T.C. Memo. 2004-140
UNITED STATES TAX COURT
KENNETH W. AND FAYETTA GRAVES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7687-02. Filed June 15, 2004.
Kenneth W. and Fayetta Graves, pro sese.
Jack H. Klinghoffer, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Chief Judge: Respondent determined a $24,921
deficiency in petitioners’ 1996 Federal income tax, a $5,818.25
addition to tax under section 6651(a)(1),1 and a $4,865.20
1
Unless otherwise stated, all section references are to the
Internal Revenue Code in effect for the taxable year in issue.
All Rule references are to the Tax Court Rules of Practice and
Procedure.
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accuracy-related penalty under section 6662. After concessions,
the issues remaining for our consideration are: (1) Whether
Kenneth W. Graves’s (petitioner) bad debt, which arose in the
course of his business as an employee, is deductible in computing
adjusted gross income or an itemized deduction in computing
taxable income; (2) whether the bad debt is $85,009 as determined
by respondent or $86,040 as now claimed by petitioners; and (3)
whether petitioners are liable for the addition to tax and
penalty under sections 6651(a)(1) and 6662, respectively.
FINDINGS OF FACT2
Petitioners resided in San Dimas, California, on the date
their petition was filed. They filed a joint Federal income tax
return for their 1996 taxable year. With respect to their 1996
return, petitioners sought a filing extension to August 15, 1997.
No further extensions were sought after the expiration of the
extension. Twenty months later, on April 16, 1999, petitioners
filed their 1996 Federal income tax return. During 1996,
petitioners received interest income. Petitioner received
pension income and unemployment compensation as well as a salary.
Mrs. Graves3 received salary and miscellaneous income as an
employee of two companies.
2
The parties’ stipulation of facts is incorporated by this
reference.
3
Mrs. Graves is a party in this case because petitioners
filed a joint return for 1996.
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Petitioner was the sole shareholder of KPS Trucking Co.,
Inc. (KPS), a corporation with 26 employees. He also was a
salaried employee of KPS, managing its daily operations. Before
1996, KPS began experiencing financial difficulties. As a
result, petitioner lent capital to KPS in an attempt to continue
business operations and to pay salaries. Petitioner made six
loans totaling $86,040.
KPS voluntarily filed for bankruptcy under chapter 7 of the
Bankruptcy Code during July 1996, and the bankruptcy proceeding
concluded on December 11, 1996. Petitioner’s loans to KPS were
the lowest in priority amongst the debts for payment, and there
were insufficient assets in the estate to satisfy KPS’s
creditors. Upon the final discharge of KPS’s debts, petitioner’s
loans remained unpaid and were worthless.
Petitioners reported an $84,7344 loss attributable to the
debt due from KPS on Schedule D, Capital Gains and Losses, of
their 1996 return. Schedule D concerns the reporting of capital
asset transactions. Petitioners also deducted the worthless debt
on page 1, line 14 of their 1996 return. Line 14 is denominated
“Other gains or (losses)”. The parties disagree as to the
treatment of the loss for tax purposes. Petitioners now contend
that they should have claimed the bad debt as a deduction on
4
Petitioners deducted $84,734 as a loss on their 1996
return but were able to substantiate $86,040 of loans at trial.
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Schedule C, Profit or Loss From Business, to arrive at their
adjusted gross income.
The loans were made in petitioner’s trade or business of
being an employee and were made to enable him to maintain his
employment with KPS. Although petitioner claimed $84,734 as a
business bad debt on his return, at trial he substantiated loans
to KPS of $86,040.
Petitioners failed to report the following items of income
on their 1996 income tax return:
Income Item Amount
Interest $3,475
State tax refund 105
Taxable pensions 29,835
Computational error 10,000
On their January 9, 2002, notice of deficiency, respondent
allowed $85,009 as a business bad debt deduction and treated it
as an itemized deduction on Schedule A, Itemized Deductions. The
amount respondent allowed is $275 greater than the amount
petitioners claimed on their 1996 return.
OPINION
The issues we consider arise from circumstances under which
petitioner lent his solely owned corporation capital so that it
could continue its operations, including the payment of salaries.
Petitioner was a salaried employee of the corporation and was in
the business of being an employee. The loans became worthless
during the 1996 tax year, and petitioner claimed the loss in
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connection with the computation of adjusted gross income.
Respondent, on the other hand, allowed the loss as an itemized
deduction in arriving at taxable income. There is also a dispute
about whether the loss is $85,009 or $86,040. Finally, we must
decide whether petitioners are liable for an addition to tax
under section 6651(a)(1) and/or an accuracy-related penalty under
section 6662.
