Hennessey v. Comm'r

T.C. Memo. 2007-131

UNITED STATES TAX COURT

GERARD AND AUDREY KATHLEEN HENNESSEY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 1032-01. Filed May 24, 2007.

W. Thomas Finley, Tammy S. Wood, and M. Seth Sosolik,

for petitioners.

Kathryn F. Patterson, Abbey B. Garber, and Adam L. Flick,

for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

NIMS, Judge: This matter is before the Court on

petitioners’ motion for award of reasonable administrative and

litigation costs, filed pursuant to section 7430 and Rules 230

through 233, and request for a hearing. Unless otherwise
 - 2 -

indicated, section references are to sections of the Internal

Revenue Code in effect at all relevant times hereunder.

References to section 7430 are to the version of that section in

effect at the time the petition was filed. However, costs

incurred on or before January 18, 1999, are subject to section

7430 as amended by the Taxpayer Relief Act of 1997, Pub. L. 105-

34, secs. 1285, 1453, 111 Stat. 1038, 1055. Costs incurred after

January 18, 1999, are subject to section 7430 as amended by the

Internal Revenue Service Restructuring and Reform Act of 1998

(RRA 1998), Pub. L. 105-206, sec. 3101, 112 Stat. 727.

Rule references are to the Tax Court Rules of Practice and

Procedure.

Pursuant to section 7443A and Rules 180 and 183, this matter

was assigned to and heard by Special Trial Judge Lewis R.

Carluzzo. His recommended findings of fact and conclusions of

law were filed and served upon the parties by Order of July 5,

2005.

By the abovementioned Order, the parties were also given

until August 31, 2005, to make specific written objections to the

Special Trial Judge’s recommended findings of fact and

conclusions of law. In response thereto, respondent filed a

timely Notice of No Objection. Petitioners timely filed 26 pages

of Objections to Recommendations (Objections).
 - 3 -

Rule 183(d) provides that due regard shall be given to the

circumstance that the Special Trial Judge had the opportunity to

evaluate the credibility of witnesses, and the findings of fact

recommended by the Special Trial Judge shall be presumed to be

correct.

We have duly considered petitioners’ Objections and are not

convinced thereby that the Special Trial Judge’s meticulous and

exhaustive recommendations are in any substantive way incorrect

or incomplete. We therefore conclude that they should be adopted

as the report of the Court. We have made no changes to the

recommended findings of fact and conclusions of law, except to

relocate a footnote into the text and renumber the remaining

footnotes, change several headings, insert an explanatory

parenthetical sentence, and modify certain introductory

provisions. The recommended findings of fact and conclusions of

law of Special Trial Judge Lewis R. Carluzzo, as so modified, are

hereinafter set forth as the report of the Court.

After concessions by respondent,1 the issues for decision

are as follows: (1) Whether respondent’s positions in the

administrative and court proceedings are substantially justified;

(2) whether petitioners unreasonably protracted the

1
Respondent concedes that petitioners: (1) Exhausted their
administrative remedies, see sec. 7430(b)(1); (2) substantially
prevailed, see sec. 7430(c)(4)(A)(i); and (3) satisfy the
applicable net worth requirement, see sec. 7430(c)(4)(A)(ii).
 - 4 -

administrative and court proceedings; and (3) whether the

administrative and litigation costs claimed by petitioners are

reasonable.

FINDINGS OF FACT

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

Petitioners are husband and wife. They resided in Richardson,

Texas, at the time that the petition was filed in this case.

References to petitioner are to Audrey Kathleen Hennessey.

In 1982, petitioners formed Beacon Telephone Systems,

Inc. (Beacon), a Texas corporation that was an S corporation

for all years relevant here. See secs. 1361(a) and 1362.

Petitioners have been the sole shareholders of Beacon since its

incorporation. According to petitioners, Beacon’s business

involves the manufacture and installation of telephone systems

that control building access. During the years in issue,

Beacon’s clients were located in Lubbock, Texas.

Petitioner was a professor at Texas Tech University (the

University) in Lubbock, Texas, during all periods relevant here.

During her 19-year tenure at the University, petitioner directed

research at the University’s Institute for Studies in

Organizational Automation (the Institute).

In 1982, petitioner started an unincorporated consulting

business, Industrial Scientific & Office Automation (ISOA

Consulting), which shared the same acronym as the Institute.
 - 5 -

In 1994, petitioner and Dr. Youling Lin (also a professor at

the University) formed ISOA, Inc., a Texas corporation that was

also an S corporation for some of the years in issue. Petitioner

and Dr. Youling Lin each owned 50 percent of ISOA, Inc.

Initially, ISOA, Inc., conducted business in Lubbock, Texas. In

1995, ISOA, Inc., moved the corporation’s business operations to

Richardson, Texas. In addition to ISOA, Inc., petitioner

continued to operate ISOA Consulting.

As part of an arrangement with the University, ISOA, Inc.,

licensed intellectual property developed at the Institute to

various third-party entities. In turn, ISOA, Inc., distributed a

portion of the licensing fees received to the University and to

student-inventors as royalty payments. In October 1996, ISOA,

Inc., entered into a final royalty fee agreement with the

University as to the distribution of the licensing fees received

by ISOA, Inc. The licensing agreement between ISOA, Inc., and

the University provided that ISOA, Inc., would retain 30 percent

of the net licensing fees received, the University would receive

15 percent, student-inventors would receive 50 percent, and a

corporate co-inventor would receive 5 percent. Additionally, per

the terms of the licensing agreement, ISOA, Inc., could be

obligated to refund any licensing fees to the third party if the

patents were not approved for the licensed intellectual property.

ISOA, Inc., used amounts from the licensing fees to pay various
 - 6 -

expenses (for example, the cost of filing a patent application)

before any royalties were paid.

According to petitioner, she typically traveled on

approximately 150 trips per year as part of her duties with the

University, ISOA Consulting, and ISOA, Inc. She testified that

University professors could be reimbursed for employment-related

travel expenses only to the extent of $1,000 per year.2 Grants

obtained by petitioner on behalf of the University also provided

for some paid travel expenses. According to petitioner, any

remaining travel expenses were paid by petitioners.

The University’s policy required that petitioner provide an

expense report for each trip regardless of whether her travel

expenses were ultimately reimbursed. According to petitioner:

(1) Original travel receipts were attached to the expense reports

submitted to the University; (2) a travel reimbursement check

from the University was usually received within 5 or 6 months

after submitting an expense report; and (3) the reimbursement

check did not always identify the specific travel expenses for

which petitioner was being reimbursed. Petitioner did not keep

records of what travel was reimbursed by the University, nor did

2
This testimony appears to be inconsistent with the
reimbursement evidence from the University, as well as the
amounts reported by petitioners as reimbursements on their tax
returns and “general ledgers”.
 - 7 -

petitioner reconcile the amounts actually reimbursed by the

University with the amounts submitted on the expense reports.

Petitioner also claimed to have paid the travel expenses of

students not employed by the University who provided assistance

on her trips. Petitioner included the students’ travel expenses

on her expense reports submitted to the University.3 According

to petitioners, Mr. Hennessey often accompanied petitioner on her

business trips. For instance, Mr. Hennessey accompanied

petitioner on her claimed business trips to the United Kingdom,

Singapore, Brazil, and Italy. Petitioners testified that they

would often conduct business related to the University, ISOA

Consulting, Beacon, and/or ISOA, Inc., on a single trip.

