T.C. Memo. 2005-67
UNITED STATES TAX COURT
LAURA D. SEIDEL, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 8964-03. Filed March 31, 2005.
Laura D. Seidel, pro se.
John Strate and Rex Lee, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOLDBERG, Special Trial Judge: Respondent determined a
deficiency in petitioner’s Federal income tax of $24,593 and an
additional tax of $4,397.87 pursuant to section 72(t) for the
taxable year 1999. Unless otherwise indicated, section
references are to the Internal Revenue Code in effect for the
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year in issue, and all Rule references are to the Tax Court Rules
of Practice and Procedure.
After concessions by the parties, the issues for decision
are: (1) Whether petitioner received a taxable distribution of
$77,000 from Lee Seidel’s (petitioner’s former husband) section
401(k) plan (401(k) plan) pursuant to a Qualified Domestic
Relations Order (QDRO) which designated her as the alternate
payee; (2) whether petitioner is entitled to business deductions
and cost of goods sold claimed on Schedule C, Profit or Loss From
Business, for an activity named Port of Mystery, involving the
sale and repair of antique jewelry; (3) whether petitioner is
liable for the 10-percent additional tax pursuant to section
72(t) because she received an early distribution from her own
401(k) plan and from Lee Seidel’s 401(k) plan; (4) whether
petitioner is entitled to an additional itemized deduction on
Schedule A, Itemized Deductions, for taxable year 1999 for
mortgage interest in the amount of $2,471.09; (5) whether
petitioner is entitled to an additional itemized deduction for
legal fees in the amount of $2,058.50 paid to Robert Fruitman,
petitioner’s divorce attorney, in taxable year 1999; and (6)
whether petitioner underwent more than one inspection of her
books of account for taxable year 1999.
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FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits thereto are
incorporated herein by this reference. Petitioner resided in
Yuba City, California, on the date the petition was filed in this
case.
Taxability of 401(k) Distribution Pursuant to a QDRO
Petitioner married Lee Seidel (Mr. Seidel) on October 23,
1993. During the marriage, Mr. Seidel was employed by the
California Water Service Company (CWSC). Mr. Seidel’s employment
with CWSC commenced in 1974 and continued beyond the dissolution
of the marriage. As an employee of CWSC, Mr. Seidel was a
participant in a tax-deferred savings plan (CWSC 401(k))
sponsored by CWSC pursuant to section 401(a) and (k). Mr.
Seidel’s participation in the CWSC 401(k) plan began sometime
between 1983 and 1985, prior to his marriage to petitioner, and
continued during the marriage. Mr. Seidel’s CWSC 401(k) plan
consisted of a separate property interest for contributions made
prior to his marriage to petitioner, and a community property
interest for contributions made during his marriage to
petitioner. The parties agree that the community property
interest in Mr. Seidel’s CWSC 401(k) plan totals $77,000.
Petitioner and Mr. Seidel each entered the marriage with
separate property interests. Petitioner had her own house which
was encumbered by a first mortgage. Mr. Seidel had his own house
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which he had purchased. Mr. Seidel’s house was encumbered by a
first and second mortgage. After their marriage, Mr. Seidel
moved into petitioner’s house.
During the beginning years of their marriage, petitioner and
Mr. Seidel took out a second mortgage on petitioner’s house. The
proceeds of this second mortgage were used to pay off the second
mortgage on Mr. Seidel’s house, to pay off some of petitioner’s
debts, and to purchase household assets.
Petitioner and Mr. Seidel separated on February 11, 1998.
During settlement negotiations to dissolve the marriage,
petitioner was represented by attorney, Robert Fruitman (Mr.
Fruitman). Mr. Seidel was represented by his attorney, Francis
L. Adams (Mr. Adams). The marriage was dissolved by the Superior
Court of California, County of Sutter (California Superior
Court), on April 27, 1999.
With respect to the division of Mr. Seidel’s CWSC 401(k)
plan, petitioner and Mr. Seidel agreed to a Marital Settlement
Agreement, dated April 19, 1999, and entered by the California
Superior Court on April 27, 1999, which provided:
the parties presently have a partial community interest
[$77,000.00] in Husband’s 401K and Husband has a partial
separate property interest in his 401K. The parties agree
that the sum of SEVENTY SEVEN THOUSAND DOLLARS AND NO/100
($77,000.00) shall be withdrawn from the 401K plan held in
Husband’s name. Husband will then deduct the federal and/or
state penalties and the federal and state taxes and any
other taxes for early withdraw [sic] from that amount, and
from that remaining balance, Husband shall arrange for the
payment of the two (2) debts owed to First Community
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Financial Services, which are secured by deeds of trust on
wife’s home. After those two (2) debts are paid, any
balance of the proceeds shall be split equally between the
parties. Any proceeds remaining in Husband’s 401K plan
shall be confirmed to Husband as his sole and separate
property.
The Marital Settlement Agreement was reviewed by Lillick &
Charles, LLP, Attorneys at Law (Lillick & Charles), and by the
administrator of the CWSC 401(k) plan, for whom Lillick & Charles
acted as counsel. Based upon this review, the plan administrator
refused to comply with the Marital Settlement Agreement because
it did not constitute a QDRO. Due to Mr. Seidel’s continuing
employment, the plan administrator would not distribute the
called for amount to Mr. Seidel.
