Craft v. Comm'r

T.C. Memo. 2005-197

UNITED STATES TAX COURT

RONNIE O. AND G. JUNE CRAFT, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 2858-04. Filed August 15, 2005.

Clinton J. Wofford, for petitioners.

Audrey M. Morris, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge: Respondent determined a deficiency of

$6,672 in petitioners’ 2001 Federal income tax. After a

concession,1 the issues for decision are: (1) Whether petitioners

are entitled to deduct expenses listed on Schedule C, Profit or

1
Respondent conceded an interest income adjustment
proposed on the notice of deficiency in the amount of $381.
 - 2 -

Loss From Business, of their 2001 return, and (2) if petitioners

are entitled to deduct the expenses, whether the expenses are

subject to the 2-percent limitation contained in section 672 and

the limitation contained in section 68.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference. At the time they filed

the petition, Ronnie O. Craft (petitioner) and G. June Craft,

husband and wife, resided in Garland, Texas. G. June Craft is a

party because she signed the joint tax return.

Petitioner is a 50-percent shareholder in Craft-Barnett

Investments, Inc. (Craft-Barnett), an S corporation which was

converted from a C corporation in 1994. James M. Barnett

(Barnett) is the other 50-percent shareholder of Craft-Barnett.

Both petitioner and Barnett, in their capacity as officers and

employees, received a salary of $50,000 from Craft-Barnett in

2001.

Petitioner is also a shareholder in Abilene Investment

Properties, Inc., a family-owned S corporation. In addition,

petitioner is a partner in the ROC Family Limited Partnership

(ROC FLP) along with his wife and children. ROC FLP owned the

2
Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code) in effect for the year in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
 - 3 -

stock of M.E. Moses, Co., Inc. (M.E. Moses), from 1991 or 1992

until around 1994.

Petitioner claimed the following expenses on the Schedule C

of his joint 2001 Federal income tax return:

Car and truck expenses $2,245.40
Depreciation 8,846.98
Legal and professional fees 4,650.00
Office supplies 449.13
Dues and subscriptions 1,162.00
Post office box rental 250.00
Total 17,603.51

Petitioner contends that these expenses consist of the following:

1. Car and truck expenses--driving petitioner did as an

executive of Craft-Barnett and consists of $1,022 for insurance

and $1,223.40 for gas and other expenses.

2. Depreciation--depreciation of office equipment used in

petitioner’s work as an executive of Craft-Barnett in the amount

of $2,086.63 and depreciation of a 2001 Chevrolet pick-up truck

used in conjunction with his work with Craft-Barnett in the

amount of $6,760.35.

3. Legal and professional fees--$3,300 in legal fees

applicable to the “settlement of certain expenses involving

transfer of M.E. Moses Company, Inc. stock in previous years”;

$1,000 in legal and accounting fees paid for “review of business

documents and review and preparation of the petitioners’ tax

return”; and $350 in legal fees paid for the preparation and

filing of a Plea of Abatement brought against petitioner by the
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Hopkins County, Texas, Property Tax Appraiser. All of these fees

were paid to petitioner’s attorney, Clinton J. Wofford.

4. Office supplies--$449.13 in office supplies which were

for use in Craft-Barnett.

5. Dues and subscriptions--these expenses were used to

acquire newspapers and similar publications to review lots and

houses for Craft-Barnett.

6. Post office box rental expense--used as the official

mailing address for Craft-Barnett, Abilene Investment Properties,

and ROC FLP.

Petitioner did not report any income for 2001 on the

Schedule C. For 2001, he reported his $50,000 salary from Craft-

Barnett on line 7 of Form 1040, U.S. Individual Income Tax

Return, and his share of the income from Craft-Barnett on

Schedule E, Supplemental Income and Loss.

Craft-Barnett adopted a resolution requiring petitioner and

Barnett, as vice president and president of the corporation

respectively, to incur expenses as may be necessary or required

and stating that they shall not be reimbursed by Craft-Barnett

for these expenses. The resolution states that petitioner “shall

also be responsible for supplying office space and his own

vehicle for his business services and shall not be reimbursed

therefor by the Corporation.”
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OPINION

I. Burden of Proof

As a general rule, the taxpayer bears the burden of proving

the Commissioner's deficiency determinations incorrect. Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Section

7491(a), however, provides that if a taxpayer introduces credible

evidence and meets certain other prerequisites, the Commissioner

bears the burden of proof with respect to factual issues relating

to the liability of the taxpayer for a tax imposed under subtitle

A or B of the Code. For the burden to shift, however, the

taxpayer must comply with the substantiation and record-keeping

requirements as provided in the Internal Revenue Code and have

cooperated with the Commissioner. See sec. 7491(a)(2).

