Egan v. Comm'r

T.C. Memo. 2005-234

UNITED STATES TAX COURT

WILLIAM A. EGAN, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4568-04. Filed October 5, 2005.

Peter B. Tiede, for petitioner.

Allison O. Woodbury, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

KROUPA, Judge: Respondent determined a $30,618 deficiency

in petitioner’s Federal income tax for 1998 and that petitioner

was liable for a $5,789 accuracy-related penalty for substantial

understatement under section 6662(a).1 After concessions,2 we

1
All section references are to the Internal Revenue Code in
effect for the year at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
2
Petitioner conceded respondent’s disallowance of
(continued...)
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are asked to decide whether petitioner is entitled to deduct

$158,381 as a business bad debt in 1998 under section 166 and

whether the accuracy-related penalty under section 6662(a) should

apply. We hold that petitioner is not entitled to deduct

$158,381 as a business bad debt and that the accuracy-related

penalty applies.

FINDINGS OF FACT

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

The stipulation of facts and the accompanying exhibits are

incorporated by this reference. Petitioner resided in Anoka,

Minnesota, at the time he filed the petition in this case.

Petitioner has owned and operated Egan Oil, a sole

proprietorship, for 43 years. Egan Oil is a distributor of Exxon

Mobil petroleum products. Egan Oil purchases petroleum products

from Exxon Mobil and then resells them to customers such as

service stations and convenience stores.

One of Egan Oil’s customers was Brooks Foods, Inc. (Brooks

Foods), a chain of food stores owned by a prominent local

businessman named Brooks Hauser. Mr. Hauser encountered business

difficulties in 1993 and 1994 and fell behind on his payments to

Egan Oil for petroleum products Brooks Foods had purchased.

Petitioner knew Mr. Hauser was attempting to rebuild his business

and was seeking to refinance. To protect himself from the

rapidly increasing balance, petitioner decided to allow only a

2
(...continued)
petitioner’s net farm loss and respondent’s reduction of
petitioner’s home mortgage interest deduction.
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balance of $400,000 at any one time. This limit was

approximately a week’s worth of Brooks Foods’ purchases of

petroleum products from Egan Oil. If Brooks Foods owed more than

$400,000, Egan Oil would not deliver any more petroleum products

to Brooks Foods until Brooks Foods reduced its outstanding

balance below $400,000.

Brooks Foods was approaching its $400,000 credit limit with

Egan Oil in May 1993. To allow Brooks Foods to continue buying

fuel from Egan Oil, Mr. Hauser made two personal notes in May

1993, each for $100,000, in favor of petitioner.

These notes represented Mr. Hauser’s personal guaranty that

the $200,000 Brooks Foods owed to petitioner would be paid.

Although there is nothing in the record showing Mr. Hauser ever

made any payments on these notes, Brooks Foods did continue

purchasing and paying for fuel from Egan Oil. Mr. Hauser also

informed petitioner that he made petitioner a beneficiary on the

life insurance policy insuring Mr. Hauser’s life.

Mr. Hauser died in 1994 with a balance still owing from

Brooks Foods to Egan Oil. After Mr. Hauser’s death, petitioner

contacted the life insurance company insuring Mr. Hauser’s life,

but learned that despite Mr. Hauser’s representations, petitioner

was not, in fact, a beneficiary of the policy insuring Mr.

Hauser’s life.
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Petitioner began further collection efforts in 1995.

Petitioner first unsuccessfully demanded payment from Brooks

Foods. Petitioner then filed a lawsuit against Brooks Foods and

Peggy Ann Hauser (Ms. Hauser), Mr. Hauser’s widow, to attempt to

recover the debt. Ms. Hauser’s attorneys responded by a letter

to petitioner in February 1995, stating that the suit against Ms.

Hauser should be dismissed as she had no active involvement in

Brooks Foods. In addition, the letter stated that secured

creditors or other parties who became shareholders before Mr.

Hauser’s death had control over all the stock of Brooks Foods.

Petitioner could not recall the outcome of the litigation at the

time of trial in this case, but he believed it had gone to court

and was apparently unsuccessful. Ms. Hauser later filed

bankruptcy and received a discharge in 1998.

