DocketNumber： Docket No. 15383-09.
Citation Numbers： 109 T.C.M. 1016, 2015 Tax Ct. Memo LEXIS 7, 2015 T.C. Memo. 4
Filed Date： 1/7/2015
Status： Non-Precedential
Modified Date： 11/20/2020
Decision will be entered under
R determined deficiencies in income tax for Ps' 2002, 2003, and 2004 taxable years arising from Ps' failure to report income they received in connection with an ESOP and an S corporation, R's disallowance of deductions for passthrough losses from Ps' wholly owned partnership, and related computational adjustments. Before trial the parties settled outstanding issues other than Ps' entitlement todeductions for passthrough losses from their partnership, and they agreed to try the case as if Ps had directly claimed on their individual returns the deductions underlying the passthrough losses.
*5
WHERRY,
| Penalty | ||
| 2002 | $355,871 | $71,174.20 |
| 2003 | 47,901 | 9,580.20 |
| 2004 | 21,289 | 4,257.80 |
After filing of a stipulation of facts, a supplemental stipulation of facts, a stipulation of settled issues (SOSI), and a stipulation, the facts of which are agreed *6 to by the parties and by this reference incorporated herein, as well as subsequent concessions, the issues remaining for decision are:
(1) whether the SOSI authorizes petitioners to deduct: (a) expenses and/or losses reported by corporate entities Capital Equity Resources, Inc. (Capital Equity), and/or Great Western Sierra Holdings, Inc. (Great Western), for 2002 and 2003; and/or (b) a $100,000 passthrough loss from their wholly owned general partnership Wakefield Business Enterprises Partnership (WBE) for 2002;
(2) whether petitioners may otherwise deduct passthrough losses from WBE of $161,085, $46,433, and $57,464 for tax years 2002, 2003, and 2004, respectively;
(3) whether petitioners may alternatively deduct*8 any or all expenses reported by WBE for tax years 2002, 2003, and 2004 on Schedules A, Itemized Deductions, for those tax years; and
(4) whether petitioners are liable for Petitioners Kennison and Mary Wakefield filed a Form 1040, U.S. Individual Income Tax Return, for each of the tax years 2002, 2003, and 2004 as married persons filing jointly. Petitioners lived in California when they filed their petition. At all times during 2002 through 2004 Mr. Wakefield worked as a stockbroker. He did so as an employee, first of Prudential Financial and then of Wachovia after it acquired Prudential Financial.*9 commissions on investment products purchased by clients whose business he brought to the firm. Before joining the securities industry Mr. Wakefield earned a degree in business administration and marketing at the University of Southern California (USC) and attended two years of law school at the University of San Fernando Valley. As of 2002 he had 30 years of experience in the securities industry. *8 On petitioners' tax returns for 2002, 2003, and 2004 Mrs. Wakefield reported her occupation as "interior design" and reported income and expenses from a residential building refurbishment business on attached Schedules C, Profit or Loss From Business. In 2002 she also received wage income from Ralph's Grocery Co. Before 2002 Mr. Wakefield met A. Blair Stover, Jr., a principal at the accounting firm Grant Thornton, which had been providing accounting services to petitioners.*10 including Nevada corporations and an ESOP. Mr. Wakefield engaged Grant Thornton to form the entities for him because he understood that doing so "would help * * * [him] in * * * [his] taxes as far as what * * * [his] tax obligations would be." Mr. Stover and his team formed the following entities (business entities) for Mr. Wakefield: (1) Great Western, an S corporation that reported Mr. Wakefield *9 as its president and an ESOP as its sole shareholder on its 2001, 2002, and 2003 tax returns; (2) Capital Equity, a C corporation with a fiscal taxable year ending on October 31 that reported Mr. Wakefield as its sole shareholder, president, or owner on its 2002 and 2003 tax returns; and (3) WBE, a 50-50 partnership between petitioners of which Mr. Wakefield served as the designated tax matters partner. Forming these entities enabled petitioners to participate in a management S corporation/ESOP transaction designed*11 to reduce ordinary taxable income by the alleged payment to a. newly created S corporation, Great Western, of alleged management fees that were reported by Great Western as income and passed through to the tax-exempt ESOP. The transaction also involved purported fee payments and expenses allocated between Capital Equity and WBE. In 2010 Mr. Stover was permanently enjoined from promoting various tax-shelter schemes, including the "ESOP/S" and "parallel C" structures. When Mr. Stover and several other individuals, including Angela Parker and Kelly Webb, decamped from Grant Thornton to another accounting firm, Kruse Mennillo, LLP (Kruse Menillo), Mr. Wakefield followed them and thereafter used Kruse Mennillo for tax preparation and other services. Ms. Parker and/or Ms. Webb prepared petitioners' and the business entities' tax returns for *10 2002, 2003, and 2004. They prepared the returns using business and personal expense summaries that Mr. Wakefield created. Mr. Wakefield signed the returns as presented to him by Kruse Mennillo. Petitioners claimed deductions for passthrough losses from WBE on Schedules E, Supplemental Income and Loss, of their 2002 through 2004 tax returns.*12 WBE reported income, deductions, and ordinary losses on Forms 1065, U.S. Return of Partnership Income, for tax years 2002, 2003, and 2004.The Notice of Deficiency Respondent mailed a notice of deficiency to petitioners on March 23, 2009. On an enclosed Form 5278, Statement - Income Tax Changes, respondent identified the following adjustments to petitioners' income for tax years 2002, 2003, and 2004: The notice also determined In the SOSI filed April 16, 2012, the parties intended to settle all issues related to petitioners' participation in the management S corporation/ESOP transaction in taxable years 2001, 2002, and 2003 by attributing to them individually the taxable income that Great Western reported as having passed through to the ESOP. The SOSI thus resolved adjustments (1) through (3) above by providing that "petitioners received, but did not report, ordinary income" of *12 $426,313 for 2002 and $84,837 for 2003. The amount petitioners were obliged to report for 2002, $426,313, represents the net amount of taxable income they avoided reporting for taxable years 2001 and 2002 because of their use of Great Western in conjunction with the ESOP. The amount petitioners were obliged to report for 2003, $84,837, represents the amount of taxable income petitioners avoided reporting for taxable year 2003 because of their use of Great Western in conjunction with the ESOP. Respondent,*14 in turn, conceded the deficiencies he had determined with respect to Capital Equity and Great Western. The parties further agreed in the SOSI that petitioners are liable for accuracy-related penalties under The WBE expenses consisted of the*15 following: 1 Petitioners did not supply WBE's 2003 Federal income tax return, and