T.C. Memo. 2013-220
UNITED STATES TAX COURT
MICHAEL P. CAHILL, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 6444-12. Filed September 18, 2013.
Michael P. Cahill, pro se.
Debra Lynn Reale and John Aletta, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
KERRIGAN, Judge: Respondent determined a deficiency of $131,195, an
addition to tax under section 6651(a)(1) of $30,653, and a penalty under section
6662(a) of $26,239 with respect to petitioner’s Federal income tax for tax year
2008.
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[*2] Respondent later determined a revised deficiency of $120,318, a revised
addition to tax under section 6651(a)(1) of $27,934, and a revised penalty under
section 6662(a) of $24,064 with respect to petitioner’s Federal income tax for tax
year 2008.1
At trial respondent asserted an increase in petitioner’s deficiency, claiming
that he had received an additional $25,000 of income from American Steamship
Owners, Shipowners Claims Bureau (Shipowners Claims Bureau).
Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the year in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure. All monetary amounts are
rounded to the nearest dollar.
After concessions the issues for consideration are whether petitioner (1)
received taxable income from Friemann Christie, L.L.C. (FC), also known as CFC
Advisors, L.L.C. (CFC); (2) received additional taxable income from the
Shipowners Claims Bureau; (3) received a taxable distribution from his section
401(k) plan (401(k) plan); (4) is entitled to deduct various expenses reported on
his Schedule C, Profit or Loss from Business; (5) is entitled to additional itemized
1
After issuing the notice of deficiency respondent reduced the amounts of
the deficiency, addition to tax, and penalty on account of an adjustment to self-
employment tax owed by petitioner.
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[*3] deductions claimed on his Schedule A, Itemized Deductions; (6) is liable for
the revised addition to tax under section 6651(a)(1); and (7) is liable for the
revised penalty under section 6662(a).
FINDINGS OF FACT
Some of the facts are stipulated and are so found. Petitioner resided in
Connecticut when he filed the petition.
Petitioner is an executive in the insurance and reinsurance business. His
work includes consulting and brokering. Petitioner holds a bachelor’s degree in
accounting and a master’s degree in business administration.
During tax year 2008 petitioner worked for BMS Intermediaries, Inc.
(BMS), which used Odyssey One Source, Inc. (Odyssey), as its payroll firm.
Petitioner received wages of $356,333 from BMS/Odyssey as well as
compensation of $5,000 directly from BMS. His contract for employment was
with Odyssey.
During the tax year in issue petitioner also received a hardship distribution
of $14,714 from a 401(k) plan provided by BMS/Odyssey and managed by
Lincoln National Life Insurance Co. Petitioner requested the distribution because
of tuition costs.
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[*4] In April 2008 BMS terminated petitioner’s employment. Later that month
petitioner contacted Peter Christie, a principal at FC. At that time FC’s only
principals were J. Bernard Friemann and Mr. Christie. Soon after, petitioner
began developing business with FC jointly.
On or about May 1, 2008, FC entered into a services, confidentiality, and
noncompete agreement (Eagle agreement) with Eagle Ocean Agencies, Inc.
(Eagle). The Eagle agreement required petitioner to provide insurance consulting
services for Eagle one day per week; in exchange Eagle would pay FC a flat fee of
$125,000 from May 1 through December 1, 2008. The Eagle agreement provided
that Eagle would reimburse FC for travel costs and related expenses monthly.
Expenses over $5,000 needed prior approval.
On May 14, 2008, petitioner received compensation income of $25,000
from the Shipowners Claims Bureau, a company affiliated with Eagle. Petitioner
provided consulting services to the Shipowners Claims Bureau.
On July 14, 2008, petitioner executed a memorandum of agreement with
Mr. Christie. In the memorandum of agreement FC agreed to provide petitioner
with two drawdown facilities which he could use to supplement his income from
FC. Because FC agreed that petitioner should receive an average monthly income
of $50,000, the memorandum of agreement allowed him to draw up to $50,000 per
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[*5] month from the first facility. The amount that petitioner could draw each
month depended on the income FC allocated to him that month. That amount,
however, would not take into account the fees that FC received from Eagle
pursuant to the Eagle agreement. The total first drawdown facility available to
petitioner was $150,000; once he reached that amount, he would be able to draw
from the second drawdown facility.
Petitioner was required to repay the first drawdown facility out of future
income allocated to him by FC. Any outstanding balances would bear interest.
The memorandum of agreement stated that all draws would be treated as income
earned by petitioner for tax purposes and FC would report any draws on a
Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., or a Form
1099-MISC, Miscellaneous Income. In August 2008 FC changed its name to
CFC.
On November 24, 2008, petitioner executed a revenue sharing and
allocation agreement (revenue sharing agreement) with Mr. Friemann, Mr.
Christie, and CFC. The revenue sharing agreement formalized the memorandum
of agreement. Its goal was to provide “a means for the balancing of distributions
between and among the Producers”-- i.e., petitioner, Mr. Friemann, and Mr.