Petitioner reported Egan Oil’s income and expenses using the

accrual method on a Schedule C, Profit or Loss from Business, for

1998. Petitioner deducted $158,381 in 1998 as a business bad

debt attributable to Brooks Foods. Petitioner reported taxable

income of $7,442 and tax of $1,052.

Petitioner claimed that Brooks Foods owed $420,000 in total

to Egan Oil and that $200,000, represented by the notes, was

secured. Petitioner’s accountant, Emile Rabinowitz (Mr.

Rabinowitz), advised petitioner to deduct $158,381, but neither

petitioner nor Mr. Rabinowitz explained how they computed this

amount. At the time of trial, petitioner no longer had records

or business ledgers for 1992 through 1995 reflecting deliveries

to, or accounts receivable from, Brooks Foods. Mr. Rabinowitz
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did not think it necessary for petitioner to keep these records

because respondent had already audited petitioner’s gross

receipts for 1992 through 1995 and those years had been settled.

Federal and State regulations required petitioner to keep

books and records for his business recording each gallon of the

approximately 40 million gallons that Egan Oil sold each year.

Petitioner had a system to track sales on a 3-day and a monthly

basis. Several different taxing authorities examined

petitioner’s records, including respondent as well as State sales

tax and excise tax authorities.

Petitioner’s accountant, Mr. Rabinowitz, was convicted in

1994 of conspiracy to defraud and impede the Internal Revenue

Service (IRS) and of filing a false income tax return. Mr.

Rabinowitz was imprisoned for approximately 3 years for these

crimes. Petitioner was aware of the trial, conviction, and

imprisonment of Mr. Rabinowitz, but he was not involved in the

crime or the criminal proceedings against Mr. Rabinowitz.

Respondent examined petitioner’s return for 1998 and issued

petitioner a Notice of Deficiency dated December 16, 2003

(deficiency notice), disallowing petitioner’s business bad debt

deduction attributable to Brooks Foods and determining that the

accuracy-related penalty should be imposed.3 Petitioner timely

filed a petition for review with this Court.

3
In the deficiency notice, respondent also disallowed
petitioner’s net farm loss and reduced petitioner’s home mortgage
interest deduction. Petitioner has conceded these adjustments.
Therefore, the only issues before us are the business bad debt
deduction and the accuracy-related penalty.
 -6-

OPINION

We are asked to decide whether petitioner may deduct

$158,381 as a business bad debt in 1998. Respondent argues that

petitioner may not deduct $158,381 as a business bad debt because

petitioner has not substantiated the amount of the deduction nor

established that the debt became worthless in 1998. Respondent

also argues that the accuracy-related penalty should be imposed.

Petitioner admits that he does not have records supporting

the deduction. Petitioner asserts that respondent is estopped

from arguing that petitioner lacks the requisite documentation

because respondent audited petitioner’s gross receipts for 1994

and that year has been settled. Petitioner also argues that he

has established that Brooks Foods owed Egan Oil more than the

$158,381 claimed and that it is irrelevant when petitioner

claimed the deduction because the deduction would have resulted

in a net operating loss that petitioner could have carried

backward or forward under section 172. Sec. 172(b)(1)(A). On

this basis, petitioner also argues that the accuracy-related

penalty should not be imposed. We address each issue in turn.

We begin with the burden of proof.

I. Burden of Proof

In general, the Commissioner’s determinations in the

deficiency notice are presumed correct, and the taxpayer bears

the burden of proving that the Commissioner’s determinations are

in error. See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933). Under certain circumstances, however, section 7491(a)
 -7-

shifts the burden of proof to the Commissioner provided the

taxpayer complies with substantiation requirements, maintains all

required records, and cooperates with the Commissioner’s

reasonable requests. Id.4

We decline to shift the burden of proof to respondent.

Petitioner has not substantiated the bad debt deduction nor

maintained the required records.5 Sec. 7491(a)(2)(A) and (B).

The burden of proof, therefore, remains with petitioner.

