T.C. Memo. 1999-303
UNITED STATES TAX COURT
KANHUA & LIHYING YOUNG, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8215-98. Filed September 15, 1999.
Lihying Young, pro se.
Roger W. Bracken, for respondent.
MEMORANDUM OPINION
PANUTHOS, Chief Special Trial Judge: Respondent determined
deficiencies in petitioners' Federal income taxes in the amounts
of $4,230 and $1,330 for the taxable years 1994 and 1995.
Respondent also determined petitioners were liable for accuracy-
related penalties under section 6662(a) in the amounts of $846
and $266 for 1994 and 1995, respectively. Unless otherwise
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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.
The issues for decision are: (1) Whether petitioners
properly reported amounts of rental income and deductions on
Schedule E of their 1994 and 1995 Federal income tax returns; (2)
whether petitioners are entitled to deduct S corporation losses
claimed on Schedule E of their 1994 and 1995 Federal income tax
returns; and (3) whether petitioners are liable for the accuracy-
related penalty pursuant to section 6662(a) for both years 1994
and 1995. Petitioners filed a timely petition with this Court.
At the time of filing the petition, petitioners resided in
Rockville, Maryland.
Background
Petitioner Kanhua Young was employed as an economist by the
U.S. Department of Commerce during the years in issue.
Petitioner Lihying Young (hereinafter petitioner) is also an
economist and the sole owner and president of OMNIX, an S
corporation. To the extent that OMNIX conducted any business
activity, such activity occurred at petitioners' home.
Petitioners timely filed their 1994 and 1995 Federal income
tax returns. Petitioners reported the following items of income
and expense on their Federal tax returns for the years in issue:
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Form 1040 - Individual Income Tax Return
1994 1995
Wages $79,880 $82,153
Taxable interest 793 521
Dividend income 1,082 1,046
Taxable refunds -0- 1,714
Capital gain/loss (1,095) 2,085
Schedule E (set forth below) (22,321) (13,032)
Total income 58,339 74,487
Less: Itemized deductions 19,493 19,260
Exemptions 4,900 5,000
Taxable income 33,946 50,227
Schedule E - Supplemental Income and Loss
1994 1995
Rents received $20,400 $20,400
Expenses:
Insurance $1,078 $955
Mortgage interest 7,233 8,169
Taxes 1,945 1,989
Utilities 689 1,063
Depreciation 1,863 1,863
Total 12,808 14,039
Income 7,592 6,361
Less: Loss from S corp.
(Schedule K-1) 29,913 19,393
Net Loss (22,321) (13,032)
OMNIX reported the following items of income and expense:
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Form 1120S - Income Tax Return for an S Corporation
1994 1995
Gross receipts $11,000 $9,000
Deductions:
Rent $20,400 $20,400
Tax/licenses 155 649
Advertising 977 989
Professional dues &
subscriptions 2,037 3,683
Photocopying & postage 10,685 205
Books & supplies 3,694 174
Transportation 1,218 1,200
Legal costs & consulting 1,747 1,093
Total 40,913 28,393
Net loss (29,913) (19,393)
In the notice of deficiency, respondent disallowed all items
of expense relating to the rental activity. Respondent also
reduced petitioners' income by the $20,400 of reported rental
income for each year in issue. Respondent allowed petitioners'
home mortgage interest and tax deductions as itemized deductions
on Schedule A for each year in the identical amounts as claimed
and disallowed on Schedule E. In addition, respondent disallowed
the losses claimed on Schedules E in the amounts of $29,913 and
$19,393 for 1994 and 1995, respectively. These losses are S
corporation losses reported to petitioners on Schedules K-1 from
OMNIX.
Discussion
1. General
We begin by noting that the Commissioner's determinations
are presumed correct. See Rule 142(a); Welch v. Helvering, 290
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U.S. 111, 115 (1933). Deductions are a matter of legislative
grace, and the taxpayer bears the burden of proving that they are
entitled to the claimed deduction. See Rule 142(a); New Colonial
Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
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,
therefore, a taxpayer is required to substantiate the deduction
through the maintenance of books and records. In addition,
section 262 denies a deduction for any personal, living, or
family expenses.
2. Schedule E - Rental Income & Expense
Petitioner testified that the rental income and expenses
claimed on Schedule E relate to her business, OMNIX. She asserts
that she conducted economic research and some marketing through
OMNIX, which was conducted out of the home owned by both
petitioners. She testified OMNIX' business office consisted of
the entire area in the house with the exception of two bedrooms.
