T.C. Memo. 1997-177
UNITED STATES TAX COURT
MACK L. MCCOY AND CATHERINE MCCOY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 9638-95. Filed April 14, 1997.
Mack L. McCoy, pro se.
Gregory J. Powers, for respondent.
MEMORANDUM OPINION
NAMEROFF, Special Trial Judge: This case was heard pursuant
to the provisions of section 7443A(b)(3)1 and Rules 180, 181, and
182. Respondent determined a deficiency in petitioners' 1991
Federal income tax in the amount of $4,200 and an accuracy-
related penalty under section 6662(a) in the amount of $840.
1
All section references are to the Internal Revenue Code
in effect for the year at issue. All Rule references are to the
Tax Court Rules of Practice and Procedure.
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The issues for decision are: (1) Whether petitioners are
entitled to a section 162 deduction for accrued expenses of
$15,000; and (2) whether petitioners are liable for the section
6662(a) accuracy-related penalty.
Background
Some of the facts have been stipulated, and they are so
found. The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time they filed
their petition, petitioners resided in Thousand Oaks, California.
References to petitioner are to Mack L. McCoy.
Petitioner is an architect by trade. In 1991, petitioner
managed an interior design firm that built model homes for
homebuilders. He worked 30 hours per week as a W-2 wage earner.
Petitioner also acted as a consultant to various individuals
under his proprietorship named Mack McCoy. As Mack McCoy’s
proprietor, petitioner provided his clients with management
services, such as marketing and overall management advice and
internal work scheduling. Petitioner indicated that his
consulting business had been on-going for about 20 years. In
1991, petitioner had one main client, a structural engineer, who
paid petitioner $2,000 per month for about five months of
services. The 1991 Schedule C for Mack McCoy reflects gross
income of $10,913.64. Petitioner used the cash method of
accounting to report Mack McCoy’s income and expenses.
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Petitioner allegedly formed another proprietorship in 1991
named The Real McCoy (Real McCoy). Petitioner's testimony
surrounding the existence and operation of Real McCoy was
sketchy. We surmise, however, that petitioner had a plan to
build industrialized (i.e., prefabricated) housing, and Real
McCoy was conceptualized to engage in the actual manufacture of
the industrialized homes.
Petitioner took no formal steps to set up Real McCoy, and he
stated it was formed just in his mind. Petitioner also indicated
that he intended someday to create a formal structure, but that
in 1991 it was just an idea. Real McCoy did not generate any
revenue for petitioner and, ultimately, never manufactured
anything. Since 1991, petitioner said he took no steps to
establish Real McCoy as an on-going business because “the market
totally went dead”. Petitioner intended to use the accrual
method of accounting to report Real McCoy’s income and expenses.
Petitioner did not invest money into Real McCoy. He stated,
however, that, while wearing his Mack McCoy hat, he drafted
architectural plans (the plans) and “sold” them to Real McCoy for
$15,000. Petitioner indicated that the plans were a useful tool
to solicit potential investors because they allowed him to
demonstrate his product on paper. Petitioner valued these plans
at $15,000. Petitioner testified that he arrived at the above
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figure using prevailing rates for similar types of architectural drawings.
According to petitioner, as proprietor of both businesses,
he took the following actions with respect to the plans: (1)
Mack McCoy drew-up the architectural plans; (2) Real McCoy agreed
to purchase the plans from Mack McCoy for $15,000; (3) Mack McCoy
delivered the plans to Real McCoy; and (4) Mack McCoy issued a
$15,000 bill to Real McCoy. Petitioner did not have any written
documentation supporting the purported transaction. Real McCoy
never paid Mack McCoy for the plans, and Mack McCoy did not
institute legal action against Real McCoy for nonpayment.
Petitioner stated that Real McCoy did not pay Mack McCoy because
“the entity never got going” and that Mack McCoy did not sue Real
McCoy because “there was nothing to gain.”
On petitioners' 1991 Schedule C for Real McCoy, petitioner
claimed a $15,000 deduction for the accrued cost of the plans.
He did not, however, include $15,000 of income on the Schedule C
for Mack McCoy. In the notice of deficiency, the Commissioner
determined that petitioners were not entitled to the $15,000
deduction because they failed to establish that they incurred an
ordinary and necessary business expense and because their method
of accounting for this deduction did not clearly reflect income.
Discussion
We begin our discussion by stating that respondent’s
determination is presumed correct, and petitioner bears the
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burden of proving otherwise. Rule 142(a); Welch v. Helvering,
290 U.S. 111, 115 (1933). Moreover, petitioner must prove
entitlement to any deduction claimed. New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 (1934).
The issue before us is whether petitioner is entitled to
accrue $15,000 as a deduction for 1991. We hold that he is not
because he failed to prove that he incurred that expense.
Section 162(a) permits the deduction of ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on a trade or business. The question of whether a
taxpayer is engaged in the active conduct of a trade or business
requires an examination of all relevant facts and circumstances.
Commissioner v. Groetzinger, 480 U.S. 23, 36 (1987). To be
deductible under section 162, expenses must relate to a trade or
business functioning at the time the expenses are incurred.
Hardy v. Commissioner, 93 T.C. 684, 687 (1989), affd. on this
point in an unpublished order of the Court of Appeals for the
Tenth Circuit filed October 29, 1990. Further, the expense must
have been incurred after the taxpayer’s trade or business
actually commenced; expenses incurred prior to that time are
nondeductible pre-opening expenses. Jackson v. Commissioner, 86
T.C. 492, 514 (1986), affd. 864 F.2d 1521 (10th Cir. 1989);
Goodwin v. Commissioner, 75 T.C. 424, 433 (1980), affd. without
published opinion 691 F.2d 490 (3d Cir. 1982); McManus v.
