T.C. Summary Opinion 2007-54
UNITED STATES TAX COURT
WAYNE B. BAILEY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 13014-05S. Filed April 3, 2007.
Wayne B. Bailey, pro se.
Aimee R. Lobo-Berg, for respondent.
VASQUEZ, Judge: This case was heard pursuant to the
provisions of section 7463 of the Internal Revenue Code in effect
when the petition was filed.1 Pursuant to section 7463(b), the
decision to be entered is not reviewable by any other court, and
1
Unless otherwise indicated, section references are to the
Internal Revenue Code, and Rule references are to the Tax Court
Rules of Practice and Procedure.
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this opinion shall not be treated as precedent for any other
case.
Respondent determined a $20,627 deficiency in petitioner’s
2001 Federal income tax, as well as a penalty of $4,125.40 under
section 6662(a). Respondent also determined a $16,293 deficiency
in petitioner’s 2002 Federal income tax, as well as a penalty of
$3,258.60 under section 6662(a). The issues for decision are:
(1) Whether the expenditures petitioner deducted on Schedule C,
Profit or Loss From Business, for 2001 and 2002 are subject to
the deductibility limitations of section 195; (2) whether
petitioner has substantiated those deductions; and (3) whether
petitioner is liable under section 6662(a) for accuracy-related
penalties for 2001 and 2002.
Background
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by reference. At the time the petition was
filed, petitioner resided in Corvallis, Oregon.
During 2001 and 2002, petitioner was employed as the vice
president of strategy and business development by The Martin-
Brower Company, LLC. At the same time, petitioner and his wife
attempted to develop a business concept he called “Tasha’s
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Cafe”.2 The concept involved a retail food and drink
establishment that served coffee and related items during the
day, and wine and related items at night. Petitioner and his
wife attempted to take a “two-pronged” approach to generating
income from the Tasha’s Cafe concept. The first “prong” was to
open a retail location in which petitioner and his wife could
operate an actual wine and coffee bar. The second “prong” was to
sell the concept to entrepreneurs as a franchise.
Petitioner outfitted the basement of his home in the style
of the proposed coffee and wine bar to determine the appearance
and operation of Tasha’s Cafe and to model the concept for
potential investors, local businesspeople, and franchisees. In
his basement, petitioner installed restaurant-level food service
equipment, coffee- and wine-related artwork, and two different
types of flooring for testing purposes. Petitioner brought
between 200 and 250 people to his basement model to promote the
retail coffee and wine bar aspect of his business. Petitioner
brought approximately 30 potential franchise customers to his
basement to demonstrate the franchise possibilities of Tasha’s
Cafe. While petitioner demonstrated the Tasha’s Cafe concept, he
served coffee, wine, and food. Petitioner was never paid for the
2
For 2001, petitioner filed Form 1040, U.S. Individual
Income Tax Return, with a filing status of single. For 2002,
petitioner filed Form 1040, with a filing status of head of
household.
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coffee, wine, or food he served in his basement, but he did
occasionally receive tips.
In pursuit of the retail aspect of the Tasha’s Cafe concept,
petitioner identified and attempted to obtain retail space in
which to operate a Tasha’s Cafe in Lombard, Illinois. Petitioner
obtained interior design schematics for the location, negotiated
business loans for capital to install equipment and furniture at
the Lombard location, negotiated the rental contract for the
location, and developed advertising strategies for the store.
However, it became evident to petitioner that opening a retail
location was much more costly than he had previously estimated,
and he abandoned the retail aspect of the business in January
2003 without having opened a cafe or sold any inventory.
Petitioner also pursued the franchise aspect of Tasha’s
Cafe. In addition to demonstrating the Tasha’s Cafe concept in
his basement, petitioner occasionally rented space at hotels near
Chicago O’Hare Airport in which he would conduct similar
demonstrations of the concept to potential franchisees flying in
from beyond the Chicago area. Petitioner estimated that he held
“a couple of dozen” such presentations at airport hotels between
2001 and 2003. Petitioner continued to market the Tasha’s Cafe
franchise concept until May of 2003, when he concluded that he
could no longer fund the development of the franchise concept.
Petitioner never sold a Tasha’s Cafe franchise.
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At several stages in petitioner’s career as a businessman
and consultant, petitioner was exposed to the food and drink
franchise industry and worked with some of the largest franchise
operators in the world, including McDonald’s Corporation.
Petitioner also earned a master’s degree in business
administration with a concentration in marketing and finance from
the University of Chicago in 1989.
