T.C. Memo. 1997-511
UNITED STATES TAX COURT
KAREN ANN KEEGAN, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 26696-96. Filed November 13, 1997.
Karen Ann Keegan, pro se.
Robert W. Dillard, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PANUTHOS, Chief Special Trial Judge: This case was heard
pursuant to the provisions of section 7443A(b)(3) and Rules 180,
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181, and 182.1 Respondent determined deficiencies in
petitioner's Federal income taxes and accuracy-related penalties
under section 6662(a) as follows:
Accuracy-Related Penalty
Year Deficiency Sec. 6662(a)
1994 $5,204.00 $1,040.80
1995 4,909.37 981.87
After concessions,2 the issues for decision are: (1)
Whether petitioner underreported gross income on her return for
the taxable year 1994; (2) whether petitioner is entitled to cost
of goods sold claimed on Schedules C of her returns for the
taxable years 1994 and 1995; (3) whether petitioner is entitled
to dependency exemptions for the taxable years 1994 and 1995; (4)
whether petitioner is entitled to head-of-household filing status
for the taxable years 1994 and 1995; and (5) whether petitioner
is liable for the accuracy-related penalty under section 6662(a)
for the taxable years 1994 and 1995.
FINDINGS OF FACT
Some of the facts have been stipulated, and they are so
found. The stipulation of facts and the attached exhibits are
1
All section references are to the Internal Revenue Code
in effect for the years in issue, unless otherwise indicated.
All Rule references are to the Tax Court Rules of Practice and
Procedure.
2
Petitioner concedes that she is not entitled to car and
truck expenses claimed on Schedule C of her 1994 tax return in
the amount of $3,132.
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incorporated herein by this reference. At the time of filing the
petition, petitioner resided at Clearwater, Florida.
1. Petitioner's Schedules C
In 1988, petitioner began operating a sole proprietorship
which offered drafting services under the name Keegan &
Associates (K & A). Petitioner managed K & A and performed any
necessary bookkeeping. Petitioner's cousin, Robert Gorges, and
their daughter, Windi Keegan (Windi), worked for K & A during the
taxable years in issue.3 Since petitioner had no drafting
experience, Mr. Gorges performed any required drafting services.
In addition, Mr. Gorges operated the business when petitioner was
away. Windi answered telephones and performed other
administrative duties.
Although petitioner did not pay Windi or Mr. Gorges a fixed
salary or weekly wage, they would from time to time take cash
from K & A. In addition, many of Mr. Gorges' and Windi's living
expenses were paid out of K & A's funds. Petitioner kept no
records of the amount of cash which K & A paid for services
rendered during the taxable years in issue.
On Schedules C of her returns for the taxable years 1994 and
1995, petitioner reported gross receipts, cost of goods sold, and
expenses related to K & A as follows:
1994 1995
3
Petitioner and Mr. Gorges have never been married.
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Income:
Gross receipts $8,010 $18,285
Cost of goods sold:
Cost of labor 6,200 10,275
Materials and supplies 1,383 2,065
Other costs --- 826
Gross income 427 5,119
Expenses:
Advertising 480 566
Car and truck 3,132 ---
Taxes and licences --- 70
Utilities --- 175
Total expenses 3,612 811
Net profit or (loss) (3,185) 4,308
2. Dependency Exemption and Filing Status for 1994 and 1995
During the fall of 1994 and throughout 1995, petitioner was
a full-time student at Eckerd College, located in St. Petersburg,
Florida. Petitioner lived in a dormitory located on Eckerd
College's campus. Petitioner's expenses for tuition, room, and
board were paid through either scholarship proceeds or student
loans. When petitioner was not living at college, petitioner
stayed at a house owned by her aunt, Helen Gorges.4 Mr. Gorges
and Windi also lived in Ms. Gorges' house throughout the years
1994 and 1995. Although there was an agreement that petitioner
and/or Mr. Gorges would pay rent in the amount of $55 per week to
Ms. Gorges, neither petitioner, Mr. Gorges, nor Windi paid rent
to Ms. Gorges during the years in issue.