Christie--by “normaliz[ing] the flow” of petitioner’s earned income with the two
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[*6] drawdown facilities. Like the memorandum of agreement, the revenue
sharing agreement provided petitioner with access to $50,000 per month from the
first drawdown facility less the sum of the amount of his “earned income received
from non-CFC production (‘Outside Income’)”, among other things. The
maximum amount petitioner could receive from the first drawdown facility was
$150,000. Any draws on the facility would bear interest. The revenue sharing
agreement also reiterated that the amounts CFC had received from Eagle with
respect to the Eagle agreement would be excluded from the drawdown
calculations.
The revenue sharing agreement further provided that CFC would report any
money petitioner received from the drawdown facilities on a Form 1099-MISC or
a Schedule K-1. The revenue sharing agreement provided that it would terminate
on November 30, 2010.
On November 25, 2008, petitioner executed a guaranty connected with the
revenue sharing agreement. The guaranty provided that if a balance remained in
the second drawdown facility on November 30, 2010, petitioner would authorize
CFC “to reallocate income” from him to Mr. Christie until the balance was
eliminated. Mr. Christie was to fund the drawdown facilities.
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[*7] In tax year 2008 petitioner received the following payments from FC/CFC:
Date of payment Amount
7/2/08 $75,000
8/15/08 25,000
9/18/08 25,000
11/25/08 25,000
12/22/08 25,000
Total 175,000
Of these payments $125,000 represented the payments FC/CFC received from
Eagle for services petitioner had rendered under the Eagle agreement. On
December 22, 2008, Eagle paid petitioner $20,000 directly.
On its 2008 Form 1065, U.S. Return of Partnership Income, CFC reported
the $175,000 paid to petitioner as a guaranteed payment to a partner. CFC also
issued petitioner a Schedule K-1 reporting a guaranteed payment of $175,000.
In or around August 2009 the relationship between petitioner and CFC
began to falter. On September 4, 2009, Mr. Christie sent petitioner a draft
operating agreement. This agreement was never executed.
On April 22, 2010, petitioner and his wife filed their joint Federal income
tax return for tax year 2008. On their Schedule A petitioner and his wife claimed a
deduction for the following miscellaneous itemized expenses:
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[*8] Expense Amount
Unreimbursed
employee expenses $31,667
Tax preparation fee 750
Other (see statement) 500
Total 32,917
On his Schedule C petitioner claimed a deduction for the following business
expenses for his consulting business:2
Expense Amount
Advertising $3,035
Car and truck 10,593
Depreciation 1,600
Insurance 14,400
Interest 6,800
Legal and
professional services 4,796
Office 29,243
Rent or lease of
vehicles, machinery,
and equipment 14,142
Repairs and
maintenance 440
2
Petitioner erroneously labeled the business on his Schedule C “Caron Croll
Group”.
-9-
[*9] Supplies 2,854
Taxes and licenses 1,980
Travel 15,095
Meals and
entertainment 10,378
Utilities 13,985
Other 15,360
Total 144,701
During 2008 petitioner’s wife received compensation income of $733 from
the Caron Croll Group, Inc.
The notice of deficiency disallowed the expense deductions petitioner
claimed on his Schedules A and C. The notice of deficiency also adjusted
petitioner’s income to reflect the payments he received from FC/CFC and the
payment he received from his 401(k) plan.
OPINION
I. Burden of Proof
Generally, the Commissioner’s determinations in a notice of deficiency are
presumed correct, and a taxpayer bears the burden of proving those determinations
are erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933). In
order to shift the burden the taxpayer must comply with all substantiation and
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[*10] recordkeeping requirements and cooperate with all reasonable requests by
the Commissioner for witnesses, information, documents, meetings, and
interviews, pursuant to section 7491(a)(2). See Higbee v. Commissioner, 116 T.C.
438, 441 (2001). Petitioner did not argue that the burden should shift, and he
failed to introduce credible evidence that respondent’s determinations are
incorrect. Accordingly, the burden of proof remains with petitioner except with
respect to the payment from the Shipowners Claims Bureau as explained below.
II. Unreported Income
A. Characterization of Payments Received From FC/CFC
Respondent contends that petitioner received $175,000 of taxable income
from FC/CFC in the form of a guaranteed payment to a partner during tax year
2008. Respondent claims that petitioner erred when he failed to report the
payment on his 2008 Federal income tax return.
Petitioner does not dispute that he received payments in the amounts
determined by respondent for the tax year in issue. Petitioner, however, claims
that he was not a partner of FC/CFC during the tax year in issue because he never
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[*11] signed CFC’s amended and revised operating agreement and that the
payments were loans from the partnership to him rather than guaranteed
payments.3
1. Petitioner as a Partner of FC/CFC
Section 761(b) defines a partner as a member of a partnership.4 Notably,
“the definition of the term ‘partnership’ sheds significant light on the definition of
the related term ‘partner’ * * * . Because a partnership can exist only in the
3
Generally, we lack jurisdiction to redetermine the partnership items of a
partnership if the partnership is subject to the provisions of the Tax Equity and
Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, sec. 402(a), 96
Stat. at 648. Blonien v. Commissioner, 118 T.C. 541, 551-552 (2002); see sec.
