Deihl v. Comm'r

T.C. Memo. 2005-287

UNITED STATES TAX COURT

JOSEPH A. AND SARI F. DEIHL, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 11136-02, 16293-02, Filed December 15, 2005.
1024-03.

During 1996, 1997, and 1998, Ps operated a
multilevel marketing enterprise through two related S
corporations, M and K.

Held: Ps are entitled to deductions claimed
through and in connection with expenditures of M and K
as redetermined herein for 1996, 1997, and 1998.

Held, further, Ps are not entitled to include in
cost of goods sold for M an amount claimed for
purchases in 1998.

Held, further, Ps are not entitled to a reduction
in adjusted gross income of $550,000 for 1996.

Held, further, Ps are liable for accuracy-related
penalties pursuant to sec. 6662, I.R.C., for 1996,
1997, and 1998.
 - 2 -

Donald W. MacPherson and Bradley Scott MacPherson, for

petitioners.

Jonae A. Harrison and J. Robert Cuatto, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WHERRY, Judge: In these consolidated cases, respondent

determined the following deficiencies and penalties with respect

to petitioners’ Federal income taxes:

Penalty
Year Deficiency Sec. 6662, I.R.C.

1996 $1,364,714 $272,942.80
1997 2,348,943 608,473.00
1998 1,108,775 221,755.00

After concessions by the parties, the principal issues for

decision are:

(1) Whether petitioners are entitled to deductions claimed

through and in connection with expenditures of two related S

corporations, Mayor Pharmaceutical Laboratories, Inc. (Mayor),

and KareMor International, Inc. (KareMor), for the taxable years

1996, 1997, and 1998;

(2) whether petitioners are entitled to include in the cost

of goods sold for Mayor an amount claimed for purchases in 1998;

(3) whether petitioners are entitled to a reduction in

adjusted gross income of $550,000 for the taxable year 1996; and
 - 3 -

(4) whether petitioners are liable for the section 6662

accuracy-related penalty for 1996, 1997, and 1998.1

Certain additional adjustments, e.g., to itemized deductions, are

computational in nature and will be resolved by our holdings on

the foregoing issues.

FINDINGS OF FACT

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

The stipulations of the parties, with accompanying exhibits, are

incorporated herein by this reference. To facilitate disposition

of the above issues, we shall first set forth general findings of

fact and then, where appropriate, make additional findings in

conjunction with our analysis of and opinion on discrete issues.

Petitioners Joseph A. and Sari F. Deihl (individually

referred to as Mr. Deihl and Mrs. Deihl, respectively) are

husband and wife. During the years in issue and at the time the

petitions were filed in these cases, petitioners resided at 4627

East Foothill Drive, Paradise Valley, Arizona 85253. Petitioners

have two children, Joseph Deihl II (Joe II) and William Deihl

(Bill). During the years in issue, Joe II was married to Kim,

and Bill was married to Denyse. Petitioners also have several

grandchildren.

1
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years in issue, and Rule
references are to the Tax Court Rules of Practice and Procedure.
 - 4 -

Mr. Deihl completed his formal education upon graduation

from the eighth grade and has since been engaged in a series of

entrepreneurial business ventures. Mrs. Deihl, who has an

eleventh grade education, was an integral participant with her

husband in these ventures. In the early 1980s, petitioners began

to investigate the possibility of developing and marketing a

vitamin complex administered in spray form. Petitioners in the

mid-1980s acquired a patent for the formula for such a spray

multivitamin and incorporated Mayor to manufacture the product.2

Petitioners jointly own 100 percent of the stock in, are officers

of, and control Mayor.

Petitioners experimented with several different

methodologies for marketing their product, which came to be known

as VitaMist. An initial attempt at placement in convenience

stores was unsuccessful. Petitioners later sold the product

through a third-party network marketing company, “Eureka Foods”,

but that company subsequently went bankrupt. Then, for a period

of several years, petitioners marketed the product through Home

Shopping Network. Eventually, in 1992, petitioners incorporated

KareMor to market the VitaMist products.3 As with Mayor,

petitioners jointly own 100 percent of the stock in, are officers

of, and control KareMor.

2
Mayor elected S corporation status in 1991.
3
KareMor elected S corporation status in 1993.
 - 5 -

KareMor was structured as a multilevel network marketing

company with hierarchical levels of distributors. In ascending

order from entry to the highest echelon, the levels included:

Consultant, Silver, Gold, Opal, Sapphire, Ruby, Emerald, Diamond,

and Crown. Distributors were independent representatives who

purchased from KareMor and then resold the VitaMist products.

Distributors also had the opportunity to recruit additional

distributors, resulting in a pyramid structure of what were

referred to as “downline” distributors. Advancement in the

KareMor organization depended upon the volume of product

purchases generated by the distributor and his or her downline

associates, as well as upon the width and depth of this downline

network.

The compensation earned by a distributor from participation

in the KareMor network similarly depended upon the volume of

product purchases generated by both the distributor and his or

her downline network. For instance, higher volume distributors

received larger discounts on VitaMist product purchases,

providing potentially greater profit margins on resales down

through their chains of downline associates and/or to ultimate

consumers. The compensation credited to a distributor could thus

generally be characterized as equivalent to a system of

commissions, bonuses, or “overrides”.
 - 6 -

In keeping with KareMor’s nature as a multilevel marketing

organization, a primary focus of the entity’s operations was on

motivating its distributors. To that end, KareMor sponsored

large-scale conventions and also conducted smaller training and

meeting events at locations throughout the country. Extensive

use was likewise made of prizes and awards as motivational

incentives, many of which were given away at the conventions.

For instance, during the years in issue, a convention was held

each calendar quarter and typically lasted 3 days. The schedule

would include substantive sessions devoted to training and

informational or motivational speakers, as well as entertainment

portions featuring musical performers, dancers, celebrities,

prizes, etc. Featured prizes might be cash, Rolex watches,

cruises, and so on.

Petitioners and members of their extended family played a

prominent role in interacting personally with distributors at

KareMor events. In these interactions, petitioners believed that

it was critical for every aspect of their lives, from their

attire and personal grooming to their residence, to portray an

appearance of extreme affluence and success. Petitioners felt

that distributors who were impressed to the point of being

overwhelmed with what could be achieved through multilevel

marketing would be encouraged to build their own downline

networks in hopes of reaping similar benefits.
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In execution of this strategy, petitioners hosted at their

residence a number of events to which distributors were invited.

Petitioners frequently used their home for training sessions,

meetings, and entertainment functions, including an annual

Halloween party attended by as many as several hundred people and

an annual “come home” event used to showcase both the corporate

properties in Phoenix and petitioners’ residence. To accommodate

such usage and their image-related goals, petitioners during the

period from late 1996 to early 1997 engaged in an extensive

renovation of their personal residence. They sought to create a

“showplace” or “trophy” home. Components of the remodel included

an enhanced driveway and fountain area, a columned porte cochere,

a large vestibule, redesigned bedroom and den/office area, raised

hallway ceilings, limestone flooring, new windows and French

doors, a lighting system, gold-leaf trim, furniture, and interior

design elements. The residential property also included a

swimming pool, tennis court, fountain, and extensive landscaping.

Both Mayor and KareMor maintain their principal corporate

office in a complex located on 24th Street in Phoenix, Arizona.4

The complex occupies the east and west sides of the street and

includes multiple buildings and surrounding landscaping. On the

east side are three buildings: A two-story office building, a

4
The record fails to clarify the precise ownership, as
between petitioners and/or one of their various entities, of this
property.
 - 8 -

manufacturing laboratory, and a storage warehouse. Five

buildings are located on the west side and consist of both office

and warehouse or industrial space, some of which is leased to

third-party tenants.

In operating their businesses, petitioners employed the

services of several professional advisers. Robert J. Hartmann,

an attorney, certified in Arizona as a tax law specialist in past

years and also holding a degree in accounting, met Mr. Deihl in

1983 and became involved in legal work for Mr. Deihl and his

companies. Mr. Hartmann initially assisted with contract

disputes and organizational issues, and by 1998 approximately 70

percent of his practice was devoted to providing services for

petitioners and their entities. At that time and at Mr. Deihl’s

request, Mr. Hartmann relocated to an office on 24th Street to be

closer to the corporate headquarters.

With respect to the accounting function, prior to about the

1991 to 1992 period, petitioners had employed the services of an

outside accounting firm, referred to as “Duskin & Duskin”,

apparently working principally with Bernie Duskin, alleged to be

a certified public accountant (C.P.A.). Mr. Duskin introduced

Mr. Deihl to Martin D. Goltz, recently arrived in Arizona from

Illinois. Mr. Goltz had received from DePaul University in

Chicago, Illinois, a degree in accounting in 1964 and then a

juris doctorate in 1967. Mr. Goltz was licensed by the State of
 - 9 -

Illinois as a C.P.A. in about 1966 and maintained that license

for approximately 20 years. He thereafter ceased to renew the

license because he had not fulfilled continuing education

requirements. Mr. Goltz similarly obtained a license to practice

law from the State of Illinois in 1967 or 1968, and he maintained

the license until he was disbarred in 1985 or 1986.

After being introduced to Mr. Deihl, Mr. Goltz was engaged

by Mayor as an independent contractor to perform part-time

accounting and consulting work. During 1994 or 1995, Mr. Goltz

was hired as a full-time employee and provided with an office at

the corporate headquarters where he displayed the various

professional degrees and certificates pertaining to his career as

a C.P.A. and attorney in Illinois. By 1996, the first of the

years in issue, Mr. Goltz served as the accountant and CFO for

both Mayor and KareMor. Mr. Goltz prepared the original income

tax returns for petitioners, Mayor, and KareMor for 1996 and

1997.

As the businesses grew throughout the years in issue,

Mr. Goltz became overwhelmed with the volume of work. An

individual hired to assist him proved to be a poor fit for the

companies and failed to relieve the burden. The business and tax

records were not computerized and were manually prepared.

Mr. Goltz estimated substantially all of the expense items,

including the inventory for both companies. As he testified:
 - 10 -

“And it certainly wasn’t intentional but it was literally

throwing numbers together to try to get the returns, you know,

filed on time.”

At some point during 1998, and apparently in conjunction

with an investigation into whether to take one of his entities

public, Mr. Deihl engaged the C.P.A. firm Donald R. Leo and

Company, Ltd., to review financial materials and tax returns. As

problems came to light, Mr. Goltz was demoted from his position

as CFO; an individual named Pam Roeper was hired to succeed him

in that role; and Mr. Leo was engaged to reconstruct financial

records, to create general ledgers, and to prepare tax returns

based thereon. Mr. Goltz stayed with the companies until late

2000 attempting to provide whatever assistance he could to Mr.

Leo. Between June of 1998 and April of 2000, Mr. Leo prepared

and filed on behalf of petitioners, Mayor, and KareMor amended

returns for 1996 and 1997, and original and (for petitioners

only) amended returns for 1998.

OPINION

I. Preliminary Matters

A. Record Generally

As indicated by the recitation of issues at the outset of

this opinion, these cases principally concern petitioners’

entitlement, through their S corporations, to deductions or

offsets for a wide range of expenditures. The notices of
 - 11 -

deficiency involved nearly a hundred adjustments, and the parties

are to be commended for substantially narrowing the categories

that remain at issue. Nevertheless, a few preliminary comments

about the status of the record are in order.

Despite the above-mentioned narrowing of the issues, the

categories that remain in dispute incorporate many dozens of

discrete outlays. The stipulated exhibits alone run well over a

thousand pages. Yet as to a substantial portion of the

individual items claimed, petitioners failed to address the

specific expenditures at trial or on brief. Petitioners’

testimony instead tended to be broad brushed and conclusory in

approach. There is no shortage of blanket testimony resorting to

use of the word “all” in various contexts that the Court is

simply unwilling to countenance at face value. Hence, from a

substantiation standpoint, the Court is apparently expected in

many instances to rely on nothing more than perhaps credit card

statements and the characterizations reflected in the general

ledgers offered by petitioners.