4
Sec. 7491 is effective with respect to court proceedings
arising in connection with examinations by the Commissioner
commencing after July 22, 1998, the date of enactment of the
Internal Revenue Service Restructuring and Reform Act of 1998,
Pub. L. 105-206, sec. 3001(a), 112 Stat. 726.
5
Petitioner relies on the footnote to the Senate report on
sec. 7491 to argue that he should still be entitled to shift the
burden of proof because his records were lost through no fault of
his own. See S. Rept. 105-174 at 46 n.27 (1998), 1998-3 C.B.
537, 582. Petitioner’s reliance is misplaced. First, petitioner
misinterprets the meaning of the footnote. The Senate was
describing the rule that permits reconstruction of records in a
situation where records are destroyed by no fault of the taxpayer
and stated that these existing rules would continue to apply.
See id.; see, e.g., sec. 1.274-5T(c)(5), Temporary Income Tax
Regs., 50 Fed. Reg. 46022 (Nov. 6, 1985). The footnote does not
suggest that a taxpayer who failed to maintain any records may
still shift the burden of proof to the Commissioner. Second,
petitioner has not introduced evidence that he maintained the
requisite records. If the records generated by his periodic
reporting system for each gallon of gas sold were indeed damaged,
petitioner presumably kept ledgers or journal entries showing
accounts receivable and the outstanding balance. No evidence of
this type was introduced, however. Further, petitioner
introduced no evidence of the damage other than a vague allusion
in Mr. Rabinowitz’s testimony that the backup records “got wet or
something, moldy” and were therefore discarded. The paucity of
the records introduced leaves us unable to assess whether it was
appropriate to discard the backup records.
 -8-

II. Substantiation

We next address whether petitioner is entitled to the

$158,381 business bad debt deduction respondent disallowed in the

deficiency notice.

Deductions are a matter of legislative grace, and the

taxpayer has the burden of proving that he or she is entitled to

the claimed deductions. Rule 142(a); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992). This includes

substantiating the amounts claimed as deductions by maintaining

the records necessary to establish that he or she is entitled to

the deduction. Sec. 6001; Hradesky v. Commissioner, 65 T.C. 87,

89-90 (1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976); sec.

1.6001-1(a), (e), Income Tax Regs. While we may estimate the

amount of allowable deductions where there is evidence that

deductible expenses were incurred, we must have some basis on

which an estimate may be made. Williams v. United States, 245

F.2d 559 (5th Cir. 1957); Cohan v. Commissioner, 39 F.2d 540 (2d

Cir. 1930); 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, supra at 560.
Petitioner failed to introduce evidence to substantiate the

amount of the bad debt deduction. While petitioner introduced

two notes made by Mr. Hauser, the notes are not in the amount of

the deduction, and petitioner did not explain how the $158,381

amount was calculated, nor how the $158,381 related to the

$200,000 of notes or the $420,000 of claimed indebtedness Brooks
 -9-

Foods owed to petitioner. Moreover, petitioner introduced no

business records showing how much Brooks Foods had purchased from

Egan Oil nor any records of what the outstanding balance was from

time to time. We are left to speculate as to the amount and are

therefore unable to estimate the amount of the deduction under

the Cohan rule. See Cohan v. Commissioner, supra at 543-544;

Worthington v. Commissioner, T.C. Memo. 1999-113; Kim v.

Commissioner, T.C. Memo. 1995-598. Introducing evidence of a

debt is not sufficient to substantiate the deduction of a

different amount. The amount of the deduction is what must be

substantiated. See Hradesky v. Commissioner, supra.

Petitioner also argues that respondent should be estopped

from arguing that petitioner lacked the necessary documentation.

Petitioner, relying on a previous audit of petitioner’s gross

receipts for 1994, explained that he considered the year closed

and therefore destroyed records for 1994. We disagree. While

the gross receipts audit may have shown the amount sold, it in no

way establishes how much Brooks Foods purchased or, more

importantly, how much Brooks Foods owed. Petitioner failed to

introduce evidence of ledgers or journal entries he presumably

kept showing his accounts receivable and the outstanding balance,

essential information that would prove the correct amount of the

deduction.

Moreover, we are skeptical how an astute businessman like

petitioner expected to be repaid the amount owed if he lacked the

documentation to show how much Brooks Foods owed. If petitioner
 -10-

wished to deduct the bad debt in 1998, petitioner should have

taken measures to preserve the requisite records, even though the

sales to which the alleged debt related were in 1994.

