T.C. Memo. 2014-125
UNITED STATES TAX COURT
DARRYL L. JONES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
TARRI M. HARROLD-JONES, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 18474-11, 18477-11. Filed June 23, 2014.
Janet L. Bolvin, for petitioners.
Melanie E. Senick, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: Mrs. Harrold-Jones provided services to Mr. Jones’ law
office. Petitioners elected to file separate Forms 1040, Individual Income Tax
Return, and both reported their activities as if Mrs. Harrold-Jones had been an
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[*2] independent contractor. Respondent issued Mr. Jones a notice of
determination of worker classification reclassifying Mrs. Harrold-Jones as an
employee of the law office. Respondent also issued petitioners separate notices of
deficiency regarding their 2007 and 2008 returns. In the notices respondent
asserted that petitioners had underreported their 2007 and 2008 income, claimed
unsubstantiated net operating loss carryforwards (NOLs), and improperly claimed
various deductions. After concessions1 the issues for decision are:
1
The parties agree that on his 2007 Schedule C, Profit or Loss from
Business, Mr. Jones understated his gross receipts by a total of $27,313.
Petitioners concede that Mr. Jones underreported his 2008 Schedule C gross
receipts by at least $173,404 and failed to report on his 2007 return offsetting
gambling winnings and losses.
Petitioners concede that on his 2007 return Mr. Jones improperly claimed
the following deductions: (1) the standard deduction, (2) depreciation expenses of
$7,171, and (3) car and truck expenses of $4,984. Petitioners concede that on his
2008 return Mr. Jones improperly claimed (1) depreciation expenses of $6,344, (2)
car and truck expenses of $4,006, and (3) office expenses of $93,449. Respondent
concedes that Mr. Jones was entitled to deduct $75,750 of contract labor expenses
on his 2007 return and $36,000 of rent expense on his 2008 return, amounts his
notice of deficiency disallowed.
Petitioners concede that on Mrs. Harrold-Jones’ 2007 return she improperly
claimed a $30,863 NOL carryforward deduction. They also concede that on her
2007 and 2008 returns she failed to report offsetting gambling winnings and
losses. Finally, petitioners agree with respondent’s adjustments to Mrs. Harrold-
Jones’ 2007 and 2008 Schedules E, Supplemental Income and Loss. Respondent
concedes that he included a nontaxable deposit of $100 in his calculation of Mrs.
Harrold-Jones’ 2008 taxable bank deposits.
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[*3] (1) whether respondent properly reclassified Mrs. Harrold-Jones as an
employee of the law office. We hold that he did not;
(2) whether Mr. Jones omitted from Schedule C of his 2008 return $45,095
of gross receipts. We hold that he did not;
(3) whether Mr. Jones improperly claimed a $179,439 NOL carryforward
deduction on his 2007 return. We hold that he did;
(4) whether Mr. Jones improperly claimed a deduction for $208,211 of
contract labor expenses on Schedule C of his 2007 return. We hold that he did but
that he is entitled to claim additional deductions to the extent Mrs. Harrold-Jones’
unreported income is attributable to payments from him;
(5) whether Mrs. Harrold-Jones underreported her 2007 and 2008 income.
We hold that she did;
(6) whether Mrs. Harrold-Jones improperly claimed various deductions on
Schedule C of her 2007 and 2008 returns. We hold that she did; and
(7) whether petitioners are liable for accuracy-related penalties under
section 6662(a).2 We hold that they are not.
2
Unless otherwise indicated all section references are to the Internal
Revenue Code in effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure.
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[*4] FINDINGS OF FACT
Some facts have been stipulated and are so found. Petitioners resided in
Alaska when they filed their petitions. We have consolidated their cases for trial,
briefing, and decision.
Mr. Jones is the owner of the Law Offices of Darryl L. Jones (law office).
Mrs. Harrold-Jones owns and operates a company called Tarri’s Business
Services. During the years in question Mrs. Harrold-Jones performed services for
the law office and also leased it commercial office space and business equipment.
Petitioners each filed Forms 1040 for 2007 and 2008 on which they elected
married filing separately status.