In this connection, and as will become clearer in the

discussion to follow, the Court observes that petitioners’

general ledger categories for expenditures seem to be vaguely

defined, overlapping, random, and self-serving. For example, the

rhyme or reason for labeling what would appear to be similar

outlays as incurred for training, meetings, and/or conventions,
 - 12 -

versus for promotion, versus for meals and entertainment, versus

for marketing, is left largely unilluminated. Additionally,

testimony regarding their preparation shows that the general

ledgers are largely noncontemporaneous attempts at reconstruction

of financial records without complete support in underlying

primary documentation. Mr. Hartmann stated at trial: “And when

Donald Leo was hired he looked at some of the tax returns that

had been filed and apparently there was no supporting books and

records that go with them. Mr. Leo was hired to create this

general ledger for the years ’95 ’96, ’97. I believe he also did

1998.” Mr. Goltz’s testimony in explaining his role after the

hiring of Mr. Leo offers further details, as follows:

A Actually what I was doing was most of my time
was spent working with the CPA, that’s Mr. Leo and his
staff, bringing the records up to snuff. Everything
was done manually before, okay. There was no computer
system in play and it was just an absolute disaster.
And I would get, I would haul boxes and boxes of
records and help with the inputting. I wasn’t doing it
but supplying information so that the records in
essence could be reconstructed because they were a
disaster.

Q Did you classify the data that was inputted
or did the person just utilize the face of the check?

A The accounting people were classifying it.
And if they had questions I’d do my best to answer them
or get the answer. Or if they needed invoices and they
didn’t have them I would do my best to, you know, get
them for them.

Q * * * What was the ultimate work product as a
result of CPA Don Leo’s efforts with your assistance?
 - 13 -

A There were statements issued for I’m not sure
of the time frame. My guess is ’95, 6, 7. Maybe I’m
wrong but I think maybe ’98. And after that I left and
I don’t really know what took place. But financial
statements were being issued--were issued.

* * * * * * *

Q Okay. Was a general ledger prepared as a
result of this effort?

A Yes.

Such testimony hardly instills a resounding confidence in the

reliability of these documents.

Furthermore, even as to those items for which the record

contains some form of invoice or receipt, those documents in and

of themselves and absent any additional explanation from

petitioners are often insufficient to establish all requisites

for the treatment claimed. Likewise, for the particular

expenditures that petitioners do touch on in the testimony

offered, their brief statements typically fall far short of

addressing all pertinent requirements for allowance.

Hence, while the Court has dealt with the record presented,

we are left with the overall impression that petitioners have

chosen to bank on a rather haphazard, big-picture, almost all-or-

nothing approach in lieu of the item-by-item documentation or

detail we would have expected for issues of this nature.

B. Burden of Proof

Against the foregoing backdrop, the Court addresses the

parties’ contentions regarding burden of proof. As a general
 - 14 -

rule, determinations by the Commissioner are presumed correct,

and the taxpayer bears the burden of proving otherwise. Rule

142(a). Section 7491 may operate, however, in specified

circumstances to place the burden on the Commissioner. Section

7491 is applicable to court proceedings that arise in connection

with examinations commencing after July 22, 1998, and reads in

pertinent part:

SEC. 7491. BURDEN OF PROOF.

(a) Burden Shifts Where Taxpayer Produces Credible
Evidence.--

(1) General rule.--If, in any court
proceeding, a taxpayer introduces credible
evidence with respect to any factual issue
relevant to ascertaining the liability of the
taxpayer for any tax imposed by subtitle A or B,
the Secretary shall have the burden of proof with
respect to such issue.

(2) Limitations.--Paragraph (1) shall apply
with respect to an issue only if--

(A) the taxpayer has complied with the
requirements under this title to substantiate
any item;

(B) the taxpayer has maintained all
records required under this title and has
cooperated with reasonable requests by the
Secretary for witnesses, information,
documents, meetings, and interviews; * * *

* * * * * * *

(c) Penalties.--Notwithstanding any other
provision of this title, the Secretary shall have the
burden of production in any court proceeding with
respect to the liability of any individual for any
penalty, addition to tax, or additional amount imposed
by this title.
 - 15 -

See also Internal Revenue Service Restructuring and Reform Act of

1998, Pub. L. 105-206, sec. 3001(c), 112 Stat. 727, regarding

effective date. Section 7491 is applicable here in that

examination of petitioner’s 1996, 1997, and 1998 tax years began

after July 22, 1998.

With respect to the deficiency determinations in dispute,

the operative rules are contained in section 7491(a).

Petitioners make the assertion, apparently for the first time on

opening brief, that the burden of proof as to factual issues

shifts to respondent because “Petitioners have produced credible

testimony and documents, most especially regarding their reliance

on CPA’s [sic] and an attorney.” The Court, however, concludes a

shift is not appropriate on this record for the reasons set forth

below.

First, as can be gleaned from the preceding discussion, the

Court finds that petitioners have failed to introduce credible

evidence with respect to the majority of the individual

expenditures in contention. Credible evidence for purposes of

section 7491(a) is defined as “the quality of evidence which,

after critical analysis, the court would find sufficient upon

which to base a decision on the issue if no contrary evidence

were submitted (without regard to the judicial presumption of IRS

correctness).” H. Conf. Rept. 105-599, at 240-241 (1998), 1998-3

C.B. 747, 994-995. Such quality is lacking in much of what has
 - 16 -

been offered here. Nonetheless, the Court need not probe this

matter in detail as to individual items because of the remaining

considerations discussed next.

Second, even where credible evidence is introduced, the

taxpayer must establish, as a prerequisite to any shift under

section 7491(a)(1), that he or she has complied under section

7491(a)(2) with all substantiation requirements, has maintained

all required records, and has cooperated with reasonable requests

for witnesses, information, documents, meetings, and interviews.

H. Conf. Rept. 105-599, supra at 239-240, 1998-3 C.B. at 993-994.

Petitioners in their burden of proof argument make no attempt to

address specifically whether they have satisfied these

conditions, and the record indicates that they have not.

Since this is primarily a substantiation matter, the ideas

of credible evidence and substantiation are to a significant

extent intertwined, and our comments above apply equally in this

context. In addition, given the circumstances surrounding the

noncontemporaneous reconstruction of records underlying the

amounts claimed by petitioners in these cases and the lack of

supporting invoices or receipts for a significant number of the

outlays, maintenance of all required records would also appear to

be lacking. Full cooperation is likewise called into question

where the record contains copies of information document requests

from respondent highlighting items requested during the
 - 17 -

examination process and never supplied. Thus, petitioners have

not shown compliance with section 7491(a)(2).

Third, this Court has noted in earlier cases the potential

impropriety of shifting the burden under section 7491(a) where

the taxpayers did not raise the issue prior to the briefing

process. E.g., Menard, Inc. v. Commissioner, T.C. Memo. 2004-

207; Estate of Aronson v. Commissioner, T.C. Memo. 2003-189.

The rationale for this concern rests upon the possible prejudice

to the Commissioner’s ability to introduce evidence specifically

directed toward cooperation during the audit period. Menard,

Inc. v. Commissioner, supra; Estate of Aronson v. Commissioner,

supra.

With respect to the accuracy-related penalty, the

Commissioner satisfies the section 7491(c) burden of production

by “[coming] forward with sufficient evidence indicating that it

is appropriate to impose the relevant penalty” but “need not

introduce evidence regarding reasonable cause, substantial

authority, or similar provisions.” Higbee v. Commissioner, 116

T.C. 438, 446 (2001). Rather, “it is the taxpayer’s

responsibility to raise those issues.” Id. Because, as will be

more fully detailed infra, respondent has introduced sufficient

evidence to render the section 6662(a) penalty at least facially

applicable, the burden rests on petitioners to show why it should

not be applied.
 - 18 -

C. Evidentiary Issue

At trial, petitioners sought to introduce into evidence a

20-minute videotape. Mr. Deihl explained that videos were taken

of conventions, training sessions, and other KareMor events.

Clips from the collection of tapes so generated were then used to

create the 20-minute summary video offered at trial. Respondent

objected to admission of the video based on rules 401, 901(a),

1001, 1002, and 1006 of the Federal Rules of Evidence, which

rules address relevance, authentication, the requirement of

original recordings, and use of summaries. The Court reserved

ruling on the tape’s admissibility and took the matter under

advisement.

Having had an opportunity to review the totality of the

record in light of the specific issues presented by these cases,

the Court believes respondent’s concerns as to relevancy are well

taken. Rule 401 of the Federal Rules of Evidence defines

“relevant evidence” as “evidence having any tendency to make the

existence of any fact that is of consequence to the determination

of the action more probable or less probable than it would be

without the evidence.” Mr. Deihl stated that the video tape

depicted “Actions at the conventions, the entertainers, the

arrivals, the pomp and circumstances, the pageantry, the gowns

worn”. Counsel for petitioners expressed the proffer as follows:

it is offered as for illustrative purposes as to what
happened with respect to the training sessions, what’s
 - 19 -

going on at the house, the hoopla, the hype, the
conventions, the costumes, the whole flavor of what
this gentlemen has created with KareMor. And that can
be illustrated by photos which we’ll move to next, but
the photos don’t show the excitement in the air like a
video does.

Initially, Mr. Deihl testified that only recordings from

1996, 1997, and 1998 were used in creating the videotape.

However, after similar assertions with respect to the years

depicted in various photographs were shown on voir dire to be

unreliable, counsel reproffered the videotape on the more general

basis of showing how KareMor operated over “the time frame of ’93

through early ’99.”

On this basis, the Court is not convinced that the videotape

would make any fact of consequence to the resolution of these

cases more probable. The record is already replete with

generalized evidence attesting to how petitioners ran a

successful multilevel marketing enterprise, complete with hype,

pageantry, and prizes, as well as a glamorous residence and

wardrobe to fit the part. The Court, as demonstrated in our

findings of fact, does not doubt that petitioners’ business model

successfully used these strategies to instill enthusiasm in the

distributors.

Nonetheless, facts of consequence to the outcome of this

proceeding are those which would establish that petitioners have

met the substantiation and other requisites for the deduction of

each of the particular expenditures made in 1996, 1997, and 1998.
 - 20 -

The videotape, by its nature, would not even connect any

individual outlay reflected in petitioners’ ledgers, credit card

statements, etc., to any specific business function during the

years in issue, since the tape purports to cover only a general

modus operandi from 1993 through 1999. Nor would it afford the

Court a rational foundation, for example, to estimate the

percentage of business versus personal use for a given type of

expense, since the tape purports to show only business events.

The Court cannot conclude that the video conforms to the

definition of relevant evidence in rule 401 of the Federal Rules

of Evidence.

Furthermore, even assuming that the videotape could clear

the relevancy hurdle, the evidence would properly be excluded

under rule 403 of the Federal Rules of Evidence, which reads:

“Although relevant, evidence may be excluded if its probative

value is substantially outweighed by the danger of unfair

prejudice, confusion of the issues, or misleading the jury, or by

considerations of undue delay, waste of time, or needless

presentation of cumulative evidence.” As indicated in the

preceding discussion, the tape would be needlessly cumulative on

this record.

Respondent did not object to admission of the photographs

offered by petitioners as generally showing petitioners’

promotional activities, including conventions, training, and
 - 21 -

parties, from 1993 to 1999. Thus, the Court has a visual

representation of petitioners’ operations. There is likewise no

shortage of generalized verbal descriptions regarding how

petitioners ran their operations, motivated distributors, gave

away prizes, created a lifestyle to envy, and so on. The

generalized summary videotape would therefore add nothing

material to the evidence before the Court. The Court shall

exclude the videotape on grounds of relevancy or cumulation and

need not reach the additional bases for exclusion argued by

respondent.

II. S Corporation Expenditure Deductions

The expenditures of Mayor and KareMor at issue in this

proceeding were categorized, first in general ledgers and then

correspondingly in relevant tax returns, notices of deficiency,

stipulations, and briefs, as pertaining to (1) capitalized

business improvements; (2) landscaping; (3) security; (4)

training, meetings, and/or conventions; (5) promotion; (6)

suspense; (7) marketing; or (8) meals and entertainment. As

alluded to previously and as will be further elucidated infra in

text, some of these classifications are ambiguous at best and do

not lend themselves to analysis of pertinent issues.