Mr. Fruitman and Mr. Adams negotiated a second Marital
Settlement Agreement which incorporated a Domestic Relations
Order (DRO). They submitted the proposed QDRO with their
respective party’s approval to Lillick & Charles on May 28, 1999.
The Marital Settlement Agreement did not provide for the payment
of funds from petitioner to Mr. Seidel for use in making the
mortgage interest payment at issue in the present case.
Petitioner expressly waived all spousal support in the Marital
Settlement Agreement.
Lillick & Charles advised Mr. Fruitman and Mr. Adams on June
7, 1999, that the proposed DRO was satisfactory, met the
requirements of a QDRO, and that the plan administrator would
make the distribution pursuant to the QDRO.
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On July 19, 1999, Mr. Seidel, Mr. Adams, petitioner, and Mr.
Fruitman signed a Stipulation and Order with respect to the QDRO.
This Stipulation and Order, which was stamped “Endorsed Filed
Aug. 3, 1999" by the Superior Court of the State of California,
requested that the Court issue an order as follows:
1. A completed Qualified Domestic Relations Order will be
prepared and submitted to the Plan for approval and the Plan
will advise counsel of their approval prior to the
signatures of the parties and their counsel and prior to
the submission to the court.
The parties presently have a partial community interest
($77,000.00) in Husband’s 401K and Husband has a partial
separate property interest in his 401K. The parties agree
that the sum of SEVENTY SEVEN THOUSAND DOLLARS AND ZERO
CENTS ($77,000.00) shall be withdrawn from the 401K plan in
Wife’s name, as an Alternate Payee, and paid over to
Wife’s attorney. The Plan’s administrators will
automatically withhold a portion of the Federal and State
tax obligation resulting from early withdrawal of the funds.
Wife’s attorney will pay out of the remaining fund balance
an amount sufficient to pay off the two (2) debts owed to
First Community Financial Services (in the approximate
amount of $28,000), which are secured by a deed of trust on
Wife’s home. The remaining fund balance shall be used to
pay Husband the sum of TEN THOUSAND DOLLARS AND ZERO CENTS
($10,000.00). Any remaining balance shall belong to Wife.
Wife’s attorney shall accomplish all disbursements from the
withdrawn funds within thirty (30) days of receipt. Any
proceeds remaining in Husband’s 401K plan shall be confirmed
to husband as his sole and separate property.
The QDRO issued by the Superior Court of the State of
California on August 3, 1999, was stamped “Endorsed Filed”. This
QDRO stated in paragraph 4:
The AP [alternate payee] account will be distributed upon
receipt by the Plan of an endorsed filed copy of this
Qualified Domestic Relations Order and an endorsed filed
copy of the Stipulation and Order that concerns this
Qualified Domestic Relations Order.
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Unlike the Stipulation and Order filed August 3, 1999, this QDRO
made no mention of the distribution of $10,000 to Mr. Seidel or
the distribution of funds to pay the debts secured by the deed of
trust. However, the QDRO incorporated into its terms the
Stipulation and Order.
Petitioner, through her attorney as her agent, received a
net distribution of $60,060 ($77,000 less Federal and State taxes
withheld of $16,940). Petitioner also received a Form 1099,
Distributions from Pensions, Annuities, Retirement or Profit-
Sharing Plans, issued by New York Life Insurance Company for
taxable year 1999 reflecting a taxable distribution of $77,000.
Upon receipt of this distribution, petitioner did not redeposit
the funds into the CWSC 401(k) plan, nor did she roll the funds
over into any other qualified plan within the 60-day grace period
allowed by section 402(c).1
On August 27, 1999, petitioner signed cashier’s checks as
follows:
1
Although a qualified pension plan is exempt from taxation
under sec. 501(a), any amounts actually distributed from such a
plan generally must be included in the distributee’s gross
income. Sec. 402(a). In order to avoid the tax consequence of a
plan distribution, the distributee may “roll over” the amount of
the distribution into another eligible plan within 60 days. Sec.
402(c).
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Check Number Payee Amount
2016074195 Lee Seidel $10,000.00
2016074191 First Community
Financial Services $24,159.662
2016074192 First Community
Financial Services $6,847.462
Also during 1999, petitioner received a $10,141.98
distribution from Putnam Investments (her own 401(k) plan) and a
$11,567.62 distribution from Standard Insurance Company.
However, petitioner reported total pension and annuity
distributions on her 1999 Federal income tax return of only
$40,172. This amount represents one-half of the net distribution
from Mr. Seidel’s CWSC 401(k) plan of $30,030 and $10,142
received from Putnam Investments. Therefore, respondent in the
notice of deficiency adjusted petitioner’s pension and annuity
income upward by $58,537. In the notice of deficiency respondent
determined (1) that petitioner failed to report the $11,567
distribution from Standard Insurance Company, and the additional
$46,970 distribution from New York Life from Mr. Seidel’s CWSC
2
These check payments made to First Community Financial
Services were made to pay off the principal balance of a second
mortgage on petitioner’s house, which was a liability assumed
during petitioner and Mr. Seidel’s marriage, and as such was a
joint liability, and to pay off another unspecified joint
liability.