6221. Partnership items include guaranteed payments, sec. 301.6231(a)(3)-
1(a)(2), Proced. & Admin. Regs., and a taxpayer’s status as a partner, McIntyre v.
Commissioner, T.C. Memo. 2009-305.
Neither FC nor CFC was a partnership subject to TEFRA because both
qualified for the small partnership exception under sec. 6231(a)(1)(B). FC and
CFC had fewer than 10 partners, and all partners were individuals rather than
“pass-thru partners” as defined by sec. 6231(a)(9). See sec. 6231(a)(1)(B).
Therefore, we retain jurisdiction to determine whether petitioner received
guaranteed payments from FC/CFC and whether he was a partner in FC/CFC.
4
Sec. 704(e)(1) defines a partner according to whether he or she “owns a
capital interest in a partnership in which capital is a material income-producing
factor”. The Court of Appeals for the Second Circuit, to which an appeal of this
case would lie, see sec. 7482(b)(1)(A), has held that sec. 704(e) is limited to
family partnerships, TIFD-IIIE, Inc. v. United States, 666 F.3d 836, 844 n.6 (2d
Cir. 2012) (“The limited purpose is reflected in the title given to § 704(e)--‘Family
partnerships’--and to § 704(e)(1)--‘Recognition of interest created by purchase or
gift.’ It is further reflected in the other two subsections of § 704(e), which apply
only to partnership interests created by gift.”).
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[*12] context of an economic relationship between one person and others, the
questions as to whether a partnership exists and whether specific persons are
partners are restatements of each other.” 1 William S. McKee et al., Federal
Taxation of Partnerships and Partners, para. 3.01[1], at 3-7 (4th ed. 2007); see also
sec. 1.704-1(e)(1)(iii), Income Tax Regs.
A partnership generally exists when persons “join together their money,
goods, labor, or skill for the purpose of carrying on a trade, profession, or business
and when there is community of interest in the profits and losses.” Commissioner
v. Tower, 327 U.S. 280, 286 (1946); see also Dickerson v. Commissioner, T.C.
Memo. 2012-60. Generally, “each partner contributes one or both of the
ingredients of income--capital or services.” Commission v. Culbertson, 337 U.S.
733, 740 (1949); see also Dickerson v. Commissioner, T.C. Memo. 2012-60.
To determine whether a partnership exists, we consider whether, in the light
of all the facts, the parties intended to join together in good faith with a valid
business purpose in the present conduct of an enterprise. Commissioner v.
Culbertson, 337 U.S. at 742; Allum v. Commissioner, T.C. Memo. 2005-177,
aff’d, 231 Fed. Appx. 550 (9th Cir. 2007). We weigh several objective factors in
an attempt to discern their true intent. These factors include the agreement
between the parties; the conduct of the parties in executing its provisions; the
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[*13] parties’ statements; the testimony of disinterested persons; the relationship
of the parties; their respective abilities and capital contributions; the actual control
of income; and the purposes for which the income is used. Commissioner v.
Culbertson, 337 U.S. at 742. None of these factors alone is determinative. See
Luna v. Commissioner, 42 T.C. 1067, 1077, 1078 (1964).
Even though petitioner did not sign CFC’s operating agreement, both he
and FC/CFC acted as though he was a partner of FC/CFC. Petitioner stated at trial
that he contacted FC because he wanted to pool his resources and to develop
business jointly with FC. When FC/CFC received a payment from Eagle pursuant
to the Eagle agreement, FC/CFC would pay over the entire amount to petitioner
immediately.
Petitioner entered into the memorandum of agreement and the revenue
sharing agreement, both of which provided for the mechanism under which he
would share in the profits of FC/CFC. Moreover, the memorandum of agreement
and the revenue sharing agreement stated that FC/CFC would issue petitioner a
Form 1099-MISC or a Schedule K-1 with respect to any money he received under
either agreement. There is no indication in the record that petitioner objected to
receiving a Schedule K-1 on the grounds that he was not a partner.
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[*14] Furthermore, the revenue sharing agreement refers to petitioner, Mr.
Friemann, and Mr. Christie as “producers”, thus placing him on the same footing
with respect to revenue sharing as Messrs. Friemann and Christie. When asked
whether the revenue sharing agreement was between CFC and partners, Mr.
Friemann testified: “It was intended to be. * * * We certainly intended that * * *
[petitioner] would be a partner in the business.” Mr. Friemann also testified that
“in 2008, when we were operating, it was always our intention that * * *
[petitioner] would be a principal of the business.”
Finally, after petitioner entered into the memorandum of agreement, FC
changed its name from “Friemann Christie” to “CFC Advisors”. Mr. Friemann
testified that they chose the name CFC so that Mr. Christie could tell his clients
that it stood for “Christie Friemann Cahill” and petitioner could tell his clients that
it stood for “Cahill Friemann Christie”. There is no indication that petitioner
objected to the name change on the grounds that he was not a partner.