4
Helen Gorges is Mr. Gorges' mother.
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Windi, in addition to working for K & A, also worked at an
IGA grocery store from January 1995 to November 1995, earning
between $120 and $130 per week. Windi used her earnings for
personal expenses.
Petitioner received assistance from Federal and State
agencies during the taxable years in issue. The assistance
included food stamps for the entire taxable year 1994 and for 3
to 4 months during the taxable year 1995. Petitioner received
monthly food stamp benefits in the amount of $212 ($2,544 per
year). Petitioner, Mr. Gorges, and Windi were also covered under
Medicaid during the taxable years in issue.
Petitioner claimed Mr. Gorges and Windi as dependents on her
returns for the years 1994 and 1995, and claimed head-of-
household filing status for each of those taxable years.
3. Respondent's Adjustments for the Taxable Years 1994 and 1995
and Reconstruction of Petitioner's Income for the Taxable
Year 1994
Upon examination, respondent disallowed the cost of goods
sold claimed by petitioner on Schedules C of her 1994 and 1995
returns. Respondent also disallowed the claimed dependency
exemptions for each of the taxable years in issue and determined
that petitioner was not entitled to claim head-of-household
filing status.
In addition to these adjustments, respondent reconstructed
petitioner's income for the taxable year 1994 by using the source
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and application of funds method. As a result, respondent
determined that petitioner failed to report gross income in the
amount of $4,578. This amount was calculated as follows:
Income:
Gross wages1 $8,707
Gross receipts (Schedule C) 8,010
1993 tax refund 198
Total known sources of income $16,915
Expenses:2
Federal taxes withheld 1,668
Schedule C expenses (as verified) 480
Personal living expenses--
Bureau of Labor Statistics3 19,345
Total expenses (21,493)
Unreported income 4,578
1
In addition to her Schedule C activities, petitioner
worked for Office Depot during the taxable year 1994 and reported
wages earned in the amount of $8,707.
2
On Schedule C of her 1994 return, petitioner claimed cost
of goods sold in the amount of $7,583. Respondent disallowed
petitioner's claimed cost of goods sold, and, accordingly,
respondent's reconstruction of petitioner's income does not
reflect cost of goods sold.
3
Respondent utilized the average annual expenditures for
1994 for one person, U.S. Department of Labor, Bureau of Labor
Statistics. One component of these living expenses is the cost
of shelter in the amount of $4,089.
OPINION
We begin by noting that petitioner bears the burden of
proving that respondent's determination is erroneous. Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Moreover,
deductions are a matter of legislative grace, and petitioner
bears the burden of proving that she is entitled to any
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deductions claimed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79,
84 (1992).
1. Respondent's Reconstruction of Petitioner's Income
Pursuant to a reconstruction of petitioner's income for the
taxable year 1994, respondent determined that petitioner had
failed to report gross income in the amount of $4,578.
Taxpayers are required to maintain adequate records of
taxable income. Sec. 6001. Where a taxpayer fails to produce or
maintain adequate records from which actual income may be
ascertained, the Commissioner may reconstruct a taxpayer's income
by any method that clearly reflects income. Sec. 446(b); Goodmon
v. Commissioner, 761 F.2d 1522, 1524 (11th Cir. 1985); Petzoldt
v. Commissioner, 92 T.C. 661, 687, 693 (1989). The method of
reconstructing income need only be reasonable in light of all
surrounding circumstances. Petzoldt v. Commissioner, supra at
687.
The source and application of funds method has been regarded
as a reasonable method of determining income. United States v.
