Wilfredo E. Rivera & Maria T. Rivera v. Commissioner

T.C. Memo. 2020-7
UNITED STATES TAX COURT
WILFREDO E. RIVERA AND MARIA T. RIVERA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 22285-16. Filed January 13, 2020.
Joseph M. Bray and Tyson R. Smith, for petitioners.
Cameron W. Carr and Thomas R. Mackinson, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: Respondent determined deficiencies in petitioners’
Federal income tax and section 6662(a)1 accuracy-related penalties as follows:
1
All section references are to the Internal Revenue Code (Code) in effect at
all relevant times, and all Rule references are to the Tax Court Rules of Practice
and Procedure, unless otherwise indicated. All monetary amounts have been
(continued...)
-2-
[*2] Penalty
Year Deficiency sec. 6662(a)
2013 $49,303 $9,860
2014 122,547 24,509
After concessions,2 the issues for decision are whether: (1) petitioners’
partnership received and failed to report gross receipts on Forms 1065, U.S.
Return of Partnership Income (partnership returns), (2) the partnership is entitled
to certain deductions claimed on the partnership returns, and (3) petitioners are
liable for section 6662(a) accuracy-related penalties.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The first
stipulation of facts, first supplemental stipulation of facts, second supplemental
stipulation of facts, and accompanying exhibits are incorporated herein by this
reference. Petitioners resided in California when they timely filed their petition.
1
(...continued)
rounded to the nearest dollar.
2
Respondent concedes that petitioners’ taxable income for 2014 does not
include a pension distribution of $99,898 and that petitioners are not liable for a
10% additional tax on that distribution. Petitioners concede all noncomputational
adjustments in the notice of deficiency except for those to gross receipts, “other
deductions”, and the imposition of sec. 6662(a) penalties. The parties also made
partial concessions, which we address in the body of this opinion.
-3-
[*3] I. Background
Petitioners were born and raised in the Philippines and immigrated to the
United States in 1983. Petitioner husband was a laboratory assistant, and
petitioner wife was a registered nurse during the years at issue. Petitioners do not
have any training in taxation or accounting.
Jet Travel International (JTI) is a travel agency that petitioners began
operating as a flowthrough partnership in 2007. Petitioners were each 50%
owners of JTI3 and reported losses therefrom on Schedules E, Supplemental
Income and Loss, for the years at issue. Petitioners, on behalf of JTI, purchased
travel tickets for resale using their American Express credit card. JTI’s clients
purchased the travel tickets by cash or check. In connection with the operation of
JTI, petitioners incurred bank charges on JTI’s behalf.
During the years at issue petitioners were also independent business owners
(IBOs) in American Communication Network, Inc. (ACN), a multilevel marketing
company that focuses on selling telecommunications services. In connection with
3
Thus, for the years at issue, JTI had 10 or fewer partners, each of whom
was an individual. As there is no indication that an election was made under sec.
6231(a)(1)(B)(ii), JTI was a small partnership under sec. 6231(a)(1)(B), and secs.
6221 to 6234 do not apply. Instead, respondent’s adjustments to JTI’s income and
expenses are to be decided in this proceeding. See New Phoenix Sunrise Corp. v.
Commissioner, 132 T.C. 161, 173 n.3 (2009) (citing Wadsworth v. Commissioner,
T.C. Memo. 2007-46), aff’d, 408 F. App’x 908 (6th Cir. 2010).
-4-
[*4] their business of selling ACN services, petitioners attended several ACN
conventions and incurred expenses for ACN-related fees, dues, and subscriptions.
Petitioners owned a 2007 Lexus ES 350 during the years at issue. They
used the automobile to travel to various ACN IBO presentations in the San
Francisco Bay area, Los Angeles, San Diego, Sacramento, and Nevada. At those
locations petitioners hosted private business receptions to recruit individuals to
join ACN.
During 2013 and 2014 JTI had a business economy checking account with
Bank of America. Petitioners also maintained two joint accounts at Bank of
America in their own names and one account at Chase in petitioner wife’s name in
2013. In 2014 petitioners continued to maintain one of the two joint accounts at
Bank of America and the Chase account. Petitioner wife deposited her wage
income into the Chase account.
In 2013 petitioners cashed a check for $160, which was reflected as a
“Counter Credit” in petitioners’ records. Petitioner husband, on JTI’s behalf,
received this check from a client as reimbursement for the payment of a rebooking
penalty.
-5-
[*5] II. Tax Reporting, Examination, and Notice of Deficiency
In 2010, at the recommendation of petitioner husband’s coworker,
petitioners hired Roosevelt L. Drummer to prepare their Federal tax returns. Mr.
Drummer had a physical office location and held himself out as a former revenue
agent (RA) for the Internal Revenue Service (IRS) and an expert in business and
taxation.
