Kanofsky v. Comm'r

T.C. Memo. 2006-79

UNITED STATES TAX COURT

ALVIN S. KANOFSKY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 12547-04. Filed April 18, 2006.

P, a full-time professor of physics at Lehigh
University, filed 1996-2000 individual income tax
returns in which he reported, on Schedule C, Profit or
Loss From Business, zero gross receipts and substantial
deductions from alleged business activities. R denied
the 1996-98 Schedule C deductions on the ground that P
was not engaged in any trade or business, and he denied
a portion of the 1999 and 2000 Schedule C deductions on
the ground that the disallowed expenses were unrelated
to P’s business activities. For all of the audit
years, however, R allowed some of P’s expenses as
deductions on Schedule A, Itemized Deductions. For
1997, R also determined that P is subject to the sec.
6662, I.R.C., accuracy-related penalty.

1. Held: R’s denial of business expense
deductions under sec. 162(a), I.R.C., sustained.
 - 2 -

2. Held, further, modifications to the deficiency
determinations for 1997-99 required in order to correct
computational errors.

3. Held, further, R’s penalty against P for 1997
sustained, in part, under sec. 6662, I.R.C.

Alvin S. Kanofsky, pro se.

Frank J. Jackson, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: By notice of deficiency dated April 19,

2004 (the notice), respondent determined deficiencies in

petitioner’s Federal income tax and an accuracy-related penalty

as follows:

Tax Year
Ending Penalty
Dec. 31 Deficiency Sec. 6662(a)

1996 $14,506 ---
1997 15,437 $3,087.40
1998 10,078 ---
1999 716 ---
2000 2,970 ---

By the petition, petitioner assigns error to respondent’s

deficiency determinations for all years and his penalty

determination for 1997. After concessions,1 the issues for

decision are whether petitioner is (1) entitled to deductions he

1
Petitioner concedes respondent’s inclusion in income of
(1) $70 of unreported interest for both 1999 and 2000, and (2) an
unreported State tax refund of $30 for 1999.
 - 3 -

claimed on the Schedules C, Profit or Loss From Business, for

each of the years at issue greater than those deductions allowed

by respondent on either Schedule C or Schedule A, Itemized

Deductions, and (2) liable for the section 6662(a) accuracy-

related penalty for 1997.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years at issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

FINDINGS OF FACT

Some facts are stipulated and are so found. The stipulation

of facts, with accompanying exhibits, is incorporated herein by

this reference.

At the time the petition was filed, petitioner resided in

Bethlehem, Pennsylvania.

Background

During the years at issue, petitioner was employed as a

full-time professor of physics at Lehigh University. Petitioner

earned a B.A. and an M.S. in physics and a Ph.D. in experimental

particle and nuclear physics from the University of Pennsylvania.

During the years at issue, petitioner owned property at 30 East

3d Street in Bethlehem, Pennsylvania (the Bethlehem property), an

apartment in Mt. Pocono, Pennsylvania, and an apartment in North
 - 4 -

Shirley, Long Island. Petitioner did not lease any of those

properties to tenants during 1996-98.

Petitioner’s Returns

For each year in issue, petitioner filed a Form 1040, U.S.

Individual Income Tax Return, showing zero taxable income and no

tax due. On a Schedule C attached to each of those returns,

petitioner listed as his principal business or profession

“research and development” and as the name of his business

“A.S.K. Enterprises”. Only the 1999 and 2000 Schedules C listed

a business address, which was 30 E. 3d St., Bethlehem, PA 18015

(the Bethlehem property). All of the Schedules C report zero

gross receipts and zero gross income, and they report the

following amounts of total expenses (and resulting losses):

Year Schedule C Expenses

1996 $72,786
1997 75,388
1998 80,675
1999 85,845
2000 80,020

The Notice

The notice disallows all of petitioner’s 1996-98 reported

Schedule C expenses and a portion ($33,945 for 1999 and $40,113

for 2000) of those expenses for 1999 and 2000. Those

disallowances are based upon respondent’s determination that

petitioner failed to establish that he “incurred or, if incurred,
 - 5 -

paid these amounts during the taxable years for ordinary and

necessary business purposes”.