Johnson, 319 U.S. 503, 517-518 (1943); Meier v. Commissioner, 91
T.C. 273, 295-296 (1988). As explained by this Court in DeVenney
v. Commissioner, 85 T.C. 927, 930 (1985):
The * * * [source and application of funds] method
is based upon the assumption that the amount by which a
taxpayer's cash expenditures during a taxable period
exceed * * * [the taxpayer's] known sources of income
for that period is taxable income, unless the taxpayer
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can show his expenditures were made from some
nontaxable source of funds. * * *
A deficiency based upon the source and application of funds
method is presumptively correct, and the burden of proof is on
the taxpayer to prove otherwise. Rule 142(a). A taxpayer may
meet this burden by proving that assets were on hand at the
beginning of the taxable period with which to make the
expenditures, that amounts received during the year were
nontaxable, or that someone else made the expenditures. Id. at
930-931.
In this instance, respondent used the average living
expenses of one person, as provided by the Bureau of Labor
Statistics (BLS), as a basis for determining that petitioner's
income for the taxable year 1994 included the cost of supporting
herself. See Denson v. Commissioner, T.C. Memo. 1982-360
(discussing the Commissioner's reliance on BLS tables). We have
previously approved the Commissioner's use of BLS data when
reconstructing a taxpayer's income. See Giddio v. Commissioner,
54 T.C. 1530, 1533 (1970). Nevertheless, if evidence exists
which indicates that a taxpayer's living expenses for the taxable
year in question were less than the average living expenses
provided in the BLS tables, we may modify the Commissioner's
reconstruction under the source and application of funds method
to account for that difference. Denson v. Commissioner, supra.
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Petitioner admitted at trial that she refused to provide
respondent with any of K & A's bank statements for each of the
taxable years in issue. Petitioner also refused to provide
respondent with any billing statements issued by K & A to its
customers during the taxable year 1994. This documentation could
have permitted respondent to ascertain the correctness of the
reported income. Given the absence of any documentation in the
record, we find that respondent was reasonable in reconstructing
petitioner's income under the source and application of funds
method.
Despite our conclusion that respondent was reasonable in the
determination to reconstruct petitioner's income, the record
indicates that petitioner's living expenses were less than the
average living expenses provided in the BLS tables. The average
living expenses provided in the BLS tables includes costs for
shelter in the amount of $4,089.5 During the taxable year 1994,
however, petitioner did not incur any rent or mortgage expense.
Accordingly, we reduce petitioner's living expenses, as reflected
in respondent's reconstruction, by the amount of $4,089.
Consequently, we conclude that petitioner failed to report income
5
Respondent did not include any funds expended for
dormitory lodging. Since the record reflects that such lodging
was paid out of loans or scholarship funds, such payments would
be properly excluded from a source and application of funds
analysis.
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during the taxable year 1994 in the amount of $489 ($4,578 less
$4,089).
2. Cost of Goods Sold
Respondent disallowed the cost of goods sold which
petitioner claimed on Schedules C of her returns for the taxable
years 19946 and 1995.
In disallowing the cost of goods sold claimed by petitioner
for 1995, respondent did not contest petitioner's
characterization of the items in question as costs of goods sold
rather than as claims for deductible expenses under section 162.
The cost of goods sold is subtracted from gross receipts for
purposes of determining gross income, whereas business expenses
are deducted from gross income. Hahn v. Commissioner, 30 T.C.
195, 197 (1958), affd. per curiam 271 F.2d 739 (5th Cir. 1959).
In effect, cost of goods sold, unlike business expenses, is
excluded from gross income. Section 1.61-3(a), Income Tax Regs.,
provides that "In a manufacturing, merchandising, or mining
business, 'gross income' means the total sales, less the cost of
goods sold".
6
We do not consider respondent's adjustment to cost of
goods sold for 1994. Any allowance by the Court would result in
an increase in petitioner's expenditures, which would have the
effect of increasing income under the source and application of
funds analysis. Since we have fully addressed respondent's
reconstruction of petitioner's income for 1994, we see no reason
to address separately respondent's adjustment with respect to
costs of goods sold for 1994.
