T.C. Memo. 2003-170
UNITED STATES TAX COURT
CATHY M. AND RANDY L. CROSSON, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 10101-01. Filed June 10, 2003.
Cathy M. and Randy L. Crosson, pro sese.
Thomas D. Yang, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: Respondent determined a $13,339 Federal
income tax deficiency and a $2,667.80 penalty under section
6662(a)1 for petitioners’ 1999 taxable year. The issues for our
consideration are: (1) Whether petitioners have shown their
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable year at
issue.
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entitlement to certain business deductions; (2) whether
petitioners are entitled to claim a bad debt loss; and (3)
whether petitioners are liable for an accuracy-related penalty.
FINDINGS OF FACT
At all times pertinent to this case, petitioners were
married and resided in Clarendon Hills, Illinois. Petitioners
filed a joint 1999 Federal income tax return, which they prepared
themselves. On that return, they reported $85,355 in wages and
$461 in interest income. They also claimed $81,289 as a business
loss. That loss was shown on a Schedule C, Profit or Loss from
Business. Randy L. Crosson (petitioner) was reflected on the
Schedule C as a “Special Trade Contractor” who operated the
business on the cash method for reported income and deductions.
No income was reported on the Schedule C, and the claimed $81,289
loss comprised $58,067 in bad debts, $12,374 in car and truck
expenses, and the remainder in various expense categories, as
follows: $420 in legal and professional services, $116 in office
expenses, $299 in vehicle or equipment rent, $357 in supplies,
$1,655 in taxes and licenses, $312 in travel, $2,018 in meals and
entertainment, $4,046 in utilities, and $1,625 in other expenses.
Petitioners did not itemize deductions on the Schedule A,
Itemized Deductions; instead, they used the standard deduction.
The wages and the claimed loss coupled with the standard
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deduction and exemptions resulted in no taxable income reflected
on petitioners’ 1999 return.
Petitioners claimed that the bad-debt loss resulted from
thefts of equipment and unpaid obligations of clients, which were
evidenced by several proofs of claim filed in a debtor’s
bankruptcy during 1995. During the early 1990s, petitioner was a
subcontractor who installed fire protection systems under the
name “Industrial Fire Protection, Inc.”.
Police reports dated November 9, 1990, and November 10,
1994, contained petitioner’s allegations that certain of his
equipment had been stolen from jobsites.
Duane O’Malley was petitioner’s debtor, and petitioner filed
various claims in Mr. O’Malley and his wife’s joint bankruptcy
proceedings. Petitioner’s claims included claims for unpaid
services rendered by petitioner and claims resulting from six
legal actions during 1990, 1992, 1994, and 1995.
Petitioner had a contentious and convoluted relationship
with the O’Malleys. Petitioner sued the O’Malleys twice during
1990 for breach of contract. In one suit he received a $2,970
judgment, which was satisfied in the amount of $3,256.34,
including interest. The other case was dismissed for want of
prosecution and refiled in 1994. Also during 1990, petitioner
was convicted of grand theft and forgery on account of his
wrongfully charging more than $3,000 on Mr. O’Malley’s business
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account. As part of a plea bargain, a restraining order was
entered barring petitioner from contact with Mr. O’Malley, his
family, or his business. Likewise, during 1991, Mr. O’Malley was
convicted for solicitation of petitioner’s murder.
During 1991, petitioner again sued Mr. O’Malley for wages as
an employee and subcontracting fees. Mr. O’Malley settled for
$2,100. During 1992, petitioner reportedly sued his own business
entity, which was a corporation, and a $5,200 judgment (plus
costs) was entered in his favor. Mrs. O’Malley was listed as a
garnishee in that proceeding. From 1993 to the time of trial of
this income tax case, various police reports reflected that Mrs.
O’Malley and her children made complaints about petitioner on
account of his alleged physical attacks or verbal threats.
The distribution report of the O’Malley bankruptcy reflected
that petitioners had filed claims in the amounts of $5,285,
$139,000, $5,000,000, $6,551.08, and $142,765.83, all of which
were disallowed.