The disallowance of petitioner’s claimed Schedule C

deductions for 1996-98 is based upon respondent’s view that

petitioner was not engaged in a trade or business during those

years. For each of those years, however, respondent allows some

of the disallowed Schedule C deductions (e.g., insurance, taxes,

mortgage interest) as Schedule A deductions with respect to

investment properties. For 1996 and 1997, respondent also allows

Schedule A deductions for employee business expenses.

By his treatment of petitioner’s Schedule C expenses for

1999 and 2000, respondent, in effect, concedes that, during those

years, petitioner was carrying on a trade or business at the

Bethlehem property, but not at his other two properties, which

respondent continues to treat as investment properties. For 1999

and 2000, respondent allows Schedule C deductions for expenses

associated with the Bethlehem property, but converts the portion

of petitioner’s Schedule C deductions for taxes and interest

associated with the other two properties into Schedule A

deductions.

The total additional Schedule A deductions allowed each year

are as follows:
 - 6 -

Year Additional Schedule A Deductions

1996 $46,632
1997 20,933
1998 42,881
1999 23,235
2000 22,414

OPINION

I. Burden of Proof

Generally, a taxpayer in this Court bears the burden of

proof. Rule 142(a)(1). In certain circumstances, however, if

the taxpayer introduces credible evidence with respect to any

factual issue relevant to ascertaining the proper tax liability,

section 7491 shifts the burden of proof to the Commissioner.

Sec. 7491(a)(1); Rule 142(a)(2). Credible evidence is evidence

the Court would find sufficient upon which to base a decision on

the issue in favor of the taxpayer if no contrary evidence were

submitted. See Higbee v. Commissioner, 116 T.C. 438, 442 (2001);

Bernardo v. Commissioner, T.C. Memo. 2004-199 n.6. Section

7491(a)(2) imposes certain prerequisites to the application of

section 7491(a)(1), including that the taxpayer has complied with

the requirements under the Internal Revenue Code “to substantiate

any item”. Sec. 7491(a)(2)(A).

As discussed infra, petitioner has failed to introduce

credible evidence of his entitlement, under section 162, to the

disallowed Schedule C deductions. Therefore, petitioner bears

the burden of proof with respect to his entitlement to those

deductions pursuant to Rule 142(a), a burden that, because of the
 - 7 -

absence of credible evidence of deductibility, petitioner cannot

sustain. See Bernardo v. Commissioner, supra n.7.

Under section 7491(c), respondent retains the burden of

production (but not the overall burden of proof) with respect to

petitioner’s liability for the accuracy-related penalty under

section 6662(a). See Higbee v. Commissioner, supra at 446-447.

II. Petitioner’s Schedule C Deductions

A. The Parties’ Arguments

On brief, respondent summarizes his position as follows:

Specifically, petitioner failed to offer any evidence,
other than his uncorroborated testimony, that he was
engaged in a trade or business in taxable years 1996,
1997 and 1998[,] and [he] failed to produce adequate
records which substantiate the disallowed Schedule C
expenses in taxable years 1996-2000 * * *.

Petitioner testified at trial and reiterates on brief that

he has been engaged in various business activities for the past

25 years, and that, as petitioner puts it on brief, during the

1996-2000 period, he was actively “developing ideas for

companies, creating companies, and expanding on earlier research

projects and ideas, developing patents, and protecting the

company interests with law suits [sic], etc. as well as using his

building for business purposes and improving the building.”

B. Deductibility of Expenses Under Section 162(a)

Section 162(a) permits a deduction for “all the ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business”. Any amount claimed as a
 - 8 -

business expense must be substantiated, and the taxpayer is

required to maintain records sufficient to establish that he or

she is entitled to the claimed deduction. Sec. 6001; Hradesky v.