Accordingly, for purposes of discussion herein, the Court will

employ the following groupings: (1) Amortization of residence

improvements; (2) landscaping; (3) security; (4) clubs; (5)
 - 22 -

entertainment; (6) gifts, awards, or cash; (7) clothing; (8)

equipment and furnishings; (9) contributions; and (10) promotion

or marketing.

A. General Rules

Deductions are a matter of “legislative grace”, and “a

taxpayer seeking a deduction must be able to point to an

applicable statute and show that he comes within its terms.” New

Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); see also

Rule 142(a). As a general rule, section 162(a) authorizes a

deduction for “all the ordinary and necessary expenses paid or

incurred during the taxable year in carrying on any trade or

business”. An expense is ordinary for purposes of this section

if it is normal or customary within a particular trade, business,

or industry. Deputy v. du Pont, 308 U.S. 488, 495 (1940). An

expense is necessary if it is appropriate and helpful for the

development of the business. Commissioner v. Heininger, 320 U.S.

467, 471 (1943). Section 262, in contrast, precludes deduction

of “personal, living, or family expenses.”

The breadth of section 162(a) is tempered by the requirement

that any amount claimed as a business expense must be

substantiated, and taxpayers are required to maintain records

sufficient therefor. Sec. 6001; Hradesky v. Commissioner, 65

T.C. 87, 89-90 (1975), affd. 540 F.2d 821 (5th Cir. 1976); sec.

1.6001-1(a), Income Tax Regs. When a taxpayer adequately
 - 23 -

establishes that he or she paid or incurred a deductible expense

but does not establish the precise amount, we may in some

circumstances estimate the allowable deduction, bearing heavily

against the taxpayer whose inexactitude is of his or her own

making. Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir.

1930). There must, however, be sufficient evidence in the record

to provide a basis upon which an estimate may be made and to

permit us to conclude that a deductible expense, rather than a

nondeductible personal expense, was incurred in at least the

amount allowed. Williams v. United States, 245 F.2d 559, 560

(5th Cir. 1957); Vanicek v. Commissioner, 85 T.C. 731, 742-743

(1985).

Furthermore, business expenses described in section 274 are

subject to rules of substantiation that supersede the doctrine of

Cohan v. Commissioner, supra. Sanford v. Commissioner, 50 T.C.

823, 827-828 (1968), affd. 412 F.2d 201 (2d Cir. 1969); sec.

1.274-5T(a), Temporary Income Tax Regs., 50 Fed. Reg. 46014 (Nov.

6, 1985). Section 274(d) provides that no deduction shall be

allowed for, among other things, traveling expenses,

entertainment expenses, gifts, and expenses with respect to

listed property (as defined in section 280F(d)(4) and including

passenger automobiles, computer equipment, and cellular

telephones) “unless the taxpayer substantiates by adequate

records or by sufficient evidence corroborating the taxpayer’s
 - 24 -

own statement”: (1) The amount of the expenditure or use; (2)

the time and place of the expenditure or use, or date and

description of the gift; (3) the business purpose of the

expenditure or use; and (4) in the case of entertainment or

gifts, the business relationship to the taxpayer of the

recipients or persons entertained. Sec. 274(d).

In addition to the general business expense deduction rule

of section 162, section 167 authorizes “as a depreciation

deduction a reasonable allowance for the exhaustion, wear and

tear (including a reasonable allowance for obsolescence)--(1) of

property used in the trade or business, or (2) of property held

for the production of income.” Sec. 167(a).

When applying sections 162 and 167 in the context of

particular items of property, the following general framework has

emerged through caselaw. Under either section, the initial

question is whether ownership and maintenance of the property is

related primarily to business or to personal purposes. Intl.

Artists, Ltd. v. Commissioner, 55 T.C. 94, 104 (1970) (and cases

cited thereat); see also, e.g., Richardson v. Commissioner, T.C.

Memo. 1996-368; Griffith v. Commissioner, T.C. Memo. 1988-445.

The answer to this question determines which of three approaches

is appropriate: (1) If acquisition and maintenance of the

property is primarily associated with profit-motivated purposes

and any personal use is distinctly secondary and incidental,
 - 25 -

expenses and depreciation are deductible; (2) if acquisition and

maintenance is motivated primarily by personal considerations,

deductions are disallowed; and (3) if substantial business and

personal motives exist, allocation becomes necessary. Intl.

Trading Co. v. Commissioner, 275 F.2d 578, 584-587 (7th Cir.

1960), affg. T.C. Memo. 1958-104; Intl. Artists, Ltd. v.

Commissioner, supra at 104-105; Richardson v. Commissioner,

supra; Griffith v. Commissioner, supra; Kenerly v. Commissioner,

T.C. Memo. 1984-117.

Where the property in question is residential in character,

a further limitation with potential bearing on business-related

deductions claimed under section 162 or 167 is contained in

section 280A. Effective for tax years beginning after 1975, that

statute reads in part:

SEC. 280A. DISALLOWANCE OF CERTAIN EXPENSES IN
CONNECTION WITH BUSINESS USE OF HOME,
RENTAL OF VACATIONS HOMES, ETC.

(a) General Rule.--Except as otherwise provided in
this section, in the case of a taxpayer who is an
individual or an S corporation, no deduction otherwise
allowable under this chapter shall be allowed with
respect to the use of a dwelling unit which is used by
the taxpayer during the taxable year as a residence.

* * * * * * *

(c) Exceptions for Certain Business or Rental Use;
Limitations on Deductions for Such Use.--

(1) Certain business use.--Subsection (a)
shall not apply to any item to the extent such
item is allocable to a portion of the dwelling
 - 26 -

unit which is exclusively used on a regular
basis--

(A) as the principal place of business for
any trade or business of the taxpayer,

(B) as a place of business which is used
by patients, clients, or customers in meeting
or dealing with the taxpayer in the normal
course of his trade or business, or

(C) in the case of a separate structure
which is not attached to the dwelling unit,
in connection with the taxpayer’s trade or
business.

In the case of an employee, the preceding sentence
shall apply only if the exclusive use referred to
in the preceding sentence is for the convenience
of his employer.

(2) Certain storage use.-- * * *

(3) Rental use.-- * * *

B. Amortization of Residence Improvements

The parties stipulated as follows: “KareMor expended monies

for lavish improvements to PETITIONERS’ personal residence.

Based upon those expenditures KareMor claimed amortized expenses.

RESPONDENT does not dispute the amounts claimed but disputes the

deductibility.” Petitioners seek deductions of $313,576 for

1996, $549,028 for 1997, and $566,559 for 1998.

Both petitioners and respondent devote extensive discussion

on brief to whether the expenditures by KareMor for improvements

satisfy the threshold business purpose criterion pertinent to

deductibility under either section 162 or 167. Respondent argues

that the amounts were not expended for ordinary and necessary
 - 27 -

business purposes, while petitioners contend that creation of a

“trophy house” generates an ordinary and necessary business

expense akin to an outlay for marketing, promotion, or

advertising. Respondent then goes on to argue that,

additionally, the standards for deductibility under section 280A

must be met but are not on these facts. Petitioners, in

contrast, maintain that section 280A does not apply. Their

position is: “Respondent’s reliance on §280A is misplaced for

the simple reason that that section deals with ‘use of a

dwelling,’ meaning use of a dwelling as a facility, not use of a

dwelling as a trophy house aka billboard in lieu of money spent

for highway billboard or other media purchases, such as radio,

t.v. and newsprint.”

Because the Court concludes that section 280A is applicable

to petitioners’ situation and that petitioners fail to meet the

requirements imposed therein, we find it unnecessary to probe

further the intricacies of sections 162 and 167. Even assuming

arguendo that the improvements could be considered sufficiently

business-related in a multilevel marketing enterprise such as

petitioners’ to support deductibility under section 162 or 167,

section 280A precludes allowance.

The test of section 280A(a) states the following general

rule: “Except as otherwise provided in this section, in the case

of a taxpayer who is an individual or an S corporation, no
 - 28 -

deduction otherwise allowable under this chapter shall be allowed

with respect to the use of a dwelling unit which is used by the

taxpayer during the taxable year as a residence.” The plain

language thus mandates that if a dwelling unit is used as a

residence, no deduction is permitted.

For purposes of this rule, “dwelling unit” is defined in

section 280A(f)(1)(A) to include “a house * * * and all

structures or other property appurtenant to such dwelling unit.”

The only exception is for such a unit “used exclusively as a

hotel, motel, inn, or similar establishment.” Sec.

280A(f)(1)(B). “Use as residence” is likewise a defined term; to

wit, a dwelling unit is used as a residence if it is used “for

personal purposes” during the taxable year for a number of days

in excess of the greater of 14 days or 10 percent of the days it

is rented at fair value. Sec. 280A(d)(1). Personal use, in

turn, is deemed to have been made of a dwelling unit for a day if

it is used for any part of the day for personal purposes by the

taxpayer or a family member. Sec. 280A(d)(2). In the case of an

S corporation, the foregoing rules are applied “by substituting

‘any shareholder of the S corporation’ for ‘the taxpayer’”. Sec.

280A(f)(2).

Given these definitions, petitioners’ semantic argument on

this issue devolves into mere sophistry. There is no doubt that

the property at 4627 East Foothill Drive is a “house”. The
 - 29 -

property was remodeled to become more grandiose, but it still

included a living room, dining room, family room, bedrooms,

bathrooms, etc. Petitioners slept there, ate there, and had free

access to all areas of the home, gardens, and amenities such as

the pool. Their grandchildren visited and could go anywhere they

pleased. Petitioners entertained guests other than distributors

at the property. Accordingly, 4627 East Foothill Drive was a

dwelling unit used by petitioners as a residence within the

meaning of section 280A.

Because section 280A applies, no deduction is allowed under

“this chapter” unless one of the enumerated exceptions is

satisfied. “This chapter” refers to chapter 1, Normal Taxes and

Surtaxes, of the Internal Revenue Code and includes both sections

162 and 167, which are contained in part VI of subchapter B of

chapter 1. Petitioners’ apparent suggestion that they can avoid

the strictures of section 280A by meeting the requisites of

section 162 or 167 and their reliance on cases involving tax

years prior to the enactment of section 280A are unfounded.

As this Court has explained:

Section 280A was added to the Internal Revenue
Code by the Tax Reform Act of 1976 to provide
“definitive rules relating to deductions for expenses
attributable to the business use of homes.” S. Rept.
94-1236 (1976), 1976-3 C.B. (Vol. 3) 807, 839. Prior
to the enactment of section 280A, this Court had
allowed a deduction for an office in an employee’s
residence on the grounds that the maintenance of such
office was “appropriate and helpful” under the
circumstances. Congress felt that clear-cut rules
 - 30 -

governing deductibility were needed because of the
administrative burdens which resulted from requiring
taxpayers to substantiate the business element of what
is normally a personal item (i.e., maintenance of a
residence). Additionally, there was the concern that,
under the standards adopted by some courts
(particularly this Court), those which were otherwise
personal expenses were being allowed as deductions.
[Baie v. Commissioner, 74 T.C. 105, 108-109 (1980); fn.
refs. omitted.]

Cases pertaining to taxable years subsequent to the 1976

effective date of section 280A have enforced the statute in the

context of both claimed expenses and depreciation. For instance,

in Griffith v. Commissioner, T.C. Memo. 1988-445, the taxpayer

claimed business expenses and depreciation with respect to his

residence for tax years both before and after section 280A’s

enactment. For 1974 and 1975, the Court applied the standards

set forth in Intl. Artists, Ltd. v. Commissioner, 55 T.C. 94

(1970), and advocated by petitioners here, but then noted that

section 280A would preclude an allocation between business and

personal use for 1976 through 1978 without a showing of exclusive

business use of a portion of the home. Griffith v. Commissioner,

supra. Similarly, addressing tax years 1980 through 1982, the

Court in Hefti v. Commissioner, T.C. Memo. 1988-22, affd. without

published opinion 894 F.2d 1340 (8th Cir. 1989), discussed the

legislative history and observed that “Any personal use of a room

or segregated area will preclude its use in computing

depreciation or other allocable expenditures”.
 - 31 -

On a related point, petitioners’ contention that the

deductions at issue should be allowed notwithstanding section

280A because the house functions as a “trophy house” or

“billboard” and could be characterized as marketing, promotion,

or advertising is essentially a claim that the applicability of

section 280A should turn on the type of business use to which the

otherwise residential property is put. This position has been

rejected in words that ring true here:

Section 280A provides a broad general rule
requiring disallowance of deductions attributable to
the business use of a personal residence, irrespective
of the type or form of business use. It is true that
the potential for abuse in this area was typified by
the situation where a taxpayer would make a dubious
claim for a home office deduction. * * * Unfortunately
for the petitioners here, the words of the law which
Congress passed are straightforward and much broader in
their applicability--sufficiently broad as to catch
petitioners in their net. We are not, therefore, at
liberty to “bend” the law, much as we may sympathize
with petitioner’s position. [Baie v. Commissioner,
supra at 110; emphasis added.]