On his Form 1040 for 2001, petitioner reported wages of
$217,771. Petitioner attached a Schedule C to his Form 1040 for
2001. On his Schedule C for 2001, petitioner claimed business
deductions of $55,348, zero gross receipts or sales, and other
income of $161. On the Schedule C for 2001, petitioner reported
the business name as “Tasha’s” and the principal business or
profession as “Retail”.
On his Form 1040 for 2002, petitioner reported wages of
$188,468. Petitioner attached a Schedule C to his 2002 income
tax return, reporting $48,001 of business deductions, zero gross
receipts or sales, and other income of $43. On the Schedule C
for 2002, petitioner reported the business name as “Tasha’s” and
the principal business or profession as “Wine Distribution/
Retail”.
On June 8, 2005, respondent sent petitioner the above-
mentioned notice of deficiency. Respondent attached to the
notice of deficiency copies of Form 4549A, Income Tax Examination
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Changes, and Form 886-A, Explanation of Adjustments. The Form
4549A reveals that the deficiency arises from respondent’s
disallowance of petitioner’s claimed business deductions for 2001
and 2002, associated reductions in itemized deductions and
exemptions for 2001 and 2002, and respondent’s imposition of
section 6662(a) penalties for 2001 and 2002.3
The only meaningful explanation for respondent’s
disallowance of petitioner’s claimed business deductions appears
on the Form 886-A and reads as follows:
We disallowed the Schedule C expense amounts shown on
your returns because we did not receive an answer to
our request for supporting information. To be allowed
a deduction, expense, exemption, credit, or other tax
benefit, you must establish that you have met all
requirements of the law. Since you did not do so, we
have adjusted your deductions shown below to the
amounts verified. Accordingly, we have increased your
income $55,348 for tax year 2001 and $48,001 for the
tax year 2002.
Discussion
I. Burden of Proof
At trial and on the brief, respondent argued that petitioner
was precluded from claiming the Schedule C deductions on his 2001
and 2002 income tax returns because the deductions related to
start-up expenditures within the meaning of section 195, and
3
Because respondent determined that petitioner was not
entitled to the deductions on his Schedules C for 2001 and 2002,
respondent also determined that petitioner’s 2001 and 2002 income
included the interest reported on the Schedules C of $161 and $43
for 2001 and 2002, respectively.
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because petitioner failed to substantiate the Schedule C
deductions.
In general, the Commissioner’s determinations set forth in a
notice of deficiency are presumed correct, and the taxpayer bears
the burden of showing that the determinations are erroneous.4
Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
However, when the Commissioner relies on a basis or theory at
trial which was not stated or described in the notice of
deficiency, and the new basis or theory requires the presentation
of different evidence, the Commissioner has raised “new matter”,
and the burden of proof falls on him with respect to that new
matter. Rule 142(a); Shea v. Commissioner, 112 T.C. 183, 197
(1999); Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507
(1989). In determining whether the Commissioner has given a
taxpayer sufficient notice of his basis for determining a
deficiency, we examine a notice of deficiency in conjunction with
documents provided to a taxpayer or his or her representative
during the examination of a taxpayer’s income tax return. Bitker
v. Commissioner, T.C. Memo. 2003-209.
A. Section 195
Amounts paid or incurred in connection with creating an
4
Petitioner has neither claimed nor shown that he
satisfied the requirements of sec. 7491(a) to shift the burden of
proof to respondent with regard to any factual issue.
Accordingly, petitioner bears the burden of proof. Rule 142(a).
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active trade or business are start-up expenditures. Sec. 195(c).
Section 195(a) generally precludes taxpayers from deducting
start-up expenditures. However, for the years at issue, section
195(b) generally allowed taxpayers to elect to amortize start-up
expenditures over a period not less than 60 months, beginning (at
the earliest) in the year in which the active trade or business
commences.5 If the start-up expenditures relate to an endeavor
that never rises to the status of an active trade or business, a
taxpayer may not amortize the start-up expenditures. See Bernard
v. Commissioner, T.C. Memo. 1998-20.
In the matter before us, respondent’s notice of deficiency
makes no mention of section 195, the language of section 195, or
the principles upon which section 195 rests. The record does not
establish that respondent raised section 195 during the
examination of petitioner’s income tax returns or otherwise
notified petitioner that section 195 was relevant to his
determination. Respondent’s section 195 argument is therefore
new matter, and respondent bears the burden of proof with respect
to section 195. Rule 142(a).
5
In 2004, Congress amended sec. 195(b) to allow electing
taxpayers to deduct start-up expenditures over a period of 180
months beginning with the month in which the active trade or
business begins. American Jobs Creation Act of 2004, Pub. L.