Petitioner testified that she charged OMNIX rent in the
amount of $1,500 per month ($18,000 annually) for the use of the
home. Petitioner also testified that she would write checks from
OMNIX to her husband for the rent. However, she did not write
the checks on a monthly basis, but "maybe altogether one check or
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two check". Petitioners paid total annual mortgage payments for
their home in 1994 and 1995 in the amount of $18,000. In
addition to the rental of the home, petitioner testified that she
also charged OMNIX a $200 monthly rental fee for the use of the
household car. Petitioners included the $18,000 rent for use of
the home and the $2,400 rent for use of the household car as
income on their Schedule E for the years in issue.
Petitioner provided no written records or other
substantiation for the rental income and rental expenses claimed
on Schedule E as required under section 6001. It is evident from
petitioner's testimony that the rental transactions did not
actually take place, but were "paper entries" for what petitioner
felt were "fair rental values" for the use of her car and home by
OMNIX. Petitioner has provided no records or credible testimony
to show that the transactions took place or that the expenses
were incurred. Accordingly, we conclude that petitioners did not
have rental income from OMNIX as reported on Schedules E during
1994 and 1995, nor did they incur rental expenses relating to
OMNIX, deductible on Schedules E. Respondent is sustained on
this issue.
3. Schedule E - S Corporation Losses
Petitioner testified that OMNIX received $11,000 and $9,000
in income during 1994 and 1995. Petitioner asserts that the
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source of income was her children and other individuals for whom
advice was provided by OMNIX.
Respondent asserts that OMNIX' claimed expenses are not
"ordinary and necessary" expenses incurred in the carrying on of
business. Respondent also asserts that the disputed items
claimed have not been substantiated.
Section 162 generally allows a deduction for ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on a trade or business. An ordinary and necessary
expense is one which is appropriate and helpful to the taxpayer's
business and which results from an activity which is common and
accepted practice. See Boser v. Commissioner, 77 T.C. 1124, 1132
(1981), affd. without published opinion (9th Cir. 1983); Shores
v. Commissioner, T.C. Memo. 1998-193; Irwin v. Commissioner, T.C.
Memo. 1996-490, affd. without published opinion 131 F.3d 146 (9th
Cir. 1997). Whether an expense is "ordinary and necessary" is
generally a question of fact. See Commissioner v. Heininger, 320
U.S. 467, 475 (1943); Walliser v. Commissioner, 72 T.C. 433, 437
(1979); Shores v. Commissioner, supra.
OMNIX claimed deductions for business expenses in the
amounts of $40,913 and $28,393 in 1994 and 1995, respectively.
Petitioner has provided no credible testimony regarding the
expenses at issue. Testimony given on the matter was both vague
and inconsistent. We cannot conclude that OMNIX conducted any
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business activity in the years in issue. Petitioner has provided
no records to show that the expenses claimed were actually
incurred, as required by section 6001, although petitioner claims
to keep adequate records with regard to her activities. We
conclude that petitioners are not entitled to the claimed
expenses pursuant to section 162 and are thus not entitled to the
net losses claimed in the amounts of $29,913 and $19,393 for 1994
and 1995, respectively. Respondent is sustained on this issue.
4. Accuracy-Related Penalty Under Section 6662(a)
Respondent determined petitioners were liable for the
accuracy-related penalty under section 6662(a) for 1994 and 1995.
The accuracy-related penalty is equal to 20 percent of any
portion of an underpayment of tax required to be shown on the
return that is attributable to the taxpayer's negligence or
disregard of rules or regulations. See sec. 6662(a), (b)(1).
"Negligence" consists of any failure to make a reasonable attempt
to comply with the provisions of the Internal Revenue Code. Sec.
6662(c). "Disregard" consists of any careless, reckless, or
intentional disregard. Id.
An exception applies to the accuracy-related penalty when
the taxpayer demonstrates (1) there was reasonable cause for the
underpayment, and (2) he acted in good faith with respect to such
underpayment. Sec. 6664(c). Whether the taxpayer acted with
reasonable cause and in good faith is determined by the relevant
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facts and circumstances. The most important factor is the extent
of the taxpayer's effort to assess his proper tax liability. See
Stubblefield v. Commissioner, T.C. Memo. 1996-537; sec. 1.6664-
4(b)(1), Income Tax Regs. Sec. 1.6664-4(b)(1), Income Tax Regs.,
specifically provides: "Circumstances that may indicate
reasonable cause and good faith include an honest
misunderstanding of fact or law that is reasonable in light of
the experience, knowledge and education of the taxpayer."
It is the taxpayer's responsibility to establish that he is
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 did not address this issue at trial or in
any pleadings filed with the Court. Petitioners claimed expenses
and losses which they failed to explain or substantiate
adequately as required under section 6001. On the basis of the
entire record, we conclude petitioners have not established the
underpayment was due to reasonable cause and that they acted in
good faith. Accordingly, we hold petitioners are liable for the
accuracy-related penalty.
To reflect the foregoing,
Decision will be entered
for respondent.