Petitioners’ claimed business travels also included personal

pleasure, for example a trip to their son’s wedding in Maryland

and to petitioner’s mother in Alaska.

According to petitioners, many of their air travel expenses

were paid with discounted tickets provided by their daughter, an

airline employee. Additionally, petitioners claimed to have

received significant discounts on car rentals and hotels.

Petitioners testified that they either repaid their daughter in

3
In addition, petitioner claimed to have often advanced the
travel expenses of students employed by the University who
traveled with her. These expenses were submitted to the
University, and the reimbursement checks were endorsed by the
students to petitioner. In addition, petitioner also testified
that such reimbursements by the University could take “up to a
year or a year and a half”.
 - 8 -

cash or paid her various expenses.4 Petitioners did not maintain

any receipts or other documentary evidence with respect to the

amounts paid to, or on behalf of, their daughter.

I. Federal Income Tax Returns

A. Petitioners’ Individual Tax Returns

Some time prior to the end of 1993, petitioners sent to the

Internal Revenue Service (IRS) a joint Form 1040, U.S. Individual

Income Tax Return, for 1992. That document had “Estimated”

written on the top of the first page (1992 “Estimated” return).

Petitioners testified that they prepared and sent the 1992

“Estimated” return in that manner because they were not in

possession of all their supporting documents and therefore were

not able to determine the exact amounts to be reported on the

return.

On or about August 12, 1994, petitioners sent to the IRS an

unsigned Form 1040 for the 1993 taxable year. Petitioners had

written “Estimated” on the top of the first page of the unsigned

1993 return (1993 “Estimated” return). The 1993 “Estimated”

return did not have any attached schedules or forms.

Petitioners claimed that they were unable to file a final

tax return for either 1992 or 1993 prior to the end of 1994 due

to time restraints from their various work responsibilities,

4
For example, on their 1994 return, petitioners deducted
$17,874 for payments made to, or on behalf of, their daughter.
 - 9 -

which included the incorporation of ISOA, Inc., and petitioner’s

competing work and travel demands, as well as a family crisis.

On December 18, 1994, after being contacted by the IRS,

petitioners sent a reply letter to the IRS which stated that

they planned to have their 1992 and 1993 returns completed by

January 15, 1995. Petitioners testified that their work

responsibilities, as well as personal concerns, prevented them

from completing their 1992 and 1993 returns by their self-imposed

January 15, 1995, deadline.

On or about March 1, 1995, respondent received a second Form

1040 for the 1992 taxable year which again had “Estimated”

written on the top of the first page.

On or about October 1, 1996, petitioners submitted an

unsigned Form 1040 to the IRS for the taxable year 1993 (1993

unsigned return).

On December 30, 1996, petitioners filed a Form 1040 for the

1993 taxable year (1993 return). On the 1993 return, among other

items, petitioners: (1) Reported a net operating loss (NOL)

carryforward deduction from 1992 of $18,347; (2) claimed a

deduction for travel expenses of $13,016 on Form 2106, Employee

Business Expenses; and (3) deducted $17,293 of travel expenses on

the Schedule C, Profit or Loss From Business, for ISOA

Consulting.
 - 10 -

On or about March 1, 1997, petitioners submitted an

additional Form 1040 to the IRS for the 1993 taxable year with

“Amended” written on the first page, as well as on several of the

pages attached to the return (1993 “Amended” return).

Petitioners reported a deduction for travel expenses of $29,978

on Form 2106. Petitioners also deducted $21,594 for travel

expenses on the Schedule C for ISOA Consulting.

Petitioners reported adjusted gross income on the four 1993

returns submitted to the IRS as follows:

Adjusted
Return gross income

1993 “Estimated” return $54,300
1993 Unsigned return 68,349
1993 Return 32,937
1993 “Amended” return 19,442

With the exception of the 1993 “Estimated” return which had no

schedules or forms attached, each of the 1993 tax returns sent by

petitioners to the IRS had double deducted expenses such as

mortgage interest and real estate taxes.

On the Schedules C for ISOA Consulting, which were attached

to the 1993 returns, petitioners reported the following amounts:5

1993 1993 1993
“Unsigned” return Filed return “Amended” return
Gross Income $27,953 $17,936 $9,576
Total Expenses (35,659) (40,707) (46,674)
Net Loss (7,706) (22,771) (37,098)

5
There was no Schedule C attached to the 1993 “Estimated”
return.
 - 11 -

On December 30, 1996, petitioners filed with the IRS a Form

1040 for the 1994 taxable year (1994 return). On the 1994

return, petitioners reported negative adjusted gross income of

$11,364 and an NOL carryforward of $51,284. Petitioners reported

deductions for travel expenses of $9,258 and $24,847 on Form 2106

and Schedule C, respectively. On the Schedule C for ISOA

Consulting, petitioners included “Royalties paid” of $46,200 as

part of the cost of goods sold. Petitioners also claimed

multiple deductions for some of the same expenses on the 1994

return.

In August 1997, petitioners sent to the IRS a second Form

1040 for the taxable year 1994 with the word “Revised” written at

the top of the first page, as well as on several attached pages

(1994 “Revised” return). On the 1994 “Revised” return,

petitioners reported deductions for travel expenses of $5,101 and

$29,533 on Form 2106 and Schedule C, respectively.

On the Schedules C for ISOA Consulting attached to the 1994

returns sent to respondent, petitioners reported the following

amounts:

1994 1994
Return1 “Revised” return

Gross income ($2,692) $13,055
Total expenses (42,272) (34,939)
2
Net loss (44,964) (20,344)
1 As noted by petitioners on both the Schedule C and Schedule E, Supplemental Income
and Loss, attached to the 1994 return, these amounts included petitioners’ portion
of the gross receipts and expenses from ISOA, Inc.

2 This amount is a mathematical error and should have been $21,884.
 - 12 -

On December 30, 1996, petitioners filed with the IRS a Form

1040 for the 1995 taxable year (1995 return). On the 1995

return, petitioners reported adjusted gross income of $25,439 and

an NOL carryforward of $50,132. Petitioners claimed deductions

for travel expenses of $9,428 and $21,565 on Form 2106 and

Schedule C, respectively. Petitioners again claimed multiple

deductions for some of the same expenses.

On or about March 14, 1997, respondent received a second

Form 1040 from petitioners for the taxable year 1995 with

“Amended” written at the top of the first page (1995 “Amended”

return). On the 1995 “Amended” return, petitioners reported

adjusted gross income of $6,395. Petitioners also reported

deductions for travel expenses of $14,586 on both the Form 2106

and Schedule C.

On or about August 18, 1997, respondent received a Form 1040

from petitioners for the 1996 taxable year. On the 1996 return,

petitioners reported adjusted gross income of $16,529 and an NOL

carryforward of $36,157. On a Schedule A, Itemized Deductions,

petitioners claimed a deduction for “Job travel: accom. in

Dallas” in the amount of $59,479. Petitioners also claimed a

deduction for travel expenses on Form 2106 of $36,714. On the

Schedule C for ISOA Consulting attached to the 1996 return,
 - 13 -

petitioners reported gross income of $38,220 and total expenses

of $38,220. On the 1996 return, petitioners claimed multiple

deductions for some of the same expenses.