108-357, sec. 902(a)(1), 118 Stat. 1651. Sec. 195 applies as so
amended to amounts paid or incurred after Oct. 22, 2004.
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B. Substantiation
Taxpayers must maintain records sufficient to enable the
Commissioner to determine their correct tax liability. Sec.
6001; Higbee v. Commissioner, 116 T.C. 438, 440 (2001); sec.
1.6001-1(a), Income Tax Regs. Taxpayers must “keep such
permanent books of account or records * * * as are sufficient to
establish the amount of gross income, deductions, credits, or
other matters required to be shown by such person in any return
of such tax or information.” Sec. 1.6001-1(a), Income Tax Regs.
The notice of deficiency in this matter, combined with
information on the attached Form 4549A and Form 886-A, adequately
reveals that respondent disallowed petitioner’s Schedule C
deductions because of petitioner’s failure to substantiate those
deductions. As discussed supra, the Form 886-A states that
respondent disallowed the Schedule C expense amounts shown on
petitioner’s 2001 and 2002 returns because petitioner failed to
provide respondent with “supporting information”. The Form 886-A
also states that petitioner “must establish that [his claimed
deductions have] met all requirements of the law.” This
substantially corresponds both with the language of section 6001
and the regulations issued thereunder, and the principles
underlying section 6001. Petitioner therefore bears the burden
of proof with respect to substantiating his claimed business
deductions. Rule 142(a).
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II. Section 195
As noted supra, taxpayers may neither deduct nor amortize
section 195 start-up expenditures if the activities to which the
expenditures relate fail to become an “active trade or business”.
Congress, through section 195(c)(2)(A), authorized the Secretary
to issue regulations to guide the determination of when an active
trade or business begins. No such regulations have yet been
issued.
In determining when an activity becomes an “active trade or
business” for the purpose of section 195(a), this Court has
sought guidance from cases interpreting the “engaged in a trade
or business” requirement for deduction under section 162. See,
e.g., Weaver v. Commissioner, T.C. Memo. 2004-108. For the
purpose of section 162, the U.S. Supreme Court has held that the
question of whether a taxpayer is “engaged in a trade or
business” requires examination of the facts in each particular
case. Commissioner v. Groetzinger, 480 U.S. 23, 36 (1987). To
be engaged in a trade or business, a taxpayer must: (1)
Undertake an activity intending to make a profit; (2) be
regularly and actively involved in the activity; and (3) actually
have commenced business operations. McManus v. Commissioner,
T.C. Memo. 1987-457, affd. without published opinion 865 F.2d 255
(4th Cir. 1988). A taxpayer is not engaged in a trade or
business “until such time as the business has begun to function
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as a going concern and performed those activities for which it
was organized.” Richmond Television Corp. v. United States, 345
F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other
grounds 382 U.S. 68 (1965). An enterprise need not have
generated sales or other revenue to have begun to carry on a
business. Jackson v. Commissioner, 864 F.2d 1521, 1526 (10th
Cir. 1989), affg. 86 T.C. 492 (1986); Cabintaxi Corp. v.
Commissioner, 63 F.3d 614, 620 (7th Cir. 1995), affg. in part,
revg. in part, and remanding T.C. Memo. 1994-316. However, mere
research into or investigation of a potential business is
insufficient to demonstrate that a taxpayer is engaged in a trade
or business. Dean v. Commissioner, 56 T.C. 895, 902 (1971).
In the matter before us, petitioner was not actively engaged
in the trade or business of the retail aspect of the Tasha’s Cafe
concept. Petitioner never obtained the necessary licenses,
materials, or inventory for the retail business, established a
retail location, or held out any goods for sale.
However, the record before us establishes that petitioner
was actively engaged in the trade or business of selling
franchises of the Tasha’s Cafe concept. Petitioner developed
detailed plans for the operation and appearance of a Tasha’s Cafe
location. Based on his analysis of the model in his basement,
petitioner determined the materials and design elements to be
used for outfitting a Tasha’s Cafe location. Most importantly,
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petitioner actually operated the franchise aspect of the Tasha’s
Cafe concept by holding numerous presentations to potential
franchisees in which he offered to sell Tasha’s Cafe franchises.
Petitioner therefore was actively engaged in the trade or
business of franchising the Tasha’s Cafe concept, and his
expenditures for 2001 and 2002 are not subject to the limitations
of section 195.
III. Substantiation
On petitioner’s Schedule C for 2001, he claimed $10,693 of
deductible car and truck expenses, $929 of deductible meals and
entertainment expenses, and $43,726 of other deductible expenses.