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401(k) plan, and (2) that petitioner was not entitled to a $5,442
“cost of goods sold” deduction on Schedule C.3
Although petitioner reported one-half of the net
distribution of $60,060, or $30,030 in gross income on her 1999
Federal income tax return, she claimed the entire credit of
$15,400 for the Federal income tax withheld on the $77,000
distribution from Mr. Seidel’s CWSC 401(k) plan, together with an
itemized deduction on Schedule A of $1,540 for the State and
local income taxes withheld on the $77,000 distribution.
Mr. Seidel did not report any part of the distribution from
the CWSC 401(k) plan on his Form 1040, U.S. Individual Income Tax
Return, for taxable year 1999.
Following the examination by the Internal Revenue Service
(IRS) of Mr. Seidel’s and petitioner’s 1999 Federal income tax
returns, Mr. Seidel took the position that petitioner should
include the full amount of the distribution of $77,000 in her
income for 1999, and petitioner took the position that Mr. Seidel
should include one-half of the distribution in his income. As a
result, respondent issued notices of deficiency to both Mr.
Seidel and petitioner to avoid the possibility of being in a
whipsaw position. Respondent determined that Mr. Seidel failed
to report $30,030 (one-half of the net distribution) in his
3
The amount of $5,442 which was disallowed by respondent is
actually the total net loss reported on Schedule C from
petitioner’s activity, Port of Mystery.
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income for 1999, and petitioner was responsible for additional
income in the amount of $46,970. Mr. Seidel filed a petition to
this Court at docket No. 8003-03S, in which he contested his
liability as to the additional one-half of the net distribution
from his CWSC 401(k) plan. Mr. Seidel’s case and this case were
tried separately on the Court’s San Francisco, California, Trial
Session beginning on March 1, 2004.
Port of Mystery
During 1997, petitioner began an activity under the name
Port of Mystery, to sell and repair antique and estate jewelry.
Although petitioner had no prior experience in this field,
petitioner claimed she had an “eye” for jewelry. During taxable
year 1999, petitioner did not maintain books and records for Port
of Mystery, such as a general ledger or other appropriate
journals. However, petitioner did attach a Schedule C, Profit or
Loss from Business, to her 1999 Federal income tax return. On
her Schedule C, petitioner claimed as follows:
Income Amount
Gross receipts $750
Less: Cost of goods sold 4,449
Gross profit (3,699)
Gross income (3,699)
Expenses
Advertising $25
Car and truck expenses 273
Depreciation and section 179 expense 181
Travel expenses 150
Utilities 394
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Other expenses:
Show booth expenses 500
Bank fees 120
Security 6% 57
Pest control 6% 43
Total expenses $1,743
Net Business Loss $5,442
As part of her business expenses, petitioner claimed a truck
and automobile expense of $273 on her original return and
increased such expense to $451 on her “amended return”.4
However, no actual log of expenses or mileage was kept as to
petitioner’s claimed automobile expense. Petitioner did keep
documents of jewelry shows that she claims she attended and
records of clients’ addresses that petitioner allegedly visited
on business matters. Petitioner did not keep a mileage log for
any business trips made in taxable year 1999. As to her other
business expenses, petitioner does not know how these expenses
and deductions were calculated.
Petitioner was disabled and unable to work from February to
June 1999. While on disability, petitioner spent no time on her
jewelry activity, the Port of Mystery. During taxable year 1999,
petitioner participated in only two shows to exhibit Port of
Mystery jewelry. The first show was a 3-day show which was held
in Sacramento, California; the second was a 2-day show which was
held in Marysville, California.
4
Such amended return was not filed with the Internal Revenue
Service but was merely exchanged with respondent’s counsel as
part of the parties’ informal document exchange.
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Petitioner admitted that she “didn’t know anything about
antique and estate jewelry as to value before [she] started the
business.” During taxable year 1999, petitioner purchased a
considerable number of books and periodicals to assist her in
learning the business of selling and repairing antique and estate
jewelry.
Additional Tax--Section 72(t)
During taxable year 1999, petitioner received a taxable
distribution from her 401(k) plan held by Putnam Investments of
$10,412. Petitioner was “nearing [her] 40th birthday” in 1999.
Audit Examination
Petitioner timely filed a Form 1040 for taxable year 1999.
Petitioner attached to her Form 1040 for taxable year 1999 a
“Special Handling” cover letter requesting a review of her
return. Respondent mailed petitioner a letter dated June 9,
2000, thanking her for her inquiry and stating that the IRS had
not “resolved the matter.” Petitioner received a letter dated
September 14, 2001, advising her that based upon review of third
party records, respondent proposed changes to her Form 1040 for
taxable year 1999. Petitioner never entered into a closing
agreement with the IRS with respect to taxable year 1999.
Petitioner never received a letter stating that the IRS had
accepted her 1999 tax return, nor had she received a letter
stating that her 1999 tax return had been audited as requested.
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Petitioner also submitted a Form 1040X, Amended U.S. Individual
Income Tax Return, for taxable year 1999 to respondent’s counsel
as part of the parties’ informal document exchange but did not
file the Form 1040X with the IRS.