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Commissioner, T.C. Memo. 1987-457, affd. without published
opinion 865 F.2d 255 (4th Cir. 1988).
Real McCoy was not a functioning business in 1991. By
petitioner’s own admission, it was just an idea in his mind that
never materialized. Petitioner took no formal actions to
establish Real McCoy as a going concern, and he has yet to
commence any sort of manufacturing activity. Moreover, Real
McCoy did not generate any revenue for petitioner and,
ultimately, never manufactured anything. In sum, even though
petitioner intended to someday build industrialized housing, he
failed to demonstrate that he actually carried on that activity
during 1991.
Petitioner did not incur a binding and enforceable liability
that would have entitled him to a deduction under section 162.
Generally, an accrual method taxpayer deducts expenses in the
year in which they are incurred, regardless of when they are
actually paid. Heitzman v. Commissioner, 859 F.2d 783, 787 (9th
Cir. 1988), affg. T.C. Memo. 1987-109. A liability is incurred
for income tax purposes in the tax year in which: (1) All events
have occurred that establish the fact of the liability; (2) the
amount of the liability can be determined with reasonable
accuracy; and (3) economic performance has occurred with respect
to the liability. Sec. 1.461-1(a)(2), Income Tax Regs.; see also
sec. 461(h). In order to be accruable, a liability must be
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binding and enforceable; the liability must not be contingent on
a future event; the amount of liability must be certain; and
there must be a reasonable belief on the part of the debtor that
the liability will be paid. Putoma Corp. v. Commissioner, 66
T.C. 652, 660 (1976), affd. 601 F.2d 734 (5th Cir. 1979); United
Control Corp. v. Commissioner, 38 T.C. 957, 967 (1962). We need
not dwell on this matter at length as petitioner failed to
demonstrate that Real McCoy incurred a binding and enforceable
liability.
During opening argument, respondent likened petitioners'
situation to those disallowed by section 267, in support of the
claim that Real McCoy's deduction should not be allowed until an
equal amount of income is recognized by Mack McCoy. Generally,
section 267 requires accrual basis taxpayers to defer deductions
for amounts payable to a related person, as specified in section
267(b), until such time as the amount is includable in the
recipient's gross income.
We need not make a determination as to whether petitioner’s
situation falls within the specified relationships found within
section 267(b).2 Section 1.267(a)-1(c), Income Tax Regs.,
reflects a general principle of tax law that no deduction is
2
Sec. 267(b) does not explicitly make reference to
transactions carried out by two proprietorships owned by a single
taxpayer, although the underlying rationale of sec. 267 appears
to be applicable.
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allowed for an unpaid expense that arises from a transaction that
is not bona fide. We find that the Real McCoy’s alleged
liability did not arise from a bona fide arm’s-length
transaction. Rather, as the record reveals, the liability arose
from a dubious transaction carried out in petitioner’s own mind
and is not supported by economic reality. Petitioner’s attempt
to use differing methods of reporting income in order to obtain
this artificial deduction will not be permitted.
For the above reasons, we hold that petitioners are not
entitled to deduct the $15,000 as an accrued business expense
under section 162. We, therefore, do not have to decide whether
their method of accounting for that deduction clearly reflects
income.
We next consider whether petitioners are liable for the
section 6662(a) accuracy-related penalty asserted against them.
We hold that they are.
Section 6662 imposes a penalty equal to a 20 percent portion
of the underpayment attributable to, inter alia, negligence or
disregard of rules or regulations. "Negligence" includes failure
to make a reasonable attempt to comply with the law, and the term
"disregard" includes careless, reckless, or intentional
disregard. Sec. 6662(c). The penalty does not apply to any
portion of an underpayment for which there was reasonable cause
and with respect to which the taxpayer acted in good faith. Sec.
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6664(c); sec. 1.6664-4(a), Income Tax Regs. The Commissioner’s
determination imposing the accuracy-related penalty is presumed
correct, and the taxpayers bear the burden of proving that they
are not liable. Rule 142(a); Tweeddale v. Commissioner, 92 T.C.
501, 505 (1989).
Petitioner’s only contention raised as a defense to the
accuracy-related penalty is his reliance on respondent’s
Publication 334, entitled "Tax Guide for Small Business".
Petitioner indicated that the following two paragraphs on page
11, of the 1993 tax year version, support his deduction and
establish that his method of accounting for that deduction
clearly reflects income:
Business and personal items. You may account for business
and personal items under different accounting methods.
Thus, you may figure the income from your business under an
accrual method even though you use the cash method to figure
personal items.
Two or more businesses. If you operate more than one
business, you generally may use a different accounting
method for each separate and distinct business if the method
you use for each clearly shows your income. For example, if
you operate a personal service business and a manufacturing
business, you may use the cash method for the personal
service business but you must use the accrual method for the
manufacturing business. [Emphasis added.]
Petitioner’s reliance on the above passages does not
establish reasonable cause to support his position. Petitioner
misunderstands these paragraphs and incorrectly applied them to
his factual situation. For example, the second paragraph
comports with code section 446(d) in stating, generally, that a
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taxpayer with two separate and distinct businesses may use
different methods of accounting to report income for each
business. This provision does not have application to
petitioners’ situation, however, as Real McCoy is not a separate
and distinct trade or business and the deduction claimed by Real
McCoy did not arise from a bona fide transaction.
As illustrated, the above passages do nothing to assist
petitioner in demonstrating reasonable cause. Since petitioner
has not raised any other arguments in his defense, we find that
he has failed to satisfy his burden. Accordingly, we hold
petitioners liable for the accuracy-related penalty asserted
against them.
To reflect the foregoing,
Decision will be entered
for respondent.