Petitioner filed for bankruptcy during October 1998. In his
bankruptcy filing, petitioner designated that the value of the
claims he had filed in the O’Malley bankruptcy was zero and
that his stolen equipment had a value in excess of $25,000.
Petitioner was discharged from his bankruptcy on February 25,
1999.
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Respondent examined petitioners’ 1999 Federal income tax
return and requested substantiation of the deductions claimed on
the Schedule C. Petitioners failed to offer substantiation, and
on May 25, 2001, respondent issued a statutory notice of
deficiency disallowing the Schedule C deductions, including the
claimed “bad debts”.
OPINION
Petitioner, on a Schedule C attached to petitioners’ joint
Federal income tax return, reported no income and claimed
deductions nearly equaling the amount of their wages reflected on
Forms W-2, Wage and Tax Statement. The claimed deductions must
be tested under sections 162(a), 165(a) and (c), and 166(a)(1).
We first address the section 162 deductions.
Section 162(a) provides deductions for “all the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business”. Deductions are strictly a
matter of legislative grace, and taxpayers must comply with
specific requirements for any deduction claimed. INDOPCO, Inc.
v. Commissioner, 503 U.S. 79, 84 (1992). Respondent determined
that petitioners failed to substantiate the claimed deductions
and/or to show that they were incurred in a trade or business.2
2
No question has been raised with respect to the burden of
proof under sec. 7491(a).
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A taxpayer is required to maintain sufficient records to
establish the amounts of income and deductions. Sec. 6001;
Higbee v. Commissioner, 116 T.C. 438, 440 (2001); sec. 1.6001-
1(a), Income Tax Regs. Petitioners have failed to provide any
substantiation to respondent or to this Court in support of the
claimed deductions for the $12,374 in car and truck expenses,
$420 in legal and professional services, $116 in office expenses,
$299 in vehicle or equipment rent, $357 in supplies, $1,655 in
taxes and licenses, $312 in travel, $2,018 in meals and
entertainment, $4,046 in utilities, and $1,625 in other expenses.
In addition to failing to substantiate the above expenses,
petitioners have failed to show that any were incurred in a trade
or business. See Kornhauser v. United States, 276 U.S. 145, 153
(1928); O’Malley v. Commissioner, 91 T.C. 352, 361 (1988), affd.
972 F.2d 150 (7th Cir. 1992). Petitioner was engaged in a trade
or business in some years prior to 1999, but the record does not
show that petitioner was engaged in a trade or business during
1999.
In addition, with respect to the $312 in travel, $12,374 in
car and truck expenses, and $2,018 in meals and entertainment,
petitioners are subject to the requirements of section 274.
Section 274(d)(4) provides that such deductions are not allowed
unless the taxpayer substantiates by adequate records
or by sufficient evidence corroborating the taxpayer’s
own statement (A) the amount of such expense or other
item, (B) the time and place of the travel,
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entertainment, amusement, * * * (C) the business
purpose of the expense or other item, and (D) the
business relationship to the taxpayer of persons
entertained * * *
As with the other business expenses, petitioners did not submit
or offer any substantiation. Accordingly, petitioners are not
entitled to the section 162 deductions claimed on the Schedule C.
On their Schedule C, petitioners also claimed a $58,067
section 166 bad debt loss, which allegedly includes the theft of
business equipment and unpaid amounts owed to petitioner for his
services.
The record does not reflect, with any specificity, the
portion of the $58,067 attributable to the theft or unpaid
obligations for services. Any theft loss would be covered under
section 165, whereas any business bad debt would be covered under
section 166.
On their bankruptcy petition, petitioners listed the loss
from the equipment theft as an amount in excess of $25,000. The
record (in particular the police reports) reflects that the
claimed equipment thefts occurred almost 10 years before the
taxable year under consideration (1999). In that regard, theft
losses are allowable in the year sustained and are treated as
sustained in the year the taxpayer discovers the loss. Sec.