Commissioner, 65 T.C. 87, 89-90 (1975), affd. per curiam 540 F.2d

821 (5th Cir. 1976); sec. 1.6001-1(a), Income Tax Regs. In some

circumstances, if a taxpayer establishes that he or she incurred

a deductible expense but cannot substantiate it in full, the

Court may approximate the amount of an allowable deduction. See

Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930) (the

Cohan rule). The approximation, however, must have some

evidentiary basis. Vanicek v. Commissioner, 85 T.C. 731, 742-743

(1985). With respect to certain business and other expenses

specified in section 274(d), more stringent substantiation

requirements apply. Those requirements supersede the application

of the Cohan rule. See sec. 1.274-5T(a), Temporary Income Tax

Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985).

C. Discussion

1. 1996-98

During the trial, petitioner tried to place in evidence a

number of documents in support of his argument that he incurred

deductible business expenses during the years at issue. Most of

those documents were not admitted into evidence, either because

they constituted inadmissable hearsay, or because their admission

into evidence would have violated the Court’s standing pretrial

order dated October 8, 2004, and, in particular, the so-called
 - 9 -

14-day rule contained in that order, which states that, in the

absence of good cause shown, the Court may exclude from evidence

any documents not “exchanged by the parties at least 14 days

before the first day of the trial session.”

The documents petitioner offered during the trial that were

accepted into evidence indicate that petitioner did, in fact,

make certain expenditures during the years at issue.2 But there

is no indication that those documents (copies of canceled checks,

bank statements, receipts, correspondence, petitioner’s

handwritten notes, and other documentation) reflect expenditures

that relate to any trade or business petitioner conducted during

the 1996-98 taxable years.

Nor does petitioner’s trial testimony support his position.

Other than stating that he has “engaged in business activity for

the past 25 years” and has been “consulting and developing

companies over many years”, and that he “started back in 1980

with a company, ASK Enterprises and * * * tried to develop the

company over the years”, his testimony generally describes the

manner in which he was thwarted by third parties from pursuing

any business activities.

Neither petitioner’s exhibits nor his testimony is

sufficient to establish that he was engaged in a trade or

business during the 1996-98 period. Moreover, petitioner’s 1996-

2
Respondent allowed some of those substantiated
expenditures as Schedule A deductions.
 - 10 -

98 Schedules C reporting zero gross receipts from A.S.K.

Enterprises support a finding that he was not engaged in any

trade or business during that period.

Assuming arguendo that petitioner made efforts to engage in

a trade or business during the 1996-98 period and he held (and

incurred expenses with respect to) his investment properties

(and, in particular, the Bethlehem property) in connection with

those efforts, such activities do not amount to “carrying on any

trade or business” within the meaning of section 162(a). See

Richmond Television Corp. v. United States, 345 F.2d 901, 907

(4th Cir. 1965), vacated and remanded on other issues 382 U.S. 68

(1965):

The uniform teaching of these several cases is
that, even though a taxpayer has made a firm decision
to enter into business and over a considerable period
of time spent money in preparation for entering that
business, he still has not “engaged in carrying on any
trade or business” within the intendment of section
162(a) until such time as the business has begun to
function as a going concern and performed those
activities for which it was organized. [Fn. ref.
omitted.]

Accord Hardy v. Commissioner, 93 T.C. 684, 687 (1989); Goodwin v.

Commissioner, 75 T.C. 424, 433 (1980), affd. without published

opinion 691 F.2d 490 (3d Cir. 1982); Madison Gas & Elec. Co. v.

Commissioner, 72 T.C. 521, 566-567 (1979), affd. 633 F.2d 512

(7th Cir. 1980).

On brief, petitioner attempts to flesh out his trial

testimony by describing in great detail his efforts, beginning in
 - 11 -

1980, at establishing various businesses. In support of those

representations petitioner attached appendices to his briefs,

which contained many of the exhibits excluded at trial as well as

additional material not presented at trial. Neither statements

in briefs nor attachments to briefs constitute admissible

evidence, and neither may be considered by the Court. See Rule

143(b); Bialo v. Commissioner, 88 T.C. 1132, 1140 (1987); Kwong

v. Commissioner, 65 T.C. 959, 967 n.11 (1976); Perkins v.

Commissioner, 40 T.C. 330, 340 (1963).3

2. 1999 and 2000

Petitioner’s evidence of business use for his three

properties is no more convincing for 1999 and 2000 than it is for

1996-98. Nevertheless, as we said supra, respondent, in effect,

concedes that petitioner used the Bethlehem property (but not his

other two properties) in carrying on a trade or business during

1999 and 2000.

