T.C. Memo. 2014-82
UNITED STATES TAX COURT
PETER J. CHAPMAN AND JULIA L. CHAPMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 25672-12. Filed May 7, 2014.
Christina M. Passard, for petitioners.
Melanie E. Senick, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: Respondent determined a $160,760 deficiency in
petitioners’ income tax and a $35,152 section 6662(a) accuracy-related penalty for
2010.1 After concessions by petitioners, the issues for decision are:
1
All section references are to the Internal Revenue Code in effect for the
year in issue, and all Rule references are to the Tax Court Rules of Practice and
(continued...)
-2-
[*2] (1) whether petitioners are entitled to a $65,000 contract labor expense
deduction for 2010. We hold that they are;
(2) whether petitioners are entitled to a $139,165 interest expense deduction
for 2010. We hold that they are entitled to a reduced amount;
(3) whether petitioners are entitled to a $910,623 bad debt deduction for
2010. We hold that they are not; and
(4) whether petitioners are liable for accuracy-related penalties under
section 6662(a). We hold that they are, but the penalties must be adjusted for
consistency with this opinion.
FINDINGS OF FACT
Petitioners are a married couple who lived in Alaska when they filed their
petition. Petitioners filed a joint Form 1040, U.S. Individual Income Tax Return,
for 2010. In 2010 Mr. Chapman engaged in real estate maintenance services
through a wholly owned LLC, Tundra Mountain Services, LLC (TMS), and real
estate investment through another wholly owned LLC, Tundra Mountain
Investment, LLC (TMI). Mr. Chapman formed TMS in 2009 and TMI in 2006. In
1
(...continued)
Procedure, unless otherwise indicated.
-3-
[*3] 2010 Mrs. Chapman was the sole shareholder of Alaska Inland Car Rental,
Inc. (AICR), a subchapter S corporation.
Petitioners reported business income and expenses from “Tundra Mountain
Enterprises” (encompassing TMI and TMS) on Schedules C, Profit or Loss From
Business, of their 2007-09 returns under the cash basis accounting method. They
reported the activity from TMS on Schedule C of their 2010 return under the cash
basis method and reported the activity from TMI on Schedule C of their 2010
return under the accrual basis accounting method.
AICR and TMS were seasonal businesses with opposing busy seasons.
TMS provided services including lawn care, snow removal, rekeying, general
maintenance, winterizations, and plumbing repairs; the winter months were its
busiest season. AICR provided car rental services and had its busiest season in the
summer. TMS occasionally contracted with AICR for its employees to perform
labor on TMS’ behalf. In particular, the AICR employees performed “routine
winterization” on properties that TMS had contracted to service or maintain. As
payment for these services, TMS paid AICR $65,000 in 2010. TMS had no direct
relationship with AICR’s employees. Petitioners deducted TMS’ payments to
AICR on their 2010 Schedule C as part of TMS’ contract labor expense.
-4-
[*4] Petitioners deducted $139,165 on their 2010 Schedule C as interest TMI
paid to two classes of lenders: (1) credit card companies for credit accounts in the
name of Bonnie Chapman, Mr. Chapman’s mother; and (2) lenders who provided
funds under 21 promissory notes. On TMI’s behalf Mr. Chapman executed a
document dated March 1, 2007, which stated that Bonnie Chapman assigned nine
of her credit card accounts for TMI’s use (assignment). The assignment document
stated that the “transfer of credit lines is considered a loan by Bonnie Chapman to
TMI for the net available credit of the items transferred” and that the “sum of
account balances on the credit lines at the date of transfer will be repaid by TMI to
the creditor on behalf of Bonnie Chapman and will be treated as an interest
payment to Bonnie Chapman by TMI”. Mr. Chapman was the only signatory to
the assignment document.
Credit card statements and bank statements show the cashflow between the
credit card accounts and TMI’s bank account. Each credit card statement from the
March 2007 billing cycle showed a balance transfer for approximately the amount
shown on the assignment document.