Accordingly, we find that petitioner was a partner of CFC during the tax year in
issue.
2. Whether the Payments Were Guaranteed Payments
Payments a partner receives from a partnership generally fall into one of
three categories. First, a partner may receive payments representing distributions
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[*15] of his or her distributive share of partnership income. See sec. 731. Second,
a partner may receive payments in circumstances where he or she is not treated as
a partner. Sec. 707(a). And third, a partner may receive guaranteed payments for
services or use of capital that do not represent distributions of partnership income.
Sec. 707(c). Specifically, section 707(c) provides:
SEC. 707(c). Guaranteed Payments.--To the extent determined
without regard to the income of the partnership, payments to a partner
for services or the use of capital shall be considered as made to one
who is not a member of the partnership, but only for the purposes of
section 61(a) (relating to gross income) and, subject to section 263,
for purposes of section 162(a) (relating to trade or business
expenses).
Whether a partner is acting in his or her capacity as a partner--rather than in
his or her capacity as one who is not a member of the partnership--while providing
services to his or her partnership is a factual determination. See Falconer v.
Commissioner, 40 T.C. 1011, 1015 (1963). The regulations provide: “In all cases,
the substance of the transaction will govern rather than its form.” Sec. 1.707-1(a),
Income Tax Regs. The inquiry under section 707(c) is whether the payments for
petitioner’s services were determined “‘without regard to the income of the
partnership.’” Falconer v. Commissioner, 40 T.C. at 1015, 1016 (quoting section
707(c)); see also sec. 1.707-1(c), Income Tax Regs.
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[*16] We are satisfied that the facts of this case place the $125,000 of payments
made to petitioner in accordance with the Eagle agreement within the ambit of the
term “guaranteed payments” pursuant to section 707(c). The Eagle agreement
provided that petitioner would provide insurance consulting services for Eagle one
day per week, in exchange for which Eagle would pay FC/CFC a flat fee of
$125,000 between May 1 and December 1, 2008. At trial Mr. Friemann testified
that petitioner provided services under the Eagle agreement. Mr. Friemann stated
that FC/CFC had hoped that in the long term he and Mr. Christie would also
provide services to Eagle, but that only petitioner provided services to Eagle.
Mr. Friemann further testified that FC/CFC paid the $125,000 to petitioner
immediately upon receipt. His testimony is consistent with FC/CFC’s bank
statements, which show that the day after FC/CFC received a payment from Eagle
or one of Eagle’s affiliates, petitioner withdrew an amount equal to the payment
received. Petitioner does not dispute that he received this money.
Moreover, the memorandum of agreement and the revenue sharing
agreement expressly stated that the payments pursuant to the Eagle agreement
would not be considered draws from either drawdown facility. Mr. Friemann
testified that they “wanted to be clear that this $125,000 would in no way reduce
how much * * * [petitioner] could draw each month on the facility”. Mr.
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[*17] Friemann also testified that the $125,000 petitioner received was not subject
to the drawdown facilities.
Petitioner thus contracted with FC/CFC to provide consulting services for a
fixed fee which was not dependent upon the profits of the partnership. Therefore,
the payments from Eagle were determined “without regard to the income of the
partnership.” Falconer v. Commissioner, 40 T.C. at 1016. Thus, $125,000 of the
$175,000 of payments made to petitioner pursuant to the Eagle agreement was
guaranteed payments. Even if petitioner had not been a partner in FC/CFC, these
payments would be taxable to him as compensation for services rendered. See sec.
61(a)(1).
Petitioner claims that the remaining $50,000 of payments he received were
not income because they were loans from the partnership to him and were subject
to repayment. CFC classified these payments as guaranteed payments on its Form
1065. Petitioner claims in his pretrial memorandum that the remaining $50,000 of
payments “may have been made under a Revenue Sharing agreement, which is
effectively a draw-down facility, subject repayment and interest.” Respondent
agrees that the $50,000 of payments was made under the first drawdown facility.
Whether a transaction is a loan for Federal income tax purposes is a
question of fact. The following factors are considered in determining whether a
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[*18] loan is bona fide: (1) the existence of a sum certain; (2) the likelihood of
repayment; (3) a definite date of repayment; and (4) the manner of repayment.
Seay v. Commissioner, T.C. Memo. 1992-254; Mangham v. Commissioner, T.C.
Memo. 1980-280. Rev. Rul. 73-301, 1973-2 C.B. 216, states that, for purposes of
section 707(a), a loan by a partnership to a partner is considered to have been
made only where the partner is under an unconditional obligation to repay a sum
certain at a determinable date.
Petitioner’s argument that the payments represent the repayment of loans is
not supported by the record. Although payments under the first drawdown facility
in theory accrued interest, neither the memorandum of agreement nor the revenue
sharing agreement provided any definite date of repayment or a manner of
repayment other than from future income allocated to petitioner. The revenue
sharing agreement was merely set to terminate on November 30, 2010. Moreover,
petitioner was required to execute a guaranty only with respect to the second
drawdown facility. Therefore, the $50,000 of payments petitioner received
pursuant to the first drawdown facility was not for repayment of loans.