Petitioners provided Mr. Drummer with copies of their Forms W-2, Wage
and Tax Statement, and other documents. Mr. Drummer prepared petitioners’
joint Federal income tax returns for the years at issue; he also prepared JTI’s
partnership returns on the basis of the information that petitioners gave him. For
both years at issue JTI treated ACN as a component of its business, reporting the
income and expenses of both JTI and ACN on its partnership returns.4
Mr. Drummer advised petitioners that they could permissibly deduct their
daughter’s college tuition if they paid it through their daughter’s S corporation.
Trusting what they understood to be Mr. Drummer’s experience as a former IRS
RA, petitioners followed his advice. The details of the arrangement are not
entirely clear. What we do know is that Mr. Drummer helped organize the
4
Neither party contends that the ACN’s reported income and expenses
should be moved to Schedules C, Profit or Loss From Business, on petitioners’
income tax returns.
-6-
[*6] S corporation, to which JTI wrote checks. The proceeds of the checks were
ultimately used to pay petitioners’ daughter’s tuition.5 JTI deducted its payments
to the S corporation as “outside services” on its 2013 and 2014 partnership
returns.6 Mr. Drummer assured petitioners that this deduction was proper, and
petitioners believed him.
On the 2013 partnership return JTI reported gross receipts of $25,639 and
claimed various deductions, including $119,815 for “other deductions”.7 On the
2014 partnership return JTI reported gross income of $15,961 and claimed “other
deductions” of $120,501.8 JTI, which purchased travel tickets for resale, did not
report any cost of goods sold on either the 2013 or 2014 partnership return.
Petitioners’ and JTI’s returns were selected for examination and assigned to
RA Eddie Wong. Petitioners provided RA Wong with their and JTI’s Bank of
5
The S corporation’s tax returns for the years at issue are not in the record.
6
The record does not establish that the S corporation provided JTI any
services.
7
For 2013 JTI’s “other deductions” comprised, among other things,
“outside services” of $40,862. Petitioners concede that this expenditure was a
nondeductible college tuition payment.
8
For 2014 JTI’s “other deductions” comprised, among other things,
“outside services” of $4,615. Petitioners concede that this expenditure was a
nondeductible college tuition payment.
-7-
[*7] America account statements. After petitioners were unable to identify the
sources of several deposits, RA Wong summoned and received records for the
Bank of America accounts. He prepared a bank deposits analysis for each year at
issue. He did not know that petitioner wife maintained an account at Chase;
accordingly, he did not include the account in his bank deposits analyses.9
Using the summoned records, RA Wong (1) totaled all deposits into
petitioners’ and JTI’s Bank of America accounts, (2) subtracted out deposits
determined to be nontaxable, including interaccount transfers and refunds, and
deposits from nontaxable sources, (3) subtracted the amounts of income that
petitioners and JTI had reported on their tax returns, and (4) determined the
resulting amounts to be JTI’s unreported gross receipts, which in turn he
determined to be items entering into the calculation of petitioners’ taxable income.
RA Wong determined that JTI had unreported gross receipts of $284,521
and $383,002 for 2013 and 2014, respectively.10 In a bank deposits analysis that
9
RA Wong, who replaced another RA during the pendency of the audit, did
not request petitioners’ bank statements in writing. The record does not indicate,
and respondent does not allege, that petitioners intentionally concealed the
existence of the Chase account.
10
RA Wong also determined that JTI had unreported “purchases” of
$249,400 and $277,430 for 2013 and 2014, respectively. For each year at issue,
RA Wong allowed JTI an additional deduction for the purchases.
-8-
[*8] petitioners prepared and provided to RA Wong during the audit, petitioners
calculated the same amounts of unreported gross receipts as RA Wong.
Respondent issued petitioners a notice of deficiency for the years at issue
reflecting RA Wong’s determinations of unreported gross receipts. The deficiency
notice also disallowed several expense deductions claimed on the 2013 and 2014
partnership returns and determined that petitioners were liable for section 6662(a)
accuracy-related penalties for the years at issue.
As stated supra note 2, petitioners concede the disallowance of all
partnership deductions except for those to “other deductions”. Petitioners also
dispute their liability for the accuracy-related penalties.
OPINION
I. Unreported Income
As a general rule, the Commissioner’s determinations in a notice of
deficiency are presumed correct, and the taxpayer bears the burden of proving that
-9-
[*9] the determinations are incorrect.11 Rule 142(a); Welch v. Helvering, 290 U.S.
111, 115 (1933).
In the Court of Appeals for the Ninth Circuit, to which an appeal of this
case presumably would lie absent a stipulation to the contrary, see sec.
7482(b)(1)(A), (2), the presumption of correctness does not attach in cases
involving unreported income unless the Commissioner first establishes an
evidentiary foundation linking the taxpayer to the alleged income-producing
activity, see Weimerskirch v. Commissioner, 596 F.2d 358, 361-362 (9th Cir.