I. Respondent’s Worker Classification Determination
Mr. Jones received a notice of determination of worker classification dated
May 9, 2011, informing him that respondent had determined that Mrs. Harrold-
Jones was an employee during taxable years 2007 and 2008. Petitioners’ returns
for those years indicated that they believed Mrs. Harrold-Jones was an
independent contractor. Mr. Jones reported her payments as contract labor and
rent expenses on his Schedule C, and Mrs. Harrold-Jones reported them as gross
receipts on her Schedule C. Mrs. Harrold-Jones paid self-employment tax, and
Mr. Jones paid no payroll taxes for her.
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[*5] On the basis of the determination, respondent sought payroll taxes from Mr.
Jones, disallowed a deduction Mrs. Harrold-Jones had claimed for self-
employment taxes, and reclassified as wages income Mrs. Harrold-Jones had
reported on her Schedules C. Mr. Jones did not file a petition with the Tax Court
contesting the determination.
Mr. Jones regularly hires extra workers to help him manage his caseload,
and in 2003 he enlisted Mrs. Harrold-Jones to work on two of his largest cases.
Petitioners were concerned that working together might damage their marital
relationship, so they carefully arranged their business relationship to give Mrs.
Harrold-Jones as much freedom as possible. Mrs. Harrold-Jones did not work at
the law office; she worked from petitioners’ home, which was about 45 miles
away. Mr. Jones told Mrs. Harrold-Jones what he needed her to do, but he
allowed her to accomplish her tasks in her own time and in her own way.
Petitioners agreed that Mr. Jones could discharge Mrs. Harrold-Jones if the
arrangement became unproductive.
One of the cases on which Mrs. Harrold-Jones worked involved a protracted
criminal investigation against Mr. Jones’ client. The client had an eccentric
personality but got along well with Mrs. Harrold-Jones, so Mr. Jones appointed
her to review documents with the client and keep her calm and focused. Mrs.
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[*6] Harrold-Jones also performed basic legal research for the law office. She did
not receive regular wages; her cases settled in 2007 and 2008, and she received a
percentage of the fees Mr. Jones collected.
In addition to the paralegal services Mrs. Harrold-Jones provided, she also
kept track of the law office’s business receipts. Whenever a member of the office
staff received payment from a client, that person would fax a copy of the check or
cash to Mrs. Harrold-Jones, who would make a record of the receipt. Mr. Jones
did not pay her for these services; this was simply part of her role as keeper of the
family finances.
II. Respondent’s Income Tax Deficiency Determinations
Petitioners received separate notices of deficiency also dated May 9, 2011,
concerning their 2007 and 2008 returns. Respondent determined that Mr. Jones
had underreported his 2008 income and had improperly claimed a number of
deductions on his 2007 and 2008 returns. Respondent determined that Mrs.
Harrold-Jones had underreported her 2007 and 2008 income and had claimed
various improper deductions on her 2007 and 2008 Schedules C and E.
Respondent also determined that Mr. Jones and Mrs. Harrold-Jones were liable for
accuracy-related penalties under section 6662.
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[*7] A. Petitioners’ Bookkeeping and Tax Reporting Procedures
Before we address the determinations in the notices of deficiency, we will
briefly describe petitioners’ bookkeeping and tax reporting procedures during the
years in issue. Mr. Jones maintained a receipt book at his office in which he
recorded client payments. He also kept a handwritten check register on which he
recorded and classified his expenditures. All of the income Mrs. Harrold-Jones
reported on her returns for the years in issue was from the law office. She used a
computer program to track and categorize her expenses.
Darlene Dotzler, a certified public accountant with more than 10 years of
experience, prepared petitioners’ returns for the years in issue. Petitioners gave
Ms. Dotzler their records about two weeks before the filing deadlines for both
years. She calculated the law office’s total receipts from Mr. Jones’ receipt books
and his bank statements. She also prepared the Forms 1099-MISC, Miscellaneous
Income, the law office distributed to its contract workers, including Mrs. Harrold-
Jones. Ms. Dotzler reported as total receipts for Tarri’s Business Services the
amounts reflected on Mrs. Harrold-Jones’ Forms 1099-MISC from the law office.
Ms. Dotzler identified deductible expenses by reviewing petitioners’ bank
statements, Mr. Jones’ handwritten check register, and Mrs. Harrold-Jones’
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[*8] computer-generated expense report. When Ms. Dotzler had completed the
returns, she reviewed them with petitioners for reasonableness.