On petitioner’s Schedules C for both 1999 and 2000, he

claims 11 expense items. For 1999, respondent challenges

portions of six of those items, and, for 2000, he challenges

portions of five. Two of those disallowed expenses (interest and

taxes, presumably associated with his other two properties) are

allowed as Schedule A deductions. Petitioner has failed to

3
Consistent with that principle, the appendices were
detached from petitioner’s brief and reply brief and returned to
petitioner pursuant to an order of this Court dated July 7, 2005.
 - 12 -

produce evidence that the amounts allowed as either Schedule A or

Schedule C deductions were insufficient or that respondent’s

division of those deductions between Schedules A and C was

improper.4

D. Conclusion

Petitioner has failed to introduce credible evidence (and,

therefore, failed to carry his burden of proving) that he is

entitled to deductions for the years at issue greater than those

allowed by respondent.

III. Respondent’s Computational Errors

A. 1997

The parties have stipulated that one of the disallowed

Schedule C deductions that is allowed as a Schedule A deduction

is $19,119 of mortgage interest. Respondent’s allowance of that

amount as a Schedule A deduction is also reflected in the

examining agent’s Form 886-A, Explanation of Items, for 1997 (the

1997 Explanation of Items). The computation of 1997 Schedule A

deductions contained in the notice, under the heading “per exam”,

allows no interest expense deduction. As a result, the total

allowable itemized deductions for 1997 (before reduction for the

overall limitation on itemized deductions under section 68) is

4
For 1999 and 2000, it is immaterial whether deductions
are allowed on Schedules A or C because petitioner’s Schedule A
deductions for those years are not subject to reduction pursuant
to either sec. 67 (2-percent floor on miscellaneous itemized
deductions) or sec. 68 (overall limitation on itemized
deductions), nor do they generate alternative minimum tax.
 - 13 -

$24,796 rather than $43,915, which would be the amount if the

$19,119 deduction for mortgage interest were included as a 1997

Schedule A deduction. In light of the 1997 Explanation of Items,

we view respondent’s stipulation that he “allowed on Schedule A *

* * interest in the amount of $19,119" as an admission that the

notice inadvertently and improperly failed to include that amount

in its computation of petitioner’s Schedule A deductions for

1997. That error necessarily results in an overstatement of

petitioner’s deficiency determination for 1997.5

B. 1998 and 1999

Respondent made two minor computational errors for 1998 and

1999.

Petitioner’s 1998 Schedule C lists total deductions of

$80,675. Both the notice and the agent’s Form 886-A for 1998

disallow the deduction of $80,765 of Schedule C expenses. On

account of that inadvertent transposition of numbers, the

deduction disallowance is $90 greater than the actual deduction.

In the notice, the computation of each year’s adjustment for

increased Schedule A deductions properly reduces Schedule A

deductions “per exam” by petitioner’s Schedule A deductions “per

5
Although the agent’s 1996-98 Forms 886-A, Explanation of
Items (the only three in evidence), permit Schedule A mortgage
interest expense deductions with respect to petitioner’s three
investment properties, the notice’s computation of Schedule A
deductions for 1998-2000 lists the additional interest expense as
“Home Interest Expense.” That mischaracterization, however, has
no impact on the deductible amounts.
 - 14 -

return”. For 1999, however, the notice computation mistakenly

fails to offset the Schedule A deductions “per exam”, which

include a $250 charitable contribution that had been reported on

petitioner’s 1999 Schedule A as filed, by the amount of that

deduction.6 Thus, the 1999 adjustment for increased Schedule A

deductions should be $22,985, not $23,235 as stated in the

notice.

C. Conclusion

The correction of the foregoing computational errors will be

reflected in the Rule 155 computation in this case.

IV. Accuracy-Related Penalty for 1997

A. Applicable Law

Section 6662 provides for an accuracy-related penalty (the

penalty) in the amount of 20 percent of the portion of any

underpayment attributable to, among other things, negligence or

intentional disregard of rules or regulations (without

distinction, negligence), any substantial understatement of

income tax, or any substantial valuation misstatement. See sec.