B. Beacon’s Tax Returns

On or about August 12, 1994, Beacon submitted an “Estimated”

Form 1120S, U.S. Income Tax Return for an S Corporation, for the

taxable year 1993 (Beacon’s 1993 “Estimated” return) along with

petitioners’ 1993 “Estimated” return. Beacon’s 1993 “Estimated”

return reflected that Beacon was on the cash receipts and

disbursements method of accounting (cash basis) for Federal

income tax purposes.6

On or about March 4, 1997, Beacon filed with the IRS a

second Form 1120S for the taxable year 1993 (Beacon’s 1993

return). Beacon’s 1993 return reported total income and total

deductions of $13,691 and $24,248, respectively, for a loss of

$10,557. Beacon’s total deductions included travel expenses of

$13,717.

Along with petitioners’ 1994 “Estimated” return, Beacon

submitted for the taxable year 1994 a Form 1120S with “Estimated”

written on the top of the first page (Beacon’s 1994 “Estimated”

return). Beacon’s 1994 “Estimated” return reported total income

and total deductions of $5,000 and $2,710, respectively.

6
At all relevant times during the years in issue, Beacon
used the cash basis method of accounting for Federal income tax
purposes.
 - 14 -

On or about June 30, 1997, Beacon submitted a second Form

1120S for the taxable year 1994 with “Amended” written on the top

of the first page (Beacon’s 1994 “Amended” return). On Beacon’s

1994 “Amended” return, Beacon reported total income and total

deductions of $4,936 and $17,760, respectively, for a loss of

$12,824. The total deductions included travel expenses of

$9,887.

On or about March 14, 1997, Beacon submitted a 1995 Form

1120S with “Amended” written on the top of the first page

(Beacon’s 1995 “Amended” return).7 On Beacon’s 1995 “Amended”

return, Beacon reported total income and total deductions of

$6,454 and $14,870, respectively, for a loss of $8,416. The

total deductions for 1995 included travel expenses of $5,615.

Beacon filed a Form 1120S for the taxable year 1996. On the

1996 Form 1120S, Beacon reported total income and total

deductions of $10,564 and $12,540, respectively, for a loss of

$1,976. For 1996, Beacon deducted travel expenses of $6,572.

C. ISOA, Inc.’s Tax Returns

On or about July 10, 1995, respondent received ISOA, Inc.’s

Form 1120S for the 1994 taxable year (ISOA, Inc.’s 1994 return).

ISOA, Inc.’s 1994 return was prepared on the cash basis method of

accounting. ISOA, Inc., reported gross profit of $18,749 and

7
Based on the record, there is no indication that Beacon
submitted any other 1995 return prior to Beacon’s 1995 “Amended”
return.
 - 15 -

total deductions of $10,384 for 1994. ISOA, Inc.’s total

deductions included travel expenses of $8,228.

On or about September 23, 1996, respondent received a 1995

Form 1120S (ISOA, Inc.’s 1995 return) prepared by Edward Chui

(Mr. Chui), the corporation’s certified public accountant. ISOA,

Inc.’s 1995 return was prepared on the cash basis method of

accounting. The 1995 Form 1120S reported total income of

$191,383 and total deductions of $170,679, for ordinary income of

$20,704. Deductions included “Royalties Paid To Investors” of

$104,860 and travel expenses of $21,069. On a balance sheet

attached to ISOA, Inc.’s 1995 return, the corporation listed

“Advances From Others” of $195,000 under “Other Current

Liabilities”. On the Statement of Assets, Liability & Equity for

the taxable year ending December 31, 1995, ISOA Inc. also

reported a current liability for “Unearned Income (Escrow)” of

$195,000.

On August 16, 1996, ISOA, Inc., terminated its S corporation

election and was thereafter a C corporation.

On or about September 13, 1996, respondent received an

amended 1994 Form 1120S for ISOA, Inc., for the taxable period

beginning August 18, 1994, and ending December 31, 1994, (ISOA

Inc.’s 1994 amended return) prepared by Mr. Chui. ISOA, Inc.’s
 - 16 -

1994 amended return was prepared on the cash basis method of

accounting. ISOA, Inc.’s 1994 amended Form 1120S reflected

ordinary income of $12,894.

On or about March 19, 1997, respondent received from ISOA,

Inc., a Form 1120S for the taxable year beginning January 1,

1996, and ending August 15, 1996. ISOA, Inc.’s 1996 return was

prepared on the cash basis method of accounting. ISOA, Inc.’s

1996 Form 1120S reported taxable income of zero and total

deductions of $69,937, for a loss of $69,937. The total

deductions included travel expenses of $22,856.

On or about March 19, 1997, respondent received ISOA, Inc.’s

Form 1120, U.S. Corporation Income Tax Return, for the taxable

year beginning August 16, 1996, and ending December 31, 1996.

The 1996 Form 1120 reflected that the return was prepared on the

accrual method of accounting. On the 1996 Form 1120, ISOA, Inc.,

reported total income of $446,454 and total deductions of

$482,825, for a loss of $36,371. On the balance sheet attached

to the Form 1120, ISOA, Inc., listed under “Other Current

Liabilities” ending balances for “Royalty Payable” and “Deferred

And Unearned Income” of $185,500 and $195,000, respectively.

II. Respondent’s Examinations

On June 12, 1996, respondent notified petitioners by letter

that their 1992 individual tax return had been selected for

examination in respondent’s Lubbock office. Revenue Agent Susan
 - 17 -

Sutton (Agent Sutton) was responsible for the examination of

petitioners’ 1992 taxable year. As part of the initial

examination for 1992, Agent Sutton requested that petitioners

provide, among other items, their 1991 through 1993 tax returns.

Respondent also scheduled an appointment in August to meet with

petitioners and discuss the examination.

Petitioners engaged Carolyn Stephenson (Ms. Stephenson), a

certified public accountant, to represent them during their

examination. Ms. Stephenson did not prepare petitioners’ 1992

return, nor did she request to see petitioners’ 1992 return.

In their initial discussion Ms. Stephenson advised Agent

Sutton that some of petitioners’ documents had been lost or

misplaced. Agent Sutton allowed petitioners until August 21,

1996, to gather the documents originally requested.

On July 9, 1996, Agent Sutton issued to petitioners an

Information Document Request (IDR) which requested, in part, that

petitioners provide by August 21, 1996, their individual tax

returns for the 1991 through 1995 taxable years, as well as

Beacon’s tax returns for the taxable years 1991 through 1995. In

addition, the IDR requested “books, records, invoices, receipts,

statements, and any other data to verify” income and expenses

with respect to petitioners’ 1992 tax year. At petitioners’
 - 18 -

request for additional time to gather the documentation, Agent

Sutton extended the time for petitioners’ response to October 1,

1996.

On or about October 1, 1996, petitioners provided Ms.

Stephenson with a box of documentation related to petitioners’

travel activities. This documentation also included petitioners’

1992 return.

On October 1, 1996, Ms. Stephenson met with Agent Sutton and

provided her some documents, including bank statements and charge

card statements, to review with respect to petitioners’ 1992

taxable year. Ms. Stephenson also informed Agent Sutton that

petitioners had been unable to collect some of the requested

documents, including travel receipts and reimbursement

documentation from the University. The meeting between Ms.

Stephenson and Agent Sutton lasted approximately 1 hour.