We now turn our attention to the disputed entries on petitioners’ returns.
B. Mr. Jones’ 2008 Schedule C Gross Receipts
Mr. Jones reported gross receipts of $298,515 on his 2008 Schedule C.
Respondent determined that Mr. Jones should have reported $517,014.
Respondent arrived at this total by reviewing Mr. Jones’ 2008 bank statements and
a report Ms. Dotzler had prepared summarizing his receipt book entries.
Respondent identified taxable deposits and transfers to Mr. Jones’ bank account
totaling $276,638. Respondent also found that Mr. Jones had recorded $240,3763
of client payments in his receipt book for 2008. Respondent added the totals from
these sources to calculate Mr. Jones’ gross receipts.
During the years in issue Mr. Jones did not deposit client payments as he
received them. He made deposits only when the law office needed money for
expenses. Consequently, respondent could not match the payments Mr. Jones
recorded in his receipt book with the deposits reflected on the law office’s bank
3
Mr. Jones did not record credit card receipts in the books, but Ms. Dotzler
included them on his return.
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[*9] statements. Respondent concluded that Mr. Jones’ deposits represented
additional receipts not recorded in the receipt book.
Mr. Jones concedes that he should have reported total receipts of $471,919
on his 2008 Schedule C; the additional $45,095 respondent calculated remains in
dispute.
C. Mr. Jones’ 2007 NOL Carryforward
Respondent disallowed a $179,439 NOL deduction Mr. Jones claimed on
his 2007 return. During respondent’s examination Mr. Jones produced copies of
his tax returns from 1997 to 2007 (except for those from 2001 and 2003) and a
schedule his accountant had prepared detailing the NOLs the law office had
generated and used in each of those years. The schedule indicates that the law
office generated the disputed NOLs in taxable years 1999, 2000, 2002, 2005, and
2006.
D. Mr. Jones’ 2007 Contract Labor Expense Deduction
Mr. Jones reported contract labor expenses of $1,394,961 on his 2007
Schedule C for the law office. Respondent initially determined that Mr. Jones had
incurred and paid contract labor expenses of only $1,113,000 in 2007.
Respondent has since conceded that Mr. Jones was entitled to an additional
$73,750. The parties also now agree that Mr. Jones erroneously included in
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[*10] contract labor expenses rental payments he made to Mrs. Harrold-Jones
totaling $54,000. Excluding the misclassified rental expenses, $154,211 of the
contract labor expenses remain in dispute.
E. Mrs. Harrold-Jones’ 2007 and 2008 Schedule C Gross Receipts
On her 2007 return Mrs. Harrold-Jones reported income of $483,000
($447,000 on Schedule C and $36,000 on Schedule E). During the examination
respondent’s revenue agent reviewed Mrs. Harrold-Jones’ bank statements and
determined she had made taxable deposits of $526,069 in 2007.
Petitioners have prepared a schedule detailing Mrs. Harrold-Jones’ 2007
deposits. The schedule is ambiguous about which deposits were taxable.
Respondent interprets the schedule to reflect $602,069 in taxable deposits and has
consequently adopted that total as the amount Mrs. Harrold-Jones should have
reported instead of the $526,069 the revenue agent calculated.
On her 2008 return Mrs. Harrold-Jones reported income of $111,000
($75,000 on Schedule C and $36,000 on Schedule E). Respondent reviewed Mrs.
Harrold-Jones’ bank statements and determined she had made taxable deposits of
$176,160 in 2008.
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[*11] F. Mrs. Harrold-Jones’ Home Sale
At trial Mrs. Harrold-Jones testified that she sold a house in 2007 and
deposited about $122,000 of the proceeds into her business account. Her 2007
return does not include any information concerning the sale. Respondent’s
revenue agent noted the deposits in her bank deposits analysis and classified them
as nontaxable. On the basis of Mrs. Harrold-Jones’ testimony, respondent now
contends that on her 2007 return she failed to report capital gain from the sale.