165(c)(3), (e); sec. 1.165-8(a)(1) and (2), Income Tax Regs.
Accordingly, petitioners would not be entitled to claim the
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losses described in the police reports. There is no evidence in
this record which shows a theft loss was sustained during 1999.
Section 166(a)(1) authorizes a deduction for a business bad
debt that becomes worthless during the year. To be entitled to
the deduction, petitioners must prove (1) that a bona fide debt
was created obligating the debtor to pay a fixed or determinable
sum of money, (2) that the debt was created or acquired in
proximate relation to a trade or business, and (3) that the debt
became worthless in the year claimed. United States v. Generes,
405 U.S. 93, 96 (1972); Calumet Indus., Inc. v. Commissioner, 95
T.C. 257, 284 (1990). A debt is bona fide if it arose “from a
debtor-creditor relationship based upon a valid and enforceable
obligation to pay a fixed or determinable sum of money.” Sec.
1.166-1(c), Income Tax Regs.
The debts petitioners claimed are for unpaid fees for
petitioner’s services. Petitioners used the cash method for
reporting income and deductions; therefore, fees for services
that remain unpaid have not been included in income. Such debts
do not constitute “bad debts” within the meaning of section 166
for which a deduction for worthlessness may be claimed. See
Gertz v. Commissioner, 64 T.C. 598, 600 (1975).
With respect to any of the claimed “bad debts” that are not
attributable to unpaid claims for services, petitioners have not
shown that there were debt obligations or that they became
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worthless during 1999. Cimarron Trust Estate v. Commissioner, 59
T.C. 195 (1959); Flood v. Commissioner, T.C. Memo. 2001-39.
Although petitioners claimed the loss in 1999, the record shows
that petitioners deemed the debt worthless as of October 1998,
when petitioner filed his bankruptcy petition. Accordingly,
petitioners are not entitled to the business bad debt deduction.
As we have found that petitioners are not entitled to their
claimed deductions, we consider next whether petitioners are
liable for a section 6662 accuracy-related penalty for
negligence. Section 6662(a) provides that if any portion of any
underpayment is due to negligence, then a taxpayer will be liable
for a penalty equal to 20 percent of the underpayment of tax
required to be shown on the return that is attributable to the
taxpayer’s negligence. Negligence is defined as “the lack of due
care or failure to do what a reasonable and ordinarily prudent
person would do” under the circumstances. Niedringhaus v.
Commissioner, 99 T.C. 202, 221 (1992). “Negligence” includes the
failure to make a reasonable attempt to comply with the
provisions of the Internal Revenue Code and also includes any
failure to keep adequate books and records or to substantiate
items properly. Id.; sec. 1.6662-3(b)(1), Income Tax Regs.
With respect to the accuracy-related penalty, respondent
bears the burden of production. Sec. 7491(c); Higbee v.
Commissioner, 116 at 446. In that regard, respondent “must come
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forward with sufficient evidence indicating that it is
appropriate to impose” the accuracy-related penalty. Id.
Respondent contends that he has met that burden. The record
reveals that petitioners have failed to comply with the
requirements of the Internal Revenue Code, including their
failure to maintain adequate books and records and/or to
substantiate the claimed business deductions.
A taxpayer may avoid the accuracy-related penalty by showing
that (1) there was reasonable cause for the underpayment, and (2)
he acted in good faith with respect to such underpayment. Sec.
6664(c)(1). Whether a taxpayer acted with reasonable cause and
in good faith is determined by the relevant facts and
circumstances, and most importantly, the extent to which he
attempted to assess his proper tax liability. Sec. 1.6664-
4(b)(1), Income Tax Regs.
Petitioners have offered no evidence to show that they kept
adequate books or can substantiate their claimed deductions.
Moreover, petitioners have not shown that there was reasonable
cause for the underreporting of their 1999 tax liability.
Accordingly, petitioners are liable for the section 6662(a)
accuracy-related penalty.
To reflect the foregoing,
Decision will be entered
for respondent.