Treatment of the Bad Debt
Section 166 provides that a business bad debt is deductible
as an ordinary deduction for the year in which the debt becomes
worthless. Specifically, section 166(a)(1) provides: “There
shall be allowed as a deduction any debt which becomes worthless
within the taxable year.” Section 166(d)(1)(A) further provides
that in the case of a taxpayer other than a corporation
“subsection (a) shall not apply to any nonbusiness debt”.
Section 166(d)(2)(A) and (B) defines a nonbusiness debt as a debt
other than:
(A) a debt created or acquired * * * in connection
with a trade or business of the taxpayer; or
(B) a debt the loss from the worthlessness of
which is incurred in the taxpayer’s trade or business.
Therefore, subsection (a) allows an ordinary loss deduction only
for business bad debts.
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Taxpayers bear the burden of showing entitlement to
deductions and must show that a bona fide debt existed and that
the debt became worthless in the year claimed.5 See sec. 166;
Rule 142(a); Dixie Dairies Corp. v. Commissioner, 74 T.C. 476,
493 (1980). The existence of a bona fide debt can be shown by
proof of 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.; see Dixie Dairies
Corp. v. Commissioner, supra. Whether a bona fide debtor-
creditor relationship exists is a question of fact to be
determined upon a consideration of the relevant facts and
circumstances. See Fisher v. Commissioner, 54 T.C. 905, 909
(1970).
It is established that being an employee may be a trade or
business for purposes of section 166. Trent v. Commissioner, 291
F.2d 669 (2d Cir. 1961), revg. 34 T.C. 910 (1960). It may be
necessary for an employee to lend money to an employer to
maintain the employee’s employment. In this case, maintaining
his employment was petitioner’s dominant motivation.
Accordingly, petitioner made the loans in his trade or business
of being an employee for purposes of section 166. Cf. id.
5
No question has been raised with respect to the burden of
proof or production under sec. 7491(a).
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Respondent concedes that petitioner’s loans were bona fide
debts that arose in the course of his trade or business of being
an employee of KPS. The parties stipulated that petitioner made
the loans to maintain his employment with KPS. The loans became
worthless during 1996 because of the bankruptcy of KPS. Finally,
petitioner was not in the trade or business of lending money;
rather, he was in the trade or business of operating a trucking
company.
In the notice of deficiency, respondent allowed $85,009 as a
bad debt deduction. However, petitioner is now claiming $86,040
for the bad debt deduction.6 The remaining question is whether
the bad debt should be allowed as a deduction from gross income
to arrive at petitioners’ adjusted gross income, or is to be
treated as an itemized deduction in computing their taxable
income.7
6
The discrepancy between $85,009 and $86,040 will be
addressed later in the opinion.
7
The significance of the parties’ dispute lies in the fact
that itemized deductions are limited by certain thresholds and
restrictions, whereas deductions used to arrive at adjusted gross
income are not. In particular, an itemized deduction in the
setting of this case would be subject to the 2-percent floor
under sec. 67.
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Respondent relies on section 62 and the related regulations
in contending that bad debt deductions in connection with the
trade or business of being an employee are treated as itemized
deductions. Section 62 provides in part:
SEC. 62(a). General Rule.--For purposes of this
subtitle, the term “adjusted gross income” means, in the
case of an individual, gross income minus the following
deductions:
(1) Trade and business deductions.--The
deductions allowed by this chapter (other than by
part VII of this subchapter) which are
attributable to a trade or business carried on by
the taxpayer, if such trade or business does not
consist of the performance of services by the
taxpayer as an employee. [Emphasis added.]
The statute provides, with exceptions none of which are
applicable here, that a taxpayer may not deduct as a trade or
business deduction items connected with the performance of
services as an employee. The parties stipulated that
petitioner’s trade or business of operating KPS consisted of his
performance of services as an employee. Under the statute, items
connected with the performance of those services are not
deductible in arriving at adjusted gross income.
Section 1.62-1T(d), Temporary Income Tax Regs., 53 Fed. Reg.
9874 (Mar. 28, 1988), further amplifies this point as follows:
“For the purpose of the deductions specified in section 62, the
performance of personal services as an employee does not
constitute the carrying on of a trade or business, except as
otherwise expressly provided.” Because petitioner’s trade or
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business consists of the performance of services as an employee,
he may not deduct the business bad debt to arrive at adjusted
gross income under section 62. Accordingly, petitioner’s
business bad debt must be treated as an itemized deduction under
section 63(d).