6662(b)(1)-(3). Respondent determined the penalty against

petitioner for 1997. Although the notice states that respondent

bases his imposition of the penalty upon “one or more” of the

three above-referenced grounds (and although the 1997

6
The amount shown as “per return” “total itemized
deductions” does not include the amount shown for
“contributions”, $250.
 - 15 -

underpayment respondent determined appears, on its face, to be a

“substantial understatement” within the meaning of section

6662(d)(1)), the only issue respondent raised on brief is whether

petitioner’s 1997 underpayment is attributable to “negligence or

disregard of rules or regulations.”7

Section 6662(c) defines the term “negligence”, for purposes

of section 6662, as including “any failure to make a reasonable

attempt to comply with the provisions of this title”, and the

term “disregard” as including “any careless, reckless, or

intentional disregard.” Negligence has been generally defined as

lack of due care or failure to do what a reasonably prudent

person would do under like circumstances. See, e.g., Hofstetter

v. Commissioner, 98 T.C. 695, 704 (1992). It “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.

Section 6664(c)(1) provides that the accuracy-related

penalty shall not be imposed with respect to any portion of an

underpayment if it is shown that there was reasonable cause for

that portion and the taxpayer acted in good faith with respect to

that portion.

7
Therefore, we consider respondent to have abandoned the
substantial understatement argument. See Bernstein v.
Commissioner, 22 T.C. 1146, 1152 (1954), affd. 230 F.2d 603 (2d
Cir. 1956); Lime Cola Co. v. Commissioner, 22 T.C. 593, 606
(1954); Roberts v. Commissioner, T.C. Memo. 1996-225.
 - 16 -

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. * * * Circumstances that may
indicate reasonable cause and good faith include an
honest misunderstanding of * * * law that is reasonable
in light of all of the facts and circumstances,
including the experience, knowledge, and education of
the taxpayer. * * *

Sec. 1.6664-4(b)(1), Income Tax Regs.

B. Analysis and Conclusion

On brief, respondent alleges that petitioner’s failure “to

maintain and produce adequate records of his alleged business

activities” shows both negligence and intentional disregard of

the section 6001 requirement to keep permanent records to

establish his gross income and deductions. Respondent also

argues that “petitioner has not offered any evidence * * * that

he acted reasonably and in good faith in filing his 1997 tax

return.” Petitioner disagrees.

From his testimony, we infer that, both before and during

the years at issue, petitioner was seeking to use one or more of

his three investment properties in the conduct of a trade or

business. Respondent does not challenge that testimony, and we

have no reason to disbelieve it.8 Petitioner’s error was to

treat the expenses associated with his attempts to establish a

business operation at one or more of his properties (essentially

8
Petitioner’s testimony is consistent with the examining
agent’s determination to treat certain of petitioner’s Schedule C
expenses for 1997 as either deductible (on Schedule A) or
capitalizable expenses associated with “rental property”.
 - 17 -

pre-startup expenses since they have not been shown to relate to

the future commencement of any specific trade or business) as

section 162(a) ordinary and necessary business expenses,

deductible on Schedule C.

We have sustained the tax deficiency for 1997 on the basis

of caselaw (including decisions of this Court) holding that

section 162(a) applies only to the expenses of an operating

business. It is clear, however, that the courts have not acted

uniformly in dealing with the issue of whether and in what

circumstances preoperating expenses may be treated as currently

deductible business expenses. In some cases (contrary to the

above-cited decisions of this Court) courts have permitted a

section 162(a) business expense deduction for preoperating

expenses. See, e.g., 379 Madison Ave., Inc. v. Commissioner, 60

F.2d 68 (2d Cir. 1932) (a net loss attributable to rent, real

estate taxes, and interest paid during the construction of a

building first ready for occupancy by tenants in a subsequent

taxable year held deductible as part of a net loss from a

“business regularly carried on”), revg. and remanding 23 B.T.A.