1979), rev’g 67 T.C. 672 (1977). The requisite evidentiary foundation is minimal
and need not include direct evidence. See Rapp v. Commissioner, 774 F.2d 932,
935 (9th Cir. 1985); Banister v. Commissioner, T.C. Memo. 2008-201, aff’d, 418
F. App’x 637 (9th Cir. 2011).
Once the Commissioner produces evidence linking the taxpayer to an
income-producing activity, the burden shifts to the taxpayer “to rebut the
11
Sec. 7491(a) provides that if, in any court proceeding, a taxpayer
introduces credible evidence with respect to any factual issue relevant to
ascertaining the liability of the taxpayer for any tax imposed by subtit. A or B and
meets other prerequisites, the Commissioner shall have the burden of proof with
respect to that issue. See Higbee v. Commissioner, 116 T.C. 438, 440-441 (2001).
However, petitioners have neither claimed nor shown that they satisfied the
requirements of sec. 7491(a) to shift the burden of proof to respondent.
Accordingly, petitioners bear the burden of proof. See Rule 142(a).
- 10 -
[*10] presumption of correctness of * * * [the Commissioner’s] deficiency
determination by establishing by a preponderance of the evidence that the
deficiency determination is arbitrary or erroneous.” Petzoldt v. Commissioner, 92
T.C. 661, 689 (1989); see also Hardy v. Commissioner, 181 F.3d 1002, 1004 (9th
Cir. 1999), aff’g, T.C. Memo. 1997-97.
Every individual liable for tax is required to maintain books and records
sufficient to establish the amount of his or her taxable income. Sec. 6001; DiLeo
v. Commissioner, 96 T.C. 858, 867 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992). As
petitioners could not identify the sources of most deposits shown on their bank
statements, they failed to produce adequate records for respondent to calculate
their taxable income flowing from JTI.
Where a taxpayer fails to maintain or produce adequate books and records,
the Commissioner is authorized to compute the taxpayer’s taxable income by any
method that clearly, in the Commissioner’s opinion, reflects income. Sec. 446(b);
Holland v. United States, 348 U.S. 121 (1954); Webb v. Commissioner, 394 F.2d
366, 371-372 (5th Cir. 1968), aff’g T.C. Memo. 1966-81. The reconstruction of
income need only be reasonable in the light of all surrounding facts and
circumstances. See Giddio v. Commissioner, 54 T.C. 1530, 1533 (1970). The
Commissioner is given latitude in determining which method of reconstruction to
- 11 -
[*11] apply when a taxpayer fails to maintain records. Petzoldt v. Commissioner,
92 T.C. 693.
Respondent employed the bank deposits method of proof to reconstruct
petitioners’ taxable income flowing from JTI. The acceptability of this method of
proof is well established. DiLeo v. Commissioner, 96 T.C. 867; Estate of
Mason v. Commissioner, 64 T.C. 651, 656 (1975), aff’d, 566 F.2d 2 (6th Cir.
1977). Bank deposits are prima facie evidence of income. Tokarski v.
Commissioner, 87 T.C. 74, 77 (1986); Estate of Mason v. Commissioner, 64 T.C.
at 656-657. When using the bank deposits method, the Commissioner is not
required to show that each deposit or part thereof constitutes income, Gemma v.
Commissioner, 46 T.C. 821, 833 (1966), or prove a likely source, Clayton v.
Commissioner, 102 T.C. 632, 645 (1994); Estate of Mason v. Commissioner, 64
T.C. 657. Unless the nontaxable nature of deposits is established, gross income
includes deposits to bank accounts where the taxpayer has dominion and control
of the funds. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431
(1955); Davis v. United States, 226 F.2d 331, 334-335 (6th Cir. 1955); Manzoli v.
Commissioner, T.C. Memo. 1988-299, aff’d, 904 F.2d 101 (1st Cir. 1990).
Respondent performed a bank deposits analysis for each year at issue and
determined that JTI’s gross receipts for 2013 and 2014 should be adjusted by
- 12 -
[*12] $284,521 and $383,002, respectively. By reconstructing JTI’s gross receipts
using the bank deposits method and demonstrating that petitioners used the bank
accounts for the business, respondent established the requisite minimal foundation
linking petitioners with an income-producing activity. Accordingly, petitioners
bear the burden of proving that respondent’s deficiency determinations are
arbitrary or erroneous.
Petitioners, who agreed with RA Wong’s bank deposits analyses during the
audit, now argue that the analyses contain several mistakes. They have met their
burden with respect to only a handful of transactions.
For 2013 respondent determined a $160 check to be taxable income.
However, petitioner husband credibly testified that he received the funds on behalf
of JTI as reimbursement for the payment of a rebooking penalty. Generally, gross
income does not include such reimbursements for expenses a taxpayer pays on
behalf of another. Gray v. Commissioner, 10 T.C. 590, 596-597 (1948); Fishman
v. Commissioner, T.C. Memo. 2011-102, slip op. at 18. We therefore find that the
$160 check payment is not includable in JTI’s gross receipts.12
12
We note that respondent allowed JTI an additional deduction for
unreported “purchases” for 2013. Respondent does not contend that this
deduction includes the $160 payment.