OPINION
As a general rule, the determinations of the Commissioner in
a notice of deficiency are presumed correct, and the taxpayer
bears the burden of proving the Commissioner’s determinations in
the notice of deficiency to be in error. Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933).
1. Taxability of 401(k) Distribution Pursuant to a QDRO
As previously stated, because Mr. Seidel took the position
that petitioner should include the full amount of the
distribution in income and petitioner took the position that Mr.
Seidel should include one-half of the distribution in income,
respondent issued notices of deficiency to Mr. Seidel and
petitioner to avoid the possibility of being in a whipsaw
position. Thus, respondent asserted that Mr. Seidel was
responsible for including the unreported income in the amount of
$30,030 on his 1999 tax return, and respondent also asserted that
petitioner was responsible for including in income the amount of
$46,970 representing the difference between $77,000 and the
$30,030 reported on her 1999 tax return.
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In the present circumstance, respondent is caught in a
potential “whipsaw” position. A whipsaw occurs when different
taxpayers treat the same transaction involving the same items
inconsistently, thus creating the possibility that income could
go untaxed or two unrelated parties could deduct the same
expenses on their separate returns. In such circumstances,
respondent is fully entitled to defend against inconsistent
results by determining in notices of deficiency that both parties
to the transaction are liable for the deficiency. Estate of
Dooley v. Commissioner, T.C. Memo. 1992-557; Moore v.
Commissioner, T.C. Memo. 1989-306.
Petitioner contends that Mr. Seidel should be liable for
one-half of the QDRO distribution: (1) Due to the community
property law of California; or (2) due to the “beneficial receipt
of the proceeds by Mr. Seidel”. We note that contrary to her
contention, petitioner claimed the entire credit of $15,400 for
the Federal income tax withheld on the total $77,000 distribution
from Mr. Seidel’s CWSC 401(k) plan, together with the entire
itemized deduction of $1,540 for the State and local income taxes
withheld on the $77,000 distribution.
Generally, under section 402(a), a distribution from a
qualified retirement plan is taxed to the distributee. Section
402(a) provides in part:
Except as otherwise provided in this section, any
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amount actually distributed to any distributee by any
employees’ trust described in section 401(a) which is exempt
from tax under section 501(a) shall be taxable to the
distributee, in the taxable year of the distributee in which
distributed, under section 72 (relating to annuities).
Under section 402(a), the general rule is that a distribution
from an exempt employees’ trust (under a tax-qualified employees’
plan) is taxed to the “distributee” under section 72, which
generally provides for current taxation of distributions as
ordinary income.
The Code does not define the word “distributee” as used in
section 402(a), neither do the regulations. The Court has
concluded that a distributee of a distribution under a plan
ordinarily is the participant or beneficiary who, under the plan,
is entitled to receive the distribution. See Darby v.
Commissioner, 97 T.C. 51, 58 (1991); Estate of Machat v.
Commissioner, T.C. Memo. 1998-154; Smith v. Commissioner, T.C.
Memo. 1996-292.
Section 402(e)(1)(A), however, provides an exception to this
general rule. Section 402(e)(1)(A) provides that an “alternate
payee” who is the spouse or former spouse of the plan participant
shall be treated as the distributee of any distribution or
payment made to the “alternate payee” under a “qualified domestic
relations order” as defined in section 414(p). Therefore, a
distribution made to such an alternate payee under a QDRO will be
taxable to the alternate payee, and not to the plan participant,
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because section 402(e)(1)(A) treats the alternate payee as the
distributee.
The Retirement Equity Act of 1984 (REA 1984), Pub. L. 98-
397, sec. 204(b), 98 Stat. 1445, added section 414(p), which
defines a QDRO. Section 414(p) provides, in pertinent part, the
following:
SEC. 414(p). Qualified Domestic Relations Order Defined.--
For purposes of this subsection and section 401(a)(13)--
(1) In General.--
(A) Qualified domestic relations order.--The term
“qualified domestic relations order” means a domestic
relations order--
(i) which creates or recognizes the existence
of an alternate payee’s right to, or assigns to an
alternate payee the right to, receive all or a
portion of the benefits payable with respect to a
participant under a plan, and
(ii) with respect to which the requirements
of paragraphs (2) and (3) are met.
(B) Domestic Relations Order.-–The term “domestic
relations order” means any judgment, decree, or order
(including approval of a property settlement agreement)
which--
(i) relates to the provision of child
support, alimony payments, or marital property
rights to a spouse, former spouse, child, or other
dependent of a participant, and
(ii) is made pursuant to a State domestic
relations law (including a community property
law).
Prior to the enactment of the Retirement Equity Act, some courts
had held that State law domestic support orders assigning or
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attaching pension benefits were preempted by ERISA’s spendthrift
provision. S. Rept. 98-575, at 20 (1984), 1984-2 C.B. 447, 456
(recognizing conflicting decisions). Congress’s primary intent
in recognizing the QDRO exception was to clarify that these
domestic support obligations did not fall within the scope of
ERISA preemption. See Mackey v. Lanier Collection Agency &
Serv., Inc., 486 U.S. 825, 838-839 (1988).
