition, we find that petitioners did not adequately disclose any of the adjusted items on the returns for the period in controversy. Accordingly, to the extent that petitioners' understatement, for any taxable period under consideration, is substantial within the meaning of section 6661, petitioners are liable for the addition to tax under section 6661. To reflect the foregoing and to reflect concessions and agreements of the parties,
Decisions will be entered under Rule 155.
Footnotes
1. 50 percent of the interest due on the deficiency.↩
1. Unless otherwise indicated, section references are to the Internal Revenue Code in effect for the years in issue. Rule references are to this Court's Rules of Practice and Procedure.↩
2. The parties' stipulation of facts and exhibits are incorporated by this reference.↩
3. We assume this was a 2-year, rather than a 4-year, college degree.↩
1. Only $ 14,154 of this amount was included in Service's cost of goods sold.↩
4. The U.S. Court of Appeals for the Eleventh Circuit has adopted, as binding precedent, decisions of the U.S. Court of Appeals for the Fifth Circuit issued prior to Oct. 1, 1981. Bonner v. City of Prichard, 661 F.2d 1206">661 F.2d 1206, 1209↩ (11th Cir. 1981).