On petitioner’s Schedule C for 2002, he claimed $1,140 of
deductible car and truck expenses, $6,265 of deductible travel
expenses, $1,131 of deductible meals and entertainment expenses,
and $39,465 of other deductible expenses.
Deductions are a matter of legislative grace, and taxpayers
generally bear the burden of proving that they are entitled to
any deductions claimed. Rule 142(a); INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 (1934). As noted supra, taxpayers
must maintain sufficient records to enable the Commissioner to
determine their correct tax liability. Sec. 6001.
Section 162 generally allows a deduction for ordinary and
necessary expenses paid or incurred during the taxable year in
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carrying on a trade or business. Such expenses must be directly
connected with or pertain to the taxpayer’s trade or business.
Sec. 1.162-1(a), Income Tax Regs. Generally, no deduction is
allowed for personal, living, or family expenses, nor is
deduction proper for expenditures that are properly categorized
as capital expenditures. See secs. 262 and 263. The
determination of whether an expenditure satisfies the
requirements of section 162 is a question of fact. Commissioner
v. Heininger, 320 U.S. 467, 475 (1943).
When a taxpayer establishes that he or she has incurred
deductible expenses but is unable to substantiate the exact
amounts, we can estimate the deductible amount, but only if the
taxpayer presents sufficient evidence to establish a rational
basis for making the estimate. See Cohan v. Commissioner, 39
F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner, 85
T.C. 731, 742-743 (1985). In estimating the amount allowable, we
bear heavily against the taxpayer where the inexactitude of the
record is of his or her own making. See Cohan v. Commissioner,
supra at 544.
However, deductions relating to travel, meals and
entertainment, gifts, or use of listed property (including
passenger automobiles) are subject to strict rules of
substantiation that supersede the doctrine in Cohan v.
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Commissioner, supra at 544. See sec. 274(d); sec. 1.274-
5T(c)(2), Temporary Income Tax Regs., 50 Fed. Reg. 46017 (Nov. 6,
1985). The term “listed property” includes passenger
automobiles. Sec. 280F(d)(4)(A)(i). For deductions to which
section 274 applies, taxpayers must substantiate certain elements
of the deductible activity or use through either adequate records
or sufficient evidence corroborating the taxpayer’s own
statement. Sec. 274(d). If a taxpayer cannot satisfy the
substantiation burden imposed by section 274(d) with respect to a
deduction to which it applies, he fails to carry his burden of
establishing that he is entitled to deduct that expense,
regardless of any equities involved. Sec. 274(d); Nicely v.
Commissioner, T.C. Memo. 2006-172; sec. 1.274-5T(a), Temporary
Income Tax Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985). Generally,
taxpayers must substantiate each required element of an
expenditure or use. Sec. 1.274-5T(b)(1), Temporary Income Tax
Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985). At a minimum, a
taxpayer must substantiate: (1) The amount of the expense, (2)
the time and place the expense was incurred, (3) the business
purpose of the expense, and (4) the business relationship to the
taxpayer of other persons benefited by the expense, if any. Sec.
274(d); Shea v. Commissioner, 112 T.C. 183, 187 (1999).
To substantiate the business deductions he claimed on his
2001 and 2002 income tax returns, petitioner presented a
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disorganized set of invoices, receipts, canceled checks, and
other documents from 2001 and 2002. At trial, petitioner offered
almost no testimony explaining the transactions underlying the
deductions on his 2001 and 2002 income tax returns. In his
testimony, petitioner also admitted that he had mistakenly
presented several documents, receipts, and canceled checks that
relate to purely personal expenditures.
Petitioner has failed to carry his burden of proof with
regard to the deductions subject to the limitations of section
274. Petitioner has not presented adequate records which
substantiate the required elements for those expenditures subject
to section 274. Nor has petitioner provided sufficient evidence
to corroborate his statements regarding his deductible
expenditures in 2001 and 2002. We therefore uphold respondent’s
determination that petitioner has not adequately substantiated
his claimed deductions for expenditures relating to travel, meals
and entertainment, or business use of cars or trucks for 2001 and
2002.
As to petitioner’s business deductions not subject to the
limitations of section 274, petitioner also has failed to
adequately substantiate nearly all of the business deductions
claimed on his Schedules C for 2001 and 2002. Petitioner has
presented almost no evidence that links the expenditures
reflected in the receipts, invoices, and checks to his business
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operations. Petitioner’s records appear to reflect some business
expenditures, but in most instances we cannot determine whether
the expenditures bear any relationship to the franchise “prong”
of Tasha’s Cafe. Nor has petitioner presented sufficient
evidence for the Court to estimate the amount of any of his
business expenditures.
