GREGORY v. COMMISSIONER

T.C. Memo. 1997-75

UNITED STATES TAX COURT

KENNETH D. SHEPHERD AND MARTHA A. GREGORY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 20377-95. Filed February 12, 1997.

Kenneth D. Shepherd and Martha A. Gregory, pro se.

Cathleen A. Jones, for respondent.

MEMORANDUM OPINION

DINAN, Special Trial Judge: This case was heard pursuant

to the provisions of section 7443A(b)(3) and Rules 180, 181, and

182.1

1
Unless otherwise indicated, all section references are
to the Internal Revenue Code in effect for the taxable years in
issue. All Rule references are to the Tax Court Rules of
Practice and Procedure.
 - 2 -

Respondent determined deficiencies in petitioners' Federal

income taxes, an addition to tax, and penalties as follows:

Addition to Tax Penalties
Year Deficiency Sec. 6651(a)(1) Sec. 6662(a) Sec. 6663(a)

1991 $2,586 --- $258 $974
1992 2,002 $79 133 1,001

After concessions,2 the issues for decision are: (1)

Whether petitioners are entitled to claim trade or business

deductions; (2) whether petitioners are entitled to claim a bad

debt deduction; (3) whether petitioners are liable for the

section 6651(a)(1) addition to tax for 1992; (4) whether

petitioners are liable for the section 6663(a) penalty for fraud;

and (5) whether petitioners are liable for the section 6662(a)

accuracy-related penalty for negligence.

Some of the facts have been stipulated and are so found.

The stipulations of fact and attached exhibits are incorporated

herein by this reference. Petitioners resided in Tulsa,

Oklahoma, on the date the petition was filed in this case.

Petitioner wife worked full time as a librarian at the Tulsa

City County library. After her regular work hours, petitioner

wife performed limited research services for her brother and at

2
In their petition, petitioners failed to address
respondent's determinations that they received and failed to
report: (1) Capital gain on the sale of a mutual fund in taxable
year 1991; (2) interest income in taxable year 1992; and (3) a
state income tax refund in taxable year 1992. We deem
petitioners to have conceded these items. Rule 34(b)(4).
 - 3 -

least one other person. Petitioner husband's claimed training is

in the area of chemical engineering and electronics.

Prior to their marriage, petitioner husband was involved in

developing a golf club cleaning machine made by Ree-Born

Industries, Inc. Specifically, petitioner husband worked on

formulating the chemical solution used to clean golf clubs. He

also negotiated with Ree-Born Industries, Inc. for the rights to

market the machine to potential purchasers, such as country

clubs.

Petitioner husband experienced some financial difficulties

in his efforts to market the golf club cleaning machine. On July

1, 1989, he signed a promissory note, in the amount of $6,000,

payable to his current wife Martha Gregory. The promissory note

states that the entire debt was to be paid in a lump sum on

January 1, 1990, together with interest computed at a variable

rate. No payments were made on the moneys, if any, advanced to

petitioner husband, nor did petitioner wife ever request any such

payments.

Petitioners were married on March 15, 1990, and filed joint

Federal income tax returns for 1991 and 1992. On those returns,

petitioners claimed Schedule C deductions for alleged losses

resulting from their activity in "Information Brokering Products

& Services" operated under the name of MGO Information Services.

Petitioners also claimed a capital loss deduction in the amount

of $3,000 on their 1991 return. The deduction was claimed as a
 - 4 -

carry forward of a capital loss resulting from the 1990 write-off

by petitioner wife of petitioner husband's alleged indebtedness

to her.

The first issue for decision is whether petitioners are

entitled to claim trade or business deductions on their 1991 and

1992 returns for expenses allegedly incurred in their research

activities. In the notice of deficiency, respondent disallowed

the claimed Schedule C deductions upon the grounds that

petitioners' research activities were not engaged in for profit,

and that, with the exception of certain expenses for interest and

taxes, petitioners failed to substantiate the claimed deductions.