As regards exceptions under section 280A(c), the record does

not show, and indeed petitioners have never claimed, that any are

met here.5 No portion of the residence was used exclusively for

business. Hence, neither petitioners nor any of their related

entities are entitled to deductions for the capitalized residence

improvements.

5
Petitioners state on brief: “Never have Petitioners
claimed that (a) their home was a place of business, or (b) that
use by distributors was exclusive.”
 - 32 -

C. Landscaping

Petitioners seek to deduct under section 162 as business

expenses of Mayor and KareMor charges for landscaping and related

maintenance. Portions of the amounts claimed have been allowed

or conceded by respondent. In support of these deductions, the

record contains principally a number of handwritten invoices

from, and copies of checks made payable to, Audelio Rios, also

known as Delio Rios. Many of the invoices provide few details as

to the work performed, and what notations are included frequently

appear to be written in Spanish. At trial, Mr. Deihl and Mr.

Hartmann testified that Mr. Rios performed landscaping and

maintenance for the corporate property on 24th Street, for

petitioners’ residence, and for the residence of Joe II, which

was located on Mountainview Drive. Certain of the invoices also

contain references to “Biol Dihol” or “3 casas” or “3 houses”,

and respondent argues that Mr. Rios provided services at Bill’s

residence as well.

To the extent that the expenditures were incurred for

landscaping and maintenance on the residential premises of

petitioners and either of their two sons, any deductions are

precluded by section 280A for reasons essentially identical to

those just discussed in connection with the improvements to

petitioners’ home. The definition of “dwelling unit” for

purposes of section 280A includes “other property appurtenant to
 - 33 -

such dwelling unit”. Sec. 280A(f)(1)(A). No portion of

petitioners’ dwelling was used exclusively for business, and the

record is devoid of any showing of business use of the home of

either son. Consequently, no deduction for landscaping

attributable to these properties is allowable.

With respect to the corporate premises, landscaping and

maintenance costs would generally be deductible under section

162. It is further undisputed that Mayor and KareMor incurred

such expenses for the 24th Street property. The difficulty

arises in that the record provides no link between the business

premises and the particular payments reflected in the general

ledgers and invoices beyond what has already been allowed or

conceded by respondent. Moreover, the evidence is not sufficient

to permit any reasonable estimate or allocation under the

principles of Cohan v. Commissioner, 39 F.2d at 543-544.

When questioned at trial, Mr. Deihl and Mr. Hartmann

attributed 70 percent of the landscaping costs to the corporate

property and 30 percent to the residential properties. However,

in the December 31, 1998, general ledgers for Mayor and KareMor,

a 60-percent business versus 40-percent personal allocation was

used for the adjusting journal entries. No attempt has been made

to explain the change in position, but the shift does suggest a

degree of arbitrariness in the figures.
 - 34 -

Mr. Deihl also testified to approximate acreage of 10 for

the corporate property, “about 1.8” for his home, and “about an

acre, acre plus” for Joe II’s residence. However, no documentary

evidence corroborates these numbers, and square footage in any

event would seem to be a poor basis for allocation when the scope

of landscaping is likely to differ markedly between a showplace

home and more prosaic commercial real estate. Furthermore, to

the extent that any references to a particular property can be

gleaned from the invoices, these would appear to be weighted

toward the residential premises. The law therefore does not

countenance any further deduction for maintenance and

landscaping.

D. Security

The disputed security services were provided by Michael Reed

and his subcontractors, by Capital Guard & Patrol, Inc., and by

Arizona Protection Agency. Invoices in the record show that

security services were provided by these entities at both the

corporate property on 24th Street and at petitioners’ personal

residence on Foothill Drive. Protection was also provided to

members of the Deihl family when traveling. Although invoices

were occasionally addressed to KareMor, the disputed security

services were paid and deducted by Mayor during 1997 and 1998 in

the claimed amounts of $192,918.70 and $72,124.64, respectively.
 - 35 -

Costs of security at the corporate property are deductible

as a business expense under section 162. On audit, after

extensive review of documentation, respondent allowed deductions

on this basis of $91,372 in 1997 and $24,267 in 1998 that the

record reasonably permitted to be identified and allocated to the

corporate property. Respondent later stipulated the concession

of an additional $1,100 for 1997, the nature of which has not

been further explained. Petitioners do not directly allude to

any particular charges disallowed that were in fact attributable

to the corporate premises and not so characterized by respondent.

However, as detailed below in connection with our investigation

of petitioners’ complaint regarding security on a trip to Puerto

Rico, the Court has concluded that an additional deduction for

security on the corporate premises is appropriate.

Costs of securing residential property are generally

nondeductible under section 280A for the reasons previously

discussed in conjunction with petitioners’ claims regarding

capitalized improvements and landscaping. Mr. Deihl testified

that security services were utilized at petitioners’ home only

during the latter part of 1996 and early 1997, but this testimony

is patently contrary to the documentary evidence. Invoices

explicitly show charges for security at the house into at least

March of 1998, and the record lacks substantiation or explanation

for a number of expenditures beyond that date. Mr. Deihl’s
 - 36 -

assertion that security expenses were 96 to 97 percent business

in nature and only 3 to 4 percent personal is likewise in direct

conflict with the respective charges shown for the Foothill Drive

and 24th Street properties in the proffered invoices. Thus, what

testimony was offered concerning the proportion of security costs

attributable to the residence has proven unreliable. Nor have

petitioners suggested grounds on which any particular expenses

disallowed as potentially residential should not be subject to

the proscriptions of section 280A.

Regarding costs for security while traveling, Mr. Deihl

testified that guards secured merchandise at conventions but also

protected family members, particularly children, by acting as a

buffer between them and the distributors and by escorting them

amongst the various rooms, etc. Petitioners’ sole and entire

argument on brief addressing security is as follows: “we find

that Respondent disallowed almost $12,000 in security expense

with respect to security guards during a trip to Puerto Rico in

February of 1998 for Petitioners’ training. Petitioners

testified about the need for security during their business

trips.”

The referenced outlay is evidenced by an invoice from

Michael Reed dated February 18, 1998, showing three charges. The

first is $8,646 for 752 hours, at the stated rate of $11.50 per

hour, on 2/8/98 through 2/21/98, at the location “POST 1”. Next
 - 37 -

listed is $3,000 for Tony, Jennifer, and Karlas “ON EP TRIP TO P.

RICO”, on 2/11 through 2/14, at the rate of $250 per guard per

day. Third is $2,829 for 246 hours, at the rate of $11.50 per

hour, on 2/8/98 through 2/21/98, at the location “POST 2”.

Respondent allowed $2,829 of the $14,475 total amount as a

deduction and disallowed the remaining $11,646.

Other invoices from Michael Reed contained in the record

show locations “HOUSE” and “PLANT”, indicating a practice of

billing based on these two categories. In examination of the

above-described and less definitive invoice, it appears that

respondent, absent further explanation from petitioners, may

arbitrarily have allowed the lesser charge. Nonetheless, on the

basis of an invoice for the previous 2-week period, which as

corrected shows an identical 246 hour and 752 hour split for

locations “HOUSE” and “PLANT”, respectively, the Court is willing

to allow petitioners an additional $5,817 in security expenses

($8,646 - $2,829) as attributable to the corporate property.6

As to the costs incurred for security while traveling,

Mr. Deihl’s testimony convinces us that while a portion may

represent legitimate business expenses, many are far more

6
The Court notes that with respect to the only other 2-week
periods in 1998 for which invoices are in the record, the
documents fail to support a similar allocation either because all
charges are characterized as attributable to “HOUSE” or because
the two locations are listed without specifying the hours or the
charges for a particular location.
 - 38 -

personal in nature. Again, however, the record provides no guide

for any reasonable estimation under Cohan v. Commissioner, 39

F.2d at 543-544. Therefore, given the state of the record7 and

petitioners’ lack of any explanation or further argument, the

Court is not in a position to conclude that respondent’s

allocations, with the limited exception discussed above, are

other than generally reasonable and supported by the available

documents.

E. Clubs

One of the many subsets of expenditures deducted by

petitioners under the category referred to as training, meetings,

and/or conventions is outlays to Arizona Club, to Gardiner’s

Resort on Camelback (also referred to as Gardiner’s Tennis

Ranch), and to Gainey Ranch Golf Club. Mr. Deihl testified that

the Arizona Club is a private social club, charging membership

fees, with restaurant, banquet, and catering facilities. He

stated that petitioners used the Arizona Club for events such as

business luncheons and training meetings. They also utilized the

catering services for outside parties at their home.

Additionally, Mr. Deihl testified that the family made personal

use of the club for events including holiday functions and

7
As an additional observation, we point out that at least
$1,800 deducted as a security expense is highly suspect in that
invoices show the amount was charged to provide band music and
three carolers at a Christmas party.
 - 39 -

children’s parties. He estimated that 80 to 85 percent of the

use was for business purposes and that 15 to 20 percent was for

pleasure or personal purposes.

Gardiner’s Resort, according to Mr. Deihl, is a private

tennis club where petitioners hosted certain smaller KareMor

meetings and events. It was Mr. Deihl’s testimony that all use

of Gardiner’s Resort was business rather than personal in nature.

As regards Gainey Ranch Golf Club, petitioners offered no mention

of this facility either at trial or on brief.

The record contains a number of invoices from each of these

clubs, and the descriptions of the charges thereon typically fall

into one of three general categories. The majority of the

descriptions include one or more words indicating food or drink

services (or tips in connection therewith), such as “Restaurant”,

“Dinner”, “Lunch”, “Food”, “Bev”, “Wine”, “Bar”, “Banquet”,

“Caterout”, “Tip”, etc. A smaller number of the descriptions

indicate equipment rentals, requested services, or labor in

connection with catered events. The remaining descriptions

principally comprise membership dues, finance charges, late fees,

or contributions to an employee Christmas fund.

As previously indicated, section 274 imposes limitations on

expenses relating to entertainment and associated facilities

beyond the general business purpose criterion of section 162.

Section 274(a) reads as follows:
 - 40 -

SEC. 274. DISALLOWANCE OF CERTAIN ENTERTAINMENT, ETC.,
EXPENSES.

(a) Entertainment, Amusement, or Recreation.--

(1) In general.--No deduction otherwise
allowable under this chapter shall be allowed for
any item--

(A) Activity.--With respect to an
activity which is of a type generally
considered to constitute entertainment,
amusement, or recreation, unless the taxpayer
establishes that the item was directly
related to, or, in the case of an item
directly preceding or following a substantial
and bona fide business discussion (including
business meetings at a convention or
otherwise), that such item was associated
with, the active conduct of the taxpayer’s
trade or business, or

(B) Facility.--With respect to a
facility used in connection with an activity
referred to in subparagraph (A).

In the case of an item described in subparagraph
(A), the deduction shall in no event exceed the
portion of such item which meets the requirements
of subparagraph (A).

(2) Special rules.--For purposes of applying
paragraph (1)--

(A) Dues or fees to any social,
athletic, or sporting club or organization
shall be treated as items with respect to
facilities.

(B) An activity described in section 212
shall be treated as a trade or business.

(C) In the case of a club, paragraph
(1)(B) shall apply unless the taxpayer
establishes that the facility was used
primarily for the furtherance of the
taxpayer’s trade or business and that the
 - 41 -

item was directly related to the active
conduct of such trade or business.