G. Mrs. Harrold-Jones’ Miscellaneous Expense Deductions
Mrs. Harrold-Jones failed to provide documentation for a number of
deductions she claimed on her 2007 and 2008 Schedules C, and respondent
consequently disallowed them. The table below summarizes the deductions
respondent disallowed:
Deduction 2007 2008
Supplies expense $2,299 $1,127
Office expense 4,649 989
Insurance expense 4,983 8,341
Depreciation expense 25,420 2,949
Car and truck expense --- 4,742
Other expense 4,612 ---
Utility expense 12,699 7,908
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[*12] Petitioners timely filed petitions contesting the determinations in their
notices of deficiency.
OPINION
I. Mrs. Harrold-Jones’ Employment Status
A. Jurisdiction
The parties have stipulated that Mr. Jones did not timely file a petition
challenging respondent’s determination that Mrs. Harrold-Jones was an employee.
Accordingly, we will not disturb respondent’s assessment of the additions to
employment tax he asserted in the notice of determination of worker classification.
Mrs. Harrold-Jones disputed respondent’s worker classification
determination in the petition she filed in response to her notice of deficiency. We
have regularly allowed taxpayers in income tax deficiency proceedings to
challenge a change in their worker classification when the change caused any
portion of their deficiency. See, e.g., Weber v. Commissioner 103 T.C. 378
(1994), aff’d per curiam, 60 F.3d 1104 (4th Cir. 1995). Respondent’s
determination that Mrs. Harrold-Jones was an employee of the law office resulted
in his disallowance of her self-employment tax deduction, which contributed to
her income tax deficiencies. Accordingly, we will review respondent’s worker
classification determination.
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[*13] B. Burden of Proof
We presume that a worker classification determination made by the
Commissioner is correct, but a taxpayer may rebut that presumption by
demonstrating by a preponderance of the evidence that the determination was
erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Boles
Trucking, Inc. v United States, 77 F.3d 236, 239-240 (8th Cir. 1996) (applying this
standard to a worker classification determination).
C. Common Law Test
Whether an individual performing services for a principal is an employee
(rather than an independent contractor) is a factual question to which common law
principles apply. Weber v. Commissioner, 103 T.C. at 386; see secs. 3121(d)(2),
3306(i). In evaluating the relationship between the principal and the worker, we
consider (1) the degree of control the principal exercised over the details of the
work; (2) which party invested in the facilities the worker used; (3) the worker’s
opportunity for profit or loss; (4) whether the principal could have discharged the
worker; (5) whether the work was part of the principal’s regular business; (6) the
permanency of the relationship; and (7) the relationship the parties believed they
were creating. Ewens & Miller, Inc. v. Commissioner, 117 T.C. 263, 270 (2001);
Weber v. Commissioner, 103 T.C. at 387. We consider all facts and
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[*14] circumstances; no one factor dictates the outcome. Ewens & Miller, Inc. v.
Commissioner, 117 T.C. at 270.
D. Analysis
1. Degree of Control
The principal’s degree of control over the details of the agent’s work is the
most important factor in determining whether an employment relationship exists.
See Clackamas Gastroenterology Assocs., P.C. v. Wells, 538 U.S. 440, 448
(2003); Weber v. Commissioner, 103 T.C. at 387. In an employer-employee
relationship the principal must have the right to control not only the result of the
employee’s work but also the means and method used to accomplish that result.
Packard v. Commissioner, 63 T.C. 621, 629 (1975). The degree of control
necessary to find employee status varies according to the nature of the services
provided. Weber v. Commissioner, 103 T.C. at 387. When the nature of the work
is more independent, a lesser degree of control by the principal may still result in a
finding of an employer-employee relationship. Robinson v. Commissioner, T.C.
Memo. 2011-99, aff’d, 487 Fed. Appx. 751 (3d Cir. 2012).
Mr. Jones did not control the details of Mrs. Harrold-Jones’ work. He told
her what he needed done, and she was free to decide how to accomplish it. Mrs.
Harrold-Jones’ most important responsibility was keeping an important client calm
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[*15] in the face of a lengthy criminal investigation. The client was eccentric but
got along well with Mrs. Harrold-Jones, so Mr. Jones trusted her to interact with
the client and review documents with her. Mr. Jones cared only about the client’s
satisfaction and did not control how Mrs. Harrold-Jones achieved it. These facts
suggest that Mrs. Harrold-Jones was an independent contractor.