29 (1931); Blitzer v. United States, 47 AFTR 2d 81-1005, at 81-

1019, 81-1 USTC par. 9262, at 86,633 (Ct. Cl. 1981) (in dicta,

the court states that preoperating expenses that are recurring in

nature and do not provide benefits extending beyond the taxable

year may be deductible under section 162); United States v. Manor

Care, Inc., 490 F. Supp. 355, 362 (D. Md. 1980) (preoperating
 - 18 -

expenses incurred by a nursing home taxpayer in the same taxable

year in which the required nursing home licenses were later

issued and operations were later commenced held to be deductible

business expenses under section 162(a) in the year incurred);9

see also Carter-Colton Cigar Co. v. Commissioner, 9 T.C. 219, 221

(1947) (vacant lot intended as the site for a warehouse and store

building to be used in the taxpayer’s tobacco business, the

construction of which was abandoned due to adverse economic

circumstances, held to constitute an asset “used in the trade or

business of [the taxpayer]” thereby giving rise to ordinary

rather than capital loss on the sale of the lot).

The foregoing cases all involve expenses (or the acquisition

and sale of property) preparatory and related to a specific

business (or business use) that is either certain or anticipated

to commence in the near future. In contrast, the evidence in

this case indicates that petitioner’s 1997 expenses were incurred

before any firm expectation of a specific business use for

petitioner’s investment properties. That is a factual

distinction that one might reasonably expect an experienced tax

professional to make, but not a physics professor, even one with

a Ph.D.10 Therefore, we find the caselaw permitting a business

9
See Goodwin v. Commissioner, 75 T.C. 424, 433 n.8 (1980),
affd. without published opinion 691 F.2d 490 (3d Cir. 1982),
wherein we question the District Court’s analysis.
10
There is no evidence that petitioner has any training or
(continued...)
 - 19 -

expense deduction for preoperating expenses to be indicative of

the fact that petitioner’s position was not unreasonable and,

therefore, not negligent; and that, in any event, petitioner

acted in good faith and with reasonable cause in treating the

expenses listed on his 1997 Schedule C as ordinary and necessary

business expenses under section 162(a). See sec. 1.6664-4(b)(1),

Income Tax Regs.; see also Keller v. Commissioner, T.C. Memo.

1996-300 (college professor who improperly claimed a travel

expense deduction for a sabbatical trip during which he engaged

in study unrelated to the stated sabbatical purpose acted in good

faith and was not liable for the accuracy-related penalty where

there were no regulations or other forms of clear-cut guidance

specifying the reach of section 274(m)(2), which denies a

deduction for the expense of travel as a form of education).

Nor do we agree with respondent that negligence and

intentional disregard are shown by petitioner’s alleged failure

to maintain and produce books and records to support his claimed

Schedule C deductions as required by section 6001. It is not

always necessary that a taxpayer maintain a formal set of readily

auditable books in order to satisfy the books and records

requirement of section 6001 and section 1.6001-1(a), Income Tax

Regs. See Westby v. Commissioner, T.C. Memo. 2004-179. At

10
(...continued)
background (other than in the preparation of his own returns) in
the area of Federal income taxation.
 - 20 -

trial, petitioner presented documentary evidence, by category, of

a portion of his claimed 1997 expenses. Moreover, the examining

agent’s 1997 Explanation of Items treats as either deductible on

Schedule A, capitalizable, or nondeductible “personal or estate

expenses” all but $8,292 of petitioner’s total 1997 Schedule C

expenses, which indicates that petitioner substantiated all but

$8,292 of those expenses during the audit.

Petitioner claimed 1997 Schedule C expenses of $75,388 and,

at trial, offered documentary evidence that, at best,

substantiates the expenditure of approximately one-half of that

amount. That lack of substantiation in the record supports the

examining agent’s determination that petitioner’s Schedule C

deductions included $8,292 of unsubstantiated expenses, and we so

find. Therefore, in accordance with section 1.6662-3(b)(1),

Income Tax Regs. (negligence includes “any failure by the

taxpayer * * * to substantiate items properly”), we sustain the

negligence penalty with respect to petitioner’s 1997 underpayment

attributable to $8,292 of unsubstantiated expenses.

Decision will be entered

under Rule 155.