Like the $125,000 of payments from the Eagle agreement, the payments
from the drawdown facility were not dependent upon the profits of the partnership.
The amount available to petitioner did not fluctuate with FC/CFC profits.
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[*19] Moreover, the memorandum of agreement and the revenue sharing
agreement expressly stated that any draws would be considered income to
petitioner and would be reported on a Form 1099-MISC or a Schedule K-1. Thus,
the remaining $50,000 of payments was also guaranteed payments.5
Accordingly, respondent correctly determined that petitioner received
taxable income of $175,000 in the form of guaranteed payments from CFC in tax
year 2008.
B. Payment From Shipowners Claims Bureau
At trial respondent asserted an increase in petitioner’s deficiency to reflect
an additional payment of $25,000 that petitioner had received from the
Shipowners Claims Bureau in tax year 2008. Respondent claims that petitioner
erred when he failed to report this amount on his 2008 Federal income tax return.
The Commissioner bears the burden of proof with respect to any increase of
deficiency. Rule 142(a)(1). Therefore, respondent bears the burden of proof with
respect to this issue.
5
For purposes of sec. 731 (the extent of recognition of gain or loss in the
case of a distribution from the partnership to the partner) advances or drawings of
money against a partner’s distributive share of income shall be treated as current
distributions. Sec. 1.731-1(a)(1)(ii), Income Tax Regs. Although the $50,000 of
payments were made under the first drawdown facility, there is no indication in
the record that the payments were made against petitioner’s distributive share of
partnership income.
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[*20] Respondent proffers (1) an invoice from petitioner to the Shipowners
Claims Bureau requesting a fee of $25,000 that would be due on May 8, 2008, and
(2) a transaction detail report from Deutsche Bank showing that petitioner
received $25,000 from the Shipowners Claims Bureau on May 14, 2008. The
treasurer of the Shipowners Claims Bureau also testified that the Shipowners
Claims Bureau made the $25,000 payment to petitioner. Finally, petitioner
admitted at trial that he received the $25,000 payment from the Shipowners
Claims Bureau but failed to report it on his 2008 Federal income tax return.
Petitioner has offered no evidence regarding this issue.
Accordingly, respondent correctly determined that petitioner received an
additional taxable income of $25,000 from the Shipowners Claims Bureau in tax
year 2008.
C. Distribution From Petitioner’s 401(k) Plan
Petitioner stipulated that he received a hardship distribution of $14,714
from his 401(k) plan in tax year 2008. Respondent claims that petitioner erred
when he failed to report this payment on his 2008 Federal income tax return.
Generally, under section 72 amounts actually distributed from retirement
accounts, such as 401(k) plans, are taxable income to the distributee in the taxable
year in which they are distributed. Secs. 402(a), 72. If the taxpayer obtains a
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[*21] distribution from a retirement account before he or she retires, only the
amounts allocable to his or her investment in the contract are excludible from
income. Sec. 72(e)(2)(B), (8)(A). Such amounts generally include contributions
to a taxpayer’s retirement account, but only if such contributions were includible
in the taxpayer’s income. Sec. 72(f). Petitioner has not established that any part
of the distribution he received from his 401(k) plan represents contributions that
were includible in his income or other investments he made in the contract.
Accordingly, respondent correctly determined that petitioner received
taxable income of $14,714 from his 401(k) plan in tax year 2008.
III. Expense Deductions
Section 162(a) allows a taxpayer to deduct all ordinary and necessary
expenses paid or incurred in carrying on a trade or business. An ordinary expense
is one that commonly or frequently occurs in the taxpayer’s business, Deputy v. du
Pont, 308 U.S. 488, 495 (1940), and a necessary expense is one that is appropriate
and helpful in carrying on the taxpayer’s business, Welch v. Helvering, 290 U.S.
at 113. The expense must directly connect with or pertain to the taxpayer’s
business. Sec. 1.162-1(a), Income Tax Regs. A taxpayer may not deduct a
personal, living, or family expense unless the Code expressly provides otherwise.
Sec. 262(a).
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[*22] Whether an expenditure is ordinary and necessary is generally a question of
fact. Commissioner v. Heininger, 320 U.S. 467, 475 (1943). A taxpayer must
show a bona fide business purpose for the expenditure; there must also be a
proximate relationship between the expenditure and his or her business.
Challenge Mfg. Co. v. Commissioner, 37 T.C. 650 (1962); see also Heinbockel v.
Commissioner, T.C. Memo. 2013-125. In general, where an expense is primarily
associated with profit-motivated purposes--and personal benefit can be said to be
distinctly secondary and incidental--it may be deducted under section 162(a). Int’l
Artists, Ltd. v. Commissioner, 55 T.C. 94, 104 (1970); see also G.D. Parker, Inc.
v. Commissioner, T.C. Memo. 2012-327. Conversely, if an expense is primarily
motivated by personal considerations, no deduction for it will be allowed under
section 162(a). Henry v. Commissioner, 36 T.C. 879, 884 (1961); see also G.D.