2. Investment in Facilities
The fact that a worker provides his or her own facilities generally indicates
independent contractor status. Ewens & Miller, Inc. v. Commissioner, 117 T.C. at
271. Mrs. Harrold-Jones worked from her home office, and the law office did not
pay any of her expenses. This suggests Mrs. Harrold-Jones was an independent
contractor.
3. Opportunity for Profit or Loss
When workers have no opportunities for profit or loss, they are more like
employees than independent contractors. See D & R Fin. Servs., Inc. v.
Commissioner, T.C. Memo. 2011-252. Mrs. Harrold-Jones did not receive regular
wages and received payment only after the cases she worked on had settled. The
payments she received depended on the amounts of the settlements in her cases,
and she conceivably could have received nothing for her efforts. Thus, she risked
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[*16] loss, and her profits were linked to her performance. These facts suggest
Mrs. Harrold-Jones was an independent contractor.
4. Right To Discharge
Petitioners admit that Mr. Jones had the right to discharge Mrs. Harrold-
Jones. This suggests she was an employee.
5. Regular Business
When an agent performs her work in the ordinary course of a principal’s
business, the agent appears to be more like an employee than an independent
contractor. Id. Mrs. Harrold-Jones primarily worked on two cases for the law
office. She reviewed documents with clients and performed general legal
research. These activities were part of the regular business of the law office.
These facts suggest Mrs. Harrold-Jones was an employee.
6. Permanency of the Relationship
A transitory work relationship may indicate independent contractor status.
Ewens & Miller, Inc. v. Commissioner, 117 T.C. at 273. Mrs. Harrold-Jones
worked for the law office only while the two cases Mr. Jones assigned her were
ongoing. She has not worked for the law office since the cases settled. Although
she worked for the law office for five or six years, her tenure was dependent on the
continuation of her cases and could have ended at any time. Her tenure was
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[*17] lengthy but by no means permanent. These facts suggest that she was an
independent contractor.
7. Relationship the Parties Thought They Created
The law office treated Mrs. Harrold-Jones as an independent contractor, and
she considered herself an independent contractor. The law office issued her Forms
1099-MISC, and she paid self-employment tax during the years in issue. The
record reflects that neither Mr. Jones nor Mrs. Harrold-Jones thought Mrs.
Harrold-Jones was an employee. This suggests she was an independent
contractor.
8. Conclusion
After considering the record and weighing all of the factors, we conclude
that Mrs. Harrold-Jones was an independent contractor during the years in issue.
Although some of the relevant factors suggest Mrs. Harrold-Jones was an
employee, on balance the record indicates that she was an independent contractor.
Mr. Jones did not control the details of Mrs. Harrold-Jones’ work; she worked
from home, and he did not supervise her. Although she ultimately worked for the
law firm for several years, her service depended on the length of her cases and
could have ended at any time without payment if the cases had not settled
favorably. Finally, petitioners did not believe they were creating an employment
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[*18] relationship and took pains to avoid such a relationship. We think these
factors sufficiently establish that Mrs. Harrold-Jones was an independent
contractor, and we hold accordingly.
II. Petitioners’ Income Tax Deficiencies
A. Burden of Proof
In these cases we address respondent’s determinations that petitioners: (1)
failed to report income and (2) improperly claimed deductions. The burden of
proof analysis is slightly different for each of these issues.
1. Unreported Income
Taxpayers are required to maintain sufficient records to enable the
Commissioner to establish the amount of their taxable income. Sec. 6001; sec.
1.6001-1(a) and (b), Income Tax Regs. If such records are lacking, the
Commissioner may reconstruct the taxpayers’ income by any method that is
reasonable under the circumstances. Petzoldt v. Commissioner, 92 T.C. 661, 687
(1989). We presume the Commissioner’s determination is correct when it is based
upon a reasonable method. Olsen v. Commissioner, T.C. Memo. 1982-697.
Respondent used the bank deposits method to reconstruct petitioners’ income.
That method is well established and was reasonable under the circumstances.
Petitioners bear the burden of proving that the deposits respondent has identified
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[*19] do not represent unreported income. DiLeo v. Commissioner, 96 T.C. 858,
869 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
In calculating Mr. Jones’ unreported income, respondent added to Mr.
