T.C. Memo. 2015-167
UNITED STATES TAX COURT
JIJUN CHEN AND XIUJING GU, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4954-14. Filed August 24, 2015.
Jijun Chen and Xiujing Gu, pro sese.
David A. Indek, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge: Respondent determined deficiencies in petitioners’ Federal
income tax and accuracy-related penalties as follows:
Accuracy-related Penalty
Year Deficiency Sec. 6662
2010 $3,231 $646
2011 6,159 1,232
2012 10,115 2,023
-2-
[*2] The issues for decision are: (1) whether petitioners are entitled to deduct
certain business expenses claimed on Schedules C, Profit or Loss From Business,
for the taxable years 2010, 2011, and 2012 (years in issue); (2) whether a State
income tax refund of $5,827 petitioners received in 2012 constitutes taxable
income for that year; and (3) whether petitioners are liable for accuracy-related
penalties under section 6662(a) for the years in issue.
Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the years in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of
facts and the attached exhibits are incorporated herein by this reference.
At the time the petition was filed, petitioners resided in Maryland.
On July 24, 2009, petitioners formed Allonger, LLC (Allonger), a private
biotechnology company. Allonger’s principal office is in Wilmington, Delaware.1
Petitioner Jijun Chen2 is Allonger’s sole shareholder and is listed as the resident
1
Allonger also has a location in Quingdao, China.
2
Mr. Chen has a medical degree and a Ph.D., both of which he obtained in
China.
-3-
[*3] agent for Allonger on the limited liability company registration. Between
July 24, 2009, and December 31, 2012, petitioners did not earn any money through
Allonger or acquire any clients or contracts for Allonger.
Petitioners have two children, A.Y.C. and E.Y.C.,3 both of whom were born
in 2001. The Forms W-2, Wage and Tax Statement, submitted to the Internal
Revenue Service (IRS) show that Allonger paid A.Y.C. and E.Y.C. wages in tax
year 2012 totaling $9,960.4 Allonger did not pay other wages or compensation to
any other individuals for the years in issue. As discussed infra, petitioners claim
various Schedule C deductions for the years in issue associated with Allonger.
For tax years 2010 and 2011 petitioners claimed refunds of $10,769 and
$14,615, respectively. On Schedule A, Itemized Deductions, of their 2011 Federal
income tax return, petitioners claimed a $6,206 deduction for Maryland State
income tax paid. In 2012 petitioners received a $5,827 Maryland State income tax
refund. Petitioners did not report the 2011 refund on their 2012 Federal income
tax return.
3
It is the Court’s policy to refer to minor children only by their initials. See
Rule 27(a)(3).
4
Petitioners did not issue Forms W-2 or Forms 1099-MISC, Miscellaneous
Income, from Allonger to their children for the 2010 or 2011 tax year.
-4-
[*4] Petitioners timely filed a joint Federal income tax return for each of the
years in issue.5 Mr. Chen listed his occupation as programmer, and Xiujing Gu
listed her occupation as professional. Respondent issued to petitioners a notice of
deficiency for the years in issue. Petitioners timely filed a petition disputing the
determinations in the notice of deficiency.
OPINION
In general, the Commissioner’s determinations in a notice of deficiency are
presumed correct, and the taxpayer bears the burden of proving that the
determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111,
115 (1933). Petitioners do not contend, and the evidence does not establish, that
the burden of proof shifts to respondent under section 7491(a) as to any issue of
fact.
A. Petitioners’ Claimed Deductions
Deductions are a matter of legislative grace, and the taxpayer bears the
burden of proving entitlement to any deduction claimed. Rule 142(a); INDOPCO,
Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering,
292 U.S. 435, 440 (1934). Section 6001 requires the taxpayer to maintain records
5
The record includes copies of petitioners’ 2010 and 2011 Forms 1040, U.S.
Individual Income Tax Return, and a transcript of petitioners’ 2012 tax return.
Attached to petitioners’ posttrial brief is a copy of their 2012 Form 1040.
-5-
[*5] sufficient to establish the amount of each deduction claimed. See also sec.
1.6001-1(a), Income Tax Regs.
Section 162(a) allows as a deduction “all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or
business”. See Boyd v. Commissioner, 122 T.C. 305, 313 (2004). A trade or
business expense is ordinary for purposes of section 162 if it is normal or
customary within a particular trade, business, or industry and is necessary if it is
appropriate and helpful for the development of the business. Commissioner v.
Heininger, 320 U.S. 467, 471-472 (1943); Deputy v. du Pont, 308 U.S. 488, 495
(1940). In contrast, section 262(a) disallows deductions for personal, living, or
family expenses.