respondent was able to retrieve only the return transcript for that year; thus, WBE's tax return for that year and the accompanying schedules explaining its claimed deductions are not in the record. Because we lack sufficient evidence to determine the sources to which WBE attributed its $128,001 of "Other Deductions" on its 2003 return, we list these values as "Unknown". At trial respondent conceded that the following components of the WBE expenses (conceded expenses) Respondent maintains that the conceded expenses may have been reimbursable and so are not properly deductible. Prudential offered reimbursement to its employees for expenses incurred in connection with the company's business, subject to an annual cap of approximately $2,000 to $2,500 during the years at issue. Mr. Wakefield typically sought reimbursement for expenses paid in cash or by check as opposed to those paid by credit card. Mr. Wakefield might possibly have received reimbursement for some of the expenses for which he and/or the business entities*17 claimed deductions, but that is very improbable given his considerable out-of-pocket expenses and his cash and check payments. At trial, to substantiate the expenses underlying their claimed deductions, petitioners introduced an exhibit consisting of three types of documents: (1) checking and credit card account statements reflecting payments they made in the tax years at issue; (2) handwritten expense summaries that Mr. Wakefield prepared and provided to Kruse Mennillo at the end of each relevant tax year;Scope of SOSI As a threshold matter, we consider whether the SOSI authorizes petitioners to deduct (1) expenses and/or losses reported by Capital Equity and/or Great Western and/or (2) a $100,000 passthrough loss from WBE for 2002. The SOSI resolved what had been the principal issues in*18 this case and in two related cases:*19 *17 the Great Western ESOP's ownership structure and management services. With respect to these issues, the notice of deficiency in this case originally determined adjustments totaling $750,486 for 2002 and $98,000 for 2003 as well as penalties. As its name implies, the SOSI embodies a partial settlement agreement. The parties' disparate interpretations of that agreement compel us to examine whether it constitutes a valid settlement, and if so, what its terms are. These two inquiries collapse into one. '"A settlement is a contract and, consequently, general principles of contract law determine whether a settlement has been reached.'" In construing a settlement agreement, we again look to contract law. 1. In the Notice of Deficiency, respondent determined petitioners had unreported income during the years, in the amounts, and due to the issues shown in the following table: In resolution of these adjustments, the parties agree petitioners received,*22 but did not report, ordinary income during the years and in the amounts shown in the following table: Petitioners contend that: (1) the amounts they must include in income pursuant to the foregoing paragraph represent gross income that Great Western reported for these tax years; and (2) for each of the tax years at issue, Kruse Menillo divvied up Mr. Wakefield's business expenses among the business entities and reported some of those expenses on each entity's return. On these premises, petitioners reason that the SOSI's first paragraph contemplates their *21 deduction of Mr. Wakefield's business expenses allocated to and reported by Capital Equity and/or Great Western, subject to substantiation requirements. Petitioners further attempt to reconstruct the complex, multiyear deferral scheme that Mr. Stover implemented on their behalf, and they trace various claimed expenses and other tax benefits through this structure. They contend that, on the business entities' returns, Kruse Menillo reported income and corresponding deductions for payments between the entities. Petitioners reason that the SOSI's first paragraph contemplates their deduction of one*23 interentity payment in the net amount of $100,000, deducted on WBE's 2002 return, that generated the income they must include for 2003. Respondent disputes petitioners' interpretation of the SOSI. He answers that: the SOSI does not, on its face, authorize petitioners to deduct any expenses or losses; respondent never understood the SOSI to authorize petitioners' proposed additional deductions; petitioners' elaborate theory for how the scheme operated relies on unsupported speculation; and "an amount of income reported on one tax return [does not] necessarily require[] a corresponding deduction on another tax return." We agree with respondent's narrower reading of the SOSI's first paragraph as it relates to deductions for business expenses that Capital Equity and/or Great *22 Western reported. On its face, the SOSI does not provide for such deductions. It does not associate the required income inclusions with Great Western but instead simply lists dollar amounts without identifying their source. It omits any reference to either Great Western or Capital Equity. Its first paragraph expressly requires only specified income inclusions without alluding to any corresponding deductions. The parties*24 did, however, affirmatively address deductions elsewhere in their agreement. The SOSI's third paragraph specifically identifies petitioners' entitlement to deduct passthrough losses from WBE as an unresolved issue. It states: 3. The following issues set forth in the Notice of Deficiency remain outstanding: That paragraph also resolves petitioners' contention regarding deduction of a $100,000 loss from WBE for 2002. The absence of any limitation or qualification on the phrase "Losses from Wakefield Partnership"*25 makes plain that the SOSI neither authorizes nor forecloses petitioners' deduction of $100,000 of the net loss that WBE reported for 2002. Like the balance of WBE's reported net loss for that year, the parties expressly designated it an open question. We conclude that the SOSI unambiguously (1) does not permit petitioners to deduct expenses exceeding those reported on WBE's returns and (2) leaves open whether they may deduct $100,000 of "loss" reported by WBE.*26 We have concluded that the SOSI does not authorize petitioners to deduct a $100,000 passthrough "loss" from WBE. Ordinarily, this would mean that petitioners may deduct the loss only if and to the extent that it is allowable absent the SOSI--e.g., if it represents an ordinary and necessary business expense deductible under Stipulations should be enforced according to their terms "unless manifest injustice would result." In deciding whether to allow a party to modify a stipulation, we consider various factors including, as relevant here, possible injustice to the moving party if the stipulation were enforced. Greatly simplified, these*28 structures routed fictional, purportedly deductible payments among various entities with different tax years in a shell game designed to generate paper losses while minimizing net taxable income left in any taxable *26 entity for any tax year.