Jones’ bank deposits receipts Mr. Jones had recorded in his receipt books. As we
discuss below, this was not reasonable, and we do not presume respondent’s
estimate is correct to the extent it resulted from the inclusion of these additional
receipts. Consequently, respondent bears the burden of proving that the amounts
from Mr. Jones’ receipt books represent unreported income in excess of Mr.
Jones’ bank deposit totals.
2. Business Expense Deductions
Section 162 allows taxpayers to claim deductions for “ordinary and
necessary” business expenses. Such deductions are a matter of legislative grace,
and taxpayers bear the burden of proving their entitlement to them. Rule
142(a)(1); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).
B. Mr. Jones’ Deficiencies
1. Mr. Jones’ Gross Receipts
Respondent reviewed Mr. Jones’ records and determined that he
underreported his 2008 gross receipts by $218,499. Mr. Jones concedes that he
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[*20] underreported his receipts by $173,404. We must resolve the dispute
concerning the remaining $45,095.
Respondent prepared a bank deposits analysis indicating Mr. Jones had
made taxable deposits of $276,638. Mr. Jones produced a summary of his receipt
book indicating that he had received $240,376 in client payments during 2008.
Respondent tried to trace the payments in the receipt book to Mr. Jones’ bank
statements but could not. He concluded that the deposits were completely
independent of the payments in the receipt book and consequently added the totals
together.
Mr. Jones testified that some overlap existed between the bank deposits and
the payments he recorded in his receipt book. He claims that respondent could not
trace the payments to his bank statements, because he did not deposit the payments
as he received them. Respondent’s revenue agent admitted that if the bank
statement did not reflect a deposit within five days of the payment date in the
receipt book, she concluded that the entries did not correspond. Mr. Jones
credibly testified that he rarely made deposits within five days of receipt. This
explains respondent’s inability to reconcile the two sources.
We believe that respondent’s method caused him to double count some of
Mr. Jones’ receipts. We find implausible respondent’s conclusion that none of
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[*21] Mr. Jones’ 2008 deposits corresponded with any payment he recorded in his
2008 receipt book. The Commissioner is entitled to a presumption of correctness
when he reconstructs a taxpayer’s income using any reasonable method. Olsen v.
Commissioner, T.C. Memo. 1982-697 (emphasis added). Respondent’s method
was reasonable only to the extent it involved reviewing Mr. Jones’ bank records.
Adding Mr. Jones’ receipt book total to his bank deposit total was not reasonable.
Accordingly, we do not presume respondent’s calculation was correct to the extent
it exceeded Mr. Jones’ taxable bank deposits.
Respondent has not produced sufficient evidence proving Mr. Jones
received and failed to report the additional payments in question. Accordingly, we
hold that Mr. Jones did not underreport his 2008 gross receipts by the $45,095
remaining in dispute.
2. Mr. Jones’ 2007 NOL Deduction
Section 172 permits taxpayers to deduct their NOLs. NOLs result when
taxpayers’ allowable deductions exceed their gross income. Sec. 172(c).
Taxpayers may carry an NOL back to each of the 2 taxable years preceding the
taxable year of the loss or carry it forward over each of the 20 taxable years
following the taxable year of the loss. Sec. 172(b). Taxpayers may elect to waive
the two-year carryback period. Sec. 172(b)(3).
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[*22] On his 2007 return Mr. Jones deducted NOLs he claims he generated in
1999, 2000, 2002, 2005, and 2006. Mr. Jones elected to waive the carryback
period for each of those years. Respondent disallowed the deduction.
To prevail, petitioners must prove (1) that Mr. Jones suffered NOLs in the
relevant years and (2) that those NOLs were not absorbed in the years preceding
2007. To carry that burden, petitioners must introduce convincing evidence not
only of Mr. Jones’ NOLs for the relevant years but also of his taxable income for
the other years (carry years) in the period beginning with 1999 and ending with
2006. See, e.g., Leitgen v. Commissioner, T.C. Memo. 1981-525, aff’d without
published opinion, 691 F.2d 504 (8th Cir. 1982).
Mr. Jones has produced two forms of documentary evidence concerning his
NOL carryforward. First, he has presented a schedule detailing the NOLs he
generated and used from 1997-2007. Second, he has furnished all his returns from
1997-2007, except those for 2001 and 2003. Mr. Jones contends that this evidence
sufficiently substantiates his entitlement to the NOL carryforward he claimed. We
disagree.