The parties are in agreement that Mr. Seidel’s CWSC 401(k)
plan meets the requirements of section 401(a). That being so,
distributions from the CWSC 401(k) plan are governed by section
402.
Petitioner relies on Powell v. Commissioner, 101 T.C. 489
(1993), in arguing that the funds distributed through the QDRO
remained community property and should be taxed as an indirect
distribution. Interpreting Darby v. Commissioner, supra, the
Court in Powell v. Commissioner, supra at 498, stated that “an
owner was not necessarily a distributee and * * * [that Darby]
specifically observed that its statement that a ‘distributee’ had
to be a participant or beneficiary was not an exclusive
definition of that word.” Applying the law as modified by REA
1984, the Court in Powell found that the plan participant’s
former spouse was the “distributee” and thereby taxable on her
share of the pension benefits. Id.
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The QDRO incorporated by its own terms the Stipulation and
Order filed August 3, 1999. The QDRO also included a calculation
of the community property interest in Mr. Seidel’s CWSC 401(k)
plan and the Stipulation and Order provided for the division of
such community property interest. The terms of the Stipulation
and Order governed petitioner’s actions and those of her attorney
as to the proceeds received through the distribution from Mr.
Seidel’s CWSC 401(k) plan. The Stipulation and Order required
petitioner’s attorney to pay out of the fund so distributed,
within 30 days of its receipt by him, two liabilities owed
jointly by petitioner and Mr. Seidel to First Community Financial
Services, and to pay to Mr. Seidel $10,000. In fact,
petitioner’s attorney made these payments, and petitioner never
actually received the proceeds that went to fulfill these
obligations.
Based on the particular facts of this case, we find that
under the present QDRO, which by its terms incorporated the
Stipulation and Order filed August 3, 1999, petitioner was
alternate payee of only a portion of the distribution; i.e.,
$51,497. This amount consists of the whole distribution of
$77,000 less $25,503. The amount of $25,503 is attributable to
Mr. Seidel as beneficiary and distributee, and it consists of
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$15,503, which is one-half of the two joint liabilities paid off
by the proceeds of the CWSC 401(k) distribution, plus the $10,000
check given to Mr. Seidel from the proceeds of the CWSC 401(k)
distribution in compliance with the Stipulation and Order.
Therefore, petitioner is liable for the tax on the
additional portion of the distribution in the amount of $21,467,
which she has not reported and of which she was the beneficiary
and alternate payee.
As stated in Powell v. Commissioner, supra at 498-499:
Our conclusion is not affected by the fact that initially
the entire distribution was made to [petitioner]. We think
[she] received the distribution * * * on behalf of the
community and that [her] later payment to [Mr. Seidel], [by
way of cash and relief of joint liabilities], was a transfer
to [him] of funds that at all times belonged to [him].
2. Schedule C Deductions for the Port of Mystery
Under section 162, a taxpayer may deduct the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on his or her trade or business. A taxpayer is engaged
in a trade or business if the taxpayer is involved in the
activity (1) with continuity and regularity, and (2) with the
primary purpose of making a profit. Commissioner v. Groetzinger,
480 U.S. 23, 35 (1987); Antonides v. Commissioner, 893 F.2d 656,
659 (4th Cir. 1990), affg. 91 T.C. 686 (1988).
Petitioner has the burden of proving that she was engaged in
a trade or business, i.e., Port of Mystery, and that she is
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entitled to the deductions claimed.5 Rule 142(a); INDOPCO, Inc.
v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 (1934); Welch v. Helvering, 290 U.S.
111 (1933). Section 7491(a) shifts the burden of proof to the
Commissioner respecting tax liability under certain
circumstances. The burden does not shift in this case because
petitioner neither alleged that section 7491(a) was applicable
nor established that she fully complied with the statutory
substantiation requirements of section 7491 as shown below. Sec.
7491(a)(2)(A) and (B).
If petitioner fails to establish Port of Mystery’s
entitlement to the deductions under section 162,6 and fails to
show error in respondent’s determination that Port of Mystery was
an activity not engaged in for profit, then section 183 limits
5
The Internal Revenue Service Restructuring & Reform Act of
1998, Pub. L. 105-206, sec. 3001, 112 Stat. 726, added sec.
7491(a), which is applicable to Court proceedings arising in
connection with examinations commencing after July 22, 1998.
Under sec. 7491(a), Congress requires the burden of proof to be
placed on the Commissioner, where a taxpayer introduces credible
evidence with respect to factual issues relevant to ascertaining
the taxpayer’s liability for tax, and meets certain other
requirements. In the instant case, petitioner has not raised the
application of this provision, and petitioner has not presented
such credible evidence, nor met all other applicable
requirements; therefore, the burden remains with petitioner.
6
Sec. 183(c) provides that an activity is not engaged in for
profit if the activity is “other than one with respect to which
deductions are allowable for the taxable year under section 162
or under paragraph (1) or (2) of section 212.”
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Port of Mystery’s deductions for expenses attributable to the
activity, as provided in section 183(b).
Section 162(a) allows a deduction for ordinary and necessary
business expenses paid or incurred during the taxable year in
carrying on any trade or business. To be “ordinary” the
transaction which gives rise to the expense must be of a common
or frequent occurrence in the type of business involved. Deputy
v. du Pont, 308 U.S. 488, 495 (1940). To be “necessary” an
expense must be “appropriate and helpful” to the taxpayer’s
business. Welch v. Helvering, supra at 113-114.