*30 No evidence in the record indicates that any services were ever rendered by any of the business entities, nor that any of these reported payments were actually made. Rather, the evidence in the record strongly suggests that this entire series of transactions was a sham. The SOSI, however, appears to respect these transactions as genuine for tax purposes. More specifically, the SOSI treats Great Western's reported gross *28 receipts for 2003, representing the last in the series of apparently sham payments, as real, taxable income, not simply a book entry*31 devoid of economic substance. Petitioners contend that the entire series of payments must be respected. Each item of income should correspond to an expense, and vice versa. Consequently, the first fee payment in the series—$120,000 by WBE in 2002--should be respected as a genuine expense. Because WBE also reported $20,000 in gross receipts for that year, the net loss would be $100,000, a deduction for which would pass through to petitioners. They advocate reading the SOSI to include these implied terms. Petitioners' logic does not support modification of or relief from the SOSI under *29 We regard settlement stipulations as contracts and thus typically require proof of a contractual defense before declining*32 to enforce them. When, as here, enforcement first comes into question at the posttrial brief stage, we have been especially reluctant to grant relief. That the SOSI embodies a negotiated settlement between the parties not only weighs against modification pursuant to For the foregoing reasons, the Court declines to modify the SOSI and concludes that petitioners remain bound by the deal they struck with respondent. They may not, pursuant to the SOSI, claim deductions for expenses exceeding those reported on WBE's tax returns or deduct a $100,000 passthrough loss from WBE attributable to the administration fee it allegedly paid or incurred in 2002. The Court will next consider petitioners' entitlement to deduct this $100,000 loss along with their entitlement to other passthrough losses from WBE. The second of the four issues presented in this case is whether petitioners may deduct passthrough losses from WBE for tax years 2002, 2003, and 2004. We hold they may not. As a general rule, the Commissioner's determination of a taxpayer's tax liability is presumed correct, and the taxpayer bears the burden of proving that the determination is improper. WBE's tax returns for tax years 2002 through 2004 report net losses generated through deductions for rents, interest, and/or other expenses. Petitioners have offered no evidence that they or any of the business entities ever incurred or paid any rent expense.See At trial the parties agreed to treat the WBE expenses as having been reported directly by petitioners on their Forms 1040. Hence, we turn to the third issue presented for decision: whether and to what extent petitioners may properly deduct the WBE expenses as Schedule A itemized deductions. Deductions are a matter of legislative grace, and taxpayers bear the burden of proving entitlement to any claimed deduction. Under If a taxpayer's records are lost or destroyed because of circumstances beyond his control, the taxpayer may instead substantiate the expenses with other credible evidence. Pursuant to While business expenses are generally deductible, personal, living, and family expenses are typically nondeductible. Business expenses described in Before we examine Mr. Wakefield's reported business expenses in detail, we consider whether his employer's reimbursement policy forecloses the desired deductions. Respondent maintains that to the extent that any of the WBE expenses were otherwise deductible under *37 It is well settled that an employee may not deduct otherwise valid unreimbursed business expenses if the employee is entitled to reimbursement from his or her employer for such expenditures. Mr. Wakefield credibly testified, in sum, that Prudential offered expense reimbursement subject to a cap of approximately $2,000 to $2,500 during the years at issue; that he typically sought reimbursement for expenses paid in cash or by check; and that he incurred at least $3,000 of cash expenses each year. He testified with certainty that WBE did not claim deductions for any of his cash expenses.' Petitioners have adequately shown that Prudential would not reimburse *38 its employees for expenses in excess of $2,500 per year and that Mr. Wakefield incurred and sought reimbursement for at least that amount of cash expenses. Therefore, on the basis of Mr. Wakefield's credible testimony, we hold that the WBE expenses, including the conceded expenses, were not reimbursable. We organize our evaluation of Mr. Wakefield's expense claims according to the categories defined on WBE's*41 tax returns. WBE deducted $120,000 for 2002 as an expense for an "administration fee". To recap, the record reflects the following correlations among the business entities' tax returns: WBE's $120,000 administration fee deduction for its tax year ending December 31, 2002, correlates with Capital Equity's reported gross receipts of $120,000 for its overlapping tax year ending October 31, 2003. For that same tax period Capital Equity deducted $98,000 for commissions accrued or paid as "Cost of goods sold", which amount correlates with WBE's reported gross receipts of $98,000 for its tax year ending December 31, 2003. According to petitioners' evidence interpreting the summary figures on WBE's tax return transcript, for that same 2003 tax year WBE deducted as part of its claimed *39 $128,001 of other deductions a $98,000 administrative fee paid to Great Western. Great Western, in turn, reported $98,000 of gross receipts for that same tax year, with deductions reducing its reported net income to the $84,837 that petitioners have agreed to include for 2003 pursuant to the SOSI. Petitioners argue that causal connections link these correlating payments, and that the $84,837*42 they must include in income originated with and directly corresponds to $100,000 of WBE's 2002 administration fee expense ($120,000 less WBE's $20,000 of reported gross receipts), reduced by business expenses deducted along the way. To support this theory, they point to the tax returns in the record and the spreadsheet for 2003. Respondent insists that this evidence does not suffice to prove the sources of the income and deductions on the various entities' tax returns. Moreover, as we observed The Court need not resolve these substantiation issues because petitioners' claim suffers from a more fundamental flaw. While the Court agrees that the computations should be consistent, it knows of no law permitting fictitious deductions or, for that matter, taxing fictitious income. "[A] taxpayer seeking a deduction must be able to point to an applicable statute and show that he comes within its terms." By order dated July 1, 2014, this Court specifically sought supplemental briefing on "the*43 legal basis, if any, for deduction by the partnership and/or petitioners of an expense corresponding to the 2003 income inclusion required by the SOSI." In their brief submitted in response to that order, petitioners failed to point to any provision of the Code or any interpretive caselaw or administrative guidance that authorizes their desired deduction. Instead, they argue that disallowing their deduction of the $100,000 administration fee equates to requiring that they include, and pay tax on, fictitious income--an inequitable result. Generally, recognition of income does not inexorably prove a corresponding Petitioners' phantom income argument amounts, in essence, to a plea for fairness. This Court strives to avoid unjust results, but "we are not a court of equity and cannot ignore the law to achieve an equitable end." In sum, petitioners have pointed us to no legal basis for their desired deduction of $100,000 of the administration fee--the $120,000 that WBE deducted, less WBE's $20,000 of gross receipts. Consequently, they may not deduct it. WBE deducted $1,574 in travel expenses for 2002 and $2,322 for 2004. Mr. Wakefield's handwritten expense summaries for 2002 through 2004 reflect various expenditures on travel, including airline tickets, taxi and shuttle service, car rental, and tolls.