- 13 -
[*13] With respect to 2014, respondent concedes on brief that the following
deposits are not includable in JTI’s gross receipts: (1) a Federal income tax refund
of $25,870 for the 2013 tax year and (2) transfers of petitioner wife’s salary
deposits from the Chase account totaling $46,000.
Other than those transactions, however, petitioners have not provided any
evidence that the remaining deposits respondent identified as income are
nontaxable. Therefore, we conclude that the remaining deposits for 2013 and
2014 are taxable income.
Petitioners argue that respondent’s determination of unreported gross
receipts should be set aside because RA Wong failed to subtract the above-
described nontaxable deposits from his bank deposits analyses. We disagree.
It is true that respondent incorrectly concluded that some bank deposits,
such as the $160 check and the $25,870 Federal income tax refund, were income.
However, courts recognize that some errors are unavoidable when an indirect
method is used to reconstruct income, especially where (as here) the taxpayer
failed to maintain adequate records. See United States v. Stonehill, 702 F.2d
1288, 1295-1296 (9th Cir. 1983); see also Canatella v. Commissioner, T.C. Memo.
2017-124, at *12-*13.
- 14 -
[*14] Given petitioners’ failure to maintain adequate records and their inability to
identify the sources of most deposits, respondent’s reconstruction of income was
reasonable in the light of the surrounding facts and circumstances. See Giddio v.
Commissioner, 54 T.C. 1533. The record establishes that RA Wong made an
effort to determine which deposits were attributable to nontaxable sources (and
indeed, he determined that some deposits were attributable to nontaxable sources).
Accordingly, we conclude that JTI had unreported gross receipts of
$284,361 and $311,132 for 2013 and 2014, respectively.
II. Substantiation of Partnership Deductions
We next address whether JTI is entitled to the “other deductions” it claimed
for the years at issue. Deductions are a matter of legislative grace, and taxpayers
generally bear the burden of proving that they are entitled to any deductions
claimed. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992);
New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
Section 162(a) generally allows a deduction for ordinary and necessary
expenses paid or incurred during the taxable year in carrying on a trade or
business. Such expenses must be directly connected with or pertain to the
taxpayer’s trade or business. Sec. 1.162-1(a), Income Tax Regs. Generally, no
deduction is allowed for personal, living, or family expenses, nor is deduction
- 15 -
[*15] proper for expenditures that are properly categorized as capital expenditures.
See secs. 262 and 263. The determination of whether an expenditure satisfies the
requirements of section 162 is a question of fact. Commissioner v. Heininger, 320
U.S. 467, 475 (1943).
A taxpayer must maintain records sufficient to enable the Commissioner to
determine his correct tax liability. Sec. 6001; Higbee v. Commissioner, 116 T.C.
438, 440 (2001); sec. 1.6001-1(a), Income Tax Regs. A taxpayer must “keep such
permanent books of account or records * * * as are sufficient to establish the
amount of gross income, deductions, credits, or other matters required to be shown
by such person in any return of such tax or information.” Sec. 1.6001-1(a),
Income Tax Regs.
If the taxpayer is able to establish that he paid or incurred a deductible
expense but is unable to substantiate the precise amount, the Court generally may
approximate the deductible amount, but only if the taxpayer presents sufficient
evidence to establish a rational basis for making the estimate (Cohan rule). See
Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); see also Vanicek v.
Commissioner, 85 T.C. 731, 742-743 (1985). However, section 274(d) overrides
the Cohan rule with regard to certain expenses, including travel and certain listed
property, which if otherwise allowable are subject to strict substantiation rules.
- 16 -
[*16] See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d per curiam,
412 F.2d 201 (2d Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax Regs., 50
Fed. Reg. 46014 (Nov. 6, 1985).
Petitioners concede respondent’s adjustments to JTI’s deductions except for
those to other deductions, which respondent disallowed in full for lack of
substantiation.13 JTI’s other deductions comprise the following reported expenses:
13
At trial respondent argued in the alternative that the ACN-related
expenses on the partnership returns should be disallowed under sec. 183. This
argument was not set forth in either the notice of deficiency or the answer.
Respondent did not move to amend his pleadings or develop this argument on
brief. We deem the issue to not be before us. See Thiessen v. Commissioner, 146
T.C. 100, 106 (2016) (“[I]ssues and arguments not advanced on brief are
considered to be abandoned.”).