Although the schedule accurately reflects the operating losses Mr. Jones
reported on his returns (at least for those in the record), Mr. Jones has presented
little evidence concerning the activity that generated those losses or his income for
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[*23] the carry years. His accountant testified that some of the losses resulted
from Mr. Jones’ advancing expenses in contingent fee cases. This vague
testimony and Mr. Jones’ tax returns alone are insufficient to substantiate the NOL
deduction. See Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979); Owens v.
Commissioner, T.C. Memo. 2001-143. Accordingly, we hold that Mr. Jones was
not entitled to claim an NOL deduction for taxable year 2007.
3. Mr. Jones’ 2007 Contract Labor Expense Deduction
Respondent determined that Mr. Jones claimed an excessive contract labor
expense deduction. After concessions and excluding expenses misclassified but
otherwise deductible, expenses of $154,211 remain in dispute.
Mr. Jones’ lone evidence concerning his contract labor deduction is a
handwritten check register that does not agree with the amount he claimed on his
return. Even if the register agreed with the return amount, it could not by itself
substantiate his contract labor expenses, because it provides only the name of the
payee and Mr. Jones’ classification of the expense. Mr. Jones has presented no
invoices or other evidence to substantiate the business purpose of the expenses the
register reflects.
Respondent’s revenue agent prepared a schedule detailing the amounts he
disallowed. Petitioners have not offered any evidence substantiating the purpose
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[*24] of the identified payments. Accordingly, we sustain respondent’s
disallowance of $154,211 of Mr. Jones’ contract labor expense deduction.
C. Mrs. Harrold-Jones’ Deficiencies
1. Mrs. Harrold-Jones’ 2007 and 2008 Income
Mrs. Harrold-Jones reported income of $483,000 and $111,000 for 2007
and 2008 respectively. Respondent’s revenue agent reviewed her bank statements
and determined she should have reported $526,069 and $176,160 respectively.
Respondent now argues that an exhibit petitioners prepared for trial represents
their admission that Mrs. Harrold-Jones should have reported $602,069 for 2007.4
Respondent has presented no evidence of his own supporting the increased
amount. We find petitioners’ exhibit too ambiguous to represent an admission and
consider instead respondent’s initial determination that Mrs. Harrold-Jones should
have reported income of $526,069 on her 2007 return.
4
The exhibit in question is a summary petitioners’ counsel prepared of Mrs.
Harrold-Jones’ 2007 bank deposits. The schedule includes all deposits to each of
Mrs. Harrold-Jones’ two bank accounts. The total for the first account is
$154,700, which appears beside the caption “net deposited income”. Petitioners
clearly intend this portion of the schedule to reflect that Mrs. Harrold-Jones made
taxable deposits of $154,700 to this account.
The second account’s total, $447,369, appears beside the caption “net
deposits excluding interest income”. This caption does not indicate petitioners
believed Mrs. Harrold-Jones made taxable deposits of $447,369 to the second
account. The caption indicates that the total excludes interest income, but it does
not indicate that the other deposits represented taxable income.
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[*25] Mrs. Harrold-Jones has had ample opportunity to review the additional
taxable deposits respondent identified, but she has presented little persuasive
evidence that the deposits were nontaxable. A $23,219 check from Mr. Jones
represents the most significant deposit petitioners claim is nontaxable. In their
brief petitioners claim the payment was a Christmas gift, but at trial Mrs. Jones
could not remember the purpose of the deposit despite prompting from her
counsel. She has identified some other deposits she contends are nontaxable, but
her argument is based on the payor and the memo line of each check deposited.
This evidence is insufficient to establish the deposits she made were nontaxable.
Accordingly, we sustain respondent’s determination of Mrs. Harrold-Jones’ 2007
and 2008 taxable income. However, in keeping with our conclusion that she was
not an employee of the law firm, we hold that her additional income was self-
employment income, not wages.5
Although respondent determined that some of Mrs. Harrold-Jones’
additional taxable receipts were from the law office, he did not allow a
corresponding increase in Mr. Jones’ Schedule C deductions. We hold that Mr.
5
Respondent has not asserted additional self-employment tax associated
with Mrs. Harrold-Jones’ unreported income.