*46 Petitioners' account statements for the three tax years at *43 issue show payments to, inter alia, airlines, a limousine service, rental car agencies, and toll lane operators. In his testimony Mr. Wakefield emphasized that regular, personal communication with his existing clients, often face-to-face, was essential to his work as a stockbroker. This "constant contact" enabled him to secure new clients through referrals and to persuade existing clients to expand their portfolios. Mr. Wakefield further testified that, because some of his clients lived in Northern California and outside the State in Arizona and Nevada, he traveled to see them on commercial airlines, renting cars and using taxis or a shuttle service in connection with his air travel. He also drove on toll roads to visit clients. Travel expenses fall within the ambit of Petitioners assert that Mr. Wakefield's discarded diaries would have supplied all of the missing details concerning his travel, and that the diaries' "inadvertent destruction" should not render the claimed expenses nondeductible. This argument will not release them from First, although Second, Mr. Wakefield's testimony reflects that his diaries were not destroyed "due to circumstances beyond [his] control" but rather of his own volition. Petitioners have failed to properly substantiate their claimed travel expenses; consequently, they may not deduct them. WBE deducted $8,091 in meals and entertainment (M&E) expenses for 2002 and $11,397 for 2004. Mr. Wakefield's handwritten expense summaries for *48 2002 through 2004 list numerous expenditures on allegedly business-related meals and entertainment, including a catered Christmas party for clients featuring entertainment. They also reflect payments to USC and to Balboa Yacht Club.*52 Petitioners' account statements for the three tax years at issue document payments to, inter alia, dozens of restaurants, theater and concert venues, a catering service, Balboa Yacht Club, and USC. Mr. Wakefield credibly testified that he frequently treated both existing and prospective clients to meals, plays, concerts, and sporting events to foster these business relationships and generate referrals. He averred that the financial markets were "always" discussed at such events. Mr. Wakefield testified that the payments to USC consisted of "donations",*53 a "committee" membership fee that secured him access to event tickets and preferential seating, and tickets to sporting *49 events to which he brought clients. With regard to the yacht club, Mr. Wakefield explained that he "did a lot of sailing" and that, until petitioners sold their sailboat, these payments covered monthly slip rental and bottom cleaning for the boat. He further testified that he took clients out for meals at the club's restaurant. Moreover, like travel expenses, M&E expenses must satisfy Hence, petitioners may not deduct any of their claimed M&E expenses. WBE deducted $4,246 in automobile expenses for 2002 and $5,539 for 2004. Mr. Wakefield's personal expense summary for 2002 reflects that he paid $701 for auto repair and $712 of Department of Motor Vehicles (DMV) fees and that he drove 16,417 miles. For 2003 and 2004 he listed mileage and auto expenses, including lease payments for a Mercedes, on his business expense summaries. Petitioners' account statements for the three tax years at issue reflect payments to the DMV. Mr. Wakefield explained that he drove regularly for business, meeting with slightly more than 50% of*56 his clients away from his office. He testified that he made approximately 200 trips per year to visit clients throughout southern *52 California and in Arizona. Mr. Wakefield used his personal vehicle for business travel but provided Kruse Mennillo only his total mileage driven for the year. In neither his contemporaneous expense summaries nor in his testimony did Mr. Wakefield make any attempt to segregate use of his car for business purposes from use for personal purposes and commuting. Miles driven to and from the office,*57 to personal appointments, to visit friends, and on other personal outings were simply lumped in with miles driven on client visits. Similarly, he claimed deductions for the entire cost of car repairs and DMV charges, despite the fact that *53 these expenses necessarily included a personal component. The record provides no factual basis upon which to estimate the business component of these expenses, and in any event, the Court lacks discretion to make such an estimate. Second, In sum, petitioners*58 have not adequately substantiated any of Mr. Wakefield's reported automobile expenses. Consequently, they may not deduct them. WBE deducted $193 in expenses for dues and publications for 2002 and $1,116 for 2004. Mr. Wakefield's expense summary for 2002 reflects that he spent $322 on a subscription to the Wall Street Journal. His 2003 summary reflects dues and publications expenses for the Chartist, Franklin Covey, the Oechsli Institute, Cabot Market Letter, and the Wall Street Journal; the 2004 summary lists only "publications", apparently lumped in with tapes, seminars, etc. Mr. Wakefield testified that the Wall Street Journal was delivered to his office and that he read it to maintain his awareness of market activity in connection with his job. Mr. Wakefield's Wall Street Journal subscription was an ordinary and necessary expense of his employment as a stockbroker and is deductible. Petitioners' checking account statement for 2002 reflects a $322.17 payment to the Wall Street Journal on April 30, 2002. Conversely, the Court has carefully reviewed petitioners' account statements (those in the record) for 2003 and 2004 and found no evidence of payments to the*59 Wall Street Journal. We will accept Mr. Wakefield's handwritten 2003 expense summary, which lists a $375 payment for the Wall Street Journal, along with his sworn testimony, corroborated by the 2002 previous year's check, as establishing that petitioners paid $375 for the Wall Street Journal in 2003. Unlike his 2003 summary, however, Mr. *55 Wakefield's 2004 summary does not