- 17 -
[*17] Expense 2013 2014
Accounting $2,603 $2,403
ACN convention --- 214
ACN fees --- 15,811
Auto and truck 10,592 10,314
Bank charges 2,304 1,404
Dues and
subscriptions 474 121
Gifts 601 300
Global Empire --- 376
Legal and
professional --- 250
“MEALS @ 100%” 17,671 ---
Meals and
entertainment 7,524 6,727
Office expense 25,306 46,685
Outside services1 40,862 4,615
Parking and tolls 73 ---
Postage 306 151
Printing --- 17
Telephone 4,858 8,119
Travel 6,641 9,854
Sales presentations --- 11,198
Supplies --- 1,942
Total 119,815 120,501
- 18 -
[*18] 1 As explained supra notes 7 and 8, petitioners have conceded that JTI is
not entitled to deductions for outside services.
Our resolution of the substantiation issue turns on the applicable law and
our determination of the credibility of the evidence presented.
A. Expenses Not Subject to Section 274
1. Accounting Expenses
JTI claimed deductions of $2,603 and $2,403, respectively, for accounting
expenses on its 2013 and 2014 partnership returns. Respondent argues that
petitioners neither substantiated the amounts claimed nor differentiated accounting
fees paid for the partnership returns and those paid for petitioners’ joint Federal
income tax returns. Accounting fees may be ordinary and necessary business
expenses which generally are deductible under section 162(a). Aref v.
Commissioner, T.C. Memo. 2009-118, slip op. at 10.
Credit card statements stipulated by the parties reflect multiple payments
designated for tax, legal, and financial services during the years at issue: three
payments to “CNG Administrative” in 2013 totaling $7,162 and two more
payments to “CNG Administrative” in 2014 totaling $5,179. However, petitioners
did not assert at trial or on brief that these payments related to the accounting
expense deductions claimed on the JTI partnership returns. Furthermore, the
- 19 -
[*19] record does not indicate what actual services petitioners or JTI received for
these payments. Accordingly, petitioners have not carried their burden of proof
with respect to accounting expenses, and we sustain respondent’s disallowance of
the deductions.
2. ACN Fees and ACN Convention
JTI deducted “ACN INC FEES” of $15,811 and “ACN CONVENTION”
expenses of $214 on its 2014 partnership return. Respondent argues that
petitioners failed to substantiate these deductions.
This court has previously found that fees paid to participate in multilevel
marketing arrangements may qualify as ordinary and necessary business expenses
under section 162(a). See Jones v. Commissioner, T.C. Memo. 2013-132, at *12,
*16-*17. Petitioner husband credibly testified that they were required to pay fees
to ACN regularly in order to participate in ACN’s multilevel marketing
arrangement. The credit card statements stipulated by the parties reflect frequent
recurring charges to ACN that total $15,620 during 2014, and we are persuaded
that those charges reflect the reported “ACN INC FEES”. We therefore find that
petitioners, on JTI’s behalf, paid ACN fees of $15,620 in 2014.
The credit card statements also reveal that the $214 deduction for “ACN
Convention” expenses is comprised of two separate payments of $150 and $64 on
- 20 -
[*20] June 20, 2014, and December 5, 2014, respectively. Petitioners’
handwritten annotation indicates that the expenses were incurred for “ACN
Magazine” and “ACN Folders”, respectively, and the credit card statements
indicate the payments were made to ACN Convention Supply.14 Given petitioner
husband’s credible testimony that petitioners attended ACN conventions in
connection with their business of selling ACN services, we find that these
expenses were ordinary and necessary business expenses.
Accordingly, JTI is entitled to deductions of $15,620 and $214 for ACN
fees and ACN convention expenses, respectively, for 2014.
3. Bank Charges
For 2013 and 2014, respectively, JTI claimed deductions of $2,304 and
$1,404 on its partnership returns for bank charges. Responded argues that
petitioners failed to substantiate these deductions.
Petitioner husband credibly testified that the use of his American Express
card to purchase airline tickets for JTI’s clients resulted in bank charges in the
amounts claimed. On the basis of petitioner husband’s credible testimony, we find
14
Respondent did not object to the introduction of petitioners’ handwritten
notes as evidence.
- 21 -
[*21] that JTI is entitled to deductions of $2,304 and $1,404 for bank charges for
2013 and 2014, respectively.
4. Dues and Subscriptions
For 2013 and 2014, respectively, JTI claimed deductions of $474 and $121
for dues and subscriptions, which respondent disallowed in full. Petitioners
testified that these expenses represented monthly payments to ACN for use of a
“business assistant”, as well as a monthly subscription to ACN’s “Success
Magazine.” However, there is insufficient evidence in the record to establish that
JTI actually paid for these products in 2013 and 2014. Accordingly, we sustain
respondents’ disallowance of JTI’s deductions for dues and subscriptions for the
years at issue.
5. Global Empire
On its 2014 partnership return JTI claimed a deduction of $376 for “Global
Empire”. Although petitioners’ credit card statements confirm that they paid $376
to Global Empire, Inc., in 2014, they did not explain the business purpose of the
expense. We therefore sustain respondent’s disallowance of this deduction.