Deductions are a matter of legislative grace, and the
taxpayer bears the burden of proving that he or she is entitled
to any deduction claimed. Rule 142(a); New Colonial Ice Co. v.
Helvering, supra. This includes the burden of substantiation.
Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), affd. per
curiam 540 F.2d 821 (5th Cir. 1976).
Section 6001 and the regulations promulgated thereunder
require taxpayers to maintain records sufficient to permit
verification of income and expenses. As a general rule, if the
trial record provides sufficient evidence that the taxpayers have
incurred a deductible expense, but the taxpayer is unable to
adequately substantiate the precise amount of the deduction to
which he or she is otherwise entitled, the Court may estimate the
amount of the deductible expense and allow the deduction to that
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extent, bearing heavily against the taxpayer whose inexactitude
in substantiating the amount of the expense is of his own making.
Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930). However, in
order for the Court to estimate the amount of an expense, the
Court must have some basis upon which an estimate may be made.
Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). Without
such a basis, any allowance would amount to unguided largesse.
Williams v. United States, 245 F.2d 559, 560-561 (5th Cir. 1957).
Further, section 274(d) prohibits the estimation of expenses for
travel or deductions with respect to certain listed property;
thus, the Cohan rule does not apply to these types of expenses.
Sanford v. Commissioner, 50 T.C. 823, 827-828 (1968), affd. per
curiam 412 F.2d 201 (2d Cir. 1969). Listed property includes
automobiles. Sec. 280F(d)(4).
During taxable year 1999, petitioner did not maintain books
and records for her jewelry activity, Port of Mystery, such as a
general ledger or other appropriate journals. Petitioner
purportedly kept “notes” of cash receipts received through her
activity. However, petitioner claims that she could not produce
such receipts because her computer, which contained a record of
such receipts and notes, “crashed”. Petitioner did not attempt
to reconstruct her records after her computer purportedly failed.
Petitioner claimed she incurred cost of goods sold in the
amount of $4,449 on her original return but changed such claim
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for cost of goods sold to $2,007 on her “amended return”.7
However, as stated above, petitioner did not maintain proper
books or even notes to substantiate such a claim. Therefore, we
hold that petitioner is not entitled to any claim for cost of
goods sold during the taxable year 1999.
Petitioner claimed a truck and automobile expense of $273 on
her original return and has increased such expense to $451 on her
“amended return”. No actual log of expenses or mileage was kept
as to petitioner’s claimed automobile expense. However,
petitioner did keep documents of shows that she claims she
attended and records of clients’ addresses that petitioner
allegedly visited on business matters. In addition, petitioner
introduced into evidence parking receipts from Sacramento and a
check from a client in the Bay Area, both of which petitioner
claims substantiates her travel to these areas. Petitioner
attempts to use these such documents to substantiate her claimed
automobile expense. However, petitioner did not keep a mileage
log for such trips.
Aside from the above-mentioned parking receipts, check, and
other documents, petitioner offered no further records to
substantiate her travel or automobile expenses. Her evidence
7
Such amended return, as previously noted, was not filed
with the Internal Revenue Service but was merely exchanged with
respondent’s counsel as part of the parties’ informal document
exchange.
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does not meet the substantiation requirements of section 274
because it does not show mileage traveled, route taken, or
business purpose of these expenses. Sec. 274(d).
As to petitioner’s other Schedule C deductions, including
utilities expense, cable expense, and bank charges, petitioner
testified that she did not know how these deductions were
calculated. She did not substantiate such expenses. Therefore,
this Court holds that such deductions are not allowed and
respondent’s disallowance of such deductions is sustained.
Due to our holding that petitioner has not substantiated any
of the claimed Schedule C deductions for Port of Mystery, it is
not necessary for us to determine whether Port of Mystery was an
activity engaged in for profit.
3. Additional Tax--Section 72
Generally, section 72(t)(1) imposes a 10-percent additional
tax on early distributions from qualified retirement plans,8
unless the distribution comes within one of several statutory
exceptions. For example, distributions that are made on or after
the date on which the taxpayer attains the age of 59½ are not
“early”, and therefore not subject to the 10-percent additional
tax. Sec. 72(t)(2)(A)(i). As relevant to the present case,
section 72(t)(2)(C) provides an exception for distributions “to
8
As relevant to the present case, a “qualified retirement
plan” includes an individual retirement account (IRA) and a
qualified pension or profit-sharing plan. Sec. 4974(c)(1), (4).
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an alternate payee pursuant to a qualified domestic relations
order”.
In the present situation, the QDRO, issued in connection
with Mr. Seidel’s CWSC 401(k) plan, designated petitioner as the
alternate payee of $51,497 of the distribution as we have found.
Therefore, petitioner is not liable for the 10-percent additional
tax pursuant to section 72(t) with respect to the portion of the
$77,000 distribution from Mr. Seidel’s CWSC 401(k) plan that is
includable in her gross income as the alternate payee. Sec.
72(t)(2)(C).