reflect a specific, itemized expense for the Wall Street Journal. Because petitioners have not shown or testified as to the amount, if any, that they actually paid for this newspaper in 2004, they may not deduct the alleged subscription cost for that year. Continuing with 2003, respondent has conceded that a $175 subscription to the Chartist and payments of $106.06 to Franklin Covey for publications were ordinary and necessary business expenses that have been adequately substantiated. Petitioners' bank statement reflects two $34 (rounded) payments to the Oechsli Institute. Nothing in the record indicates what product or service was received in exchange or what business purpose this payment served; however, the Court will take judicial notice that this institute helps financial professionals. The same is true of the*60 $99 payment for the Cabot Market Letter. Accordingly, petitioners may deduct the $68 of total payments to the Oechsli Institute and the $99 payment to Cabot Marketing for 2003. Finally, petitioners have not identified which publications Mr. Wakefield received in 2004 or how they related to his business. These expenses may not be subject to the strict substantiation requirements of In sum, petitioners may deduct publication expenses of $193*61 for 2002 and $542 for 2003 under WBE deducted $4,060 in legal and/or professional fees for 2002 and $3,850 for 2004. Mr. Wakefield's 2002 expense summary reflects that he paid $4,767 to *57 Kruse Mennillo, $200*62 to Hoeppner & Associates, and $1,800 to Nevada Corporation Associates (NCA). His 2003 and 2004 summaries also reflect payments to Kruse Mennillo and NCA. Mr. Wakefield testified that Kruse Mennillo charged him $450 for tax preparation in 2002 and that the balance paid to the firm in that year was for other services. In 2003 he again paid Kruse Mennillo for tax return preparation and other tax-related services. Mr. Wakefield stated that he paid NCA to maintain the ESOP and the business entities and that he paid the law firm Hoeppner & Associates to prepare corporate documents for Capital Equity and Great Western. Petitioners' account statements document payments to Kruse Mennillo of $450 in 2002 and $2,000 in 2003. The statements do not reflect any professional fee payments in 2004. Respondent has conceded that petitioners may deduct a $297 payment to NLH Financial Services for 2003.See We cannot, however, allow any of petitioners' other claimed deductions for professional and legal fees. As noted, petitioners offered no substantiating evidence for 2004. Although their account statements partially substantiate the previous years' reported expenses, those expenses lack any demonstrated nexus to Mr. Wakefield's job as a stockbroker. Mr. Wakefield could not explain what other services, beyond inappropriate tax evasion activities, Kruse Mennillo performed for him, let alone what business*64 purpose they served. With regard to the other service providers, who formed and maintained the business entities, he testified that the business entities were created to reduce his tax liability. *59 Nothing in the record tends to prove that these professional and legal expenses were either ordinary or necessary; and in any event, WBE deducted $12,573 in expenses for promotions and meetings for 2002 and $7,544 in expenses for promotions and seminars for 2004. Mr. Wakefield's expense summaries reflect that he spent, cumulatively, thousands of dollars in 2002 through 2004 at the Huntington Beach Waterfront Hilton (Hilton), on promotional pens, Christmas gift baskets for clients, and other client gifts. Mr. Wakefield testified that he hosted seminars for clients and prospective or potential clients three to four times each year at the Hilton. At these seminars he would discuss*65 subjects such as how a presidential election might affect the stock market or what economic trends to expect for the coming year, pay for *60 attendees' meals and parking, and collect their contact information for postseminar followup. He also distributed customized pens imprinted with his name and contact details to seminar attendees. Mr. Wakefield secured new clients through the seminars. Respondent has conceded that petitioners may deduct $350.28 for 2002 and $541.88 for 2004 for promotional pens.*66 or with the amounts petitioners cite in their posttrial brief. Without any reasonable basis to estimate the true amounts of petitioners' seminar expenditures, we decline to find that they may *61 deduct these expenditures, for any year, in any amounts greater than those respondent conceded. Mr. Wakefield testified that in 2002 he purchased Christmas gift baskets costing approximately $65 each from a business called Wine Country for his top 10 clients. His Prudential Financial credit card statement substantiates a $635.70 payment to Wine Country Gift Baskets. When asked about the amount he spent in 2003, Mr. Wakefield estimated that he had given gift baskets to the top 20 clients that year. Three entries on his 200.3 Wachovia bank statement substantiate a total expense of $1,436.11. Like travel, M&E, and automobile expenses, expenditures on gifts must meet the heightened standard of No evidence in the record confirms that petitioners actually paid for gift baskets in 2004. For 2002 and 2003 petitioners' evidence of their per-unit cost, description, and business purpose derives from their bank statements and Mr. *62 Wakefield's testimony. The Court finds Mr. Wakefield's testimony on these subjects credible, although he plainly stated from memory the baskets' unit price and the number of clients to whom he sent them. Nevertheless, his memory, when sales tax is added, is consistent with the numbers on his account statements. With respect to the dates of delivery and the recipients' relationships to him, Mr. Wakefield spoke generally of sending the baskets to his top clients at "Christmas". Mr. Wakefield's testimony, records of his top clients, and the account statements suffice to substantiate these expenses as required by WBE deducted $1,109 in parking expenses*68 for 2002. Mr. Wakefield's expense summaries reflect that he paid for "office parking" in 2002, "car parking" in 2003, and "parking fees" in 2004. Petitioners' account statements document payments to Ace Parking at least once during each tax year at issue. In his testimony Mr. Wakefield explained that he paid a monthly fee to park his car in the lot next to his office. *63 The cost of parking at one's workplace, like other ordinary commuting expenses, is a personal expense that may not be deducted. WBE deducted $1,028 of telephone service expenses and $77 of Internet service expenses for 2002 and a total of $1,354 for 2004. Mr. Wakefield's expense summaries for 2002 through 2004 reflect payments for Palm Pilot and AOL Internet services as well as payments to three telephone service providers, including AT&T Wireless.