If the taxpayer establishes that an expense is deductible but is unable to
substantiate the precise amount, we may estimate the amount, bearing heavily
against the taxpayer whose inexactitude is of his or her own making. See Cohan
v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). The taxpayer must present
sufficient evidence for the Court to form an estimate because without such a basis,
any allowance would amount to unguided largesse. Williams v. United States, 245
F.2d 559, 560-561 (5th Cir. 1957); Vanicek v. Commissioner, 85 T.C. 731, 742-
743 (1985).
-6-
[*6] However, section 274 overrides the Cohan rule with regard to certain
expenses. See Sanford v. Commissioner, 50 T.C. 823, 828 (1968), aff’d per
curiam, 412 F.2d 201 (2d Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax
Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985). Under section 274(d), the taxpayer
must meet stricter substantiation requirements to be allowed a deduction under
section 162. The heightened substantiation requirements of section 274(d) apply
to: (1) any traveling expense, including meals and lodging away from home;
(2) any item with respect to an activity in the nature of entertainment, amusement,
or recreation; (3) an expense for gifts; or (4) the use of “listed property” as defined
in section 280F(d)(4), including any passenger automobiles. To deduct these
expenses, the taxpayer must substantiate by adequate records or by sufficient
evidence corroborating the taxpayer’s own statement: (1) the amount of the
expense; (2) the time and place of the expense; and (3) the business purpose of the
expense. Sec. 274(d); see Oswandel v. Commissioner, T.C. Memo. 2007-183,
2007 Tax Ct. Memo LEXIS 185, at *7. Even if such an expense would otherwise
be deductible, section 274 may still preclude a deduction if the taxpayer does not
present sufficient substantiation. Sec. 1.274-5T(a), Temporary Income Tax Regs.,
supra.
-7-
[*7] Petitioners reported zero gross receipts for Allonger for each of the years in
issue. Petitioners claimed deductions for Schedule C business expenses pertaining
to Allonger of $30,739 for 2010, $44,182 for 2011, and $43,730 for 2012, all of
which are in issue. These Schedule C expenses are as follows:
Expense 2010 2011 2012
Advertising --- $202 $222
Car and truck $11,850 19,010 10,544
1
Contract labor --- 350 250
Depreciation 2,505 2,774 4,705
Employee benefit programs 3,446 4,844 5,178
Insurance 546 614 626
Legal and professional 571 --- ---
Office expense 2,144 3,711 1,939
Repairs and maintenance 920 1,323 919
Supplies 999 1,773 951
Taxes and licenses --- 725 550
Travel 1,594 2,779 2,410
Meals and entertainment 1,839 2,269 1,941
Utilities 2,317 3,768 3,432
Wages --- --- 9,960
Other expenses 2,008 40 103
Total 30,739 44,182 43,730
1
Attached to petitioners’ posttrial brief is a copy of their 2012
Schedule C, showing a $250 contract labor expense claimed for this
year. The notice of deficiency indicates that this amount was claimed
for 2010.
Although not specifically argued by petitioners, it appears that certain
expenses claimed on their Schedules C for the years in issue are car and truck
-8-
[*8] mileage expenses and home office expenses. For clarity we will address
petitioners’ claimed expenses in three categories: car and truck expenses, home
office expenses, and other expenses.
1. Car and Truck Expenses
Petitioners claimed car and truck expenses for each of the years in issue, and
these expenses are subject to the heightened substantiation requirements of section
274(d). See secs. 274(d)(4), 280F(d)(4)(A)(i). As applicable to vehicle expenses,
section 274(d) requires the taxpayer to substantiate by adequate records or by
sufficient evidence corroborating the taxpayer’s own statement: (1) the mileage;
(2) the time and place of the use; and (3) the business purpose of the use. See
Solomon v. Commissioner, T.C. Memo. 2011-91, 2011 Tax Ct. Memo LEXIS 90,
at *8. Substantiation by adequate records requires the taxpayer to maintain an
account book, a diary, a log, a statement of expense, trip sheets, or a similar record
prepared contemporaneously with the use or expenditure and documentary
evidence (e.g., receipts or bills) of certain expenditures. See sec. 1.274-
5(c)(2)(iii), Income Tax Regs.; sec. 1.274-5T(c)(2), Temporary Income Tax Regs.,
50 Fed. Reg. 46017 (Nov. 6, 1985). A log that is kept on a weekly basis is
considered contemporaneous for this purpose. See sec. 1.274-5T(c)(2)(ii)(A),
Temporary Income Tax Regs., 50 Fed. Reg. 46017-46018 (Nov. 6, 1985). The
-9-
[*9] level of detail required for substantiating by adequate records the business use
of listed property depends on the facts and circumstances of such use. See id.
subdiv. (ii)(C), 50 Fed. Reg. 46018-46019.
We find that petitioners have failed to prove that they are entitled to deduct
any car and truck expenses for the years in issue as required under section 274(d).