On October 3, 1996, Agent Sutton issued an IDR which

requested, in part, the “items requested in the original

appointment letter that has [sic] not yet been provided.” The

IDR also requested, in part, all tax returns from petitioners and

Beacon for the taxable years 1991 through 1995 and ISOA, Inc.,

for the taxable years since its incorporation. In addition,

Agent Sutton requested supporting documentation with respect to a
 - 19 -

number of petitioners’ claimed expenses. Ms. Stephenson notified

Agent Sutton that the requested information would be provided by

the middle of November.

On November 15, 1996, Agent Sutton issued an IDR and

requested, among other items, substantiation of the income and

expenses with respect to petitioners’ 1993 through 1995 taxable

years, Beacon’s 1992 through 1995 taxable years, and “any other

entities which [petitioners] control or own” for the taxable

years 1992 through 1995. The IDR requested that this information

be provided by December 5, 1996.

In December 1996, Agent Sutton spent 2 days at Ms.

Stephenson’s office reviewing the documentation made available by

petitioners. On December 30, 1996, during respondent’s

examination, petitioners filed the 1993 return, 1994 return, and

1995 return.

On January 2, 1997, respondent notified petitioners by

letter that their individual returns for the taxable years 1993

through 1995 were also under examination, as well as Beacon’s tax

returns for the 1992 through 1995 taxable years and ISOA Inc.’s

tax returns for the 1994 and 1995 taxable years.

By letter dated January 17, 1997, petitioners requested that

the examination of the taxable years 1993 through 1995 be

transferred to respondent’s Dallas, Texas, office.
 - 20 -

On January 23, 1997, Agent Sutton issued an IDR which again

requested, in part, copies of Beacon’s and ISOA, Inc.’s tax

returns for the taxable years in issue, as well as the general

ledgers which support all of the tax returns under examination.

Petitioners requested additional time to comply with the IDR

because of the large volume of documents in petitioners’

possession and the need to review each adjustment on their

“general ledgers”. On February 20, 1997, petitioners requested

additional time in order to reconstruct some records and to put

the 1994 and 1995 taxable years in a general ledger format.

Additionally, Ms. Stephenson notified Agent Sutton and claimed

that during this time petitioner’s work demands were also

“overwhelming to her.”

By letter dated February 10, 1997, respondent denied

petitioners’ request to transfer the examination to respondent’s

Dallas, Texas, office.

On March 10, 1997, Agent Sutton received from petitioner

what have been referred to by petitioners as “general ledgers”.

On March 14, 1997, Agent Sutton received revised general ledgers

for 1994 and 1995. (We have not undertaken to evaluate the so-

called general ledgers as to whether they fall within a normal

definition of “general ledger”. See Webster’s Third New

International Dictionary (1986), which defines general ledger as

follows: “the principal and controlling ledger of a business
 - 21 -

enterprise containing individual or controlling accounts for all

assets, liabilities, net worth items, revenue, and expenses”.)

The general ledgers provided to Agent Sutton list dates, amounts,

and types of expenses, but generally did not identify the

business purpose of the listed expense or provide any supporting

documentation. Petitioners provided Agent Sutton with revised

versions of the general ledgers several times as petitioners

continued to sort through their information. Additionally,

petitioners claimed that they were unable to provide supporting

documentation to Agent Sutton along with the “general ledgers”

because this information was located in Dallas. Ms. Stephenson

added that any such documents by themselves would not have been

helpful without input from petitioner, whom she claimed was busy

with work and travel at this time.

The examination of petitioners’ “general ledgers” raised

additional concerns with Agent Sutton. Many of the amounts on

the “general ledgers” provided by petitioners did not reconcile

to corresponding deductions on any of the numerous tax returns

provided by petitioners during the examination. Ms. Stephenson

noted that even with the final amounts on the “general ledgers”,

Agent Sutton might not “find the exact number on the tax return.”

In addition, some expenses listed on the “general ledgers”

included amounts which had been reimbursed by the University.

For example, one “general ledger” indicated that the
 - 22 -

reimbursements from the University to petitioner had been equally

split between petitioner’s employee business expenses at the

University and ISOA, Inc. Additionally, the amount of

petitioner’s travel expenses at the University on a general

ledger for 1993 did not equal the travel expenses claimed on the

1993 Form 2106. The “general ledgers” also indicated that

petitioners often claimed per diem expenses as well as hotel and

meal expenses for the same travel. There were also personal

expenses, including women’s clothing and car rental expenses for

petitioners’ son, which were included on the “general ledgers”

and deducted by petitioners on their tax returns under

examination.

During the examination, Agent Sutton was also provided with

a draft audit report prepared by the University. The draft audit

report raised questions regarding irregularities with respect to

petitioner’s expense reimbursements from the University.

On May 29, 1997, after examining the information provided to

that date, Agent Sutton issued an IDR to petitioners with more

than 300 questions and document requests. This again included,

in part, requests for substantiation for the claimed business

expense deductions, as well as an explanation of the $195,000 of

“Advances From Others” with respect to ISOA, Inc.’s 1995 return.8

8
Throughout the proceeding, the parties refer to this as
the “deferred income” issue. We do likewise.
 - 23 -

In a June 3, 1997, letter to Agent Sutton, Ms. Stephenson

requested that a sampling technique be used with respect to the

requested documents since petitioners would have to review over

24,000 documents in response to the latest IDR. Agent Sutton

denied petitioners’ request to sample the expenses listed on the

returns and the related substantiation because there were too

many discrepancies in the returns and submitted documentation to

warrant sampling petitioners’ records. However, Agent Sutton

informed Ms. Stephenson that petitioners should provide only the

information and documentation that was possible without

disrupting their professional lives or spending excessive sums of

money.

On June 30, 1997, petitioners sent their response to the

latest IDR to Agent Sutton. For example, petitioners’ response

to a request for hotel receipts was “Samples are attached”.

However, respondent did not receive any such receipts attached to

the IDR. In describing the $195,000 of licensing fees received

by ISOA, Inc., in 1995 but not reported in the corporation’s

taxable income, petitioners stated that this amount was “held

for $1.5 million buyout of intellectual property from [the

University] within 5 years. Funds can be used to offset approved

costs of licensing intellectual property per [ISOA, Inc./the

University] agreement. [ISOA, Inc.] must show reasonable progress

each year toward accumulation of the $1.5 million”.
 - 24 -

On August 25, 1997, Agent Sutton prepared and sent a

Referral Report of Potential Criminal Fraud Cases to the Criminal

Investigation Division (CID) of the IRS with respect to

petitioners, Beacon, and ISOA, Inc., for the taxable years under

examination (the criminal fraud referral). The criminal fraud

referral for petitioners and Beacon was based, in part, on the

substantial overstatement of deductions with respect to income

and the overall incompleteness of documentation provided by

petitioners at that point in the examination. With respect to

ISOA, Inc., the criminal fraud referral was based largely on the

$195,000 of “deferred income” from licensing fees that was

omitted from income and classified by ISOA, Inc., as “Advanced

Royalties” on the 1995 return. Special Agent Mike Metzler of the

CID informed petitioners that their individual returns for the

taxable years at issue were under a criminal fraud investigation.