(3) Denial of deduction for club dues.--
Notwithstanding the preceding provisions of this
subsection, no deduction shall be allowed under
this chapter for amounts paid or incurred for
membership in any club organized for business,
pleasure, recreation, or other social purpose.

Regulations further define entertainment as “any activity

which is of a type generally considered to constitute

entertainment, amusement, or recreation, such as entertaining at

night clubs, cocktail lounges, theaters, country clubs, golf and

athletic clubs, sporting events, and on hunting, fishing,

vacation and similar trips”, sec. 1.274-2(b)(1)(i), Income Tax

Regs., and explain:

An objective test shall be used to determine whether an
activity is of a type generally considered to
constitute entertainment. Thus, if an activity is
generally considered to be entertainment, it will
constitute entertainment for purposes of this section
and section 274(a) regardless of whether the
expenditure can also be described otherwise, and even
though the expenditure relates to the taxpayer alone.
This objective test precludes arguments such as that
“entertainment” means only entertainment of others or
that an expenditure for entertainment should be
characterized as an expenditure for advertising or
public relations. * * * [Sec. 1.274-2(b)(1)(ii), Income
Tax Regs.]

Turning to the situation before us, the Court is satisfied

that the Arizona Club, Gardiner’s Resort, and Gainey Ranch Golf

Club are clubs within the meaning of the above-quoted statute and

regulations. Section 274(a)(3) operates as a complete and

outright ban on any deduction for club membership dues. Pursuant
 - 42 -

to regulations, this rule applies to “membership in any club

organized for business, pleasure, recreation, or other social

purpose”, which definition includes, but is not limited to,

“country clubs, golf and athletic clubs, airline clubs, hotel

clubs, and clubs operated to provide meals under circumstances

generally considered to be conducive to business discussion.”

Sec. 1.274-2(a)(2)(iii)(a), Income Tax Regs. Membership dues and

related charges paid to the Arizona Club, Gardiner’s Resort, and

Gainey Ranch are therefore nondeductible.

With respect to other amounts paid to clubs, legislative

history accompanying passage of section 274(a)(3) in 1993, after

stressing the blanket disallowance for club dues, states:

“Specific business expenses (e.g., meals) incurred at a club are

deductible only to the extent they otherwise satisfy the

standards for deductibility.” H. Conf. Rept. 103-213, at 583

(1993), 1993-3 C.B. 393, 461. Here, the record fails to show

that the payments made to the Arizona Club, Gardiner’s Resort,

and Gainey Ranch do so. Petitioners claimed expenses under the

characterization of training, meetings, and/or conventions but

have offered insufficient evidence to connect any of the

expenditures to a particular business outing or function.

Generalized testimony and unsupported estimates regarding

business use constrain us to rely on the invoices themselves.

These invoices indicate meal and entertainment expenditures
 - 43 -

subject to a number of restrictions under section 274, and

petitioners have not shown otherwise. Even leaving aside

potentially applicable limitations under section 274(a) and (n),

it is enough to note that petitioners have in any event failed to

substantiate the expenditures pursuant to the exacting strictures

of section 274(d).

F. Entertainment

With respect to various other specific expenditures claimed

either under training, meetings, and/or conventions or under

promotion, petitioners offered testimony suggesting a connection

to activities or functions of a nature generally thought to

pertain to entertainment.8 Although petitioners deducted these

amounts as expenses for training, meetings, and/or conventions or

for promotion, they once again failed to offer any evidence that

would link the costs to any particular business function or event

or would show that the standards of section 274 should not apply.

8
As noted in our preliminary remarks, with respect to a
substantial portion of the items deducted as expenses for
training, meetings, and/or conventions or for promotion,
petitioners failed to address the specific expenditures at trial
or on brief. It is here in particular that the Court is
unwilling to rely on the self-serving characterizations used in
the general ledgers or mere credit card charge statements, which
standing alone do little to establish even a threshold business
purpose. We are equally unwilling to credit petitioners’ blanket
assertion that all charges to their “company” card were properly
business related. Such a position simply is not credible on the
record presented.
 - 44 -

More than $11,000 was reported as paid to Aramark Sports &

Entertainment in June of 1998, but no invoices or bills are

contained in the record. The sole testimony regarding these

amounts was the following statement by Mrs. Deihl: “I believe

those are entertainers that we hired because we used to for the

conventions and different events that went on we would hire

dancers and magicians and all sort of entertainers.” Similarly,

Mrs. Deihl testified as to payments to Arizona Arts Chorale in

March of 1997 deducted by KareMor: “Arizona Arts Chorale I

believe is a local chorus or singing group”, which was hired to

“Entertain distributors” for business events. While the Court

has little doubt that petitioners did employ various entertainers

in conjunction with business functions, this generalized

testimony is insufficient to establish the deductibility of any

particular outlay for purposes of either section 162 or section

274.

A like problem exists with respect to payments to Affairs

Unlimited in the amount of $6,000 made in September of 1997 and

deducted by KareMor and in the amount of $11,372.56 made in

November of 1997 and deducted by Mayor. The sole explanation in

the record is: “They’re a staging company. They set up sets and

decor for parties.” The Court was not provided with evidence or

facts about the nature of any specific “parties” that would

support deductibility of these items.
 - 45 -

In at least two instances, petitioners apparently attempted

to deduct tickets purchased to entertainment events produced by

third parties. An expenditure labeled “TICKET SALES” for ASU

Gammage in October of 1998 was deducted by KareMor under the

training, meetings, and/or conventions category, and Mrs. Deihl

testified: “I do know, I do vaguely recall the fact that we took

quite a few distributors during one of the meetings or

conventions that was here to Gammage for a program. I don’t

remember what the program is.” Petitioners also claimed a

$21,220 deduction through KareMor for tickets to one or more

Arizona Diamondbacks baseball games. They characterized this

expense as one for meals and entertainment but offered no

evidence or argument at trial or on brief. Both of these items

would seem to be classic section 274 scenarios, but the

documentation is patently insufficient to validate any

deductions.

G. Gifts, Awards, or Cash

In the course of the multilevel marketing enterprise,

petitioners through Mayor and KareMor gave away, principally to

distributors, substantial quantities of cash and merchandise.

These items were generally intended to serve a motivational

purpose, generating incentive and excitement. In some instances,

random cash awards presumably served an additional purpose of

encouraging distributors to attend business program
 - 46 -

presentations. Concerning the deductibility of such items, the

parties focused their discussion and arguments at trial and on

brief on the following categories: Cash, items purchased at

Neiman Marcus, items purchased at Landmark Jewelers Ltd. (other

than Rolex watches), Rolex watches, items purchased at Saba’s

Western Wear,9 and Boss Day Planners.

As relevant here, the proper standard for determining the

deductibility of the various items given away by petitioners’

corporations depends upon which of two broad characterizations is

applicable to each item. See, e.g., Dobbe v. Commissioner, T.C.

Memo. 2000-330, affd. 61 Fed. Appx. 348 (9th Cir. 2003); Jordan

v. Commissioner, T.C. Memo. 1991-50; McCue v. Commissioner, T.C.

Memo. 1983-580; St. John v. Commissioner, T.C. Memo. 1970-238.

Deductions for business gifts within the meaning of section

274 are flatly disallowed to the extent that the expense for

gifts to a particular individual exceeds $25 for the taxable

year. Sec. 274(b)(1); sec. 1.274-3(a), Income Tax Regs. The

term “gift” for purposes of this section is defined as “any item

excludable from gross income of the recipient under section 102

which is not excludable from his gross income under any other

9
Due to the abbreviations and other simplification used in
many of the documents in the record, the precise name of various
of the establishments at which claimed expenditures were incurred
is unclear. The Court therefore has sought merely to enable a
reasonable identification of the vendors based on available
information in the record.
 - 47 -

provision of” chapter 1 of the Internal Revenue Code. Sec.

274(b)(1); sec. 1.274-3(b)(1), Income Tax Regs. A gift in this

statutory sense, in turn, “proceeds from a ‘detached and

disinterested generosity’”. Commissioner v. Duberstein, 363 U.S.

278, 285 (1960) (quoting Commissioner v. LoBue, 351 U.S. 243, 246

(1956)); see also Dobbe v. Commissioner, supra. Such business

gifts not in excess of $25 are deductible to the extent that the

strict substantiation rules of section 274(d) are satisfied.

In contrast, expenditures for transfers made in recognition

of past services or as an incentive for future performance have

been permitted as deductions under section 162 on grounds that

they involve compensation includable in the gross income of the

recipient. See, e.g., Dobbe v. Commissioner, supra; McCue v.

Commissioner, supra; St. John v. Commissioner, supra. Prizes and

awards to sales personnel have been placed in this category.

See, e.g., Dobbe v. Commissioner, supra; Jordan v. Commissioner,

supra; McCue v. Commissioner, supra.

Concerning the cash, Mr. Hartmann and Mr. Deihl testified

with regard to petitioners’ practices in giving away cash at

distributor conventions. They refer to a convention event known

as “Make Joe pay” time, when Mr. Deihl would hand out “cash

prizes” or “awards” ranging from approximately $500 up to $2,500.

Mr. Deihl also mentioned gimmicks such as taping $20 bills under

chair seats for random recipients.
 - 48 -

Based on this testimony, the Court is satisfied that

petitioners did use cash as an incentive or award to motivate

distributors, and these sums would conceivably be deductible

under section 162 as payments for past or future services.

Respondent likewise apparently accepted this view and accordingly

allowed a deduction for cash that petitioners were able, through

documentary evidence, to show was employed in such a manner.10

Specifically, petitioners provided one convention agenda listing

giveaways of $2,100, and respondent permitted a deduction for

that amount. For a greater deduction, petitioners rely on the

categorical statement that all cash claimed by petitioners as a

training, meetings, and/or convention expense or as a promotion

expense was “Absolutely” not used for personal purposes.

However, without more corroboration, the Court cannot credit such

a blanket assertion and is left without a basis for estimate.

Furthermore, regarding diversions such as the random taping

of smaller bills under chairs, the underlying motive would appear

to be more disinterested than compensatory. Petitioners would

have no idea what attendee would select a particular seat, and

that individual could be a child or an accompanying friend or

family member as to whom any compensatory rationale would be a

10
Respondent also permitted Mayor deduction in 1997 of
claimed cash amounts that the record established were used to pay
in cash specific service providers employed for business
purposes. Petitioners have not alleged comparable facts with
respect to any further cash amounts.
 - 49 -

far greater stretch. Hence, these amounts would appear to be

business gifts subject to the strictures of section 274 and not

substantiated as required therein.

With respect to purchases made at Neiman Marcus, Mr. Deihl

testified: “we purchased items there and gifts for all the

advisory boards and for the Crowns at all the conventions and

things of that nature. We also purchased the--some Christmas

gifts for the employees from Neiman Marcus every year.” He

offered additional details in the following colloquy on direct

examination:

Q For what purpose did you use Neiman Marcus,
what kinds of purchases?

A Well, it would be three separate things. One
would be gifts from their gift gallery to the
individuals.

Q Stop there. Gift from their gift gallery to
be used as gifts or to be used as rewards?

A To be used as, the purchase could be either
one, for rewards or gifts. I cannot determine what
that is from there. But they also supplied some of the
gowns for the ladies in question that would come from
Neiman Marcus also.

Q To your knowledge any personal expenditures?
I should say expenditures in Neiman Marcus for personal
use? Without looking at the documents, just a general
question, Mr. Deihl, just a general question.

A Well, most of the time when we did things at
Neiman Marcus on behalf of the company we used the
company’s credit card, an American Express card. In
private uses we’d use our Neiman Marcus charge card
which is a separate structure entirely.
 - 50 -

The testimony pertaining to Landmark Jewelers was similar in

that Mr. Deihl indicated that purchases were made at the jewelry

store for both promotional rewards and “actual gifts”. He

further stated that he did not “recall” making any personal

purchase at Landmark Jewelers during the years in issue, although

Mrs. Deihl admitted that personal items had been bought at

Landmark Jewelers in earlier years. Likewise, Mr. Deihl

testified to having purchased at Saba’s “little cowboy boot

trinkets” to give away to convention participants. However, he

also conceded that he made personal clothing purchases at Saba’s

as well.