Parker, Inc. v. Commissioner, T.C. Memo. 2012-327. A taxpayer’s general
statement that his or her expenses were incurred in pursuit of a trade or business is
not sufficient to establish that the expenses had a reasonably direct relationship to
any such trade or business. Ferrer v. Commissioner, 50 T.C. 177, 185 (1968),
aff’d per curiam, 409 F.2d 1359 (2d Cir. 1969); see also Adams v. Commissioner,
T.C. Memo. 2013-92.
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[*23] Deductions are a matter of legislative grace, and a taxpayer must prove his
or her entitlement to a deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79,
84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). To that
end, taxpayers are required to substantiate each claimed deduction by maintaining
records sufficient to establish the amount of the deduction and to enable the
Commissioner to determine the correct tax liability. Sec. 6001; Higbee v.
Commissioner, 116 T.C. at 440.
Certain expenses specified in section 274 are subject to strict substantiation
rules. To meet these strict substantiation rules, a taxpayer must substantiate by
adequate records or by sufficient evidence corroborating the taxpayer’s own
statement (1) the amount, (2) the time and place of the travel or use, and (3) the
business purpose. Sec. 274(d). To substantiate by adequate records, the taxpayer
must provide (1) an account book, log, or similar record and (2) documentary
evidence, which together are sufficient to establish each element of an
expenditure. Sec. 1.274-5T(c)(2)(i), 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
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[*24] 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.
A. Petitioner’s Schedule C Expenses
On his 2008 Federal income tax return petitioner reported the following
expenses on his Schedule C, some of which respondent has conceded:
Schedule C Amount Amount Amount
expenses claimed conceded disallowed
Travel $15,095 $13,112 $1,983
Meals and
entertainment 10,378 8,202 2,176
Car and truck 10,593 7,624 2,969
Utilities 13,985 6,866 7,119
Office 29,243 17,495 11,748
Depreciation 1,600 2,350 (750)
Taxes and
licenses 1,980 2,807 (827)
Legal 4,796 5,425 (629)
Advertising 3,035 3,035 -0-
Other 15,360 1,796 13,564
Interest 6,800 5,998 802
Insurance 14,400 3,718 10,682
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[*25] Supplies 2,854 -0- 2,854
Maintenance
and repairs 440 -0- 440
Vehicle lease 14,142 14,086 56
Total 144,701 92,514 52,187
Respondent also has conceded that petitioner is entitled to an education
credit of $1,600 for educational expenses incurred by his wife for the tax year in
issue.
Petitioner claims he should be able to deduct the remaining expenses
relating to: (1) travel, (2) meals and entertainment, (3) car and truck, (4) utilities,
(5) office expenses, (6) other expenses, (7) interest, (8) insurance, (9) supplies,
(10) maintenance and repairs, and (11) vehicle lease. Travel expenses, meals and
entertainment expenses, car and truck expenses, and vehicle lease expenses are all
subject to the strict substantiation rules of section 274(d). Secs. 274(d)(1), (2), (4),
280F(d)(4)(A)(i) and (ii).
To substantiate his expenses, petitioner offers American Express bank
statements, which show his travel, restaurant, merchandise, super market, auto,
fees and adjustments, and insurance expenses. Petitioner also offers typed or
handwritten lists for each type of expense, which provide the month, name of
vendor, amount, and a very general explanation for each item listed. These lists
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[*26] appear to have been created by petitioner. There is no indication when
petitioner compiled these lists. Petitioner did not testify specifically about any of
the expenses.
The American Express bank statements and self-compiled lists petitioner
provided for those expenses do not provide enough information for us to
determine what he actually purchased with respect to those expenses and to what
extent these purchases had a business purpose.
Petitioner has offered no receipts regarding his car and truck expenses,
utility expenses, interest expenses, supply expenses, and maintenance and repair
expenses. The sparse number of receipts and invoices that petitioner does offer
fail to provide enough information for us to determine to what extent these
purchases had a business purpose.
Petitioner has failed to meet the strict substantiation requirements of section
274(d) with respect to the travel expenses, meals and entertainment expenses, car
and truck expenses, and vehicle lease expenses. Petitioner has also failed to meet
the substantiation requirements with respect to the utility expenses, office
expenses, other expenses, interest expenses, insurance expenses, supply expenses,
and maintenance and repair expenses. Petitioner is not entitled to deduct any of
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[*27] these expenses in excess of the amounts respondent has already conceded, if
at all, for tax year 2008.
B. Petitioner’s Schedule A Expenses
On his 2008 Federal income tax return, petitioner claimed a deduction for
miscellaneous Schedule A expenses totaling $32,917, relating to unreimbursed
employee expenses, tax preparation fees, and other expenses. In the notice of
deficiency respondent disallowed a deduction for $28,823 of petitioner’s Schedule
A expenses. In particular, respondent disallowed a deduction for the following
Schedule A expenses: (1) vehicle expenses; (2) expenses for travel away from
home; (3) business expenses; (4) expenses for meals and entertainment; (5)
expenses relating to tax preparation; and (6) other expenses marked “see
statement”.