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[*26] Jones is entitled to deductions to the extent Mrs. Harrold-Jones’ increases in
income are attributable to payments from him.
2. Mrs. Harrold-Jones’ Home Sale
Solely on the basis of Mrs. Harrold-Jones’ testimony at trial, respondent
alleged that Mrs. Harrold-Jones had sold property and failed to report capital gain.
Because respondent did not raise this argument until after trial, it constitutes a new
matter, and he bears the burden of proving facts sufficient to sustain his position.
See Rule 142(a)(1). Mrs. Harrold-Jones testified that she thought the sale
occurred in 2007 but was not sure. The record is unclear about when Mrs.
Harrold-Jones sold the home, the extent of her gain, and whether the gain was
taxable. Respondent has not proved Mrs. Harrold-Jones should have reported
capital gain on the home sale for 2007, and we accordingly hold for petitioners on
this issue.
3. Mrs. Harrold-Jones’ Miscellaneous Expense Deductions
Respondent’s revenue agent reviewed a number of Schedule C expenses for
which Mrs. Harrold-Jones claimed deductions. Mrs. Harrold-Jones produced
documentation substantiating only portions of many of the deductions she
claimed. Respondent disallowed the portions of the deductions Mrs. Harrold-
Jones could not substantiate.
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[*27] Mrs. Harrold-Jones has provided a list of checks she wrote during 2008, but
she has presented no evidence demonstrating a business purpose for any of the
payments. She has offered expense account detail reports for her 2007 deductions
but has presented no supporting documents. This evidence is insufficient to prove
her entitlement to deductions greater than those respondent allowed, and we
accordingly sustain his decision to disallow them.
III. Penalties
A taxpayer may be liable for a 20% penalty on any underpayment of tax
attributable to negligence or disregard of rules or regulations or a substantial
understatement of income tax. Sec. 6662(a) and (b)(1) and (2). Taxpayers may
avoid accuracy-related penalties if they can show they had reasonable cause for
their underpayments and that they acted in good faith. Sec. 6664(c)(1); sec.
1.6664-4(b), Income Tax Regs.; see also Neonatology Assocs., P.A. v.
Commissioner, 115 T.C. 43, 98 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002); secs.
1.6662-3(a), 1.6664-4(a), Income Tax Regs.
Respondent imposed accuracy-related penalties on petitioners because he
determined their underpayments were attributable to substantial understatements
of income tax, or in the alternative, negligence. Petitioners argue that they are not
liable for penalties, because they had reasonable cause for their underpayments
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[*28] and acted in good faith. The basis for petitioners’ reasonable cause defense
is their reliance on Ms. Dotzler to prepare their returns.
When taxpayers rely on the professional judgment of a competent tax
adviser to whom they have provided all necessary and relevant information, the
taxpayers’ behavior may be consistent with ordinary business care and prudence.
United States v. Boyle, 469 U.S. 241, 250-251 (1985). To establish reasonable
cause via reliance on the advice of a tax adviser, taxpayers must prove by a
preponderance of the evidence that: (1) the adviser was a competent professional
who had sufficient expertise to justify reliance, (2) the taxpayers provided
necessary and accurate information to the adviser, and (3) the taxpayers relied in
good faith on the adviser’s judgment. Neonatology Assocs., P.A. v.
Commissioner, 115 T.C. at 98-99. Petitioners have established these facts.
Ms. Dotzler is a certified public accountant with more than 10 years of
experience. Her credentials and experience sufficiently justified petitioners
reliance on her to prepare their returns.
Petitioners provided Ms. Dotzler with complete and accurate financial
records during the years in issue. Petitioners furnished bank statements, expense
reports, and income records, and they were available at all hours to answer
questions. Ms. Dotzler testified that petitioners provided her with sufficient
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[*29] information with which to prepare their returns. She admitted that she made
several mistakes that petitioners, who lacked tax expertise, could not have
detected.
Petitioners credibly testified that they relied in good faith on Ms. Dotzler to
prepare their returns. Petitioners reviewed Ms. Dotzler’s work and failed to
recognize errors she made, but we do not believe their failure was in bad faith.
Petitioners have successfully established reasonable cause for their underpayments
and accordingly are not liable for accuracy-related penalties.
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,
Decisions will be entered under
Rule 155.