However, petitioner concedes that she received a taxable
distribution from her 401(k) plan held by Putnam Investments for
taxable year 1999 in the amount of $10,412. Petitioner also
testified that she was “nearing [her] 40th birthday” in the
taxable year 1999. Therefore, the distribution from petitioner’s
401(k) plan is considered “early” and subject to the 10-percent
additional tax, unless one of the enumerated statutory exceptions
applied. Petitioner put forth no arguments that an exception
applied to such distribution; thus the distribution of $10,412
from Putnam Investments is subject to the 10-percent additional
tax under section 72(t).
4. Mortgage Interest Deduction
Section 163(a) allows a deduction for all interest paid or
accrued within the taxable year on indebtedness. Section
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163(h)(1), however, provides that, in the case of a taxpayer
other than a corporation, no deduction is allowed for personal
interest. Qualified residence interest is excluded from the
definition of personal interest and thus is deductible under
section 163(a). See sec. 163(h)(2)(D). Qualified residence
interest is any interest which is paid or accrued during the
taxable year on acquisition indebtedness or home equity
indebtedness. See sec. 163(h)(3)(A). Acquisition indebtedness
is any indebtedness secured by the qualified residence of the
taxpayer or incurred in acquiring, constructing, or substantially
improving the qualified residence. See sec. 163(h)(3)(B). Home
equity indebtedness is any other indebtedness secured by the
qualified residence to the extent the aggregate amount of such
indebtedness does not exceed the fair market value of the
qualified residence reduced by the amount of acquisition
indebtedness on the residence. See sec. 163(h)(3)(C)(i). The
amount of home equity indebtedness for any taxable year cannot
exceed $100,000. See sec. 163(h)(3)(C)(ii). The indebtedness
generally must be an obligation of the taxpayer and not an
obligation of another. See Golder v. Commissioner, 604 F.2d 34,
35 (9th Cir. 1979), affg. T.C. Memo. 1976-150.
However, a deduction with respect to interest arising out of
a joint obligation of a taxpayer and another party is only
allowable to the taxpayer to the extent he or she makes payment
- 27 -
of the interest out of his or her own funds. See Finney v.
Commissioner, T.C. Memo. 1976-329, and authorities cited therein.
In Finney, the taxpayer and his wife were separated during
the taxable year 1971 and held a residence as tenants by the
entirety during that year. Although the mortgage interest
payments were nominally made by the taxpayer’s wife, this Court
concluded that he had satisfied his burden of proving that the
funds used to make the interest payments were his funds, and he
was therefore entitled to the deduction. However, in reaching
this conclusion we relied upon a stipulation entered into between
respondent, the husband, and the wife that the funds used to make
the interest payments were supplied by the husband.
Another case dealing with this issue is Kohlsaat v.
Commissioner, 40 B.T.A. 528 (1939). In Kohlsaat, the Board of
Tax Appeals9, likewise, concluded that taxpayer-husband was
entitled to a deduction for mortgage interest payments made with
respect to a former marital residence even though the payments
were nominally made by his ex-wife. However, in that case the
divorce decree provided that in addition to his obligation to
make monthly alimony payments to his ex-wife, he was directed to
pay $225 per month to his ex-wife, and she was directed to use
these funds to make the mortgage payments for which he was
9
The Revenue Act of 1942, ch. 619, 56 Stat. 798, established
the Tax Court of the United States on Oct. 21, 1942, which
superseded the United States Board of Tax Appeals.
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primarily and personally liable. Because of these circumstances,
the Board concluded: “No part of the $225 monthly payments
represented alimony or any ‘allowance’ to the wife. She could
not use the funds for any other purpose than to pay the carrying
charges on the mortgaged property and to reduce the principal
mortgage debt. In so doing she acted as agent or trustee for the
petitioner.” Kohlsaat v. Commissioner, supra at 534.
Petitioner provided no documentation, such as canceled
checks or Forms 1099, that substantiates her claim that she made
payments of mortgage interest in the amount of $2,471.09 in
taxable year 1999. Petitioner’s only evidence, in this respect,
is a statement from First Community Financial Services addressed
to Mr. Seidel reflecting that he paid $2,471.09 in interest in
taxable year 1999. Since there is no evidence that petitioner’s
funds were in fact used to make these payments, and the burden of
proof is upon her to establish that it was in fact her funds that
were used to make the payments, we must conclude that petitioner
is not entitled to the deduction claimed because she has not
established that the payments were made with her funds. Rule
142; Diez-Arguelles v. Commissioner, T.C. Memo. 1984-356;
Kazupski v. Commissioner, T.C. Memo. 1982-182; Finney v.
Commissioner, supra; Kohlsaat v. Commissioner, supra.
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5. Attorney’s Fees Deduction
At trial, petitioner claimed an itemized deduction on
Schedule A for attorney’s fees in the amount of $2,058.50.
Personal, living, and family expenses generally are not
deductible by taxpayers. Sec. 262(a). Attorney’s fees and other
costs paid in connection with a divorce generally are personal
expenses and therefore nondeductible. Sec. 1.262-1(b)(7), Income
Tax Regs. On the other hand, expenses paid for the production or
collection of income, or in connection with the determination,
collection, or refund of any tax, generally are deductible. Sec.