6. Legal and Professional
On its 2014 partnership return JTI claimed a deduction of $250 for legal and
professional expenses. While petitioners’ credit card statements reflect multiple
- 22 -
[*22] payments for possible tax, legal, and financial services during 2014,
petitioners offered no testimony or other evidence linking the services to their
business activities with JTI. We therefore sustain respondent’s disallowance of
this deduction.
7. Office Expenses and Supplies
For 2013 and 2014, respectively, JTI deducted office expenses of $25,306
and $46,685. In 2014 JTI also deducted $1,942 in expenses as “[s]upplies”.
Respondent argues that petitioners failed to substantiate these reported expenses.
The cost of materials and supplies consumed and used in operations during
a taxable year is generally considered an ordinary and necessary expense of
conducting a business. See sec. 162(a); Bruns v. Commissioner, T.C. Memo.
2009-168, slip op. at 25; sec. 1.162-3, Income Tax Regs. Petitioner husband
credibly testified at trial that the claimed office expenses represented purchases for
printers and ink. However, petitioners’ credit card statements reflect total
payments of only $365 during 2013 at office supply retailers such as Office Depot,
the UPS Store, and Staples. The record does not indicate that JTI incurred rental
or other office-related expenses.
- 23 -
[*23] Accordingly, JTI is entitled to a deduction of $365 for office expenses for
2013. We sustain respondent’s disallowance of the remaining $24,941 for 2013.
We also sustain respondent’s disallowance in full with respect to 2014.
8. Parking and Tolls
JTI claimed a deduction of $73 for parking and tolls on its 2013 return.
Petitioners provided no testimony or other evidence to establish that the amounts
claimed were actually paid in 2013 or that these expenses were ordinary and
necessary business expenses. We therefore sustain respondent’s disallowance of
this deduction.
9. Postage and Printing
For 2013 and 2014, respectively, JTI claimed deductions of $306 and $151
for postage; it also claimed a deduction of $17 for printing on its 2014 return.
Petitioners did not offer testimony or other evidence that the amounts claimed
were paid during the years at issue or that the reported expenses were ordinary and
necessary business expenses. Accordingly, we sustain respondent’s disallowance
of these deductions.
10. Sales Presentations
JTI claimed a deduction of $11,198 for sales presentations on its 2014
return. Although petitioners testified that they traveled frequently to places like
- 24 -
[*24] Los Angeles and San Diego for sales presentations related to their ACN
business, they did not provide evidence that the reported expenses were actually
paid in 2014. Accordingly, we sustain respondent’s disallowance of the
deduction.
11. Telephone
For 2013 and 2014, respectively, JTI deducted telephone expenses of
$4,858 and $8,119 on its partnership returns. Respondent argues that these
deductions were properly disallowed for lack of substantiation. Telephone
expenses may be deductible under section 162(a) if the expenses incurred are
ordinary and necessary in carrying on a trade or business. Aref v. Commissioner,
slip op. at 11.
At trial petitioner husband testified that the reported telephone expenses for
2013, totaling $4,858, were attributable to ACN and JTI. However, petitioners’
credit card statements reflect total telephone expenditures of only $2,476.
Because it is impossible to determine from the record which expenses related to
petitioners’ business and which to their personal use, we are unable to allow any
deduction for 2013 for telephone expenses. See Vanicek v. Commissioner, 85
T.C. 742-743.
- 25 -
[*25] With respect to tax year 2014, the credit card statements indicate that
petitioners paid five different telephone carriers that year. Two of those carriers
relate to petitioners’ JTI and ACN businesses. The record reflects that petitioners
paid $1,330 to ACN for digital phone services and $668 to Digitrain, Inc., which
petitioners indicated in a handwritten note was for a “phone purchased to qualify
IBO”. Petitioner husband credibly testified that petitioners were actively soliciting
sales with respect to their ACN venture.
Accordingly, we find that petitioners (on behalf of JTI) paid $1,998 for
telephone services in 2014. JTI may deduct this amount for 2014.
B. Expenses Subject to Section 274
Section 274(d) provides that no deduction is allowed with respect to travel,
entertainment, or listed property (as defined in section 280F(d)(4)) unless the
taxpayer substantiates by adequate records or by sufficient evidence corroborating
the taxpayer’s own statement (1) the amount of expense or item, (2) the time and
place of the travel, entertainment, or expense, (3) the business purpose of the
entertainment or expense, and (4) the business relationship to the taxpayer of the
person or persons entertained.
To substantiate by adequate records, the taxpayer must provide (1) an
account book, log, or similar record prepared at or near the time of the expenditure
- 26 -
[*26] and (2) documentary evidence, which together are sufficient to establish
each element of an expenditure. Sec. 1.274-5T(c)(2), Temporary Income Tax
Regs., 50 Fed. Reg. 46017 (Nov. 6, 1985). Documentary evidence includes
receipts, paid bills, or similar evidence. Sec. 1.274-5(c)(2)(iii), Income Tax Regs.