*69 Petitioners' account statements reflect numerous payments to telephone and Internet service providers. With respect to telephone service, Mr. Wakefield testified that he made "a number" of calls from home but could not elaborate on how often or to whom he made these calls. He explained that the numbers on his expense summaries reflected his total phone bills. With respect to Internet service, Mr. Wakefield *64 could not describe the purpose of the Palm Pilot service charges and offered no explanation for the AOL charges. While the record amply documents that petitioners incurred expenses for telephone service and Internet service, no credible evidence links these expenses with Mr. Wakefield's employment as a stockbroker. Even assuming that some of the calls Mr. Wakefield made were to clients or otherwise for business, WBE deducted $6,302 of marketing expenses for 2002. Mr. Wakefield's expense summary for that year lists expenditures totaling $10,275 for services from Bill Good Marketing, Comp View, Carleton Sheets Marketing, H.S. Dent, and CIS Marketing; his 2004 summary lists only a $2,000 expense for Brian Tracy Business Clinic. Because for 2002 respondent has conceded that payments to Bill Good, H.S. Dent, and CIS Marketing totaling $9,431.96 were all ordinary and *65 necessary business expenses,*71 we consider only the Comp View, Carleton Sheets, and Brian Tracy expenses. Petitioners' account statements document payments totaling $602 to Comp View in 2002. At trial, however, Mr. Wakefield could offer no specific information about his purchase from Comp View. Under cross-examination, when confronted with evidence that the company sold and installed audio and video equipment, he retreated from his initial generalization that the expense must have been for "typical learning seminars for me, subscription things for me for my business." Given Mr. Wakefield's lack of certainty and memory concerning what he bought from Comp View, we find that petitioners have not presented credible evidence that his Comp View purchase served a business purpose. Accordingly, petitioners may not deduct that expense. *66 Turning to the Carleton Sheets expense, in line with Mr. Wakefield's summary, petitioners'*72 account statements document a $224.80 payment. At trial Mr. Wakefield testified that Mr. Sheets is well known in the real estate industry and "had marketing ideas" and that he had paid for tapes that Mr. Sheets produced. Even assuming that these tapes represented an ordinary and necessary expense of Mr. Wakefield's stockbrokerage job, their cost would not increase the allowed deduction. WBE deducted only $6,302 in marketing expenses for 2002, and respondent has already conceded marketing expenses in excess of that amount. Lastly, Mr. Wakefield testified, and respondent offered no evidence to contradict, that he spent $2,000 in monthly subscription charges throughout 2004 on educational tapes and disks produced by Brian Tracy Business Clinic. The tapes focused on marketing, client appreciation, and ways to enhance one's business. These instructional tapes represented an ordinary and necessary business expense to Mr. Wakefield. Petitioners' account statements, however, document only one $4.95 payment on May 25, 2004, to Brian Tracy Business Clinic, so their deduction is limited to that amount.*67 In sum, in addition to the conceded expenses, petitioners may deduct $4.95*73 of marketing expenses for 2004 under WBE deducted $313 in office expenses for 2002. Mr. Wakefield's handwritten expense summary for that year lists expenditures of $306 for office water and $215 at Office Depot. As to the water, Mr. Wakefield testified that because Prudential did not supply coffee facilities or other refreshments for clients, he paid to stock his office with cups and bottled water from Arrowhead or Sparkletts. He described his Office Depot purchase as consisting of "supplies * * * for the computer, et cetera" but did not specifically articulate a business purpose for the purchase or even confirm that the computer in question was a business computer or was at his office. Although WBE deducted $3,436 in contract labor expenses for 2002. On his expense summary for that year Mr. Wakefield listed payments totaling $5,727 to "employee" Chris Schilling. At trial he explained that Mr. Schilling was a recent college graduate and a registered broker whom Mr. Wakefield had hired to assist with his brokerage business. Mr. Schilling's responsibilities included "prospecting", sending mailers, soliciting clients via telephone, and obtaining signatures from clients. Mr. Wakefield paid Mr. Schilling on an hourly basis, usually for eight-hour days, three to four times per week. Mr. Wakefield further testified that he issued Mr. Schilling "a 1099 because I had to pay him out of pocket", but no Form 1099-MISC, Miscellaneous Income,*75 was stipulated or introduced into evidence. *69 On the basis of Mr. Wakefield's testimony, we find that Mr. Schilling's wages were an ordinary and necessary expense of Mr. Wakefield's stockbrokerage business. However, petitioners' account statements substantiate only three payments to Mr. Schilling, totaling $2,604.85. These payments tie in with the first three items on Mr. Wakefield's expense summary, but no charges on petitioners' statements document the remaining five payments listed on the summary. We hold that respondent properly disallowed all of petitioners' deductions for passthrough losses from WBE for tax years 2002 through*76 2004. Pursuant to the parties' agreement, however, we have examined WBE's deductions as if petitioners had claimed them directly on their individual tax returns. In addition to the conceded expenses, subject to the limitations of We move now to the final issue presented for decision, namely, whether petitioners are liable for accuracy-related penalties pursuant to Respondent asserts two justifications for imposition of the penalty on petitioners: negligence and a substantial understatement of income tax for each year. Whether any substantial understatement exists, and if so, in what amount, will depend upon the recalculation of petitioners' tax liability for each year in light of the SOSI, the parties' other concessions, and the holdings reached in this opinion. We leave these calculations to the parties under Regardless of whether any substantial understatement is present, however, petitioners are liable for the negligence penalty under First, petitioners failed to exercise due care and to act with reasonable prudence. . Moreover, Mr. Wakefield provided his accountants with annual expense summaries on which he casually mixed business and personal expenses. He used *74 the same accounts for personal and business expenses, then reported all food and beverage charges on those accounts for the entire year as business related. Because he used his personal automobile for business, he sought to deduct all expenses associated with the vehicle, notwithstanding its dual function. And because he made business calls from home, he attempted to deduct his personal phone bills in their entirety. As we have repeatedly emphasized: "[A]ttempt[s] to deduct personal expenses in contravention of the plain*80 language of Second, we have described at length how petitioners failed to maintain adequate records and substantiate their tax items. They contend, in substance, that Mr. Wakefield kept meticulous diaries fully substantiating all of their reported expenses, that he unwittingly discarded these diaries, and that they should be held to a lower standard as a result. Yet Mr. Wakefield made no attempt to reconstruct the diaries. Hence, even if the*81 As an affirmative defense to the substantial understatement and negligence penalties, petitioners contend that they had reasonable cause for the positions taken on their returns, and that they acted in good faith.