Accordingly, we find that petitioner has not introduced

evidence to substantiate the deduction, and therefore, petitioner

may not deduct any amount with respect to the bad debt allegedly

owed him by Brooks Foods.6

III. Year of Worthlessness

We next address petitioner’s argument that it is irrelevant

which year petitioner claimed the deduction because it would have

created a net operating loss that petitioner could have carried

forward or backward under section 172. See sec. 172(b)(1)(A).

Petitioner’s position is contrary to established law.

The bad debt deduction is available only for those debts

that become worthless during the taxable year. Sec. 166(a)(1).

Moreover, petitioner must prove that the debt had value at the

beginning of the year and that it became worthless during that

6
Petitioner also failed to prove that the debt was bona
fide. See sec. 166(a)(1). Petitioner did not show that a valid,
enforceable obligation was created to pay a fixed or determinable
sum of money. See sec. 1.166-1(c), Income Tax Regs. In
addition, petitioner did not show whether interest was charged,
whether Egan Oil recorded the amount allegedly owed as a debt on
its books, whether any payments were made on the debt, or whether
Egan Oil had any collateral other than the note or the alleged
life insurance policy. We have no proof of these facts other
than petitioner’s own testimony that a petroleum purchase
transaction took place between Brooks Foods and Egan Oil. The
notes Mr. Hauser made to guarantee payment, simply a formal
indication that a debt was owed, are not sufficient to establish
that a bona fide debt existed. See Sundby v. Commissioner, T.C.
Memo. 2003-204; Hotel Cont’l., Inc. v. Commissioner, T.C. Memo.
1995-364, affd. without published opinion 113 F.3d 1241 (9th Cir.
1997).
 -11-

year. Hotel Cont’l., Inc. v. Commissioner, T.C. Memo. 1995-364,

affd. without published opinion 113 F.3d 1241 (9th Cir. 1997).

Worthlessness is an objective determination, but is generally

fixed by identifiable events that form the basis of reasonable

grounds for abandoning any hope of recovery. Am. Offshore, Inc.

v. Commissioner, 97 T.C. 579, 594 (1991); Dustin v. Commissioner,

53 T.C. 491, 501 (1969), affd. 467 F.2d 47 (9th Cir. 1972); Hotel

Cont’l., Inc. v. Commissioner, supra. Debts are wholly worthless

when the taxpayer had no reasonable expectation of repayment.

Crown v. Commissioner, 77 T.C. 582, 598 (1981).

Petitioner is not entitled to a bad debt deduction in 1998

because petitioner has failed to show the debt had value at the

beginning of 1998. In fact, the evidence of petitioner’s

collection efforts in earlier years tends to show that any value

the debt had was lost before 1998. For example, Mr. Hauser died

in 1994. Mr. Hauser was the sole or majority shareholder of

Brooks Foods. There is evidence that secured creditors or other

parties who became shareholders of Brooks Foods before Mr.

Hauser’s death had control over all the stock shortly after Mr.

Hauser died. In addition, correspondence from the life insurance

company that insured the life of Mr. Hauser in 1994 indicated

petitioner was not entitled to any life insurance proceeds.

Petitioner filed a lawsuit against Brooks Foods and Ms. Hauser

attempting to recover the debt in 1995, which was ultimately

fruitless. This evidence supports the conclusion that the debt

had no value by the beginning of 1998.
 -12-

The only evidence linking the debt to 1998 is Ms. Hauser’s

discharge in bankruptcy for that year. We find no connection

between Ms. Hauser’s bankruptcy and the claimed bad debt. Ms.

Hauser was not the debtor, and she was not connected to the

business. Moreover, petitioner has not shown how Ms. Hauser

could otherwise be liable for Brooks Foods’ debts. Accordingly,

we find her bankruptcy discharge is of no consequence to the

worthlessness of the debt. In fact, the 1995 letter to

petitioner from Ms. Hauser’s attorneys indicated to petitioner

that he would not likely collect from Ms. Hauser. Petitioner did

not introduce any evidence of actions petitioner took with

respect to the debt from 1995 to 1998. Unfortunately, it appears

that Mr. Hauser duped petitioner the same as Ms. Hauser’s

attorneys stated that Mr. Hauser had duped others.

We are convinced that any debt of Brooks Foods to Egan Oil

had no value before 1998. Petitioner may not, therefore, deduct

the debt owed by Brooks Foods in 1998 because petitioner has not

substantiated the amount of the deduction nor shown that it

became worthless in 1998.