To substantiate by sufficient evidence corroborating the taxpayer’s own statement,
the taxpayer must establish each element by his or her own statement and by
documentary evidence or other direct evidence. Sec. 1.274-5T(c)(3)(i), Temporary
Income Tax Regs., 50 Fed. Reg. 46020 (Nov. 6, 1985). To establish the business
purpose of an expenditure, however, a taxpayer may corroborate his or her own
statement with circumstantial evidence. Id.
1. Auto and Truck
For 2013 and 2014, respectively, JTI claimed deductions of $10,592 and
$10,314 for auto and truck expenses. Respondent disallowed deductions for these
expenses for lack of substantiation.
A taxpayer may deduct the cost of operating an automobile under section
162 to the extent that it is used in a trade or business.15 Bruns v. Commissioner,
15
A taxpayer may deduct vehicle expenses by using either actual cost or the
standard mileage rate, provided he substantiates the amount of business mileage
and the time and purpose of each use. See sec. 1.274-5(j)(2), Income Tax Regs.;
Rev. Proc. 2010-51, 2010-51 I.R.B. 883.
- 27 -
[*27] slip op. at 23. However, under section 262 no portion of the cost of
operating an automobile that is attributable to personal use is deductible. A
passenger vehicle is listed property under section 280F(d)(4) and is therefore
subject to the requirements of section 274(d).
Petitioner husband testified that petitioners used their 2007 Lexus ES 350 to
travel to various ACN IBO presentations in the San Francisco Bay area, Los
Angeles, San Diego, Sacramento, and Nevada. However, petitioners produced no
mileage logs, receipts, or other documentation for these expenses as required by
section 274(d). In the absence of adequate records or other sufficient
corroborating evidence to establish each element of JTI’s claimed auto expense
deductions, we sustain respondent’s determination on this issue.
2. Gifts
For 2013 and 2014, respectively, JTI claimed deductions of $601 and $300
for gifts. The cost of gifts may be an ordinary and necessary business expense if
the gifts are connected with the taxpayer’s opportunity to generate business
income. Bruns v. Commissioner, slip op. at 19. Deductions for gifts are subject to
the requirements of section 274(d).
At trial petitioner husband testified that the gifts in question were birthday
presents. However, petitioners produced no evidence as to the business purpose of
- 28 -
[*28] the gifts as required by section 274(d). We therefore sustain respondent’s
determination on this issue.
3. Meals and Entertainment
On its 2013 return JTI claimed deductions of $17,671 and $7,524,
respectively, for “MEALS @ 100%” and meals and entertainment. For 2014 JTI
deducted $6,727 for meals and entertainment. Respondent argues that petitioners
have not substantiated these deductions.
Petitioner husband testified that the reported meal expenditures were for
groceries, restaurants, and meetings at home conducted as part of the ACN
business. However, the credit card statements and accompanying information in
the record do not detail the time, place, and business relationship for each
expenditure. Additionally, the receipts do not indicate that the meals were
conducted for a business purpose.
Because the record lacks adequate records or other sufficient evidence to
establish each element of their claimed meal and entertainment expense
deductions, we sustain respondent’s determination on this issue.
- 29 -
[*29] 4. Travel
For 2013 and 2014, respectively, JTI claimed deductions of $6,641 and
$9,854 for travel. Respondent argues that petitioners have not substantiated these
reported expenses.
Petitioner husband testified that they traveled four times a year to ACN
conventions. Additionally, the record includes cover pages, American Express
statements, and other hotel and airline receipts pertaining to petitioners’ 2014
travel expenses. However, the record does not contain any documentary evidence
or other direct or circumstantial evidence of the business purpose of each reported
travel expense.
Because petitioners did not establish by adequate records or other sufficient
evidence the business purpose of their reported travel expenses, they have not met
the requirements of section 274(d). We sustain respondent’s determination on this
issue.
III. Accuracy-Related Penalties
Finally, we determine whether petitioners are liable for accuracy-related
penalties. Pursuant to section 6662(a) and (b)(1) and (2), a taxpayer may be liable
for a penalty of 20% on the portion of an underpayment of tax due to:
(1) negligence or disregard of rules or regulations or (2) a substantial
- 30 -
[*30] understatement of income tax. “Negligence” is defined as any failure to
make a reasonable attempt to comply with the provisions of the Code; this
includes a failure to keep adequate books and records or to substantiate items
properly. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs. Negligence has
also been defined as the failure to exercise due care or the failure to do what a
reasonable person would do under the circumstances. See Allen v. Commissioner,
92 T.C. 1, 12 (1989), aff’d, 925 F.2d 348 (9th Cir. 1991); Neely v. Commissioner,
85 T.C. 934, 947 (1985). “Disregard” includes any careless, reckless, or
intentional disregard. Sec. 6662(c).