Hence, as to each of the foregoing establishments, the

record supports that purchases falling into more than one of the

various categories that affect deductibility, i.e., compensatory

awards, business gifts, and personal items, were made. Some

charges are therefore potentially allowable under section 162

alone, others are limited by section 274, and still others are

nondeductible under section 262. Yet the record is insufficient

for the Court to differentiate and separate the actual charges

claimed into the appropriate categories. Petitioners generally

chose not to offer item-by-item explanations,11 and with the

11
In one instance, Mr. Deihl was questioned at trial about
a particular invoice item from Landmark Jewelers, namely, a
$13,900 sapphire, diamond, and platinum ring. His response was:
“Sapphire is one of the achievement levels that we have in the
(continued...)
 - 51 -

multiple possibilities that exist, including a category mandating

strict substantiation under section 274, the Court is in no

position to guess.

As regards Rolex watches, Mr. Deihl testified concerning how

these items were given away as prizes at conventions to top-

performing distributors. The Court is satisfied that petitioners

did in fact give away Rolexes as compensatory awards potentially

deductible under section 162. The documentary record includes

two charges specifically identified as for Rolex watches, made at

Landmark Jewelers in May and September of 1997. However, only as

to the September purchase does the record offer any evidence that

could tend to corroborate that the particular watch was employed

as a prize at a convention in the manner suggested. Based on the

agenda for the KareMor convention held in the Fall of 1997, the

Court would be willing to find that a $13,400 business expense

for a Rolex watch had been substantiated and would be allowable

were it not for the consideration discussed in the following

paragraph. Otherwise no sufficient evidence was presented, and

the possibility of personal use was also addressed only by

uncorroborated testimony that no Rolex watches were bought for

family members.

11
(...continued)
organization. But as I sit here at this point in time I don’t
remember how this was done or whether it was done for Women of
KareMor or something of that nature.” Such testimony only
underscores the shortcomings of the record in these cases.
 - 52 -

An additional problem was highlighted in the testimony,

which problem applies to the Rolex watches as well as to the

other alleged incentive awards. To wit, the record leaves

substantial uncertainty surrounding the issuance of Forms 1099,

Miscellaneous Income, to the distributors. Mr. Deihl on several

occasions made statements to the effect that: “everybody in the

company received a 1099 that would have included any cash or

Rolexes or any other prizes that they won to my knowledge”, along

with “all their commissions and everything else they’ve earned.”

On this point, the Court observes that petitioners’ entities

claimed substantial deductions under the category “commissions”,

separate and apart from the deductions in dispute in these

proceedings. No attempt has been made to elucidate us as to how

the commission deductions were computed vis-a-vis the amounts

assertedly reported on Forms 1099 and the amounts claimed for the

various incentive awards under training, meetings, and/or

conventions, under promotion, or under suspense. As a result,

the record is ambiguous as to how the amounts deducted as

commissions were determined and whether there exists any

potential for a double deduction if additional amounts were to be

allowed for incentive awards. For all of the reasons discussed

above, the state of the record renders it inappropriate to permit

any further deduction for the motivational giveaways.
 - 53 -

The final type of giveaway addressed by the parties was

separately discussed on brief and appears to have been given

principally for purposes other than motivation. Concerning the

Boss Day Planners, Mr. Deihl testified: “As a new distributor

came on board he received a day planner which also contained all

the policies and procedures of KareMor and the code of ethics

that they were to follow and what was dismissible and where we

could terminate even the independent distributor for immoral acts

or things of that nature.” The record contains copies of checks

payable to Boss Day Planners, all dated 1999, which total

$136,444.35. Petitioners, through KareMor, claimed $113,544.35

of this expenditure as a deduction for marketing in 1998.

On brief, respondent concedes that a valid business purpose

supported the outlay to Boss Planners but maintains that the

charges were contested in 1998 and not paid until 1999.

Referencing the checks just described, respondent states: “each

check is dated after April 14, 1999, the date of settlement of

the dispute between Petitioners and Boss Day Planners.”

Petitioners’ response to this argument, consisting in its

entirety of two sentences, is as follows: “As to the Boss

Planners marketing expense, Respondent recognizes (opening brief,

p.66) that the payments were made but not until after April 14,

1999. However, 1999 is a closed year and thus, the deduction

should be permitted for 1998.”
 - 54 -

Petitioners apparently do not contest the underlying facts

upon which respondent’s argument relies but instead offer,

without further explanation or support, what would seem to be a

novel legal theory. Section 461 provides general rules with

respect to the proper year for taking deductions, which in turn

rest in part on the taxpayer’s method of accounting under section

446. An accrual method taxpayer, such as KareMor and Mayor in

these cases, is typically entitled to a deduction “in the taxable

year in which all the events have occurred that establish the

fact of the liability, the amount of the liability can be

determined with reasonable accuracy, and economic performance has

occurred with respect to the liability.” Secs. 1.446-

1(c)(1)(ii)(A), 1.461-1(a)(2)(i), Income Tax Regs.; see sec.

461(h)(1), (4).

The first prong of the above test requires the existence of

the liability to be fixed and noncontingent. Vastola v.

Commissioner, 84 T.C. 969, 977 (1985). The second prong

addresses amount, and the interaction of these two requirements

is illustrated by regulation:

While no liability shall be taken into account before
economic performance and all of the events that fix the
liability have occurred, the fact that the exact amount
of the liability cannot be determined does not prevent
a taxpayer from taking into account that portion of the
amount of the liability which can be computed with
reasonable accuracy within the taxable year. For
example, A renders services to B during the taxable
year for which A charges $10,000. B admits a liability
to A for $6,000 but contests the remainder. B may take
 - 55 -

into account only $6,000 as an expense for the taxable
year in which the services were rendered. [Sec. 1.461-
1(a)(2)(ii), Income Tax Regs.]

Thirdly, economic performance generally occurs in connection with

the provision of services or property as the services or property

is provided. Sec. 461(h)(2)(A); sec. 1.461-4(d)(2)(i), Income

Tax Regs. An exception to this rule, under which economic

performance is deemed to occur only when payment is made, applies

in specified circumstances where the liability to make payments

arises, inter alia, out of a breach of contract. Sec. 1.461-

4(g)(2), Income Tax Regs.

Here, the record lacks any specific information with regard

to the nature of the underlying dispute and settlement with Boss

Day Planners. Consequently, the Court is unable to ascertain

whether any, much less all, of the three requirements for accrual

have been satisfied. We are faced with a situation where

petitioners do not dispute that they contested at least a portion

of the charges attendant to the Boss Day Planners transaction in

1998, they have not established any particular amount as to which

they had agreed by the end of the taxable year, and they made no

payments during the taxable year. The Court cannot countenance a

deduction in these circumstances.
 - 56 -

H. Clothing

Among the expenditures claimed by petitioners under the

categories of training, meetings, and/or conventions or of

promotion were a number of charges incurred at establishments

such a Capriccio’s Apparel, Battaglia Shop, Saba’s Western Wear,

Bardelli Apparel, Cuzzens Forum, Danese Creations, Andrelani, and

Neiman Marcus. The sole documentary evidence for the majority

of these expenditures consists of credit card statements showing,

if anything, a one- or two-word explanation such as

“APPAREL/ACCESSORIES”. Only for purchases at Neiman Marcus do we

have any appreciable number of invoices.

Petitioners did not testify specifically as to any of these

charges but did offer generalized statements about their

purchases at these establishments. Mr. Deihl stated that

Capriccio’s Apparel was a women’s fashion store, where Mrs. Deihl

and other women of the family would purchase gowns to be worn on

a one-time basis. He likewise explained that Battaglia Shop was

a highend men’s and women’s clothing store where purchases “for

business purposes” were made. His testimony about Saba’s,

previously alluded to, admitted that both business and personal

purchases were made at the western wear shop.

Petitioners’ position on and rationale for the deductibility

of such items was expounded in the following testimony:
 - 57 -

Q And describe for the Court your method of
operation with respect to wardrobe or costume for those
in your company participating at the conventions?

A Well, if you’re going to give the appearance
of affluence you have to be capable of looking the
part. And obviously wearing a different suit between
the morning session and the evening session has bearing
on it. More so with the women.

As I said earlier, we worked the tables, both my
sons and their wives and my wife. We would visit all
5,000 people. We would talk to all five, shake hands
with them, turn around and they would have met all
three of the families during that last night at that
last time. So it would be imperative that the gowns
worn by the girls especially could not be the same ones
that they had on at an earlier function because they
were always a constant reference at the tables by the
distributors saying “What a beautiful gown.” “Isn’t
that gorgeous.”

It was obviously over the top type dress. I mean
you couldn’t wear it to the grocery store or the gym or
anything but it was done on purpose so that all the
children and everybody else had matching outfits on and
it just generated the enthusiasm backwards from them
that they wanted to be and participate.

Q * * * The wardrobe we’re talking about that
was paid for by the companies?

A Yes.

Q And what was the policy as to whether the
women could wear the dress more than once?

A No. The dress, once the dress had been seen
it could not be seen again.

Q And then what happened to the dress?

A They all went to charity or were just given
away to third parties.

Q And what rule, if any, with respect to the
men?
 - 58 -

A The men was a little bit easier because most
of the time they would just have to have tuxedos. Our
requirement on the men was that they just couldn’t--you
can’t just walk into and buy a tuxedo at Men’s
Wearhouse and expect somebody to say, “Gee, that’s a
great looking piece of garment.” It’s how it’s
tailored and how it fits that has more intensity to it.

* * * * * * *

Q What was the rule with respect to the men as
to whether they were to wear the clothing purchased by
the company for reasons other than company purposes?

A There was a six month rule: they had to
rotate suits or tuxes, clothing, at least they couldn’t
wear the same tie and pushout or anything else like
that. And the suit had to be rotated out so that
nobody saw them and they could say, “Hey, you were
there in that suit yesterday or the day before.” * * *

Q What was the rule, if any, with respect to
whether the men could wear the clothing other than for
a company function?

A It was never stated as such but nobody did
it, only because you were always overdressed whenever
you went into something. I mean when you--the exact
same tie and shirt and went with the exact same suit so
it was a perfect fit and appearance. Now, you may have
six different ties and shirts for that suit. But, you
know, if you walked down the street in it you would
almost look like a model walking around.

The test for the deductibility of clothing costs as ordinary

and necessary business expenses under section 162 rests on three

criteria: The clothing must be (1) required or essential in the

taxpayer’s employment, (2) not suitable for general or personal

wear, and (3) not so worn. Hynes v. Commissioner, 74 T.C. 1266,

1290 (1980); Yeomans v. Commissioner, 30 T.C. 757, 767-768

(1958); Bernardo v. Commissioner, T.C. Memo. 2004-199. In
 - 59 -

applying the second prong, some cases have reflected a subjective

gloss, while others have taken an objective approach. For

instance, as this Court recently explained:

The subjective test applied by this Court in
Yeomans v. Commissioner, 30 T.C. 757, 768 (1958) [“not
suited for her private and personal wear”] has been
specifically rejected by the Court of Appeals for the
Fifth Circuit in favor of an objective test, which
denies a business expense deduction for the cost of
clothing that is “generally accepted for ordinary
street wear” (i.e., for ordinary street wear by people
generally rather than by the taxpayer specifically).
Pevsner v. Commissioner, 628 F.2d 467, 470 (5th Cir.
1980), revg. T.C. Memo. 1979-311 * * * [Bernardo v.
Commissioner, supra.]

We further noted that the objective test “casts a wider net.”

Id.

Here, petitioners cite Yeomans v. Commissioner, supra, while

respondent points to Pevsner v. Commissioner, supra. However,

the difference in approaches is immaterial in that petitioners

have not established that they met either test. A substantial

majority of the outfits revealed in photographs introduced by

petitioners of various events and conventions, albeit often

formal, are tasteful and would not be out of place in a myriad of

business or social settings where participants are expected to

“dress up”. Although a few of the ensembles do trend toward the

“costume” appellation that petitioners urge, petitioners have

made no attempt to show any linkage between specific charges and

the corresponding articles of clothing. Hence, petitioners

clearly fall short of deductibility under an objective approach.
 - 60 -

Even under a subjective methodology, the evidence in the

record is simply insufficient to permit a deduction. Assuming

arguendo that a once-wear policy would render clothing unsuitable

for personal wear in petitioners’ particular situation, Mr.