IV. Accuracy-Related Penalty

We turn now to respondent’s determination in the deficiency

notice that petitioner is liable for the accuracy-related penalty

under section 6662. Respondent has the burden of production

under section 7491(c) and must come forward with sufficient

evidence that it is appropriate to impose the penalty. See

Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001).
 -13-

Respondent determined that petitioner is liable for the

accuracy-related penalty for a substantial understatement of

income tax under section 6662(b)(2) for 1998. There is a

substantial understatement of income tax if the amount of the

understatement exceeds the greater of either 10 percent of the

tax required to be shown on the return, or $5,000. Sec.

6662(d)(1)(A); sec. 1.6662-4(a), Income Tax Regs.

Petitioner reported tax due of $1,052, while respondent

determined the required tax due was $31,670, and therefore

determined a deficiency of $30,618. Petitioner understated his

income tax for 1998 in an amount greater than $5,000 or 10

percent of the tax required to be shown on the return.

Respondent has, therefore, met his burden of production with

respect to petitioner’s substantial understatement of income tax.

The accuracy-related penalty under section 6662(a) does not

apply to any portion of an underpayment, however, if it is shown

that there was reasonable cause for the taxpayer’s position and

that the taxpayer acted in good faith with respect to that

portion. Sec. 6664(c)(1); sec. 1.6664-4(b), Income Tax Regs.

The determination of whether a taxpayer acted with reasonable

cause and in good faith depends on the pertinent facts and

circumstances, including the taxpayer’s efforts to assess his or

her proper tax liability, the knowledge and experience of the

taxpayer, and the reliance on the advice of a professional. Sec.

1.6664-4(b)(1), Income Tax Regs.
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When a taxpayer selects a competent tax adviser and supplies

him or her with all relevant information, it is consistent with

ordinary business care and prudence to rely upon the adviser’s

professional judgment as to the taxpayer’s tax obligations.

United States v. Boyle, 469 U.S. 241, 250-251 (1985). To prove

reasonable cause due to reliance on the advice of a tax adviser,

however, the taxpayer must show that the adviser was a competent

professional with sufficient expertise to justify reliance.

Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 99

(2000), affd. 299 F.3d 221 (3d Cir. 2002); Ellwest Stereo

Theatres v. Commissioner, T.C. Memo. 1995-610.

Petitioner bears the burden of proof with respect to the

defenses to the accuracy-related penalty. Higbee v.

Commissioner, supra. Petitioner has not proven that either his

attorneys or accountants, on whom he claims to have relied, were

competent professionals with sufficient expertise to justify

reliance or that he provided them with all relevant information.

See Ellwest Stereo Theatres v. Commissioner, supra. Petitioner

introduced no evidence of the identity of the attorneys on whom

he relied, much less their qualifications and expertise in terms

of tax matters. See id. We therefore do not find that

petitioner has shown these advisers to be competent professionals

with significant expertise so that his reliance on them is

justified. See Neonatology Associates, P.A. v. Commissioner,

supra; Ellwest Stereo Theatres v. Commissioner, supra.
 -15-

Petitioner does claim to have relied on the advice of Mr.

Rabinowitz, his accountant, who testified at trial. We note,

however, that petitioner knew of Mr. Rabinowitz’s trial,

conviction in 1994, and incarceration for conspiracy to defraud

and impede the IRS and for filing a false tax return. We do not

find that under these circumstances any reliance upon Mr.

Rabinowitz for tax advice was justified. Nor is there proof that

Mr. Rabinowitz was supplied with all information relevant to the

items on petitioner’s return. Thus, we do not find that

petitioner acted with reasonable cause and in good faith.

After considering all of the facts and circumstances, we

find that petitioner has failed to establish that he had

reasonable cause and acted in good faith with respect to the

understatement. Accordingly, we find that the accuracy-related

penalty applies to petitioner’s underpayment in 1998.

We therefore find that petitioner may not deduct the

$158,381 as a bad debt in 1998 and that petitioner is liable for

the accuracy-related penalty. Accordingly, we shall sustain

respondent’s determinations in the deficiency notice.

To reflect the foregoing,

Decision will be entered

for respondent.