From the record before us, petitioner has presented some
canceled checks and paid invoices that show deductible
expenditures for legal fees, marketing expenses, and charitable
donations related to his Tasha’s Cafe franchising operations.
Those expenditures amount to $2,195 in legal fees and marketing
expenses for 2001, and $550 in charitable donations for 2002.
Except as noted above, petitioner has not produced
sufficient evidence to persuade us that respondent’s
determinations are in error. Consequently, with the exceptions
noted above, we sustain respondent’s deficiency determination.
IV. Penalties
A. Section 6662(a) Penalty
As noted supra, respondent determined section 6662(a)
penalties of $4,125.40 and $3,258.60 for 2001 and 2002,
respectively. Respondent determined that petitioner’s 2001 and
2002 underpayments of tax were attributable to negligence or
disregard of rules and regulations, or alternatively that the
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2001 and 2002 underpayments are attributable to substantial
understatements of income tax.
Pursuant to section 6662(a), a taxpayer may be liable for a
penalty of 20 percent of the portion of an underpayment of tax
(1) attributable to a substantial understatement of tax, or (2)
due to negligence or disregard of rules or regulations. Sec.
6662(b). The term “understatement” means the excess of the
amount of tax required to be shown on a return over the amount of
tax imposed which is shown on the return, reduced by any rebate
(within the meaning of section 6211(b)(2)). Sec. 6662(d)(2)(A).
Generally, an understatement is a “substantial understatement”
when the understatement exceeds the greater of $5,000 or 10
percent of the amount of tax required to be shown on the return.
Sec. 6662(d)(1)(A). The term “negligence” in section 6662(b)(1)
includes any failure to make a reasonable attempt to comply with
the Internal Revenue Code and any failure to keep adequate books
and records or to substantiate items properly. Sec. 6662(c);
sec. 1.6662-3(b)(1), Income Tax Regs. Negligence has also been
defined as the failure to exercise due care or the failure to do
what a reasonable person would do under the circumstances. See
Allen v. Commissioner, 92 T.C. 1, 12 (1989), affd. 925 F.2d 348,
353 (9th Cir. 1991); Neely v. Commissioner, 85 T.C. 934, 947
(1985). The term “disregard” includes any careless, reckless, or
intentional disregard. Sec. 6662(c).
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B. Burden of Proof
The Commissioner has the burden of production with respect
to the accuracy-related penalty. Sec. 7491(c). To meet this
burden, the Commissioner must produce sufficient evidence
indicating that it is appropriate to impose the penalty. See
Higbee v. Commissioner, 116 T.C. 438, 446 (2001). Once the
Commissioner meets this burden of production, the taxpayer must
come forward with persuasive evidence that the Commissioner’s
determination is incorrect. Rule 142(a); see Higbee v.
Commissioner, supra. The taxpayer may meet this burden by
proving that he or she acted with reasonable cause and in good
faith. See sec. 6664(c)(1); see also Higbee v. Commissioner,
supra; sec. 1.6664-4(b)(1), Income Tax Regs.
C. Analysis
In the matter before us, respondent has met his burden of
production under section 7491(c). The record shows that both
petitioner’s 2001 and 2002 income tax returns contain
understatements of tax greater than $5,000. See sec.
6662(d)(1)(A)(ii). Accordingly, petitioner bears the burden of
proving that the accuracy-related penalties should not be imposed
with respect to any portion of the understatements for which he
acted with reasonable cause and in good faith. See sec.
6664(c)(1); Higbee v. Commissioner, supra at 446.
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Petitioner has failed to meet his burden of persuasion with
respect to the accuracy-related penalties. Petitioner claimed
substantial deductions for which he apparently maintained no
records. At trial, petitioner admitted that some of the
deductions on his Schedules C for 2001 and 2002 may have
represented personal expenditures, including the costs of a
family trip to Mexico and payments for insurance premiums on his
personal automobiles. As noted supra, petitioner likely incurred
several business expenditures during 2001 and 2002. However,
petitioner has not produced any evidence establishing that he
acted with reasonable cause and in good faith with respect to any
portion of the understatements of tax on his 2001 and 2002 income
tax returns. Therefore, to the extent that we uphold
respondent’s determination of deficiencies for 2001 and 2002, we
conclude that petitioner is liable for the section 6662(a)
penalties.
To reflect the foregoing,
Decision will be entered
under Rule 155.