Petitioners did not provide any records to establish the mileage driven, the time
and place of vehicle use, or the business purpose of the use. Accordingly, we
sustain respondent’s disallowance of petitioners’ claimed car and truck expense
deductions for the years in issue.
2. Home Office Expenses
Although petitioners did not specifically deduct expenses for the business
use of their home, many of the claimed Schedule C expenses are considered home
office expenses and thus are subject to the requirements of section 280A. For
example, petitioners submitted into evidence seven Howard County, Maryland,
water and sewer bills pertaining to their residential address in Columbia,
Maryland.
Section 280A(a) provides as a general rule that no deduction otherwise
allowable to an individual “shall be allowed with respect to the use of a dwelling
unit which is used by the taxpayer during the taxable year as a residence.” The
- 10 -
[*10] term “dwelling unit” is defined as “a house, apartment, condominium,
mobile home, boat, or similar property, and all structures or other property
appurtenant to such dwelling unit.” Sec. 280A(f)(1)(A). However, section
280A(c) contains an exception to the general disallowance of subsection (a). In
pertinent part, section 280A(c)(1) provides:
SEC. 280A(c). Exceptions for Certain Business or Rental Use;
Limitation on Deductions for Such Use.--
(1) Certain business use.--Subsection (a) shall not apply
to any item to the extent such item is allocable to a portion of
the dwelling unit which is exclusively used on a regular basis--
(A) as the principal place of business for any trade
or business of the taxpayer,
(B) as a place of business which is used by
patients, clients, or customers in meeting or dealing with
the taxpayer in the normal course of his trade or
business, or
(C) in the case of a separate structure which is not
attached to the dwelling unit, in connection with the
taxpayer’s trade or business.
For an expense related to a dwelling unit to fit within this exception, some portion
of the dwelling unit must be used regularly and exclusively for the taxpayer’s trade
or business. See Scully v. Commissioner, T.C. Memo. 2013-229, at *21.
- 11 -
[*11] Petitioners contend that, for the years in issue, they used their entire
personal residence to operate Allonger. The only evidence petitioners provided to
support this contention was Mr. Chen’s unpersuasive testimony. Furthermore, the
Maryland Department of Assessments and Taxation lists Allonger’s principal
office in Wilmington, Delaware. We find that petitioners have failed to
demonstrate or prove that any portion of their dwelling was regularly and
exclusively used for business purposes for the years in issue. Accordingly, we
sustain respondent’s disallowance of deductions for the home office expenses for
the years in issue.
3. Other Expenses
To substantiate the remaining Schedule C expenses claimed for the years in
issue, petitioners offered into evidence a self-created spreadsheet of expenses.
The spreadsheet contains category titles, dates, names of vendors/items, and
amounts. The vast majority of these items, from what we can perceive, are for the
tax year 2010, and a few are for tax year 2011. There is no indication of
expenditures for tax year 2012. Petitioners’ spreadsheet lists vendors such as
Macy’s, JCPenney, Toys R Us, Hair Cuttery, The Sandal Factory, Mikes Music of
Maryland, and Olenka School of Music.
- 12 -
[*12] Petitioners have failed to substantiate that any of the expenses on their
spreadsheet were incurred by Allonger in carrying on its trade or business. At trial
Mr. Chen acknowledged that many of the expenses claimed by petitioners as
business expense deductions were indeed personal in nature and were for the
benefit of petitioners’ children. Among other things, Mr. Chen acknowledged
that: (1) for the years in issue the employee benefits program expenses consisted
entirely of sending his children to daycare; (2) for 2010 travel and entertainment
expenses were incurred educating his children; and (3) for 2011 a $757
depreciation expense was for depreciating his children’s musical instruments.
Petitioners did not explain how these expenses are ordinary and necessary in
carrying on the business operations of Allonger. These expenses are clearly
personal in nature and are expressly disallowed as a deduction by section 262(a).
Furthermore, to the extent that these expenses constitute entertainment,
amusement, or recreational expenses, petitioners have failed to meet the
heightened substantiation requirements of section 274(d).
Petitioners also claimed a deduction for total wages of $9,960 that Allonger
paid to A.Y.C. and E.Y.C. during 2012. Mr. Chen testified that his children--who
were 11 years old in 2012--were paid for “doing some office cleaning * * * [and]
office organiz[ing]”. However, aside from the Forms W-2 submitted to the IRS,
- 13 -
[*13] petitioners have produced no documentation to establish that the minor
children performed work for Allonger in 2012 or that Allonger actually paid this
expense. Therefore, we cannot conclude that petitioners’ minor children
performed work for Allonger or that Allonger paid wages of $9,960 to petitioners’
children in 2012.
Petitioners have not sufficiently substantiated that they incurred any
ordinary and necessary business expenses relating to the business operations of
Allonger for the years in issue. Accordingly, we sustain respondent’s
disallowance of petitioners’ other expenses claimed on Schedules C for the years
in issue.