Because the business bad debt is deductible as an itemized
deduction, it is subject to the 2-percent floor under section 67.
Section 67(a) provides in pertinent part: “In the case of an
individual, the miscellaneous itemized deductions for any taxable
year shall be allowed only to the extent that the aggregate of
such deductions exceeds 2 percent of adjusted gross income.”
Section 67(b) defines miscellaneous itemized deductions as
itemized deductions that are not listed therein. Section 166
business bad debts are not listed under section 67(b).
Therefore, we hold that petitioner’s business bad debt deduction
is a miscellaneous itemized deduction and is subject to the 2-
percent floor under section 67.
Amount of Business Bad Debt
We next consider the amount of petitioner’s business bad
debt deduction.8 The parties disagree on the amount to be
deducted. Petitioners initially deducted $84,734 on their
Federal income tax return. After examination, respondent allowed
8
As previously noted, no question has been raised with
respect to the burden of proof or production under sec. 7491(a).
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$85,009. Petitioners are now claiming $86,040 for the business
bad debt deduction.
Petitioners contend that an amended return was sent to the
Internal Revenue Service claiming $86,040 for the business bad
debt on Schedule C and correcting the pension income. Respondent
has no record of receiving the amended return. Irrespective of
whether an amended return was filed, petitioners bear the burden
of showing the amounts of deductions. Specifically, petitioners
bear the burden of proving they are entitled to the deductions
claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); Higbee v. Commissioner, 116 T.C. 438, 440 (2001).
Respondent allowed an $85,009 business bad debt deduction in
the notice of deficiency. That allowance was $275 more than the
$84,734 petitioners claimed on their original return. At trial,
petitioner, by means of testimony and documents, substantiated
that the loans to KPS totaled $86,040. On the basis of this
evidence, we hold petitioners are entitled to a deduction for the
business bad debt in the amount of $86,040.
Addition to Tax and Accuracy-Related Penalty
Respondent determined an addition to tax under section
6651(a)(1) and an accuracy-related penalty under section 6662(a).
Section 7491(c) requires the Commissioner to carry the burden of
production in any court proceeding with respect to the liability
of any individual for any penalty, addition to tax, or additional
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amount. To meet this burden, the Commissioner must come forward
with sufficient evidence indicating that it is appropriate to
impose the relevant penalty. See Higbee v. Commissioner, supra.
If the Commissioner carries this burden, taxpayers then bear the
burden of showing that the addition or penalty does not apply;
i.e., that there was reasonable cause, substantial authority,
etc. Id.
Petitioners failed to timely file their 1996 return. In
order to be relieved of the addition to tax, petitioners must
establish that their failure was due to reasonable cause and not
willful neglect. Id.; see sec. 6651(a)(1). Reasonable cause is
shown when “the taxpayer exercised ordinary business care and
prudence and was nevertheless unable to file the return within
the prescribed time”. Sec. 301.6651-1(c)(1), Proced. & Admin.
Regs.
Petitioners’ 1996 return was due on August 15, 1997, upon
expiration of their filing extension. Petitioners did not
request a second extension. Instead, petitioners contend they
were not able to file their return until April 16, 1999, because
they were waiting for the final loss figure from the KPS
bankruptcy proceeding. Petitioners’ argument falls short,
however, because they knew the amount of the loans made to KPS.
In addition, petitioners could have filed a timely return and
later amended it if the information changed for any reason,
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including some event in the bankruptcy proceeding. Petitioners
have not shown reasonable cause for their failure to timely file.
Respondent has met his burden of production with regard to this
addition to tax. Accordingly, we hold petitioners are liable for
the addition to tax under section 6651(a)(1).
Respondent also determined petitioners are subject to a
penalty under section 6662(a). This penalty is imposed on any
portion of an underpayment of tax required to be shown on a
return when the underpayment is due to negligence or disregard of
rules or regulations, or a substantial understatement of income
tax. See sec. 6662(a) and (b).
A substantial understatement of tax is defined as an
understatement of tax that exceeds the greater of 10 percent of
the tax required to be shown on the tax return or $5,000. See
sec. 6662(d)(1)(A)(i) and (ii). The understatement may be
reduced by an amount attributable to any item for which there was
adequate disclosure and a reasonable basis for which there was
substantial authority. See sec. 6662(d)(2)(B). Section 6662(c)
defines negligence as “any failure to make a reasonable attempt
to comply with the provisions of this title”, and disregard means
any “careless, reckless, or intentional disregard.”