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Petitioner's business provided drafting services, and
nothing in the record indicates that K & A was engaged in
manufacturing or merchandising. Therefore, we consider the cost
of goods sold in question to be claims for business expense
deductions under section 162.
Section 162(a) provides that there shall be allowed as a
deduction all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or
business. Section 6001 requires that a taxpayer liable for any
tax shall maintain such records, render such statements, make
such returns, and comply with such regulations as the Secretary
may from time to time prescribe. To be entitled to a deduction
under section 162(a), therefore, a taxpayer is required to
substantiate the deduction through the maintenance of books and
records.
In the event that a taxpayer establishes that he or she has
incurred a deductible expense, but is unable to substantiate the
precise amount of the expense, we may estimate the amount of the
deductible expense. Cohan v. Commissioner, 39 F.2d 540, 543-544
(2d Cir. 1930). We cannot estimate deductible expenses, however,
unless the taxpayer presents evidence sufficient to provide some
rational basis upon which estimates may be made. Vanicek v.
Commissioner, 85 T.C. 731, 743 (1985).
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Petitioner's claimed expenses for the taxable year 1995
relate to the cost of labor, the cost of materials and supplies,
and "other costs". We first address petitioner's claims for
expenses relating to labor costs. Although petitioner kept no
documentation concerning amounts paid by K & A for services
rendered and testified that the amounts reflected on the returns
were estimates, we are convinced that Mr. Gorges and Windi
performed services for K & A and were compensated. Particularly,
petitioner's lack of drafting experience serves as strong
indication that she relied upon Mr. Gorges to perform necessary
drafting services. Moreover, given petitioner's status as a
full-time student during the fall of 1994, we are convinced that
petitioner relied upon Windi to perform various administrative
duties while petitioner was not available. In return, K & A
provided for a portion of Mr. Gorges' and Windi's living
expenses. Employing the rule of Cohan v. Commissioner, supra, we
conclude that petitioner is entitled to a deduction for
compensation paid to Mr. Gorges and Windi in the amount of $5,000
for 1995.
We now address petitioner's claims for expenses relating to
materials and supplies and "other costs" with respect to the
taxable year 1995. Petitioner testified that, in similar fashion
to the claimed labor expenses, the amounts reflected on her
return as expenses for materials and supplies and for "other
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costs" were estimated. Petitioner failed to provide any detailed
testimony concerning these claimed expenses and offered no
written substantiation. We, therefore, have no basis to make an
estimate. Petitioner has failed to meet her burden of proving
entitlement to these claimed expenses. Rule 142(a).
Accordingly, we sustain respondent's determination to that
extent.
3. Dependency Exemption and Filing Status for 1994 and 1995
(a) Dependency
Section 151(c) allows an exemption amount for each
dependent: (1) Whose gross income for the taxable year is less
than the exemption amount, or (2) who is a child of the taxpayer
and is a student who has not attained the age of 24 at the close
of such calendar year. Sec. 151(c)(1)(A) and (B)(ii).
Dependents are generally defined as individuals who receive over
half of their support from a taxpayer in the calendar year in
which that taxpayer's taxable year begins. Sec. 152(a).
For purposes of determining whether or not an individual
received over one-half of his or her support from the taxpayer
during a given calendar year, there shall be taken into account
the amount of support received from the taxpayer as compared to
the entire amount of support which the individual received from
all sources. Sec. 1.152-1(a)(2)(i), Income Tax Regs. Support
includes amounts which an individual has contributed to his or
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her own support. Sec. 1.152-1(a)(2)(ii), Income Tax Regs. To
determine whether a taxpayer has furnished over half of an
individual's support, there must be included the cost of food,
shelter, clothing, medical and dental care, education, and the
like. Sec. 1.152-1(a)(2)(i), Income Tax Regs. Although the
amount of an item of support is usually its cost, where lodging
is furnished to an individual, the amount of support is the fair
market value of such lodging. Id. Welfare payments or similar
public assistance received directly by a claimed dependent, or
received by the taxpayer for the benefit of a claimed dependent,
are not considered support furnished by the taxpayer. Gulvin v.