B. State Income Tax Refund
Generally, if an amount deducted on a prior year’s tax return resulted in a
reduction of tax and a tax benefit to the taxpayer and is subsequently recovered,
that amount must be included in gross income for the year the recovery is
received. See sec. 111(a); Kadunc v. Commissioner, T.C. Memo. 1997-92, 1997
Tax Ct. Memo LEXIS 104, at *5-*6. Therefore, gross income includes a refund of
State income tax for the year received to the extent that the payment of such tax
was claimed as a deduction for a prior taxable year which resulted in a reduction
- 14 -
[*14] of Federal income tax. See Kadunc v. Commissioner, 1997 Tax Ct. Memo
LEXIS 104, at *5-*6.
On Schedule A of their 2011 Federal income tax return petitioners claimed a
$6,206 deduction for State and local income taxes paid. In 2012 petitioners
received a State income tax refund of $5,827 from the State of Maryland for
income tax paid during 2011. Petitioners did not report this amount as income on
their 2012 Federal income tax return. Petitioners did not provide any evidence to
dispute their receipt of the refund in 2012 or explain their failure to report such
amount as income on their 2012 income tax return. Accordingly, we sustain
respondent’s determination that the $5,827 State income tax refund is includable
in petitioners’ gross income for their 2012 tax year.
C. Accuracy-Related Penalties
In the notice of deficiency respondent determined that petitioners are liable
for section 6662(a) accuracy-related penalties of $646, $1,232, and $2,023 for the
taxable years 2010, 2011, and 2012, respectively. Respondent contends that
petitioners’ underpayments of tax are attributable to either negligence or
substantial understatements of income tax. Section 6662(a) and (b)(1) and (2)
imposes an accuracy-related penalty of 20% on any portion of an underpayment
which is attributable to, among other things, negligence or intentional disregard of
- 15 -
[*15] the rules or regulations or any substantial understatement of income tax. For
purposes of section 6662, the term “negligence” includes any failure to make a
reasonable attempt to comply with the provisions of the Code, and the term
“disregard” includes any careless, reckless, or intentional disregard for the rules or
regulations. Sec. 6662(c); see also Neely v. Commissioner, 85 T.C. 934, 947
(1985). Negligence also includes any failure to exercise ordinary and reasonable
care in the preparation of a tax return or any failure to keep adequate books and
records and to properly substantiate items. Sec. 1.6662-3(b)(1), Income Tax Regs.
On the other hand, a substantial understatement of income tax exists when the
taxpayer’s understatement for the taxable year exceeds the greater of 10% of the
tax required to be shown on the return or $5,000. Sec. 6662(d)(1)(A).
The Commissioner bears the burden of production concerning the
imposition of penalties and must provide sufficient evidence indicating that it is
appropriate to impose the penalty. See sec. 7491(c); Higbee v. Commissioner, 116
T.C. 438, 446 (2001). Once the Commissioner meets his “burden of production”,
the “burden of proof” remains with the taxpayer, including the burden of proving
that the penalty is improper due to reasonable cause under section 6664. Rule
142(a); Higbee v. Commissioner, 116 T.C. at 446-447.
- 16 -
[*16] For the years in issue, we find that petitioners acted negligently by failing to
keep adequate books and records and by not exercising reasonable care given the
circumstances. Petitioners could not and did not substantiate the deductions that
respondent disallowed. That petitioners claimed Schedule C deductions that were
personal in nature and not supported by their documentation exhibits that, at the
very least, they were careless in complying with their income tax obligations.
Section 6664(c)(1) provides that the penalty under section 6662(a) shall not
apply to any portion of an underpayment if it is shown that there was reasonable
cause for the taxpayer’s position and that the taxpayer acted in good faith with
respect to that portion. See Higbee v. Commissioner, 116 T.C. at 448. The
determination of whether the taxpayer acted with reasonable cause and in good
faith is made on a case-by-case basis, taking into account all the pertinent facts
and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Petitioners have the
burden of proving that the penalty is inappropriate because of reasonable cause
under section 6664. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-
447. Petitioners have failed to argue or prove that the penalties are inappropriate
because of reasonable cause. Accordingly, we hold that petitioners are liable for
the accuracy-related penalties under section 6662(a) for their underpayments of
tax for the years in issue.
- 17 -
[*17] Petitioners are liable for accuracy-related penalties under section 6662(a).
On brief respondent states that portions of the above amounts are based on the
adjustment of refundable credits, and therefore the amounts will need to be
recalculated in a Rule 155 computation. See Rand v. Commissioner, 141 T.C. 376
(2013).
In reaching our decision, we have considered all arguments made by the
parties, and to the extent not mentioned or addressed, they are irrelevant or
without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.