TMI issued 21 promissory notes between December 14, 2006, and March
26, 2009. Each note had different terms regarding principal amounts, interest
rates, and payment terms. Caitlyn Isch, Bonnie Chapman, and Gary Isch each held
-5-
[*5] one of the notes issued by TMI. TMI’s 2010 bank statements show aggregate
payments of $5,580 to Caitlyn Isch, $4,417.50 to Bonnie Chapman, and $1,800 to
Gary Isch, respectively. TMI’s 2010 bank statements do not reflect any payments
to any of the lenders for the other 18 promissory notes.
Before 2010 TMI invested money in several real estate projects with Adam
Rust and his limited liability company, Acuity Enterprises LLC (Acuity). As
evidence of TMI’s investment, Mr. Rust executed 12 promissory notes between
August 30, 2006, and January 15, 2008. Ten of the notes had an annual interest
rate of more than 40%. All of the notes provided that principal and interest would
be due as a balloon payment at maturity. The parties earmarked all of the notes for
specific real estate projects but did not secure the notes with any of the underlying
real estate. Mr. Chapman would meet with contractors, real estate agents, and
developers during the course of the development of each of the projects.
Mr. Rust filed a bankruptcy petition on October 21, 2010. The U.S.
Bankruptcy Court for the District of Oregon discharged Mr. Rust’s debts.
Petitioners deducted principal and interest on their 2010 Schedule C because of
Mr. Rust’s bankruptcy discharge.
Respondent issued a notice of deficiency to petitioners in July 2012,
reflecting his disallowance of petitioners’ deductions for contract labor expenses,
-6-
[*6] interest expenses, and a bad debt. Additionally, respondent imposed an
accuracy-related penalty. Petitioners timely petitioned this Court.
OPINION
I. Burden of Proof
Generally, taxpayers bear the burden of proving, by a preponderance of the
evidence, that the determinations of the Commissioner in a notice of deficiency are
incorrect. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
Deductions are a matter of legislative grace, and taxpayers bear the burden of
proving entitlement to any claimed deductions. Rule 142(a)(1); INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992). To satisfy this burden, taxpayers must
present sufficient records to substantiate their deductions. See sec. 6001;
Hradesky v. Commissioner, 65 T.C. 87, 90 (1975), aff’d, 540 F.2d 821 (5th Cir.
1976); Gorokhovsky v. Commissioner, T.C. Memo. 2012-206, aff’d, __ Fed.
Appx. __, 2003 WL 5716541 (7th Cir. Oct. 22, 2013); sec. 1.6001-1, Income Tax
Regs.
II. Contract Labor Deduction
TMS contracted out labor to AICR employees in 2010, and TMS paid AICR
$65,000 for the use of its employees. Petitioners deducted the $65,000 payment
on their 2010 Schedule C as a contract labor expense.
-7-
[*7] Section 162(a) provides a deduction for certain ordinary and necessary
business-related expenses. An expense is ordinary if it is normal, customary, or
usual within the relevant business. See Deputy v. du Pont, 308 U.S. 488, 495
(1940). An expense is necessary if it is appropriate and helpful for the business.
Commissioner v. Heininger, 320 U.S. 467, 471 (1943); Welch v. Helvering, 290
U.S. 111, 113 (1933); see also sec. 1.162-7(a), Income Tax Regs.
The transaction at issue here is between Mr. Chapman’s wholly owned LLC
(TMS) and Mrs. Chapman’s wholly owned corporation (AICR). Transactions
between related parties warrant particular scrutiny for tax characterization. See
United States v. Uneco, Inc. (In re Uneco), 532 F.2d 1204, 1207 (8th Cir. 1976);
PepsiCo Puerto Rico, Inc. v. Commissioner, T.C. Memo. 2012-269. However, it is
one thing to say that transactions between related parties should be carefully
scrutinized and quite another to say that a genuine transaction should be
disregarded for tax purposes simply because it occurred between related parties.
Respondent argues that petitioners failed to prove this $65,000 payment was
an ordinary and necessary business expense. Respondent’s argument is premised
entirely on his assertions that neither AICR nor its employees provided any actual
services to TMS. We do not agree.