On January 20, 1998, Agent Sutton issued a Revenue Agent’s

Report (RAR) with respect to petitioners’ 1992 taxable year (1992

RAR). The 1992 RAR proposed an income tax deficiency of $14,750

and total penalties of $14,604. The 1992 RAR, in part,

disallowed all of petitioners’ claimed Schedule C deductions on

the basis that ISOA Consulting was not a trade or business and

that the claimed expenses were either nondeductible personal

expenses or that they had been deducted by petitioners elsewhere

on the 1992 return.
 - 25 -

On February 2, 1998, the criminal fraud investigation was

closed without a recommendation for prosecution.

On February 13, 1998, respondent issued a notice of

deficiency to petitioners with respect to their 1992 taxable

year.

On March 10, 1998, Agent Sutton informed petitioners that

the examination was expanding to include the 1996 taxable year

with respect to petitioners, Beacon, and ISOA, Inc. At that

time, Agent Sutton issued an IDR with respect to the 1996 tax

returns for petitioners, Beacon, and ISOA, Inc.9

On August 12, 1998, Agent Sutton issued separate proposed

RARs for petitioners, Beacon, and ISOA, Inc., with respect to the

remaining taxable years under examination. Agent Sutton offered

to have a conference with petitioners and Ms. Stephenson on

August 25, 1998, to discuss the proposed adjustments. Agent

Sutton stated that the proposed RARs were meant to let

petitioners “know what the proposed adjustments were and provide

[Ms. Stephenson] and the taxpayers time to talk to me or provide

more books and records.”

On August 24, 1998, after the proposed RARs had been issued,

Ms. Stephenson notified Agent Sutton that petitioners did not

9
The request included the tax returns for ISOA, Inc., for
the taxable year 1996 ending on August 15 and December 31.
 - 26 -

agree with the adjustments in the proposed RARs sent on August

12, 1998, and requested that the returns under examination be

reviewed by respondent’s Appeals Office.

On August 27, 1998, respondent issued to petitioners a 30-

day letter for their 1993 through 1995 individual taxable years

and a 30-day letter for their 1996 individual taxable year.

Respondent proposed deficiencies, additions to tax, and penalties

as follows:10

Additions to tax Penalty
Year Deficiency sec. 6651(a)(1) sec. 6663

1993 $25,046 $2,866 $18,785
1994 31,754 8,019 23,815
1995 74,895 11,277 56,171
1996 33,656 --- 25,242

Respondent, in part, disallowed a number of claimed business

expense deductions claimed by petitioners for lack of

substantiation and business purpose. Respondent also asserted

that several of petitioners’ claimed business expense deductions

were either reimbursed by the University, personal in nature, or

deducted multiple times among petitioners, Beacon, and ISOA, Inc.

On August 27, 1998, respondent issued separate 30-day

letters to Beacon and ISOA, Inc., with respect to the

corporations’ taxable years under examination. The 30-day letter

10
Respondent and petitioners resolved the issues that arose
during the examination of petitioners’ 1992 individual tax return
with no additional tax or penalties due.
 - 27 -

sent to ISOA, Inc., stated, in part, that the company had failed

to report $195,000 of income in 1995 which had been erroneously

classified by petitioners as “deferred income”. Specifically,

Agent Sutton noted that ISOA, Inc., received the $195,000 in

licensing fees from the company’s clients with no restrictions on

the use of the funds and that the licensing fees had been

deposited in the company’s bank account like all other receipts

by the company.

By letter dated October 28, 1998, Anthony Rebollo (Mr.

Rebollo), an attorney hired by petitioners, protested the 30-day

letters issued to petitioners, Beacon, and ISOA, Inc., and

requested an Appeals conference to discuss respondent’s proposed

adjustments made with respect to all of the tax returns under

examination. Mr. Rebollo also noted, in part, that “the

taxpayers’ records are voluminous and, with respect to some

issues, can be difficult and time consuming to analyze” and that

petitioners’ “extremely hectic schedule requiring extensive

travel and a great deal of stress” had “contributed to some of

the problems” in petitioners’ case.

In November 1998, petitioners were notified that their case

had been transferred to respondent’s Appeals Office. Appeals

Officer Estevan Medina (Appeals Officer Medina) was assigned to

review petitioners’ 1993 through 1996 taxable years. By letter

dated March 11, 1999, Appeals Officer Medina informed Ms.
 - 28 -

Stephenson as to the general scope and course of the Appeals

review process with respect to petitioners. Appeals Officer

Medina also informed Ms. Stephenson as to the categories of

expenses with respect to petitioners, Beacon, and ISOA, Inc.,

that would be examined. Appeals Officer Medina further noted

that the examiner would initially apply a sampling technique to

review petitioners’ substantiation. Ms. Stephenson was

subsequently informed by Appeals Officer Medina that any

settlement with respect to petitioners’ 1992 taxable year was

irrelevant because each year stands on its own and that each

issue raised during the original audit had to be addressed at

Appeals.

After discussing petitioners’ case with Appeals Officer

Medina, Ms. Stephenson notified petitioners by letter as to

the nature of the Appeals Office review. Specifically, Ms.

Stephenson informed petitioner that if the sampling process did

not yield sufficient results then the examiner might deny a

deduction in whole or in part, or “she will have to look at every

item of deduction”.

Revenue Agent Jean Wharton (Agent Wharton) was assigned to

examine petitioners’ records during the Appeals Office review.

Petitioners did not support Appeals Officer Medina’s suggestion

to add a second revenue agent to expedite the Appeals

examination.
 - 29 -

From May to September 1999, Agent Wharton spent 14 days at

petitioners’ residence reviewing records and documentation with

respect to the 1993 through 1996 taxable years. This included

more than 20 boxes of travel documentation from petitioners and

their related entities. This documentation included, among other

items, restaurant receipts, hotel receipts, and business cards.

During Appeals consideration, Agent Wharton often did

not receive adequate documentation from petitioners and Ms.

Stephenson in response to questions raised during her

examination. For example, in some cases the only substantiation

Agent Wharton received with respect to the business purpose of

certain travel expenses was business cards.

During her review, Agent Wharton noted that she had several

versions of “general ledgers” and that none completely reconciled

to any of the returns in respondent’s possession. For example,

Agent Wharton determined that in 1995, petitioner frequently

traveled from Lubbock, Texas, to Richardson, Texas, on day trips

with no overnight stays. However, in addition to the actual

travel expenses, petitioner claimed per diem expenses for at

least 100 days. Petitioner also claimed a per diem expense for

time in Hawaii while she waited to have a visa approved for a

trip to Australia. During her review, Agent Wharton found that

petitioners deducted $59,479 on their 1996 Schedule A for “Job

travel: accom. in Dallas”. Petitioners’ 1996 general ledger
 - 30 -

indicated that this amount included petitioners’ mortgage

payments, car loan payments, and payments for home furnishings.

Agent Wharton also determined that a majority of shipping

expenses were for items shipped to family members for which there

was no clear business purpose.

On January 12, 2000, Appeals Officer Medina met with

petitioners, Ms. Stephenson, and Mr. Rebollo to discuss Agent

Wharton’s review and the adjustments he was willing to concede in

order to facilitate a possible settlement. Petitioners rejected

the settlement proposal. Subsequent settlement proposals by Ms.

Stephenson were rejected by Appeals Officer Medina.

By letter to Mr. Rebollo dated January 28, 2000, Appeals

Officer Medina again explained the results of Agent Wharton’s

examination and respondent’s position with respect to the

proposed adjustments.