Petitioner claims he should be allowed to deduct these expenses, or, in the
alternative, that he should be able to move these expenses to his Schedule C and
deduct them there.
For his Schedule A vehicle expenses, travel expenses, and meals and
entertainment expenses petitioner offers no evidence to support these claims
beyond what he offers to substantiate the corresponding Schedule C expenses.
Petitioner’s evidence thus does not sufficiently indicate that the vehicle expenses,
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[*28] travel expenses, and meals and entertainment expenses were ordinary and
necessary unreimbursed employee expenses directly related to a trade or business
during the tax year in issue.
For his Schedule A business expenses petitioner offers: (1) a list titled
“Business Expenses”; (2) American Express bank statements showing his
merchandise expenses; (3) an invoice from T-Mobile; (4) an unidentified
statement showing charges for travel expenses and services; and (5) an American
Express bank statement showing his travel expenses. Other than the T-Mobile
invoice petitioner provided no receipts regarding his reported business expenses.
It is impossible for us to determine what petitioner actually purchased from these
vendors or to what extent the purchases had a business purpose. Likewise, it is
impossible to determine to what extent the items purchased from T-Mobile had a
business purpose.
For his Schedule A tax preparation expenses petitioner offers a bill from his
accountant, which refers to the preparation of his 2008 Federal and State income
tax returns. The bill, however, is dated October 22, 2008, more than two months
before the close of petitioner’s 2008 taxable year and more than a year before he
filed his 2008 Federal tax return.
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[*29] Petitioner offers no evidence to support his Schedule A other expenses
marked “see statement”.
Petitioner has failed to meet the strict substantiation requirements of section
274(d) with respect to the Schedule A vehicle expenses, travel expenses, and
meals and entertainment expenses. Petitioner has likewise failed to meet the
substantiation requirements with respect to the Schedule A business expenses, tax
preparation expenses, and other expenses. Petitioner is not entitled to deduct any
of these expenses on his Schedule A for tax year 2008 because he has failed to
establish that he incurred these expenses.
Even if petitioner were to establish that he incurred the expenses reported
on his Schedule A, petitioner would not be entitled to deduct those expenses on
his Schedule C. A taxpayer may deduct unreimbursed employee expenses as an
ordinary and necessary business expense under section 162. Lucas v.
Commissioner, 79 T.C. 1, 7 (1982); see also Farias v. Commissioner, T.C. Memo.
2011-248. A taxpayer may engage in the trade or business of “being an
employee”. O’Malley v. Commissioner, 91 T.C. 352, 363-364 (1988).
Unreimbursed employee expenses are classified as miscellaneous itemized
deductions and are deductible only to the extent they exceed 2% of the taxpayer’s
adjusted gross income. See sec. 67; sec. 1.67-1T(a)(1)(i), (b), Temporary Income
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[*30] Tax Regs., 53 Fed. Reg. 9875-9876 (Mar. 28, 1988). An employee may also
deduct miscellaneous itemized deductions on Schedule A for expenses incurred
while looking for a new job in the employee’s current field of employment. See
Primuth v. Commissioner, 54 T.C. 374, 378-379 (1970); see also Hughes v.
Commissioner, T.C. Memo. 2008-249. These expenses likewise are deductible
only to the extent they exceed 2% of the taxpayer’s adjusted gross income. Sec.
1.67-1T(a)(1)(i), (b), Temporary Income Tax Regs., supra. Employee expenses,
however, are not deductible to the extent that a taxpayer obtained or could have
obtained reimbursement from his other employer. Lucas v. Commissioner, 79
T.C. at 7; Stolk v. Commissioner, 40 T.C. 345, 357 (1963), aff’d, 326 F.2d 760 (2d
Cir. 1964).
Petitioner admitted at trial that the expenses he deducted on Schedule A
were incurred before May 2008. Petitioner was employed by BMS until his
termination in April 2008, and he testified at trial that he had a noncompete
agreement with BMS. He did not begin working with FC/CFC until May 1, 2008.
Therefore, if petitioner incurred any of these expenses, they were incurred before
he began his consulting business with FC/CFC at a time when he was still
employed by BMS, thereby making them employee business expenses which must
be reported as a miscellaneous itemized deduction on Schedule A. Moreover, if
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[*31] the expenses were incurred by petitioner for the purpose of finding new
employment in the field of insurance consulting, they would be reportable, if at all,
as miscellaneous expenses on Schedule A. Thus, even if petitioner had
established that he incurred the expenses, they would be reportable as
miscellaneous itemized deductions on Schedule A and would be limited to the
amount exceeding 2% of his adjusted gross income.
Petitioner is not entitled to deduct any Schedule A amounts as additional
Schedule C expenses for tax year 2008.