Commissioner, 644 F.2d 2 (5th Cir. 1981), affg. T.C. Memo. 1980-
111; Williams v. Commissioner, T.C. Memo. 1996-126, affd. without
published opinion 119 F.3d 10 (11th Cir. 1997).
In cases where two or more persons contribute to the support
of an individual, section 152(c) provides that a taxpayer is
treated as contributing over one-half of the support of an
individual for the calendar year if: (1) No one person
contributed over half of the individual's support; (2) over half
of such support was received from persons each of whom, but for
the fact that he or she did not contribute over half of such
support, would have been entitled to claim such individual as a
dependent for the taxable year beginning in such calendar year;
(3) the taxpayer contributed over 10 percent of such support; and
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(4) each person described in (2) (other than the taxpayer) who
contributed over 10 percent of such support files a written
declaration that he or she will not claim such individual as a
dependent for any taxable year beginning in such calendar year.
Respondent argues that petitioner is not entitled to the
claimed dependency exemptions because she did not provide over
one-half of the support for Windi and Mr. Gorges during the
taxable years in issue. Petitioner bears the burden of proof on
this issue. Rule 142(a); Seraydar v. Commissioner, 50 T.C. 756,
760 (1968).
Petitioner offered little evidence concerning the amount of
support she provided to Mr. Gorges or Windi. Furthermore, Mr.
Gorges and Windi resided rent-free in a home owned by Ms. Gorges,
and they received Government benefits during each of the years in
issue. In this regard, Ms. Gorges did not file a written
declaration that she would not claim either Mr. Gorges or Windi
as dependents on her return. Sec. 152(c). Moreover, Mr. Gorges
and Windi worked, received income, and provided for their own
personal living expenses during each of the years in issue.
Accordingly, petitioner has failed to establish that she is
entitled to the claimed exemptions for either Mr. Gorges or Windi
during each of the taxable years in issue. Therefore, respondent
is sustained on this issue.
(b) Filing Status
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Petitioner claimed head-of-household filing status on her
returns for the taxable years 1994 and 1995. Under section
2(b)(1), a taxpayer who is unmarried may file a return as "head
of household" if that taxpayer maintains as his or her home a
household which constitutes for more than one-half of such
taxable year the principal place of abode of certain described
individuals.
In this case, petitioner has failed to establish that she
maintained a household within the meaning of section 2(b).
Petitioner neither owned nor paid rent for the house where Windi
or Mr. Gorges resided during the taxable years in question.
Moreover, Mr. Gorges is not a person who comes within the
provisions of section 2(b)(1) and section 151. Accordingly, we
sustain respondent on this issue.
4. Accuracy-Related Penalty Under Section 6662(a)
Respondent determined that petitioner was liable for the
accuracy-related penalty under section 6662(a) for the taxable
years 1994 and 1995. The accuracy-related penalty is equal to 20
percent of any portion of an underpayment attributable to a
taxpayer's negligence or disregard of rules or regulations. Sec.
6662(a) and (b)(1). The term "negligence" includes any failure
to make a reasonable attempt to comply with the provisions of the
Internal Revenue Code, and the term "disregard" includes any
careless, reckless, or intentional disregard. Sec. 6662(c). The
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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. 6664(c). Generally,
taxpayers bear the burden of proving that they are not liable for
the accuracy-related penalty imposed by section 6662(a). Rule
142(a); Tweeddale v. Commissioner, 92 T.C. 501, 505 (1989).
Petitioner has failed to offer any evidence to suggest that
she acted with reasonable cause and good faith with respect to
the issues discussed herein. Petitioner has failed in her burden
of proving that she is not liable for the accuracy-related
penalty. We, therefore, sustain respondent's determination that
petitioner is liable for the accuracy-related penalty under
section 6662(a) for the taxable years 1994 and 1995.
To reflect the foregoing,
Decision will be entered
under Rule 155.