*82 *83 We determine "whether a taxpayer acted with reasonable cause and in good faith * * * on a case-by-case basis, taking into account all pertinent facts and circumstances", including "the taxpayer's education, sophistication and business *77 experience". Good-faith reliance on professional advice is not a silver bullet. Mr. Wakefield testified that Mr. Stover pitched him on the multientity structure that petitioners ultimately purchased. Petitioners have emphasized their reliance on Mr. Stover's expertise and that of Angela Parker and Kelly Webb, whom Mr. Stover brought with him from Grant Thornton to Kruse Mennillo and who prepared petitioners' tax returns for 2002 through 2004. But the advice petitioners received from these individuals was tainted. Mr. Stover designed and marketed the structure, and he, Ms. Parker, and Ms. Webb shared a financial interest in providing services to the sham business entities they created for petitioners. Mr. Wakefield emphasized that he trusted Mr. Stover's representations concerning the business entities because Grant Thornton was a "Big 8 firm." He nevertheless did not hesitate to follow Mr. Stover and his team to Kruse Mennillo. Mr. Wakefield admitted that he did not understand what purpose the business entities served other than reducing his tax liability,*85 but the record does not reflect that he ever sought independent tax advice. Mr. Wakefield was the sole witness to testify at trial. His self-serving testimony will not, alone, establish reasonable cause. "[W]e have found reliance to be unreasonable where a taxpayer claimed to have relied upon an independent adviser because the adviser either did not testify or testified too vaguely to convince us that the taxpayer was reasonable in relying on the adviser's advice". Mr. Wakefield should have realized that something was amiss. The Court has considered all of petitioners'*88 contentions, arguments, requests, and statements. To the extent not discussed herein, we conclude that they are meritless, moot, or irrelevant. To reflect the foregoing,(1) Other income $270,000 --- --- (2) Tax benefit 29,800 $98,000 --- from ESOP (3) Recapture of 450,686 --- --- ESOP tax benefit (4) Passthrough 161,085 46,433 $57,464 losses from WBE (5) Itemized 27,347 4,333 1,724 deductions (6) Exemptions 5,280 5,490 --- Total adjustments 944,198 154,256*13 59,188 Repairs & maintenance --- --- $649 Rent --- $1,362 3,600 Interest $18,083 15,070 20,093 Other expenses 163,002 128,001 33,122 Admin. fee 120,000 Unknown --- Travel 1,574 Unknown 2,322 Auto 4,246 Unknown 5,539 Dues & publ'ns 193 Unknown 1,116 Legal & prof'l fees 4,060 Unknown 3,850 Promos, mtgs, & seminars 12,573 Unknown 7,544 Parking 1,109 Unknown --- Telephone & Internet servs. 1,105 Unknown 1,354 Marketing 6,302 Unknown --- 313 Unknown --- Contract labor 3,436 Unknown --- Meals & entertainment 8,091 Unknown 11,397 Franklin Covey*16 Dues & publ'ns --- $106.06 --- The Chartist Dues & publ'ns --- 175.00 --- Sales Techs. Dues & publ'ns $228.00 --- --- NLH Fin. Legal & Servs. Assocs. prof'l fees --- 297.00 --- Promos, Hilton mtgs, & seminars seminars 9,180.97 2,411.92 $3,852.00 Nat'l Pen Co. Protnos, mtgs, & seminars 350.28 --- 541.88 CIS Marketing Marketing 5,900.33 5,973.04 --- HS Dent Marketing 531.63 --- --- Bill Good Marketing 3,000.00 --- --- Total 19,191.21 8,963.02 4,393.88 2002 Other Inc. $270,000.00 2002 Recapture of Mgt ESOP Tax Benefit $450,686.00 2002 Tax Benefit from Mgt. ESOP $29,800.00 2003 Tax Benefit from Mgt. ESOP $98,000.00 2002 $426,313.00 2003 $84,837.00 2002, 2003, 2004 Losses from Wakefield Partnership 2002, 2003, 2004 I.R.C. § 6662(a) Penalty based on "Losses from Wakefield Partnership" Admin. fee --- --- --- Travel --- --- --- M&E --- --- --- Automobile --- --- --- Dues & publ'ns $193.00 $542.00 --- Legal & prof'l fees (tax prep.) 150.00 150.00 --- Promotions, mtgs. & seminars 250.00 500.00 --- Parking --- --- --- Telephone & Internet servs. --- --- --- Marketing --- --- $4.95 Office expense 235.20 --- --- Contract labor 2,604.85 --- ---
1. All section references are to the Internal Revenue Code of 1986, as amended and in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure, unless otherwise indicated.↩
2. Following the parties' lead, we disregard the ownership change and refer to Mr. Wakefield's employer simply as Prudential. Wachovia itself was subsequently acquired by Wells Fargo.↩
3. Mr. Stover's inappropriate, unlawful Federal and State income tax schemes involving Roth individual retirement accounts and employee stock option plans (ESOPs) are well known by this Court.
4. For each of those tax years, WBE did not elect and was not otherwise subject to the consolidated audit provisions of
5. As we explain below, petitioners contend that Mr. Wakefield actually incurred and paid the expenses that WBE reported on its returns (WBE expenses) in connection with his employment as a stockbroker. Petitioners represent that the same is true of the expenses that Capital Equity and Great Western reported.↩
6. The parties characterized all remaining issues as purely computational. We agree.↩
7. Respondent also conceded that petitioners had adequately substantiated $300 per year of
8. Mr. Wakefield's expense summaries also bore handwritten notations from his counsel and from at least one other party, presumably someone at Kruse Mennillo.↩
9. The related cases were:
10. The amounts shown represent only the adjustments specifically related to Great Western because these seem like the appropriate points of comparison for the amounts of income petitioners agreed to include. Omitted from these sums are the adjustments for (1) "Losses from Wakefield Partnership", (2) itemized deductions, and (3) exemptions. Adjustment (1) is considered later in this opinion. Adjustments (2) and (3) are computational.↩
11. "Although petitioners' 2001 tax year is not presently before the Court, the parties have stipulated that their agreement included this concession by respondent. We note it for completeness.↩
12. Petitioners have not argued that the SOSI is not a valid and enforceable settlement agreement, but their expansive interpretation of the SOSI's language suggests that they may have been mistaken as to its scope. As with a contract, however, a unilateral mistake generally will not justify relief from an otherwise valid stipulation.
13. Even if the SOSI itself were ambiguous, the most credible available extrinsic evidence supports the foregoing conclusions. Because neither party had addressed on brief petitioners' legal basis (other than the SOSI), if any, for deducting the $100,000 passthrough loss from WBE for 2002, we sought supplemental briefing on this issue.