IV. Addition to Tax and Penalty
Under section 7491(c) the Commissioner bears the burden of producing
evidence with respect to the liability of the taxpayer for any addition to tax or
penalty. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447. Once
the Commissioner meets this burden, the taxpayer must come forward with
persuasive evidence that the Commissioner’s determination is incorrect. Higbee v.
Commissioner, 116 T.C. at 446-447.
A. Section 6651(a)(1) Addition to Tax
Respondent determined that petitioner is liable for an addition to tax
pursuant to section 6651(a)(1) because he did not timely file his 2008 Federal
income tax return. Section 6651(a)(1) provides for an addition to tax for failure to
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[*32] timely file a Federal income tax return unless it is shown that such failure
was due to reasonable cause and not willful neglect. See also United States v.
Boyle, 469 U.S. 241, 245 (1985). A failure to file a timely Federal income tax
return is due to reasonable cause if the taxpayer exercised ordinary business care
and prudence but nevertheless was unable to file the return within the prescribed
time. See sec. 301.6651-1(c)(1), Proced. & Admin. Regs.
Petitioner filed his 2008 Federal income tax return on April 22, 2010.
Respondent has shown that petitioner failed to timely file his Federal income tax
return for 2008. Consequently, we conclude that respondent has satisfied the
burden of production under section 7491(c); petitioner must come forward with
evidence to prove he is not liable for the addition to tax.
Petitioner failed to introduce any evidence that he is not liable for the
addition to tax or that his failure to timely file was due to reasonable cause and not
willful neglect. Accordingly, petitioner is liable for the addition to tax pursuant to
section 6651(a)(1).
B. Section 6662(a) Accuracy-Related Penalty
Respondent determined that petitioner is also liable for the accuracy-related
penalty pursuant to section 6662(a) for tax year 2008. Section 6662(a) imposes a
20% penalty on any underpayment attributable to, among other things, (1)
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[*33] negligence or disregard of rules or regulations within the meaning of section
6662(b)(1), or (2) any substantial understatement of income tax within the
meaning of section 6662(b)(2). Only one accuracy-related penalty may be applied
with respect to any given portion of an underpayment, even if that portion is
subject to the penalty on more than one of the grounds set out in section 6662(b).
Sec. 1.6662-2(c), Income Tax Regs.
The phrase “substantial understatement of income tax” means an
understatement that exceeds the greater of $5,000 or 10% of the income tax
required to be shown on the tax return for the taxable year. Sec. 6662(d)(1)(A).
Respondent determined that petitioner should have reported an income tax liability
of $125,154 on his 2008 Federal income tax return. Respondent also determined
that petitioner understated his income tax by $120,318 for the tax year in issue.
Respondent has since conceded that petitioner is entitled to $92,514 of deductions
on his Schedule C and a credit of $1,600 for educational expenses. This will result
in a lesser deficiency that may or may not exceed the greater of $5,000 or 10% of
the income tax required to be shown on the tax return.
Even if petitioner’s understatement is not substantial, respondent claims that
petitioner is liable for the section 6662(a) penalty due to negligence. Negligence
includes any failure to make a reasonable attempt to comply with the provisions of
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[*34] the internal revenue laws, to exercise due care, or to do what a reasonable
and prudent person would do under the circumstances. Sec. 6662(c); Neely v.
Commissioner, 85 T.C. 934, 947 (1985); sec. 1.6662-3(b)(1), Income Tax Regs.
Negligence also includes any failure by a taxpayer to keep adequate books and
records or to substantiate items properly. Sec. 1.6662-3(b)(1), Income Tax Regs.
Respondent has shown that petitioner failed to report as income payments
totaling $175,000 that he received from FC/CFC, for which he received a
Schedule K-1; a payment of $25,000 that he received from the Shipowners Claims
Bureau; and a hardship distribution of $14,714 that he received from his 401(k)
plan. Respondent has further shown that petitioner failed to produce any
documentary evidence showing that the expenses he reported on his Schedules A
and C were ordinary and necessary expenses connected to a trade or business or
his job. Respondent thus has shown that petitioner acted negligently.
Petitioner therefore is liable for the accuracy-related penalty unless he can
show he had reasonable cause for and acted in good faith regarding part of the
underpayment. See sec. 6664(c)(1); sec. 1.6664-4(a), Income Tax Regs. For
purposes of section 6664(c) a taxpayer may establish reasonable cause and good
faith by showing reliance on professional advice. Sec. 1.6664-4(b)(1), Income
Tax Regs. A taxpayer reasonably relied on professional advice if he or she proves
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[*35] the following by a preponderance of the evidence: (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. See Neonatology
Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d
Cir. 2002); see also Rule 142(a); Welch v. Helvering, 290 U.S. at 115.
Petitioner failed to introduce any evidence that he relied on professional
advice or otherwise had reasonable cause for and acted in good faith regarding
part of the understatement.
Accordingly, petitioner is liable for the accuracy-related penalty under
section 6662(a).
Any contentions we have not addressed are irrelevant, moot, or meritless.
To reflect the foregoing,
Decision will be entered
under Rule 155.