In April 2000, petitioners engaged new counsel, W. Thomas

Finley (Mr. Finley) to represent them in their dispute. After an

April 28, 2000, meeting, Mr. Finley agreed to provide Appeals

Officer Medina additional substantiation prior to any decision by

the Appeals Office.

On June 20, 2000, Mr. Finley sent a new settlement proposal

to Appeals Officer Medina, along with additional substantiation

and spreadsheets prepared by Ms. Stephenson. In a letter to

Appeals Officer Medina dated August 1, 2000, Ms. Stephenson
 - 31 -

provided a summary of petitioners’ positions with respect to the

issues of the latest settlement proposal. With respect to the

deferred income issue, Ms. Stephenson stated that this amount was

“the accumulation of royalties owed to inventors” and that ISOA,

Inc., was “merely a conduit for distributing these royalty

payments to the inventors.” Ms. Stephenson for the first time

also claimed that ISOA, Inc.’s 1995 return erroneously indicated

that the corporation was on the cash basis method of accounting.

In addition, Ms. Stephenson stated that ISOA, Inc., was an

accrual basis taxpayer and that the proper accounting treatment

of the “deferred income” would have been “to recognize the

royalty income when received and set up a corresponding payable

to the inventors for the same amount.”

By letter to Ms. Stephenson dated August 11, 2000, Appeals

Officer Medina rejected petitioners’ June 2000 settlement

proposal.

III. The Notice of Deficiency

On October 19, 2000, respondent issued to petitioners a

notice of deficiency for their 1993 through 1996 individual

taxable years. The notice of deficiency also included

adjustments with respect to Beacon for the taxable years 1993

through 1996 and ISOA, Inc., for the taxable years 1995 and
 - 32 -

1996.11 In the notice, respondent asserted, in part, that

numerous business expenditures claimed by petitioners, Beacon,

and ISOA, Inc., had not been adequately substantiated and did not

have a business purpose. Respondent also determined that Beacon

and ISOA, Inc., had failed to properly include certain amounts in

income. Specifically, respondent determined that ISOA, Inc.,

failed to properly include the $195,000 of “deferred income” in

the corporation’s 1995 taxable income. The notice of deficiency

determined deficiencies, additions to tax, and accuracy-related

penalties, as follows:12

Additions to tax Penalty
Year Deficiency sec. 6651(a)(1) sec. 6662

1993 $23,733 $2,538 $4,747
1994 28,514 7,209 5,703
1995 75,089 11,306 15,018
1996 28,307 --- 5,661

IV. The Petition and Proceedings to Date

On January 17, 2001, petitioners timely filed a petition

with the Court. Petitioners placed all of the amounts in the

notice of deficiency in dispute. Petitioners alleged, among

other things, that the claimed business expense deductions with

respect to petitioners’ business activities had been adequately

11
The adjustments with respect to ISOA, Inc., for the
taxable year 1996 were for the corporation’s taxable year ending
Aug. 15, 1996.
12
The sec. 6663 fraud penalty was conceded as a result of
Appeals Office consideration.
 - 33 -

substantiated and were ordinary and necessary business expenses.

The petition further alleged that Beacon and ISOA, Inc., did not

fail to properly report any items of taxable income.

On March 8, 2001, Mary Kay McIlyar (Ms. McIlyar), the

District Counsel attorney to whom the case was assigned, filed an

answer to the petition which denied all of petitioners’

assignments of error.

Ms. McIlyar met with Agent Wharton, Ms. Stephenson, and Mr.

Finley to discuss petitioners’ case. At this meeting, it was

decided that petitioners would provide “mockup” tax returns which

would include only the amounts that could be adequately

substantiated by petitioners. These “mockup” tax returns would

not be filed with the IRS.

Years after petitioners’ filed returns, “Estimated” returns,

“Revised” returns, and “Amended” returns, Ms. Stephenson prepared

the “mockup” tax returns along with “general ledgers” to support

the amounts on these returns. Between June and September of

2001, Mr. Finley provided Ms. McIlyar with the “mockup” returns

for the entities and taxable years in issue. Many of the amounts

on the “mockup” tax returns differed from the amounts on the tax

returns petitioners had previously submitted to the IRS. Revenue

Agent Richard Laakso (Agent Laakso) was assigned to examine the

“mockup” returns and the “general ledgers” prepared by Ms.

Stephenson. Agent Laakso selected a limited number of entries
 - 34 -

from the most recent “general ledgers” to verify the amounts on

the “mockup” tax returns. During his review of the “mockup” tax

returns, Agent Laakso occasionally needed to request additional

substantiation. After reviewing the “mockup” tax returns, Agent

Laakso discussed settlement proposals for each taxable year in

issue with Ms. Stephenson. The settlement proposals reached

between Agent Laakso and Ms. Stephenson were then submitted to

Ms. McIlyar and Mr. Finley to negotiate any possible final

settlements.

On December 5, 2001, Mr. Finley sent respondent a separate

settlement offer for each of the years 1993 through 1996 with

total tax liabilities for each year as follows:

Total
Year tax liability

1993 $5,000
1994 5,450
1995 7,700
1996 1,750

On February 11, 2002, the settlement offers for 1993 and

1994 were accepted by Ms. McIlyar in the amounts proposed by Mr.

Finley.

On February 19, 2002, Ms. McIlyar proposed settlements for

the 1995 and 1996 taxable years as follows:

Total Penalty
Year tax liability sec. 6662(a)

1995 $12,921 ---
1996 7,330 $1,466
 - 35 -

On April 12, 2002, a stipulated decision document was signed

and submitted to the Court reflecting the following settlement:

Penalty
Year Deficiency sec. 6662(a)

1993 $5,000 ---
1994 5,450 ---
1995 12,921 ---
1996 7,330 $1,466

On May 14, 2002, petitioners filed their motion for an

award of costs.13 Accordingly, on May 14, 2002, the stipulated

decision was vacated, recharacterized, and filed as a stipulation

of settlement. On June 26, 2002, petitioners filed an amended

motion for costs.

On August 26, 2002, respondent filed an objection to

petitioners’ amended motion for an award of costs. According to

respondent’s objection: (1) The positions maintained by

respondent in the administrative and court proceedings were

substantially justified; (2) petitioners unreasonably protracted

both the administrative and court proceedings; (3) petitioners

did not incur any costs in connection with either the

administrative or court proceedings; and (4) the administrative

and litigation costs claimed by petitioners were unreasonable in

amount.

13
Respondent’s counsel agreed to the settlement unaware of
petitioners’ intention to file the motion here under
consideration after the stipulated decision had been entered.
 - 36 -

On April 30, 2003, petitioners filed a reply. Pursuant to

petitioners’ request, an evidentiary hearing was conducted on

petitioners’ motion in Dallas, Texas.

OPINION

Administrative costs incurred in connection with an

administrative proceeding may be awarded under section 7430(a)

only if a taxpayer: (1) Is the prevailing party, and (2) did

not unreasonably protract the administrative proceeding. Sec.

7430(a) and (b)(3).14 Similarly, litigation costs incurred in

connection with a court proceeding may be awarded only if a

taxpayer: (1) Is the prevailing party; (2) has exhausted his or

her administrative remedies within the IRS; and (3) did not

unreasonably protract the court proceeding. Sec. 7430(a) and

(b)(1), (3).

A taxpayer must satisfy each requirement in order to be

entitled to an award of administrative or litigation costs under

section 7430. Sec. 7430(a)(1) and (2), (c)(1) and (2); Rule

232(e).