Respondent's determinations are presumed to be correct, and

petitioners bear the burden of proving otherwise. Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933). Furthermore,

deductions are strictly a matter of legislative grace, and

petitioners must demonstrate their entitlement to any deductions

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). This includes the requirement that petitioners

substantiate any deductions claimed. Hradesky v. Commissioner,

65 T.C. 87 (1975), affd. 540 F.2d 821 (5th Cir. 1976).

Section 162(a) allows a taxpayer to deduct the ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business. Whether an activity

constitutes the taxpayer's trade or business within the meaning
 - 5 -

of section 162(a) generally depends upon whether the taxpayer's

purpose for engaging in the activity is for income or profit, and

whether the activity is conducted with continuity and regularity.

Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987). Section

183(a) disallows any deductions attributable to "activities not

engaged in for profit" except as provided in section 183(b).

Respondent argues that petitioners' research activity was

not engaged in for profit and any claimed deductions are subject

to the limitations of section 183(b). Furthermore, respondent

contends that petitioners must substantiate any deductions

claimed. Rule 142(a).

Whether a taxpayer engaged in an activity with the primary

purpose of making a profit is a question of fact. Dreicer v.

Commissioner, 78 T.C. 642, 644-645 (1982), affd. without

published opinion 702 F.2d 1205 (D.C. Cir. 1983); sec. 1.183-

2(a), Income Tax Regs. While a reasonable expectation of profit

is not required, taxpayer's profit objective must be bona fide.

Taube v. Commissioner, 88 T.C. 464, 478-479 (1987). In making

this determination, the Court gives more weight to objective

facts than to a taxpayer's mere statement of intent. Dreicer v.

Commissioner, supra at 645; sec. 1.183-2(a), Income Tax Regs.

Section 1.183-2(b), Income Tax Regs., provides a

nonexclusive list of factors to be considered in determining

whether an activity is engaged in for profit. The factors

include: (1) The manner in which the taxpayer carried on the
 - 6 -

activity; (2) the expertise of the taxpayer or his advisers; (3)

the time and effort expended by the taxpayer in carrying on the

activity; (4) the expectation that the assets used in the

activity may appreciate in value; (5) the success of the taxpayer

in carrying on other similar or dissimilar activities; (6) the

taxpayer's history of income or losses with respect to the

activity; (7) the amount of occasional profits, if any, which are

earned; (8) the financial status of the taxpayer; and (9) whether

elements of personal pleasure or recreation are involved.

Petitioners failed to produce books or records supporting

the existence of a profit-seeking business, aside from two

personal planning diaries that contained vague notations. In

addition, their income from this activity was sporadic and

unsubstantiated. At trial, petitioner husband was able to recall

only three clients during 1991 and 1992 aside from petitioner

wife's brother. Petitioner husband testified that they received

$700 from their research activity from these clients, although it

was possible that $100 of that amount may have been received

during 1990. In addition, one of the alleged clients did not pay

petitioners for services rendered. No records were offered to

substantiate the billing of these clients or the receipt of

payments. We are not required to accept the self-serving

testimony of taxpayers without further corroborating evidence.

Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).
 - 7 -

In addition, we are particularly troubled by the failure of

petitioner wife to testify about the research activity. As a

full-time librarian for many years, petitioner wife likely

possessed significant expertise in the field of information

retrieval. In fact, Ms. Helen Page, the revenue agent assigned

to audit petitioners' returns, testified that petitioner husband

made several representations that his wife was the sole

participant in the research activity. Although present at trial,

petitioner wife did not testify in support of petitioners' claim

that they operated a research business for profit. It may be

presumed that her testimony, if given, would have been

unfavorable to petitioners. Mecom v. Commissioner, 101 T.C. 374,

385 n.17 (1993), affd. without published opinion 40 F.3d 385 (5th

Cir. 1994); Wichita Terminal Elevator Co. v. Commissioner, 6 T.C.

1158, 1165 (1946), affd. 162 F.2d 513 (10th Cir. 1947).