212(1), (3). This is the case even if the expenses are paid in
connection with a divorce. Swain v. Commissioner, T.C. Memo.
1996-22, affd. without published opinion 96 F.3d 1439 (4th Cir.
1996); sec. 1.262-1(b)(7), Income Tax Regs.
The legal fees which petitioner paid to her attorney were
paid in order to secure petitioner’s divorce and property
settlement. Petitioner expressly waived all spousal support
(i.e., alimony). However, a portion of petitioner’s attorney’s
fees was paid in order to secure the production of income;
namely, the distribution from Mr. Seidel’s CWSC 401(k) plan
includable in her income as alternate payee. Therefore, under
section 212 and under the Cohan rule, we may estimate the amount
of the Schedule A itemized deductible expense. Thus, we hold
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that petitioner may claim a deduction for attorney’s fees in the
amount of $1,377.10
6. Audit Examination
Section 7605(b) provides:
No taxpayer shall be subjected to unnecessary examination or
investigations, and only one inspection of a taxpayer’s
books of account shall be made for each taxable year unless
the taxpayer requests otherwise or unless the Secretary,
after investigation, notifies the taxpayer in writing that
an additional inspection is necessary.
This Court stated in Digby v. Commissioner, 103 T.C. 441,
445 (1994):
The Supreme Court, after a review of the legislative
history, interpreted the purpose of section 7605(b) as being
congressional recognition of “a need for a curb on the
investigating powers of low-echelon revenue agents, and
considered that it met this need simply and fully by
requiring such agents to clear any repetitive examination
with a superior.” United States v. Powell, 379 U.S. 48, 55-
56 (1964); 61 Cong. Rec. 5855 (Sept. 28, 1921). The Powell
case involved the enforcement of a summons to appear before
a special agent and produce for reexamination certain
corporate records, on the ground that suspected fraud would
reopen the expired 3-year period of limitations on
assessment and collection. Section 7605(b) was considered
in that context to determine whether that section, either
alone or in conjunction with others, placed a probable cause
standard or other restrictions on the Commissioner’s agents
before a tax year may be reexamined. The Supreme Court
held, with respect to section 7605(b) that, generally, “no
severe restriction was intended”, and regarding unnecessary
examinations, courts are not required “to oversee the
Commissioner’s determinations to investigate.” United
States v. Powell, supra at 54, 56.
10
This amount was arrived at by multiplying petitioner’s
total attorney’s fees by a fraction, the numerator of which is
the taxable portion of CASC 401(k) plan distribution and the
denominator of which is the total amount of the CASC 401(k) plan
distribution ($2,058.50 x ($51,497 ÷ $77,000) = $1,377).
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Thus, the Internal Revenue Service is generally limited to
one inspection of a taxpayer’s books and records for each taxable
year unless the taxpayer requests a second audit or the Service
notifies the taxpayer in writing that an additional inspection is
necessary. United States v. Powell, supra; De Masters v. Arend,
313 F.2d 79, 85 (9th Cir. 1963).
However, the review of records of third parties does not
constitute an inspection of the taxpayer’s books and records.
Digby v. Commissioner, supra at 447. Moreover, mere
communication with the taxpayer does not fall within the scope of
an inspection of books and records. Benjamin v. Commissioner, 66
T.C. 1084, 1098-1099 (1976), affd. 592 F.2d 1259 (5th Cir. 1979).
With this background we consider petitioner’s contention
that respondent has violated the requirements of section 7605(b)
by subjecting petitioner to three separate inspections of her
books and records.
Petitioner attached to her Form 1040 for taxable year 1999,
a “Special Handling” cover letter requesting a review of her
return. Petitioner presented no evidence that respondent audited
her return as a result of this request. In fact, respondent
mailed petitioner a letter thanking her for her inquiry and
stating that the IRS had not “resolved the matter.” Such a
response to a taxpayer’s inquiry does not constitute an
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inspection of her books of account. See Benjamin v.
Commissioner, supra.
Petitioner received a letter dated September 14, 2001,
advising her that based upon review of third party records,
respondent proposed changes to her Form 1040 for taxable year
1999. The review of records of third parties does not constitute
a review of a taxpayer’s books and records. Digby v.
Commissioner, supra.
Petitioner’s argument that respondent has violated section
7605(b) is grounded on respondent’s issuing to petitioner a tax
refund before auditing her 1999 tax return. Petitioner admits
that she never entered into a closing agreement with the IRS with
respect to taxable year 1999. Petitioner also admits that she
never received a letter stating that the IRS had accepted her
1999 tax return, nor had she received a letter stating that her
1999 tax return had been audited as requested by her special
handling request.
Instead, petitioner’s argument of multiple audits relies on
petitioner’s testimony that her refund was evidence of an audit
that resulted from her special handling request. Such testimony
and argument do not substantiate her claim of a violation of
section 7605(b).
There is no evidence in the record that substantiates
petitioner’s claim that the IRS audited her income tax return by
- 33 -
inspecting her books of account before issuing petitioner her
1999 income tax refund. We hold that respondent did not subject
petitioner to multiple inspections of her books of account and
thus did not violate section 7605(b).
To reflect the foregoing,
Decision will be entered
under Rule 155.