To be a “prevailing party”, the taxpayer must: (1)

Substantially prevail with respect to either the amount in

14
Administrative costs include only the costs incurred on
or after the earlier of: (1) The date of receipt by the taxpayer
of the decision by the Appeals Office; (2) the date of the notice
of deficiency; or (3) the date on which the first letter of
proposed deficiency which allows the taxpayer an opportunity for
administrative review in the IRS Appeals Office is sent. Sec.
7430(c)(2).
 - 37 -

controversy or the most significant issue or set of issues

presented; and (2) satisfy the applicable net worth requirement.

Sec. 7430(c)(4)(A). Respondent concedes that petitioners have

satisfied the requirements of section 7430(c)(4)(A). According

to respondent, however, petitioners are not prevailing parties

within the meaning of section 7430 because respondent’s positions

in the administrative and court proceedings were substantially

justified. Sec. 7430(c)(4)(B)(i).

In general, the Commissioner’s position is substantially

justified if, based on all of the facts and circumstances and the

legal precedents relating to the case, the Commissioner acted

reasonably. Pierce v. Underwood, 487 U.S. 552 (1988); Sher v.

Commissioner, 89 T.C. 79, 84 (1987), affd. 861 F.2d 131 (5th Cir.

1988). In other words, to be substantially justified, the

Commissioner’s position must have a reasonable basis in both law

and fact. Pierce v. Underwood, supra; Rickel v. Commissioner,

900 F.2d 655, 665 (3d Cir. 1990), affg. in part and revg. in part

on other grounds 92 T.C. 510 (1989). A position is substantially

justified if the position is “justified to a degree that could

satisfy a reasonable person.” Pierce v. Underwood, supra at 565

(construing similar language in the Equal Access to Justice Act).

Thus, the Commissioner’s position may be incorrect but

nevertheless be substantially justified “‘if a reasonable person
 - 38 -

could think it correct’”. Maggie Mgmt. Co. v. Commissioner, 108

T.C. 430, 443 (1997) (quoting Pierce v. Underwood, supra at 566

n.2).

The relevant inquiry is “whether * * * [the Commissioner]

knew or should have known that * * * [his] position was invalid

at the onset”. Nalle v. Commissioner, 55 F.3d 189, 191 (5th Cir.

1995), affg. T.C. Memo. 1994-182. We look to whether the

Commissioner’s position was reasonable given the available facts

and circumstances at the time that the Commissioner took his

position. Maggie Mgmt. Co. v. Commissioner, supra at 443;

DeVenney v. Commissioner, 85 T.C. 927, 930 (1985). In deciding

whether the Commissioner’s position was substantially justified,

a significant factor is whether, on or before the date the

Commissioner assumed the position, the taxpayer provided “all

relevant information under the taxpayer’s control and relevant

legal arguments supporting the taxpayer’s position to the

appropriate Internal Revenue Service personnel.”15 Sec.

301.7430-5(c)(1), Proced. & Admin. Regs.

The fact that the Commissioner eventually concedes or loses

a case does not establish that his position was unreasonable.

15
“Appropriate Internal Revenue Service personnel” are
those employees who are reviewing the taxpayer’s information or
arguments, or employees who, in the normal course of procedure
and administration, would transfer the information or arguments
to the reviewing employees. Sec. 301.7430-5(c)(1), Proced. &
Admin. Regs.
 - 39 -

Estate of Perry v. Commissioner, 931 F.2d 1044, 1046 (5th Cir.

1991); Sokol v. Commissioner, 92 T.C. 760, 767 (1989). However,

the Commissioner’s concession is a factor to be considered.

Powers v. Commissioner, 100 T.C. 457, 471 (1993), affd. in part,

revd. in part and remanded on another issue 43 F.3d 172 (5th Cir.

1995).

As relevant here, the position of the United States under

consideration with respect to the recovery of administrative

costs is the position taken by the Commissioner as of the date of

the notice of deficiency. Sec. 7430(c)(7)(B)(ii); Fla. Country

Clubs, Inc. v. Commissioner, 122 T.C. 73 (2004), affd. 404 F.3d

1291 (11th Cir. 2005). The position of the United States under

consideration with respect to the recovery of litigation costs is

the position taken by the Commissioner in the answer to the

petition. Bertolino v. Commissioner, 930 F.2d 759, 761 (9th Cir.

1991); Sher v. Commissioner, 861 F.2d at 134-135; see sec.

7430(c)(7)(A). Ordinarily, we consider the reasonableness of

each of these positions separately in order to account for a

change in the Commissioner’s position. Maggie Mgmt. Co. v.

Commissioner, supra at 442 (citing Huffman v. Commissioner, 978

F.2d 1139, 1144-1147 (9th Cir. 1992), affg. in part and revg. in

part on other grounds T.C. Memo. 1991-144). In the present case,

however, we need not follow this approach because respondent’s
 - 40 -

position was essentially the same in the administrative and Court

proceedings. See Maggie Mgmt. Co. v. Commissioner, supra at 442.

The parties agree, more or less, that prior to the

settlement, the items at issue as a result of respondent’s

examination were primarily: (1) Petitioners’ claimed business

expense deductions; and (2) ISOA, Inc.’s “deferred income” in

1995 in the amount of $195,000. We have previously adopted an

issue-by-issue approach to the awarding of costs under section

7430, apportioning the requested award among the issues according

to whether the position of the United States was substantially

justified. Swanson v. Commissioner, 106 T.C. 76, 102 (1996);

O’Bryon v. Commissioner, T.C. Memo. 2000-379; see also Powers v.

Commissioner, 51 F.3d 34, 35 (5th Cir. 1995). We follow that

approach here and separately discuss whether respondent’s

position was substantially justified with respect to each of the

above issues.16

I. Business Expense Deductions

In the notice of deficiency, respondent disallowed various

business expense deductions claimed on petitioners’ individual

tax returns, as well as the tax returns of Beacon and ISOA, Inc.,

16
Much of petitioners’ presentation at the hearing
addressed the criminal referral and the proposed civil fraud
penalty. Although the civil fraud penalty was proposed in the
revenue agent’s report, it was neither included in the notice of
deficiency nor the answer. Consequently, the substantial
justification of respondent’s proposed imposition of the civil
fraud penalty is not considered here. See sec. 7430(c)(7).
 - 41 -

because petitioners did not: (1) Adequately substantiate those

deductions; and/or (2) establish the business purpose for the

deductions.

We begin with a fundamental proposition of Federal income

taxation. Deductions are matters of legislative grace. New

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

Commissioner, 89 T.C. 816, 842 (1987). Taxpayers are required to

substantiate the claimed deductions by maintaining records

necessary to establish entitlement and the amount of the

deduction in question. Sec. 6001; Meneguzzo v. Commissioner,

43 T.C. 824, 831-832 (1965); sec. 1.6001-1(a), Income Tax Regs.;

see Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); Welch v. Helvering, 290 U.S. 111, 115 (1933); Segel v.

Commissioner, supra; Hradesky v. Commissioner, 65 T.C. 87, 90

(1975), affd. per curiam 540 F.2d 821 (5th Cir. 1976). In

general, the burden to demonstrate entitlement to a claimed

deduction rests with the taxpayer. Rule 142(a); Underwood v.

Commissioner, 56 F.2d 67 (4th Cir. 1932), revg. 20 B.T.A. 1117

(1930).