After considering the above factors, we find that

petitioners have failed to prove that they engaged in the

research activity with the requisite profit objective necessary

to support deductions under section 162(a).3 We hold that

petitioners are not entitled to deduct expenses related to their

research activity as trade or business expenses under section

162(a) because such activity was not engaged in for profit, but

that such expenditures may be deducted to the extent allowed by

3
Our finding on this point likewise precludes claiming
the disputed deductions under section 212(1).
 - 8 -

section 183(b). Where there is no profit objective, section

183(b)(1) allows only deductions which are allowable independent

of profit objective, and section 183(b)(2) allows other

deductions only to the extent that they do not exceed gross

income derived from the activity reduced by the deductions

allowable under section 183(b)(1).

Any deductions allowable under section 183(b)(1) are to be

deducted from adjusted gross income in computing taxable income.

Jasionowski v. Commissioner, 66 T.C. 312, 320 (1976). These

deductions may be taken only if the taxpayer itemizes his

deductions. Rev. Rul. 75-14, 1975-1 C.B. 90. Respondent

concedes that petitioners have substantiated their house-related

expenses for interest and taxes and has allowed petitioners

itemized deductions for the interest and taxes in lieu of the

smaller standard deductions claimed by them on their returns.

Petitioners' 1991 and 1992 Schedules C showed gross income

from their research activity in the amounts of $1,454 and $1,833,

respectively. For such taxable years, the itemized deductions,

in the amounts of $6,553 and $6,911, respectively, allowed under

sections 163, 164, and 183(b)(1), exceed the gross income claimed

from petitioners' research activity. Therefore, petitioners are

precluded from taking any further deductions for expenses related

to such activity even if substantiated. Sec. 183(b)(2). We

therefore sustain respondent's determination on this issue.
 - 9 -

The second issue for decision is whether petitioners are

entitled to claim a bad debt deduction for 1991. In the notice

of deficiency, respondent disallowed the claimed bad debt

deduction upon the grounds that petitioners did not establish

that a debtor-creditor relationship was intended by the alleged

loan, and, even if such relationship existed, petitioners did not

establish that the debt was worthless or that any attempt was

made to collect the loan.

As a general rule, section 166 allows a deduction for any

bad debt that becomes worthless during the taxable year. Section

166(d), however, distinguishes business bad debts from

nonbusiness bad debts. Nonbusiness bad debts may be deducted in

the same manner as short-term capital losses, subject to the

limitations on capital losses as provided in section 1211. Sec.

166(d); sec. 1.166-5(a), Income Tax Regs.

Nonbusiness bad debt means a debt other than a debt created

or acquired in connection with a trade or business of the

taxpayer or a debt the loss from the worthlessness of which is

incurred in the taxpayer's trade or business. Sec. 166(d)(2).

The use of the borrowed funds by the borrower is of no

consequence in making the determination of worthlessness. Sec.

1.166-5(b), Income Tax Regs. In this case, the alleged debt

would have been nonbusiness debt created outside petitioner

wife's trade as a librarian. The funds were allegedly advanced

so petitioner husband would be able to further market the golf
 - 10 -

club cleaning machine. At no time did petitioner wife have any

business interest in the debt.

A loss from a nonbusiness debt shall be treated as sustained

only if and when the debt becomes totally worthless, and no

deduction shall be allowed for a nonbusiness debt which is

recoverable in part during the taxable year. Sec. 1.166-5(a)(2),

Income Tax Regs. Whether and when a debt becomes worthless is a

question of fact, in which all relevant evidence is considered,

including the full value of the collateral, if any, securing the

debt and the financial condition of the debtor. Sec. 1.166-2(a),

Income Tax Regs.

The taxpayer must show that she intended to enforce

collection of the debt, but some event occurred during the

taxable year in which the deduction is sought that rendered the

debt uncollectible. Davis v. Commissioner, 88 T.C. 122, 142-144

(1987), affd. 866 F.2d 852 (6th Cir. 1989). Although the

taxpayer need not resort to legal action, she must show that the

debt became worthless in the year the debt is claimed. Sec.

1.166-2(b), Income Tax Regs.