-8-
[*8] Mr. Chapman testified that TMS is in the business of providing services
such as lawn care, snow removal, rekeying, general maintenance, winterizations,
and plumbing repairs. He also testified that the labor AICR provided included
“routine winterizations” during AICR’s slow season. We find Mr. Chapman’s
testimony credible. In addition, TMS’ business required the labor reflected by this
expense. Accordingly, we are convinced that TMS paid AICR $65,000 in
exchange for its employees to perform TMS’ services and that this expense was
ordinary and necessary for TMS to carry out its business operations.
Respondent also argues that the $65,000 payment was in substance a
contribution to capital. However, because the payment was compensation for
services the AICR employees performed, we do not agree that this payment was a
capital contribution.
Accordingly, petitioners have satisfied their burden of proving the $65,000
payment to AICR met the requirements for deductibility of a trade or business
expense.
III. Interest Expense Deduction
Section 163(a) allows a deduction for all interest paid or accrued on
indebtedness within the taxable year. As an exception, section 163(h) generally
disallows a deduction for personal interest. Petitioners claimed a deductible
-9-
[*9] interest expense of $139,165 for 2010 as a result of two types of obligations:
(1) interest Mr. Chapman purportedly paid on a number of credit lines in the name
of Bonnie Chapman but “assigned” to TMI, and (2) interest accrued on notes TMI
and Mr. Chapman issued.
A. Assignment of Credit Lines
Under section 163(a), taxpayers may deduct interest expenses only if they
arose from the taxpayers’ own indebtedness; they cannot deduct interest expenses
that arose from another’s indebtedness. Golder v. Commissioner, 604 F.2d 34, 35
(9th Cir. 1979), aff’g T.C. Memo. 1976-150. In the absence of an obligation of the
taxpayer to pay interest, the taxpayer is barred from deducting interest
notwithstanding the taxpayer’s characterization of payments as interest payments.
Motel Co. v. Commissioner, 340 F.2d 445, 447 (2d Cir. 1965), aff’g T.C. Memo.
1963-174.
Petitioners argue that TMI may deduct the interest paid on the credit lines
Bonnie Chapman assigned to TMI under section 163(a). To support their
argument, petitioners provided a copy of the assignment document, the creditors’
records showing balance transfers at the time of the assignment, and the creditors’
records showing the payments towards interest in 2010.
-10-
[*10] Each of the credit card statements from 2008 (the assignment year) shows a
balance transfer but does not show the origin or purpose of the balance transfer.
Interest expenses and their underlying debt are allocated according to the use of
the debt proceeds. See Robinson v. Commissioner, 119 T.C. 44, 70-72 (2002);
sec. 1.163-8T(c)(1), Temporary Income Tax Regs., 52 Fed. Reg. 25000 (July 2,
1987). Although petitioners assert that the balance transfers were a means of
raising funds for Mr. Chapman’s real estate investment business, petitioners failed
to show the use of the debt proceeds for a business purpose. We note that the debt
was incurred in the name of Mr. Chapman’s mother, Bonnie Chapman. Mr.
Chapman testified that he relied upon her credit in the business. However, his
vague and general testimony does not provide a sufficient basis to trace the debt to
business expenses. Accordingly, petitioners have failed to satisfy their burden of
proving that the interest was properly allocable to their trade or business. In
Robinson v. Commissioner, 119 T.C. at 70-72, we found that such a tracing
regime is in conformity with the disallowance of interest expenses under section
163(h).
Additionally, petitioners provided a number of bank statements and credit
card statements showing payments from TMI’s bank account to a number of credit
lines, including the credit lines covered by the assignment. Although the
-11-
[*11] statements show TMI made payments on the credit lines, the statements
again fail to show the nature of the expenditures that generated the debt carried on
the credit lines.
Because petitioners have failed to meet their burden of proving the interest
payments were not Bonnie Chapman’s personal obligation or that the underlying
debt was an ordinary and necessary obligation of the business, petitioners are not
entitled to an interest expense deduction for interest on the assigned credit lines.