14. In the parallel C structure, an S corporation would zero out its operating income with deductions for fictitious service fees paid at yearend to a sham corporation with a tax year ending November 30 or earlier, thereby achieving up to 11 months' deferral for the S corporation shareholder.
15. Exhibit 8-J at Bates page 000193 indicates that only the statutorily permitted 50% of the $15,557 of meals and entertainment expenses, $7,779, was included in the $30,001.
16. In their opening brief petitioners classify their payments to Nevada Corp. Associates for 2003 and 2004 as rent. For 2002, however, they classify the payments as professional fees, and Mr. Wakefield testified that these payments were for maintaining the corporations.↩
17. Along with other miscellaneous itemized deductions, unreimbursable business expenses are subject to the 2% of adjusted gross income floor under
18. On brief petitioners characterize Mr. Wakefield's toll road expenses as "office expense" rather than travel for 2003. Because Mr. Wakefield testified that he used toll roads when visiting clients, we analyze these payments as travel expenses. To the extent that he traveled on toll roads between his home and office,
19. The Court notes that in several cases the airline charges occur in pairs, suggesting that two seats to the same destination were purchased on the same day. Notwithstanding
20. In their reply brief petitioners offer a slightly different story, claiming that the diaries were lost as a result of their being "essentially abandoned by their initial counsel" in this case. They cite
21. It appears from petitioners' substantiation evidence that Kruse Mennillo may have classified these expenses as promotions rather than as M&E on WBE's 2002 return. Petitioners follow this classification in their brief. Because of Mr. Wakefield's testimony concerning their nature and purpose, however, we analyze them as entertainment expenses.
22. Petitioners have not argued that these "donations" were charitable contributions deductible under
23. Mr. Wakefield's 2002 expense summary lists 10 separate amounts for payments to Balboa Yacht Club, all but 1 of which (reflecting an apparent, misreading of a 0 as a 6) correspond to charges listed on petitioners' account statements. The first eight amounts range from $541 to $690. Mr. Wakefield identified the final two amounts, $186 and $159, as payments made solely for meal charges after petitioners had sold their boat.↩
24. Mr. Wakefield testified that his accountants discounted his mileage using a percentage which the accounting firm determined on its own and apparently assumed reflected his probable actual personal versus business mileage. Mr. Wakefield also submitted his total car repair costs as business expenses, ostensibly because Kruse Mennillo told him he could deduct them.↩
25. WBE deducted only $193 in publication expenses for 2002. Therefore, only $193 of petitioners' reported passthrough net loss from WBE for that year could potentially be attributable to Mr. Wakefield's Wall Street Journal subscription. We must accordingly cap their deduction at that amount. Respondent has conceded that a $228 Sales Technologies newsletter subscription Mr. Wakefield purchased in 2002 was an ordinary and necessary business expense that has been adequately substantiated. We exclude this concession from the $193 cap because Mr. Wakefield did not classify this payment as a publication expense on his handwritten summary for the year, and the record indicates that WBE deducted it as a marketing expense.
We note that, under petitioners' theory, Kruse Mennillo allocated the balance of the $322 Wall Street Journal expense for 2002 to Great Western and/or Capital Equity. Neither entity's return has been adjusted. Hence, any 2002 publication expense allocated to and deducted by Capital Equity, a C corporation, reduced its net taxable income for that year, and any 2002 publication expense allocated to and deducted by Great Western, petitioners' wholly owned S corporation, reduced the amount of income that petitioners must include for 2002 pursuant to the SOSI.
26. Mr. Wakefield did not list this payment as a business expense on the summary he supplied to Kruse Mennillo for 2003, such that it could have been deducted on WBE's return.↩
27. Petitioners do not seek to deduct expenses for pens in excess of these amounts.↩
28. Mr. Wakefield testified that the promotional pens he distributed to seminar attendees cost less than $4 each, so they do not count toward the $25 limit.
29. Mobile telephones qualified as listed property subject to
30. Except with respect to H.S. Dent, the amount of respondent's concession equals or exceeds the corresponding amount on Mr. Wakefield's handwritten summary. For H.S. Dent, although Mr. Wakefield's summary reflects payments of $282 and $269, totaling $551, respondent conceded only $532. The difference apparently arises from the parties' disparate reading of a blurred digit on Mr. Wakefield's credit card statement: Mr. Wakefield read the amount of his January 4, 2002, charge to H.S. Dent as $281.93, whereas respondent reads it as $261.93. Because of the poor quality of the copy, the Court cannot discern whether the digit is a 6 or an 8 and so will leave the amount of respondent's concession undisturbed. Respondent also conceded expenses of $5,973.04 for payments to CIS Marketing for 2003. This concession corresponds to a notation on Mr. Wakefield's 2003 expense summary.
31. No evidence indicates that any entity other than WBE reported any of Mr. Wakefield's claimed expenses for 2004. Hence, although WBE did not classify any expenses as marketing related on its 2004 return, we see no possibility of a double deduction.↩
32. Petitioners' checking account statement reflects that Mr. Wakefield wrote two checks to "Chris Schilling", on April 4 and July 8, 2002, in amounts corresponding precisely to the first two payments noted on his summary. The statement lists a third check, payable to "C S" and written on May 2, 2002, in an amount corresponding precisely to the third payment on Mr. Wakefield's summary.↩
33. Petitioners raise two additional defenses: (1) substantial authority and (2) reasonable basis and adequate disclosure.
34. The regulations under
35. For a taxpayer to rely reasonably upon advice, "the taxpayer must prove * * * that the taxpayer meets each requirement of the following three-prong test: (1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment."
United States v. Stover , 731 F. Supp. 2d 887 ( 2010 )
Lohrke v. Commissioner , 48 T.C. 679 ( 1967 )
Michaels v. Commissioner , 53 T.C. 269 ( 1969 )
Sharon v. Commissioner , 66 T.C. 515 ( 1976 )
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Paschall v. Commissioner , 137 T.C. 8 ( 2011 )
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Indopco, Inc. v. Commissioner , 112 S. Ct. 1039 ( 1992 )
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W. Horace Williams, Sr., and Viola Bloch Williams v. United ... , 245 F.2d 559 ( 1957 )