Respondent argues that the July 1, 1989, promissory note did

not create a bona fide debt since there is no evidence that

anything of value was received by petitioner husband in

consideration of his promise to pay. In the alternative,

respondent contends that if there was a bona fide debt,
 - 11 -

petitioners have not shown that such debt became wholly worthless

in 1990 or 1991.4

After considering all of the relevant facts, we find that,

regardless of whether the promissory note signed by petitioner

husband created a bona fide debt, petitioners have not shown that

the debt became totally worthless in 1990 or 1991. The record

contains no evidence of any attempts by petitioner wife to

enforce repayment of the loan. Although petitioners were not

married at the time petitioner husband signed the loan agreement,

their marriage only 2-1/2 months after the debt's repayment date

indicates that petitioner wife decided not to collect an

otherwise collectible debt from her new husband. See Davies v.

Commissioner, 54 T.C. 170, 176 (1970). In the absence of any

credible proof supporting a finding that the loan became

uncollectible in 1990 or 1991, we find that petitioners failed to

carry their burden in that respect.

Petitioner husband testified that the loan was incurred to

finance his marketing of the golf club cleaning machine and his

failure to sell any of these units foreclosed any chance that he

would be able to repay the loan, thus making it worthless. There

4
We note that the original claim for a bad debt
deduction was in 1990, a taxable year not before the Court. This
case concerns only petitioners' claimed bad debt deduction in
1991. Our decision controls the deductibility of the debt in
1991 regardless of whether the debt first became worthless in
1990 or 1991.
 - 12 -

is no evidence in the record to support this contention, and we

reject it. We sustain respondent's determination on this issue.

The third issue for decision is whether petitioners are

liable for the section 6651(a)(1) addition to tax for failure to

timely file their 1992 Federal income tax return.

Section 6651(a) imposes an addition to tax for the failure

to timely file a return, unless the taxpayer establishes: (1)

The failure did not result from "willful neglect," and (2) the

failure was "due to reasonable cause". "Willful neglect" has

been interpreted to mean a conscious, intentional failure or

reckless indifference. United States v. Boyle, 469 U.S. 241,

245-246 (1985). "Reasonable cause" requires the taxpayer to

demonstrate that he exercised ordinary business care and prudence

and was nonetheless unable to file a return within the prescribed

time. United States v. Boyle, supra at 246. The addition to tax

equals 5 percent of the tax required to be shown on the return

for the first month with an additional 5 percent for each

additional month or fraction of a month during which the failure

to file continues, not to exceed a maximum of 25 percent. Sec.

6651(a)(1).

Petitioner husband claims that petitioners timely filed

their 1992 Federal income tax return because of the extensions

approved by respondent. Petitioners' 1992 return was filed with

respondent on November 11, 1993. Petitioners' Form 2688,

attached to their 1992 return, shows that respondent approved an
 - 13 -

extension only until October 15, 1993. Petitioners have offered

no evidence that they were granted any further extension of time.

Since no explanation for the lateness of their filing was

offered, we hold that petitioners have not proved that their

failure to timely file was due to reasonable cause rather than

willful neglect. Accordingly, we sustain respondent on this

issue.

The fourth issue for decision is whether petitioners are

liable for the section 6663(a) penalty for fraud for each of the

years in issue. Respondent determined that petitioners were

liable for the fraud penalty for underpayments attributable to

disallowed deductions for household-related business expenses.

Section 6663(b) provides that if respondent establishes that

any part of any underpayment of tax required to be shown on a

return is due to fraud the entire underpayment shall be treated

as attributable to fraud and subjected to a 75 percent penalty

unless the taxpayer establishes, by the preponderance of the

evidence, that some part of the underpayment is not attributable

to fraud.5 Respondent must establish by clear and convincing

evidence: (1) An underpayment of tax by the taxpayer, and (2)

that some part of the underpayment is due to fraud. Section

5
We note that in the notice of deficiency respondent
determined that only the portion of each underpayment resulting
from the disallowed household expenses is attributable to fraud.
Therefore we need consider the fraud issue only with regard to
that portion of each underpayment.
 - 14 -

7454(a); Rule 142(b); Clayton v. Commissioner, 102 T.C. 632, 646

(1994); King's Court Mobile Home Park, Inc. v. Commissioner, 98

T.C. 511, 515-516 (1992). Since we have already decided that

petitioners underpaid their Federal income taxes in 1991 and

1992, we need only address the issue of whether a part of that

underpayment is due to fraud.