B. Promissory Notes
Whether a particular accounting method clearly reflects income is a factual
question. Sam W. Emerson Co. v. Commissioner, 37 T.C. 1063, 1067 (1962). A
taxpayer’s labeling of his tax return as “accrual” is not determinative of the
designation. See Aluminum Castings Co. v. Routzahn, 282 U.S. 92, 99 (1930).
Taxpayers may adopt any permissible method of accounting in connection with
each separate and distinct trade or business, the income of which is reported for
the first time. Sec. 1.446-1(e)(1), Income Tax Regs. Without the Commissioner’s
approval, a taxpayer must report income in accordance with the method of
accounting the taxpayer used for previous years. Sec. 446(e); FPL Grp., Inc. v.
Commissioner, 115 T.C. 554, 574-575 (2000); see also Shoong Inv. Co. v.
Anglim, 45 F. Supp. 711 (N.D. Cal. 1942).
-12-
[*12] Mr. Chapman formed TMI in 2006. From 2006 to 2010 petitioners reported
their TMI income and claimed deductions on their personal income tax returns.
Petitioners changed their TMI accounting method in 2010 from the cash basis
method to the accrual basis method. However, petitioners have not shown any
reason TMI’s items of income and deduction should be calculated under the
accrual basis method. Although they were free to adopt the accrual basis method
if it clearly reflected income, they had to do so for the first taxable year TMI was
in operation, see sec. 1.446-1(e)(1), Income Tax Regs., or secure the consent of the
Commissioner before changing methods, see sec. 1.446-1(e)(2), Income Tax Regs.
Petitioners are not entitled to switch to the accrual basis method absent the
Commissioner’s approval.
Petitioners contend that the distinction between cash basis and accrual basis
is insignificant because they actually paid their interest obligations under the notes
as they came due in 2010. Petitioners have substantiated this claim only to a very
limited extent. Petitioners provided evidence of TMI’s interest payments on only
3 of the 21 promissory notes. For example, TMI’s bank statements show that
petitioners made payments totaling $11,797.50 to Bonnie Chapman, Gary Isch,
and Caitlyn Isch in 2010. Petitioners have not shown that the interest on the
remaining 18 notes was actually paid during 2010.
-13-
[*13] Petitioners assert that TMI’s $11,797.50 interest payments were on debts
incurred for nonpersonal purposes. See sec. 163(h)(1). Mr. Chapman credibly
testified that the funds were used in TMI’s real estate business. Accordingly,
petitioners are entitled to an interest expense deduction for only the $11,797.50
they properly substantiated.
IV. Bad Debt Deduction
Petitioners contend that the promissory notes Mr. Rust issued constitute
bona fide debts acquired in connection with a trade or business that became
wholly worthless in 2010. Respondent contends that these debts are not bona fide
debts, because they did not arise from a debtor-creditor relationship. We agree
with respondent.
Section 166(a)(1) allows taxpayers to deduct bona fide business debts that
have become wholly worthless within a taxable year. A bona fide debt arises from
a debtor-creditor relationship based upon a valid and enforceable obligation to pay
a fixed or determinable amount of money. Kean v. Commissioner, 91 T.C. 575,
594 (1988); sec. 1.166-1(c), Income Tax Regs. A gift or contribution to capital
may not be considered a debt for purposes of section 166. Sec. 1.166-1(c), Income
Tax Regs.
-14-
[*14] A contribution to capital in this instance would be in the form of a joint
venture. A joint venture is “‘an association of persons to carry out a single
business enterprise for profit’”. Beck Chem. Equip. Corp. v. Commissioner, 27
T.C. 840, 848-849 (1957) (quoting 48 C.J.S. Joint Adventures, secs. 1 and 2)
(citing Estate of Koen v. Commissioner, 14 T.C. 1406 (1950), and Osborn v.
Commissioner, 22 B.T.A. 935, 945 (1931)); Gurtman v. Commissioner, T.C.