“Understatement” means the excess of the amount of the tax required to be
shown on the return over the amount of the tax imposed which is shown on the
return, reduced by any rebate. Sec. 6662(d)(2)(A). A “substantial
understatement” of income tax is defined as an understatement of tax that exceeds
the greater of 10% of the tax required to be shown on the tax return or $5,000.
Sec. 6662(d)(1)(A).
The accuracy-related penalty does not apply with respect to any portion of
the underpayment for which the taxpayer shows that there was reasonable cause
and that he acted in good faith. See sec. 6664(c)(1). The decision as to whether a
taxpayer acted with reasonable cause and in good faith is made on a case-by-case
- 31 -
[*31] basis, taking into account all of the pertinent facts and circumstances. Sec.
1.6664-4(b)(1), Income Tax Regs. “Circumstances that may indicate reasonable
cause and good faith include an honest misunderstanding of fact or law that is
reasonable in light of all of the facts and circumstances, including the experience,
knowledge, and education of the taxpayer.” Id. Reliance on a tax professional
demonstrates reasonable cause when a taxpayer (1) selects a competent tax
adviser, (2) supplies the adviser with all relevant information, and (3) relies in
good faith on the adviser’s professional judgment. See Neonatology Assocs., P.A.
v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
The Commissioner bears the burden of production with respect to the
taxpayer’s liability for the section 6662(a) penalty and must produce sufficient
evidence indicating that it is appropriate to impose the penalty.16 See sec. 7491(c);
Higbee v. Commissioner, 116 T.C. 446-447. Once the Commissioner meets his
burden of production, the taxpayer must come forward with persuasive evidence
that the Commissioner’s determination is incorrect or that the taxpayer had
16
Sec. 6751(b)(1) requires written supervisory approval of the initial
determination of certain penalties. The Commissioner’s burden of production
under sec. 7491(c) includes establishing compliance with sec. 6751(b)(1). See
Graev v. Commissioner, 149 T.C. 485, 493 (2017), supplementing and overruling
in part 147 T.C. 460 (2016); see also Clay v. Commissioner, 152 T.C. 223, 249
(2019). The parties have stipulated that respondent complied with the
requirements of sec. 6751(b)(1) in this case.
- 32 -
[*32] reasonable cause or substantial authority for the position. See Higbee v.
Commissioner, 116 T.C. 446-447.
Respondent satisfied his burden of production with respect to negligence or
disregard of rules or regulations. See secs. 6662(a) and (b)(1), 7491(c).
Petitioners underreported JTI’s gross receipts and did not maintain sufficient
records to substantiate many of the expenses underlying JTI’s deductions. The
disallowed deductions in this case are directly attributable to petitioners’ failure to
maintain adequate records.17
Petitioners, who bear the burden of persuasion, argue that their reliance on
Mr. Drummer constitutes reasonable cause and good faith. We agree in part and
disagree in part. Petitioner husband credibly testified that he believed Mr.
Drummer was a former IRS RA on the basis of a coworker’s recommendation, and
we find it more likely than not that petitioners reasonably believed Mr. Drummer
was a competent tax adviser. See Lopez v. Commissioner, T.C. Memo. 2017-171,
at *11-*12 (citing Neonatology Assocs. P.A. v. Commissioner, 115 T.C. 99).
The fact that petitioners hired Mr. Drummer to prepare their returns does
not, by itself, establish that they acted with reasonable cause and good faith. See
17
To the extent the Rule 155 computations establish that petitioners have
substantial understatements of income tax, respondent has also met his burden of
production in this regard. See secs. 6662(a) and (b)(2), 7491(c).
- 33 -
[*33] Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 99-100. They
must also establish that they supplied him with all relevant information and relied
in good faith on his professional judgment. See id. Petitioners have met this
burden only with respect to JTI’s deductions for “outside services”.
At trial petitioner husband credibly testified that Mr. Drummer advised him
that petitioners could deduct their daughters’ tuition if they paid it through an
S corporation. Following Mr. Drummer’s advice, petitioners reported these
payments as deductible “outside services” on JTI’s 2013 and 2014 returns. While
this tax position might be “too good to be true” in other circumstances, we believe
petitioners acted in good faith here. We observed at trial that petitioners face a
significant language barrier. They have no formal training in accounting or
taxation and believed that Mr. Drummer was a tax expert and former IRS RA.
Accordingly, Mr. Drummer’s advice carried significant weight for them. We
therefore find that petitioners acted with reasonable cause and in good faith with
respect to JTI’s deductions for “outside services” for 2013 and 2014.
Regarding all other adjustments to petitioners’ returns, petitioners have not
shown that they acted with reasonable cause and good faith. The record does not
establish that petitioners gave Mr. Drummer all relevant information with respect
to their business income and expenses. We therefore sustain those portions of the
- 34 -
[*34] accuracy-related penalties that do not pertain to JTI’s “outside services”
deductions.
The Court has considered all of the parties’ arguments and, to the extent not
discussed above, concludes that those arguments are irrelevant, moot, or without
merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.