Fraud is established by proving that a taxpayer intended to

evade tax believed to be owing by conduct intended to conceal,

mislead, or otherwise prevent the collection of such tax.

Clayton v. Commissioner, supra at 647. Direct evidence of the

requisite fraudulent intent is seldom available, but fraud may be

proved by examining circumstantial evidence indicative of the

taxpayer's motives. Recklitis v. Commissioner, 91 T.C. 874, 910

(1988). Over the years, courts have developed various factors,

or "badges", which tend to establish the existence of fraud. See

Clayton v. Commissioner, supra at 647.

Respondent contends that petitioners fraudulently attempted

to evade the payment of tax by misrepresenting that their

personal residence at 1419 Zunis Avenue was a property used

exclusively for business purposes. Petitioners maintain that

although petitioner wife did live at that residence at one time,

she and petitioner husband moved out of that house prior to the

taxable years in issue.

We find that respondent has clearly and convincingly proven

that petitioners fraudulently claimed 1419 Zunis Avenue as
 - 15 -

business property in an attempt to evade paying income tax. Mr.

Bryan Kinney, owner of the garage apartment that petitioners

claimed as their personal residence, testified that petitioners

never lived in such apartment. In addition, when initially asked

by Ms. Page, respondent's auditing agent, petitioner wife refused

to answer the simple question of where she lived. Finally, both

petitioner wife's 1991 and 1992 Forms W-2 show her home address

as 1419 Zunis Avenue. These factors, among others, convince us

that petitioners did use such address as a personal residence.

Petitioners have presented no credible evidence refuting this

finding. We therefore sustain respondent's determination that

petitioners are liable for the fraud penalty for that portion of

the underpayment attributable to disallowed household-related

expenses which petitioners claimed as business deductions.

The fifth issue for decision is whether petitioners are

liable for the section 6662(a) accuracy-related penalty for

negligence. Respondent's determination of negligence is presumed

to be correct, and petitioners bear the burden of proving that

the penalty does not apply. Rule 142(a); Welch v. Helvering, 290

U.S. 111, 115 (1933); Bixby v. Commissioner, 58 T.C. 757, 791-792

(1972).

Section 6662(a) imposes a 20-percent penalty on the portion

of the underpayment attributable to any one of various factors,

one of which is negligence or disregard of rules or regulations.

Sec. 6662(b)(1). Respondent determined that petitioners are
 - 16 -

liable for the accuracy-related penalty imposed by section

6662(a) for the portion of the underpayment not related to the

house-related expenses, and that such portion of the underpayment

of tax was due to negligence or disregard of rules or

regulations. "Negligence" includes a failure to make a

reasonable attempt to comply with the provisions of the Internal

Revenue laws or to exercise ordinary and reasonable care in the

preparation of a tax return. Sec. 6662(c); sec. 1.6662-3(b)(1),

Income Tax Regs. "Disregard" includes any careless, reckless, or

intentional disregard of rules or regulations. Sec. 6662(c);

sec. 1.6662-3(b)(2), Income Tax Regs.

However, 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 with respect to that portion and that the

taxpayer acted in good faith with respect to that portion. The

determination of whether a 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. The most important factor is

the extent of the taxpayer's effort to assess his proper tax

liability for the year. Id.

Based on the record, we find that petitioners have not

proved that any part of the underpayment for either of the years

in issue was due to reasonable cause or that they acted in good
 - 17 -

faith. Accordingly, we hold that petitioners are liable for the

section 6662(a) accuracy-related penalty as determined by

respondent.

To reflect the foregoing,

Decision will be entered

for respondent.