Deihl’s generalized testimony does little to show that each of

the claimed charges was in fact for the purchase of such a once-

wear item. As respondent notes, among the Neiman Marcus charges

is one showing two turtlenecks at $165 each. We are unconvinced

that Mr. Deihl’s testimony is not overly broad and exaggerated,

and we are left with no reasonable basis on which to make any

estimate as to legitimately once-wear garments.12

I. Equipment and Furnishings

The credit card statements submitted in conjunction with

expenditures claimed under training, meetings, and/or conventions

and under promotion also reflect purchases at various

establishments labeled with descriptions indicating some form of

equipment, furnishings, or similar items. For instance,

petitioners seek to deduct charges to Circuit City and Best Buy

characterized as “ELECTRONICS/APPLIANCES”. Petitioners’

12
As a final observation, we note that an additional basis
for disallowance rests in the fact that Mr. Deihl indicated that
garments were given to charity, thereby raising the possibility
of a double deduction absent evidence that these amounts were not
already incorporated in the charitable contribution deductions
claimed by the various related entities.
 - 61 -

testimony with respect to expenses of this genre consists in its

entirety of the following from Mrs. Deihl:

Q Okay. I also see some major expenses for
Circuit City during that time frame; do you know what
these were for?

A The only thing I can think of is it would be
computers but I’m not really sure.

Q Computers for personal use or for--

A No. Computers--

Q --business?

A No, for business use. It would either be
computers or equipment for the company or for the
buildings.

Given the admitted ambiguity in this testimony, i.e., Mrs. Deihl

conceded that she was “not really sure”, petitioners have failed

to establish either what was purchased or the business use

therefor. Moreover, computers or peripherals would be subject to

the strict substantiation rules of section 274(d) as listed

property, absent a showing that the exception set forth in

section 280F(d)(4)(B) should apply.

Petitioners also claim an outlay by KareMor on September 5,

1997, to Synthony Music for “MUSICAL EQUIP/ACC/SVC”, as to which

Mrs. Deihl testified: “Probably in-house, I would think that was

part of the in-house recording equipment that we have.” From

this obtuse statement, the Court can draw little and certainly

not adequate substantiation of a business expenses under section

162.
 - 62 -

As representative of the vast collection of expenditures

left unexplained, the Court further notes a similar difficulty

with a number of credit card charges that refer to furniture,

furnishings, home furnishings, leather furnishings, and related

items, as well as to charges at Bed, Bath & Beyond. Or consider

outlays for luggage. Without evidence, business relationship is

mere speculation, an endeavor not within the purview of this

Court.

Nonetheless, as to a charge for exercise equipment,

Mr. Deihl testified with specificity that the purchase was for a

workout center for employees at the office complex and

distinguished the more expensive gymnasium structure purchased

for his home. The Court concludes that the $665.74 April 2,

1997, KareMor charge is a deductible business expense.

J. Travel

The disallowed deductions include several charges that the

credit card statements indicate were for airline tickets to

destinations such as Brazil, Ireland, and Iceland. Mr. Deihl

testified generally that attorneys, including Mr. Hartmann, were

sent on “Business related” travel. He stated that an individual

involved in marketing and promotion, Jim Palasota, was sent to

Iceland “To do a training meeting and for the business.”

Mr. Deihl also affirmed that he went to Ireland “Because we were

looking to expand our facilities into Ireland and we were invited
 - 63 -

there by the Irish government”. He likewise asserted globally

that he had never taken a vacation or an airline trip for

personal reasons during the years in issue. No details of any of

the trips were offered.

Leaving aside other potentially applicable limitations, the

Court observes that any deduction for travel would at minimum

require compliance with the strict substantiation provisions of

section 274(d). Yet Mr. Deihl’s testimony in this regard, not to

mention the uninformative credit card documents, falls woefully

short. We do not even know the dates of the travel. No

deduction is permitted.

K. Contributions

Petitioners’ records or testimony link several expenditures

to the idea of a contribution and/or charitable entity. For

example, concerning an $800 May 6, 1996, Mayor check to New

Arizona Family characterized in the general ledger as for “Golf

Registration”, Mr. Deihl testified: “The New Arizona Families,

it’s a charity here in town that we helped co-sponsor and

participated in a golf outing with them.” Petitioners sought to

deduct the amount under training, meetings, and/or conventions.

A $1,000 June 3, 1997, KareMor charge to Phoenix Zoo was labeled

on credit card statements as “ADMISSION/TICKETS”, but Mrs. Deihl

testified: “I would assume it was a donation to the Phoenix

Zoo.” The amount was claimed under promotion.
 - 64 -

A KareMor December 31, 1998, ledger entry for $25,840 to the

Heart Association, likewise deducted under promotion, was allowed

to the extent of $23,440, and the balance of $2,400 was denied.

The record contains a receipt from the American Heart Association

issued in connection with the 1998 Heart Ball acknowledging cash

received of $25,000, less a value of $1,560 for 10 seats at the

Heart Ball (including dinner, entertainment, and favors), for a

charitable contribution of $23,440. No further testimony was

offered.

Petitioners also originally sought deduction of a $5,000

Republican Party contribution for KareMor in 1998 under training,

meetings, and/or conventions. A $5,000 amount under this heading

was conceded by petitioners in the stipulation of facts without

indication of the specific charge or charges involved.

Petitioners did not present any argument on brief relating to

this expenditure. The only other expense of $5,000 disallowed

under this category for KareMor in 1998 was one of the payments

to Aramark Sports & Entertainment, and petitioners on brief

requested a finding of fact supporting deduction of outlays to

this entity.

Although petitioners have never articulated any particular

legal theory bearing on the deductibility of the above payments,

we make the following general observations. Section 170(a)

provides for deduction of charitable contributions made to or for
 - 65 -

the use of an organization described in section 170(c) and

verified as required by the statute and corresponding

regulations. As one example of the requisite verification,

contributions of $250 or more are disallowed unless the taxpayer

substantiates the donation with a contemporaneous written

acknowledgment by the donee. Sec. 170(f)(8).

Here, only with respect to the American Heart Association

expenditure did petitioners offer a statement in compliance with

section 170(f)(8), and respondent properly allowed a deduction to

the extent supported by that document. No basis for any greater

deduction has been suggested.

Concerning the other deductions, the record not only reveals

problems under section 170(f)(8) but also raises additional

issues. Nothing establishes that any were made to qualified

donees. The $5,000 payment to the Republican Party was

apparently conceded, and political contributions are generally

disallowed in any event. Cloud v. Commissioner, 97 T.C. 613,

628-629 (1991). Finally, the Court is not satisfied that the

payments to New Arizona Family and the Phoenix Zoo in fact

represented contributions and not some form of entertainment

expenditure subject to section 274.

L. Promotion or Marketing

There are two other expenditures, one of which actually

consists of two separate charges, that petitioners deducted under
 - 66 -

the label of either promotion or marketing and as to which they

commented specifically at trial or on brief. Petitioners claimed

as promotion expenses for KareMor in 1997 payments of $2,000 and

$200 made to Gold’s Gym on June 11 and 17, respectively. A

purchase order and an invoice show that the amounts were paid for

equipment rental, gym rental, and labor in connection with a

“Birthday lift” by Peter Lupus on June 17, 1997. Peter Lupus was

“the strongman off Mission: Impossible” and “a spokesperson for

the company”. Petitioners also offered a photograph of the June

17 event, about which Mr. Deihl testified:

A * * * [The photo] is taken in California at
Gold’s Gym. It is Peter Lupus in a KareMor sponsored
event. He is 65 years of age there. He is lifting a
250,000 pounds in 30 minutes. VitaMist has rented the
gym. Guinness Book of World Records is there. A
weights and measure officer from the state of
California is there to determine the weights and the
lifting and the preciseness of everything. Buddy
Hackett was there. Landau I think his name is from
Mission: Impossible also was there. News events were
there and it was promoted and on the news later that
evening.

Q And I notice you have VitaMist on the
clothing of--gym clothing I suppose of Mr. Lupus?

A Mr. Lupus all his clothing had VitaMist made
into it and attached to it, especially his workout
gear.

The picture shows Mr. Lupus decked in VitaMist garb, and the

Court is satisfied that this event represents a promotional

endeavor. An additional deduction of $2,200 will be permitted.
 - 67 -

In contrast, and demonstrating the sharp distinction in how

petitioners supported a few expenses and left the Court to make a

leap of faith about the remainder, petitioners deducted under

marketing for KareMor $72,500 paid to Lifestyle Advantage in May,

June, and July of 1998 for what is characterized in the KareMor

ledger as “Sales Aides”. Respondent noted on opening brief the

absence of any evidence or testimony regarding these outlays. In

response, petitioners on reply brief offer the following: “And

in reference to Lifestyle Advantage * * * [the general ledger]

shows that this 1998 expenditure ($72,500) is for ‘sales aids’

which should not be surprising, given that Petitioners grossed

$19 million in that year.” Such a statement is utterly useless

to the Court in addressing any elements whatsoever of

deductibility. No further deduction is warranted for these

payments.

III. Cost of Goods Sold

On page 2 of its 1998 Form 1120S, U.S. Income Tax Return

for an S Corporation, Mayor included $747,535 of “Purchases” in

computing cost of goods sold. Respondent disallowed $123,250 of

“Purchases” with the explanation: “The year end accrued payable

to Arizona Natural Resources in the amount of $123,250 was never

paid, as there was a dispute over this debt. Thus the $123,250

is not deductible.” During 1998, Arizona Natural Resources,

Inc., manufactured for Mayor a line of cosmetics marketed as the
 - 68 -

Sari Collection,13 and various payments were made to the company

throughout the taxable year. However, as shown in a handwritten

notation on an invoice from Arizona Natural Resources and in

Mayor’s general ledger, petitioners paid only a portion of a

billed charged and accrued the remaining $123,250 as an

additional account payable as of December 31, 1998.

Petitioners mention the purchases adjustment in their

pretrial memorandum, stating: “This is a timing issue. The

dispute was denied and the $123,250 was paid to Arizona Natural

resources [sic], plus interest and attorney fees. Petitioners

should not be required to go back and amend returns for a year in

which the amount was actually paid.” Petitioners do not discuss

the matter on opening brief, while respondent concedes that

petitioners did incur valid business expenses with respect to the

Sari cosmetic line but argues: “Because there was a dispute over

this amount [the $123,250], it was never paid. If it were to

have been paid, however, deduction would not be permissible until

the date of payment.” Petitioners respond on reply brief, with

their argument, in its entirety, consisting again of two

sentences: “The monies owed Arizona Natural Resources were paid,

but after 1998, and thus, for a period closed for the companies.

Thus, the amount should be deducted for 1998.”

13
Petitioners from time to time diversified the products
offered through their multilevel marketing structure.
 - 69 -

Hence, although the parties’ statements pertaining to this

adjustment are less than a model of clarity, the circumstances

underlying, as well as the parties’ arguments with respect to,

the payable to Arizona Natural Resources would appear not to be

materially distinguishable from those concerning the payments to

Boss Day Planners discussed above. Petitioners contested a

portion of the charges asserted by Arizona Natural Resources and

paid only after resolution of the dispute. In this connection,

the Court takes judicial notice of litigation filed in 1999 by

Arizona Natural Resources against Mayor, KareMor, and petitioners

individually, which culminated in a judgment in favor of Arizona

Natural Resources for $333,258.13, inclusive of interest,

attorney’s fees, and costs, on October 8, 2003. Ariz. Natural

Res., Inc. v. Mayor Pharm. Labs., Inc., No. CV1999-070010 (Ariz.

Super. Ct., Oct. 8, 2003).