Petitioner did not claim that section 7491(a) applies.

Furthermore, petitioner failed to introduce sufficient evidence

to shift the burden to respondent. Accordingly, section 7491(a)

does not apply in this case.

In the statutory notice of deficiency herein, respondent

stated that the expenses petitioner listed on the Schedule C must

be taken as deductions on Schedule A, Itemized Deductions, and

are subject to the 2-percent limitation. In his calculations in

the notice of deficiency, respondent did not allow these expenses

as Schedule A deductions subject to the 2-percent limitation. In

his pretrial memorandum and opening statement at trial,
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respondent contended that these expenses should be disallowed

altogether, or if allowed, should be subject to the 2-percent

limitation of section 67. Furthermore, petitioner knew that the

issue of whether the expenses were properly deductible by him on

his individual tax return was before the Court, and he presented

evidence on that subject. Therefore, the burden of proof remains

with petitioner on all issues in this case.

II. Expenses Related to Craft-Barnett

A. Corporate Expenses v. Individual Expenses

The first issue is whether the expenses are properly

deductible by petitioner or whether they are expenses of the

corporation not deductible by petitioner.

Deductions are a matter of legislative grace; petitioners

have the burden of showing that they are entitled to any

deduction claimed. 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). The taxpayer is required to maintain

records that are sufficient to enable the Commissioner to

determine his correct tax liability. See sec. 6001; sec. 1.6001-

1(a), Income Tax Regs. In addition, the taxpayer bears the

burden of substantiating the amount and purpose of the claimed

deduction. See Hradesky v. Commissioner, 65 T.C. 87, 90 (1975),

affd. per curiam 540 F.2d 821 (5th Cir. 1976).
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A corporation is treated as a separate entity from its

shareholders for tax purposes. Moline Props. Inc. v.

Commissioner, 319 U.S. 436, 438-439 (1943). The voluntary

payment of corporate expenses by officers, employees, or

shareholders may not be deducted on the taxpayer’s individual

return. Deputy v. Du Pont, 308 U.S. 488, 494 (1940); Noland v.

Commissioner, 269 F.2d 108 (4th Cir. 1959), affg. T.C. Memo.

1958-60; Rink v. Commissioner, 51 T.C. 746, 751 (1969). Such

payments constitute either capital contributions or loans to the

corporation and are deductible, if at all, only by the

corporation. Deputy v. Du Pont, supra; Rink v. Commissioner,

supra.

A corporate resolution or policy, however, requiring a

corporate officer to assume certain expenses indicates that those

expenses are his expenses as opposed to those of the corporation.

Noyce v. Commissioner, 97 T.C. 670, 683-684 (1991); see also

Johnson v. Commissioner, T.C. Memo. 1984-598. The corporate

resolution enacted by Craft-Barnett requires petitioner to assume

certain expenses including providing office space and a vehicle,

and therefore the expenses covered by the corporate resolution

are petitioner’s expenses.

B. Individual Expenses: Shareholder v. Employee

After determining that the expenses listed in the corporate

resolution are petitioner’s expenses, we next have to decide
 - 8 -

whether petitioner incurred these expenses as an employee or

shareholder of Craft-Barnett. If petitioner incurred these

expenses to protect his equity interest in Craft-Barnett, the

expenses would be capitalized and would not be deductible by

petitioner. Section 162(a) allows a deduction for all ordinary

and necessary expenses incurred in carrying on a trade or

business. The performance of services as an employee constitutes

a trade or business. O'Malley v. Commissioner, 91 T.C. 352, 363-

364 (1988). An ordinary expense is one that is common and

acceptable in the particular business. Welch v. Helvering, supra

at 113-114. The principal function of the word “ordinary” in

section 162(a) is to clarify the distinction between expenses

which are currently deductible and expenses which are capital in

nature. Commissioner v. Tellier, 383 U.S. 687, 689 (1966); Noyce

v. Commissioner, supra at 686. A necessary expense is an expense

that is appropriate and helpful in carrying on the trade or

business. Heineman v. Commissioner, 82 T.C. 538, 543 (1984). As

petitioner’s expenses were not incurred in the acquisition or

enhancement of a capital asset but in the conduct of his duties

as an employee of Craft-Barnett, the expenses are ordinary. The

expenses incurred by petitioner were necessary to fulfill his

duties as vice president of Craft-Barnett.