Memo. 1975-96. Whether a joint venture was formed for tax purposes presents a
question of fact. Gurtman v. Commissioner, T.C. Memo. 1975-96. The
fundamental question is whether the parties intended to, and did in fact, join
together for the accomplishment or conduct of an undertaking or enterprise. Luna
v. Commissioner, 42 T.C. 1067, 1077 (1964).
There is sufficient evidence showing that Mr. Chapman and Mr. Rust
intended to work together in a joint venture in real estate investment. The record
establishes that the promissory notes formalizing the arrangement represented a
capital investment by Mr. Chapman, with interest set at unusually high rates to
account for Mr. Chapman’s personal involvement in the projects. The “debt” was
not secured by the real estate or any other collateral, and Mr. Chapman provided
services on the projects. Mr. Chapman would meet with contractors, real estate
agents, and developers. The evidence of the actual transfer to Mr. Rust of funds in
-15-
[*15] the amounts of the alleged notes is insufficient and the high level of risk and
involvement by Mr. Chapman is indicative of a capital contribution to a joint
venture, not a credit arrangement, in any event.
The notes were earmarked as investments in specific parcels of real
property, but as stated previously, none of the notes was secured by any of the
underlying properties. Mr. Rust defaulted on the principal payments as they came
due under the notes.2 Yet TMI allegedly provided additional funds to Mr. Rust.
Petitioners contend that the notes represent bona fide debt because the notes
are binding obligations for fixed amounts and terms, but the terms meant nothing
in practice. Petitioners further argue that the interest they received from Mr. Rust
in previous tax years is evidence of a debtor-creditor relationship. However, the
alleged interest payments do not prove a debt existed, because, among other
reasons, the payments were not consistent and regular. These payments could well
have been for services or return on investment.
In summary, although the notes had stated terms, the evidence indicates
petitioners did not enforce payment at maturity. The interest rates were well above
market levels. Mr. Chapman maintained an active role in the development of the
2
The first note in the series is dated August 30, 2006, with a term of 12
months. Acuity issued an additional four notes for a stated aggregate sum of
$104,230 after the first note matured.
-16-
[*16] projects. The record establishes that the parties intended the notes to act
both as an investment and as compensation for Mr. Chapman’s personal
involvement in the projects.
On the basis of the foregoing, we hold the notes do not support a bad debt
deduction for 2010.
V. Accuracy-Related Penalty
Section 6662(a) and (b)(2) imposes an accuracy-related penalty if any part
of an underpayment of tax resulted from a substantial understatement of income
tax. The penalty is 20% of the portion of the underpayment to which the section
applies. Sec. 6662(a).
The Commissioner bears the burden of production on the liability for an
accuracy-related penalty in that he must come forward with sufficient evidence
indicating that it is proper to impose the penalty. See sec. 7491(c); see also
Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner
meets this burden, the burden of proof remains with the taxpayer, including the
burden of proving that the penalty is inappropriate because of reasonable cause
and good faith. Higbee v. Commissioner, 116 T.C. at 446-447.
Respondent meets his burden of production by showing that petitioners’
understatement of income tax is “substantial”. Bronstein v. Commissioner, 138
-17-
[*17] T.C. 382, 388 (2012). Individuals substantially understate their income tax
when their understatement exceeds the greater of $5,000 or 10% of the tax
required to be shown on the return. Sec. 6662(d)(1)(A). Petitioners bear the
burden of proving that the accuracy-related penalty is inappropriate because of
reasonable cause and good faith. See sec. 6664(c)(1). Whether the taxpayer acted
with reasonable cause and good faith is determined by the pertinent facts and
circumstances. Brunsman v. Commissioner, T.C. Memo. 2003-291; sec. 1.6664-
4(b)(1), Income Tax Regs. Petitioners have failed to provide evidence of their
reasonable cause or good faith. Accordingly, if the Rule 155 computation
demonstrates that petitioners’ understatement exceeds the threshold, the 20%
penalty will apply.
In reaching our holdings herein, we have considered all arguments made,
and, to the extent not mentioned above, we conclude they are moot, irrelevant, or
without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.