Cost of goods sold operates as a reduction in gross income,

rather than as a deduction from gross income. See sec. 1.61-

3(a), Income Tax Regs. Nonetheless, the test for determining

whether an accrual method taxpayer is entitled to include an

amount in cost of goods sold is the same as that for determining

the appropriateness of a deduction. Id.; sec. 1.446-1(c)(1)(ii),

Income Tax Regs. In other words, an amount may be included in

cost of goods sold “in the taxable year in which all the events

have occurred that establish the fact of the liability, the
 - 70 -

amount of the liability can be determined with reasonable

accuracy, and economic performance has occurred with respect to

the liability.” Sec. 1.446-1(c)(1)(ii), Income Tax Regs.

Here, as was the case with the outlay to Boss Day Planners,

the record suggests that some, if not all, of the requisites for

inclusion of the $123,250 in cost of goods sold have not been

met. Respondent is sustained on this issue.

IV. Reduction in Adjusted Gross Income

The parties’ positions with regard to the propriety of a

reduction in petitioners’ 1996 gross income center on the concept

of duplication. Petitioners contend that unless their gross

income for 1996 is reduced by $550,000, they will be taxed twice

on this amount. They allege that such a reduction was made with

respect to 1997 and that a like treatment should be accorded for

1996. Respondent contends that an adjustment was made to 1997 to

eliminate duplicate reporting for that year which does not exist

for the 1996 year.

Again, the underlying documentary record on this issue

leaves much to be desired. Mr. Goltz prepared petitioners’

original Forms 1040, U.S. Individual Income Tax Return, for 1996

and 1997. Subsequently, Mr. Leo prepared Forms 1040X, Amended

U.S. Individual Income Tax Return, for each of those years. On

the 1996 Form 1040X, petitioners reported an increase in adjusted

gross income of $550,000, derived from an additional $550,000 of

nonpassive income from partnerships and S corporations. On the
 - 71 -

1997 Form 1040X, petitioners reported an increase in adjusted

gross income of $1,700,000, also derived from an additional

$1,700,000 of nonpassive income from partnerships and S

corporations.

The adjustments and deficiencies asserted in the statutory

notices for 1996 and 1997 were thereafter computed based on the

amounts reported in the Forms 1040X. Among the adjustments

reflected in the notice of deficiency for 1997 is a decrease in

income of $1,700,000 labeled “AGI CHANGE FORM 1040X” and

explained: “The $1,700,000 shown on your 1040X return for the

estimated increase in income from the related entities is

adjusted as shown above.” No similar adjustment was reflected in

the notice of deficiency for 1996.

Respondent on reply brief addresses the circumstances behind

the difference as follows:

Petitioners’ 1997 Forms 1040 and 1040X were prepared by
two different Certified Public Accountants. * * *
Insofar as Petitioners’ 1997 Form 1040X reported an
amount previously reported in the Form 1040, namely
$1,700,000.00 (now $1,750,000.00), the examiner
appropriately adjusted Petitioners’ Form 1040X by
reducing Petitioners’ income by the duplicative amount.

In taxable year 1996, on the other hand, there
were no such duplicative amounts between Petitioners’
Forms 1040 and 1040X. Consequently, Respondent’s
examiner made no similar adjustment in Petitioners’
1996 income as in their 1997 income. * * *

Thus, respondent offers an explanation as to why a reduction

for the increased adjusted gross income reported on a Form 1040X
 - 72 -

would be necessary in calculating a deficiency that is based on

the tax reported in the Form 1040X. Such could be the case where

the Form 1040X in fact duplicated amounts reported in the

original Form 1040. Petitioners, in contrast, seem to argue that

a like reduction is more uniformly necessary. Such could be the

case only if the deficiency were to be computed based on the tax

reported in the original Form 1040, without giving credit for

additional tax paid with the Form 1040X. In fact, some of the

language used by petitioners could signal a misunderstanding of

the basis for the 1996 and 1997 deficiencies, although a cursory

review of the notices and relevant returns shows that the

baseline numbers in the notices were taken from the Forms 1040X,

not the Forms 1040.

So long as the amended returns are used as the starting

point, there would generally be no need to eliminate the

additional income reported therein from the deficiency

calculation. Here, although the manner in which the $1,700,000

was duplicated between the original and amended 1997 returns is

not clear from the record, respondent was entitled to determine

and concede on audit that it had been. Petitioners have not so

much as alluded to, much less demonstrated, any analogous

duplication between the original and amended 1996 returns.

Accordingly, the Court has no grounds for mandating a concession

by respondent of income voluntarily reported by petitioners on

their own Form 1040X for 1996.
 - 73 -

V. Accuracy-Related Penalties

Subsection (a) of section 6662 imposes an accuracy-related

penalty in the amount of 20 percent of any underpayment that is

attributable to causes specified in subsection (b). Subsection

(b)(1) of section 6662 then provides that among the causes

justifying imposition of the penalty is negligence or disregard

of rules or regulations.

“Negligence” is defined in section 6662(c) as “any failure

to make a reasonable attempt to comply with the provisions of

this title”, and “disregard” as “any careless, reckless, or

intentional disregard.” Caselaw similarly states that

“‘Negligence is a lack of due care or the failure to do what a

reasonable and ordinarily prudent person would do under the

circumstances.’” Freytag v. Commissioner, 89 T.C. 849, 887

(1987) (quoting Marcello v. Commissioner, 380 F.2d 499, 506 (5th

Cir. 1967), affg. on this issue 43 T.C. 168 (1964) and T.C. Memo.

1964-299), affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S.

868 (1991). Pursuant to regulations, “‘Negligence’ also includes

any failure by the taxpayer to keep adequate books and records or

to substantiate items properly.” Sec. 1.6662-3(b)(1), Income Tax

Regs.

An exception to the section 6662(a) penalty is set forth in

section 6664(c)(1) and reads: “No penalty shall be imposed under

this part with respect to any portion of an underpayment if it is
 - 74 -

shown that there was a reasonable cause for such portion and that

the taxpayer acted in good faith with respect to such portion.”

Regulations interpreting section 6664(c) state:

The determination of whether a taxpayer acted with
reasonable cause and in good faith is made on a case-
by-case basis, taking into account all pertinent facts
and circumstances. * * * Generally, the most important
factor is the extent of the taxpayer’s effort to assess
the taxpayer’s proper tax liability. * * * [Sec.
1.6664-4(b)(1), Income Tax Regs.]

Reliance upon the advice of a tax professional may, but does

not necessarily, demonstrate reasonable cause and good faith in

the context of the section 6662(a) penalty. Id.; see also United

States v. Boyle, 469 U.S. 241, 251 (1985); Freytag v.

Commissioner, supra at 888. Such reliance is not an absolute

defense, but it is a factor to be considered. Freytag v.

Commissioner, supra at 888.

In order for this factor to be given dispositive weight, the

taxpayer claiming reliance on a professional must show, at

minimum: “(1) The adviser was a competent professional who had

sufficient expertise to justify reliance, (2) the taxpayer

provided necessary and accurate information to the adviser, and

(3) the taxpayer actually relied in good faith on the adviser’s

judgment.” Neonatology Associates, P.A. v. Commissioner, 115

T.C. 43, 99 (2000), affd. 299 F.3d 221 (3d Cir. 2002); see also,

e.g., Charlotte’s Office Boutique, Inc. v. Commissioner, 425

F.3d 1203, 1212 & n.8 (9th Cir. 2005) (quoting verbatim and with

approval the above three-prong test), affg. 121 T.C. 89 (2003);
 - 75 -

Westbrook v. Commissioner, 68 F.3d 868, 881 (5th Cir. 1995),

affg. T.C. Memo. 1993-634; Cramer v. Commissioner, 101 T.C. 225,

251 (1993), affd. 64 F.3d 1406 (9th Cir. 1995); Ma-Tran Corp. v.

Commissioner, 70 T.C. 158, 173 (1978); Pessin v. Commissioner, 59

T.C. 473, 489 (1972); Ellwest Stereo Theatres v. Commissioner,

T.C. Memo. 1995-610.

As previously indicated, section 7491(c) places the burden

of production on the Commissioner. The notices of deficiency

issued to petitioners generally asserted applicability of the

section 6662(a) penalty on account of negligence or disregard,

substantial understatement, and/or substantial valuation

misstatement. See sec. 6662(b). Respondent in its pretrial

memorandum and on brief has addressed only negligence or

disregard of rules or regulations as the basis for the penalties,

and we shall do likewise.

We conclude that respondent has met the section 7491(c)

burden of production with respect to the negligence penalties.

The evidence adduced in these cases reveals a serious dearth of

adequate records and substantiation for reported items. With

this threshold showing, the burden shifts to petitioners to

establish that they acted with reasonable cause and in good faith

as to the claimed items.

Petitioners here assert a reliance defense as the basis upon

which they should be relieved of liability for the section

6662(a) penalties. Mr. Deihl, Mrs. Deihl, and Mr. Goltz
 - 76 -

testified as to petitioners’ total reliance on Mr. Goltz and the

other professionals hired with respect to the accounting and tax

preparation functions. Respondent, in seeking to counter this

defense, focuses in particular on an alleged lack of competence

on the part of Mr. Goltz. Petitioners in retort devote

substantial discussion to why their reliance on a professional

who essentially “duped” them was nonetheless reasonable. The

Court, however, is unconvinced that questions of Mr. Goltz’s

competency are sufficiently central to this issue to warrant the

emphasis placed thereon by the parties.

The deficiencies at issue were determined from the positions

reported in the amended returns for 1996, 1997, and 1998 prepared

on behalf of petitioners by Mr. Leo. Any reliance was therefore

necessarily placed in significant part on Mr. Leo. No one has

addressed Mr. Leo’s competency in this proceeding. Matters of

competency, i.e., the first prong of the above-quoted test, thus

become more tangential to our analysis.

The second prong, on the other hand, lies at the crux of

petitioners’ entitlement to the relief sought. Petitioners must

establish that they provided necessary and accurate information

with respect to all items reported on their tax returns, such

that it can be said that the incorrect returns resulted from

error on the part of the adviser(s). See, e.g., Westbrook v.

Commissioner, supra at 881; Ma-Tran Corp. v. Commissioner, supra
 - 77 -

at 173; Pessin v. Commissioner, supra at 489. Petitioners here

have not done so. They have shown neither that they initially

gave all requisite information to Mr. Goltz nor that Mr. Leo had

available for his use sufficient accurate materials to prepare

correct returns.

For instance, did petitioners at one time provide to their

advisers receipts or invoices that would substantiate the many

expenditures for which the record contains no documentary

evidence? With respect to those items that were reflected in

available receipts or invoices, did petitioners offer to their

advisers further explanation, particularly in connection with

purchases at retail establishments, as to the intended recipient

and/or use of the articles purchased? When they were at

conventions, potentially away from their accounting staff, did

they maintain documentation of business expenses that arose and

carefully segregate any personal purchases? Were the

professionals, like the Court, limited in various circumstances

to blanket statements that “all” outlays at a certain location or

using a particular credit card related to the businesses? What

specific information was available to the advisers with respect

to the improvements to petitioners’ residence? On this record,

the Court simply cannot conclude that petitioners have met the

evidentiary burden of the second prong of the test for reasonable

reliance.

The Court likewise has reservations about petitioners’

compliance with the third prong that flow to a certain degree
 - 78 -

from the problems raised by the first two criteria. Mr. Leo was

hired to reconstruct records and to prepare corrected returns, so

petitioners at that time were well aware of serious deficiencies

in Mr. Goltz’s performance in these respects. To have taken a

hands-off approach at that juncture, relying on Mr. Goltz to

provide any necessary underlying information and explanations,

would not seem consistent with ordinary care and prudence. It

further would seem to negate a claim that reliance on the

resultant product could be in good faith. Mr. Goltz would appear

even less likely than petitioners in this scenario to recall, for

example, verbal descriptions that had at one time elucidated the

generic descriptions in receipts, invoices, or credit card

statements. Yet the record contains no suggestion that

petitioners assisted in the reconstruction in any meaningful way.

On these facts, petitioners have failed to establish that

they met each and every requirement necessary for successful

imposition of a reliance defense. Petitioners remain liable for

the section 6662(a) accuracy-related penalties.

The Court has considered all other arguments made by the

parties and, to the extent not specifically addressed herein, has

concluded that they are without merit or are moot. To reflect

the foregoing and concessions by the parties,

Decisions will be entered

under Rule 155.