Therefore, we conclude that the expenditures attributable to

Craft-Barnett are deductible by petitioner as ordinary and
 - 9 -

necessary expenses of his trade or business of being a Craft-

Barnett employee.

C. Proper Placement of Deductions

After concluding that the expenses are properly deductible

by petitioner, the next issue is whether petitioner properly

deducted the expenses on his Schedule C or whether the expenses

are subject to the 2-percent limitation of section 67 and the

limitation in section 68.

Section 62 lists the deductions from gross income which are

allowed for the purpose of computing adjusted gross income.

Section 62(a)(1) provides the general rule that trade or business

deductions are allowed for the purpose of computing adjusted

gross income “if such trade or business does not consist of the

performance of services by the taxpayer as an employee.”

Expenses of employment, if incurred under a reimbursement

arrangement with the employer, are deductible in computing the

employee’s adjusted gross income. See sec. 62(a)(2). Otherwise,

individuals with unreimbursed trade or business expenses from

their employment must deduct these expenses subject to the 2-

percent limitation of section 67. Gonzalez v. Commissioner, T.C.

Memo. 1997-430. These expenses may be further reduced pursuant

to section 68 if the individual’s “adjusted gross income exceeds

the applicable amount”. Sec. 68(a).
 - 10 -

Petitioner claims that his Schedule C trade or business is

“being an employee for livelihood or for profit.” As

petitioner’s trade or business is being an employee, these

expenses are subject to the 2-percent limitation of section 67

and further limitations under section 68.

D. Listed Expenses

After concluding that petitioner is entitled to deduct

expenses associated with his employment with Craft-Barnett

subject to the limitations contained in sections 67 and 68, we

must examine each expense listed by petitioner to determine any

further limitation on deductibility.

1. Car and Truck Expenses

Petitioner is entitled to deduct the expenses listed as car

and truck expenses because automobile expenses are specifically

listed in the corporate resolution. Petitioner used his truck to

travel from his office to job sites, the bank, and title

companies. Therefore, petitioner is entitled to deduct the

$2,245.40 of car and truck expenses.3

2. Depreciation Expense

Petitioner claimed $8,846.98 in depreciation expenses on his

2001 return of which $6,760.35 is related to his truck and

$2,086.63 is related to office equipment.

3
Respondent states that he does not raise the issue of
compliance with the substantiation requirements of sec. 274(d),
and therefore sec. 274 is not an issue.
 - 11 -

As stated above, petitioner bears the burden of maintaining

the records needed to establish his entitlement to deductions.

Sec. 6001; sec. 1.6001-1(a), Income Tax Regs. To substantiate

entitlement to a depreciation deduction, the taxpayer must show

that the property was used in a trade or business (or other

profit-oriented activity) and must establish the property’s

depreciable basis by showing the cost of the property, its useful

life, and the previously allowable depreciation. Cluck v.

Commissioner, 105 T.C. 324, 337 (1995).

Petitioner did not produce any evidence at trial to

substantiate the claimed depreciation expense. Petitioner

attached to his pretrial memorandum documents related to his

claimed deduction for depreciation expenses. Evidence must be

submitted at trial; documents attached to briefs and statements

made therein do not constitute evidence and will not be

considered by the Court. Rule 143(b); Evans v. Commissioner, 48

T.C. 704, 709 (1967), affd. per curiam 413 F.2d 1047 (9th Cir.

1969); Lombard v. Commissioner, T.C. Memo. 1994-154, affd.

without published opinion 57 F.3d 1066 (4th Cir. 1995).

Accordingly, these documents are not in evidence, and we sustain

respondent’s determination regarding the depreciation expenses.

3. Office Supplies and Dues and Subscriptions

Petitioner claimed $449.13 in office supplies and $1,162 for

dues and subscriptions. These expenses are deductible by
 - 12 -

petitioner as they are ordinary and necessarily incurred as part

of petitioner’s duties as vice president of Craft-Barnett and to

maintain an office pursuant to the corporate resolution.