Respondent relies on the record, which reflects that there
was a substantial understatement in this case. That satisfies
respondent’s burden of production as to the substantial
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understatement penalty. Accordingly, petitioners must show that
the accuracy-related penalty should not be imposed with respect
to any portion of the understatement for which they acted with
reasonable cause and in good faith. See sec. 6664(c)(1); Higbee
v. Commissioner, supra at 448. The decision as to whether
petitioners acted with reasonable cause and in good faith is one
that depends on all the facts and circumstances. See sec.
1.6664-4(b)(1), Income Tax Regs. An honest misunderstanding of
fact or law that is reasonable in light of the experience,
knowledge, and education of the taxpayer may indicate reasonable
cause and good faith. See Higbee v. Commissioner, supra at 449
(citing Remy v. Commissioner, T.C. Memo. 1997-72).
Petitioner was a truck driver who was able to gradually
purchase more equipment and hire employees to drive the trucks.
Petitioner’s skills are in the trucking business. Petitioner
attempted to complete his own tax return for 1996. His confusion
as to how to properly complete the form is evidenced by his use
of Schedule D, which is used for reporting capital gains and
losses. Under section 1211(b), which applies to capital gains
and losses, petitioner would have been limited to a $3,000
deduction. Petitioner intended to claim a bad debt deduction of
$86,040.
Petitioner was forthright and fully disclosed the amount of
the business bad debt. Petitioner made an honest and good faith
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attempt at accurately reporting the bad debt. The fact that
petitioner mistakenly placed the $86,040 deduction on the wrong
line on the first page of the 1996 return corresponds with his
confusion in using Schedule D. On the basis of petitioners’
position and their reporting on page 1 of their 1996 return, they
should have reported the loss on Schedule C. Even if petitioners
had used a Schedule C, respondent contends that they would have
been negligent because the loss should have been shown on a
Schedule A as an itemized deduction.
In light of petitioner’s educational background, the
circumstances of this case, and the multiplicity of possibilities
for claiming business bad debts, petitioner has shown good faith
and reasonable cause for the way he reported the bad debt
deduction. We hold that the accuracy-related penalty does not
apply to the portion of the understatement attributable to the
adjustment concerning the bad debt.
Petitioners concede that they failed to report income from
interest, a State tax refund, and pensions in the total amount of
$33,415, resulting in a substantial underreporting of income.
Petitioners further concede that they “missed” or overlooked
Forms 1099 with the result that they underreported income.
The unreported income was substantial in amount because the
understatement of income tax exceeds the greater of 10 percent of
the tax required to be shown on the tax return or $5,000. The
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tax shown on the 1996 return was $1,174. The tax required to be
shown on the return was $26,095. Ten percent of $26,095 is
$2,609.50. The amount of the understatement of tax on
petitioners’ return is $24,921. Respondent has therefore
demonstrated that petitioners have substantially understated
their income tax for 1996.
Further, according to the regulations, negligence includes
“any failure by the taxpayer to keep adequate books and records”.
Sec. 1.6662-3(b), Income Tax Regs. In this instance petitioners
were negligent by failing to keep adequate books or records and
report the income items. Therefore, on the basis of substantial
understatement of income tax and petitioners’ failure to keep
adequate records, the accuracy-related penalty applies to the tax
on $33,415 of underreported income.
Petitioners concede that they made a $10,000 computational
error on their original return which resulted in an
underreporting of income. This computational error resulted in a
32.88-percent understatement of the income petitioners reported.
Petitioners have not provided a reasonable explanation for the
resulting portion of the understatement of income tax or shown
that they exercised reasonable care in the preparation of their
tax return. See sec. 1.6662-3(b)(1), Income Tax Regs.
Accordingly, petitioners are liable for the accuracy-related
penalty with regard to the $10,000 error.
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Petitioners also concede that they erroneously deducted
self-employment tax. The regulations provide that negligence is
shown when “A taxpayer fails to make a reasonable attempt to
ascertain the correctness of a deduction * * * on a return which
would seem to a reasonable and prudent person to be ‘too good to
be true’ under the circumstances”. See sec. 1.6662-3(b)(1)(ii),
Income Tax Regs. In these circumstances, petitioners did not
report any self-employment tax on their return, nor did they
attach the requisite schedule for such tax.
Petitioners have not provided a foundation or predicate for
claiming a self-employment tax deduction. It was not reasonable
for them to claim a deduction for self-employment tax.
Accordingly, petitioners are liable for the section 6662
accuracy-related penalty with respect to the amount of the
understatement of income tax attributable to the self-employment
tax deduction.
We have considered all of petitioners’ arguments, and to the
extent that they are not mentioned herein, we find them to be
moot or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.