4. Post Office Box Rental

Petitioner incurred an expense of $250 for the rental of a

post office box. The post office box was used for Craft-Barnett,

Abilene Investment Properties, Inc., and ROC FLP. Accordingly,

petitioner can only deduct one-third of the $250 expense as this

expense is incurred as part of petitioner’s responsibility to

maintain an office. The other two-thirds relate to Abilene

Investment Properties, Inc., and ROC FLP, and petitioner has not

proved that he was required to incur this expense on behalf of

these entities or that this was an unreimbursed employee business

expense of these entities.

III. Expenses Not Related to Craft-Barnett

Petitioner claimed $3,300 in legal fees on the return for

attorney’s fees in settlement of certain expenses involving the

transfer of M.E. Moses stock.

Whether an ordinary and necessary litigation expense is

deductible under section 162(a) or 212 depends on the origin and

character of the claim for which the expense was incurred and

whether the claim bears a sufficient nexus to the taxpayer’s

business or income-producing activities. See Woodward v.

Commissioner, 397 U.S. 572 (1970); United States v. Gilmore, 372
 - 13 -

U.S. 39, 44-45 (1963); see also Peckham v. Commissioner, 327 F.2d

855, 856 (4th Cir. 1964), affg. 40 T.C. 315 (1963); Guill v.

Commissioner, 112 T.C. 325 (1999). Ordinary and necessary

litigation costs are generally deductible under section 162(a)

when the matter giving rise to the costs arises from, or is

proximately related to, a business activity. See Woodward v.

Commissioner, supra; Kornhauser v. United States, 276 U.S. 145,

153 (1928). Litigation costs must be "attributable to a trade or

business carried on by the taxpayer" in order to be deductible as

a business expense. Sec. 62(a)(1); see Guill v. Commissioner,

supra.

The ascertainment of a claim’s origin and character is a

factual determination that must be made on the basis of the facts

and circumstances out of which the litigation arose. See United

States v. Gilmore, supra at 47-49. The most important factor to

consider is the circumstances out of which the litigation arose.

See Guill v. Commissioner, supra; Boagni v. Commissioner, 59 T.C.

708 (1973). In passing on this factor, the fact finder must take

into account, among other things, the allegations set forth in

the complaint, the issues which arise from the pleadings, the

litigation’s background, nature, and purpose, and the facts

surrounding the controversy. See Davis v. Commissioner, T.C.

Memo. 1999-250; see also Guill v. Commissioner, supra; Boagni v.

Commissioner, supra at 713.
 - 14 -

Petitioner’s legal expense of $3,300 pertaining to

settlement of a case involving M.E. Moses stock was properly

denied by respondent. As petitioner’s investments in M.E. Moses

were through ROC FLP, this litigation expense arose through

petitioner’s membership in the partnership and therefore is not

directly related to petitioner’s individual business or income-

producing activities. This expense properly belongs to the

partnership. Partnerships constitute separate entities, distinct

from their partners, in determining the character of income and

deductibility of business expenses. Sec. 703; United States v.

Basye, 410 U.S. 441, 448 (1973). A partnership must report its

income and expenses on an aggregate approach, and once these

amounts are ascertained, the partnership form is disregarded, and

the income and expenses flow through to the individual partners.

United States v. Basye, supra.

Therefore, while petitioner may be able to deduct a portion

of this expense through the partnership, the expense must first

be aggregated with other partnership income and expenses and then

distributed to the partners. To be deductible, business expenses

must be the expenses of the taxpayer claiming the deduction.

Hewett v. Commissioner, 47 T.C. 483, 488 (1967). Petitioner

cannot convert the expense into one of his own simply by agreeing

to pay for it personally. Accordingly, respondent’s

determination on this issue is sustained.
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Petitioner also claimed $1,350 in professional and legal

fees, consisting of $1,000 in legal and accounting fees paid for

business document review and preparation of petitioners’ tax

return and $350 in legal fees paid for the preparation and filing

of a Plea of Abatement regarding property taxes. These fees are

deductible under section 212(3) as they are “in connection with

the determination, collection, or refund of any tax”, but they

are only deductible as a miscellaneous itemized deduction to the

extent the aggregate of such deductions exceeds 2 percent of

adjusted gross income pursuant to section 67.

To reflect the foregoing,

Decision will be entered

under Rule 155.