Generally, section 162(a) allows “as a deduction all the

ordinary and necessary expenses paid or incurred during the

taxable year in carrying on any trade or business”, including a

taxpayer’s trade or business as an employee. See Primuth v.

Commissioner, 54 T.C. 374, 377-378 (1970). To support expenses
 - 42 -

entitled to a section 162(a) deduction, a taxpayer must provide

evidence to establish a sufficient connection between the

deduction and his trade or business. Gorman v. Commissioner,

T.C. Memo. 1986-344.

Certain expenses that otherwise qualify for deduction under

section 162(a) require enhanced, more specified substantiation

under section 274. These include travel, food, and entertainment

expenses. For these items, taxpayers must show that an expense

was “directly related” to the business activity, and must provide

the business purpose, amount, and time and place of the

expenditure. Sec. 274(a); sec. 1.274-5T(b)(2), Temporary Income

Tax Regs. 50 Fed. Reg. 46014 (Nov. 6, 1985). In order to

substantiate these types of deductions by means of adequate

records, a taxpayer must maintain a diary, a log, or a similar

record, and documentary evidence that, in combination, are

sufficient to establish each element of each expenditure or use.

Sec. 1.274-5T(c)(2)(i), Temporary Income Tax Regs., 50 Fed. Reg.

46017 (Nov. 6, 1985).

If the allowance of a deduction claimed on a return is

challenged by respondent, respondent is not obliged to concede

the taxpayer’s entitlement to the deduction until adequate

substantiation for the deduction has been provided by the
 - 43 -

taxpayer. See Huynh v. Commissioner, T.C. Memo. 2002-110;

Gealer v. Commissioner, T.C. Memo. 2001-180; O’Bryon v.

Commissioner, supra; Cooper v. Commissioner, T.C. Memo. 1999-6.

What constitutes adequate substantiation for challenged

deductions, of course, is fertile ground for disputes between a

taxpayer and respondent, and we recognize that the nature and

quantum of substantiation for a given deduction can vary with

the circumstances. Welch v. Helvering, supra. Guidance

published by respondent identifies generally how a deduction may

be substantiated, but notes that proof that an expenditure was

made or incurred does not necessarily establish that a taxpayer

is entitled to a deduction for that expenditure. Taxpayers are

advised to keep any other documents that may prove entitlement to

the deduction. See Rev. Proc. 92-71, 1992-2 C.B. 437.

Furthermore, a taxpayer’s self-serving declaration is generally

not a sufficient substitute for records. See Weiss v.

Commissioner, T.C. Memo. 1999-17.

Respondent’s position with respect to the disallowance of

deductions claimed on petitioners’ returns flows from the

examination of those returns, and it is clear that a taxpayer’s

return is hardly substantiation for items reported on that

return. See Seaboard Commercial Corp. v. Commissioner, 28 T.C.

1034, 1051 (1957); Halle v. Commissioner, 7 T.C. 245, 247 (1946),

affd. 175 F.2d 500 (2d Cir. 1949).
 - 44 -

According to petitioners, their hectic work schedules

precluded them from filing timely individual tax returns for the

years 1993 through 1995. Petitioners’ 1993, 1994, and 1995

returns were not received by respondent until December 30, 1996,

and then each was followed by an “amended” or “revised” version.

In addition to filing multiple versions of untimely tax

returns, petitioners repeatedly failed to respond timely and

adequately to respondent’s numerous requests for information and

documentation during the examination. Petitioners attribute

these failures to their busy work and travel schedules.

Petitioners complain of respondent’s practice of issuing multiple

IDRs for the same information, but ignore their own behavior as

the reason for such multiple requests.

Nothing introduced at the hearing establishes that

respondent’s agents improperly or unreasonably failed to accept

adequate substantiation for the deductions in dispute. Many of

petitioners’ claimed business expense deductions were for travel

and entertainment. As previously noted, that type of expense is

subject to strict substantiation requirements to be allowed as a

deduction. As best as can be determined from the hearing record,

petitioners provided little substantiation with respect to much

of their travel and entertainment expense deductions. For

example, petitioners provided only business cards to substantiate

the business purpose of some claimed travel expenses.
 - 45 -

Petitioners had no receipts for amounts deducted as travel

expenses that were allegedly paid to their daughter in exchange

for travel coupons. Many questions were raised by the revenue

agent regarding petitioner’s reimbursements for University-

related travel, but petitioners delayed responding to those

questions, or failed completely to do so, even though an

investigation by the University focused upon those

reimbursements.17

From their presentation at the hearing, it appears that

petitioners, for the most part, consider the “general ledgers”

provided to the examining agents as adequate substantiation for

the challenged deductions. Ignoring for the moment

inconsistencies from version to version, the “general ledgers”

provided little support for the challenged deductions. The

“general ledgers” lacked meaningful descriptions of the listed

expenditures or their business purpose, and, on an item by item

basis, the amounts reported on the “general ledgers” often did

not support the amounts reported on any of the returns submitted

by petitioners. Contrary to the significance that petitioners

attribute to the “general ledgers”, in many ways, those documents

actually support respondent’s requests for additional information

for certain deductions inasmuch as entries contained in the

17
Petitioner was given the opportunity at the hearing to be
recalled as a witness to explain the nature of the University’s
investigation, but she chose not to do so.
 - 46 -

“general ledgers” suggest that petitioners improperly deducted:

(1) Personal items as business expenses; (2) actual travel

expenses in addition to per diem amounts; and (3) mortgage

payments, automobile payments, and home furnishings as “job

travel” expenses. Furthermore, the “general ledgers” were

continually revised during the examination of petitioners’

returns. This suggests that petitioners did not keep these

records contemporaneously with their expenditures or that entries

originally made were in some manner or another erroneous.

Respondent properly requested supporting documentation for

entries made in the “general ledgers”, but some requests were

ignored and many responses were delayed.

A taxpayer’s poorly detailed and noncontemporaneous records

are hardly proper substantiation for challenged deductions, and

secondary sources, such as petitioners’ “general ledgers”,

offered in support of a taxpayer’s business expense deductions

need not be accepted by respondent or this Court. See Krieger v.

Commissioner, T.C. Memo. 1993-347, affd. without published

opinion 64 F.3d 657 (4th Cir. 1995); Bard v. Commissioner, T.C.

Memo. 1990-431; Farguson v. Commissioner, T.C. Memo. 1983-615.

Under the circumstances, including the confusion no doubt

caused by the use of similar acronyms for different entities, we

find no fault with respondent’s refusal to accept the “general

ledgers” and other information provided by petitioners as
 - 47 -

adequate substantiation for the business expense deductions

disallowed in the notice of deficiency. Taking into account

controlling legal precedent and based on the facts available to

respondent when the notice of deficiency was issued, as well as

when the answer was filed, we find that respondent’s position

that results from that refusal has a reasonable basis in law and

fact and therefore is substantially justified. See Maggie Mgmt.

Co. v. Commissioner, 108 T.C. at 443.

Our conclusion on this point is not altered by the fact that

a settlement was achieved after “mock-up” tax returns that

differed from all of the returns previously submitted by

petitioners and additional substantiation were provided and

reviewed by respondent’s counsel. See Harrison v. Commissioner,

854 F.2d 263, 265 (7th Cir. 1988), affg. T.C. Memo. 1987-52;

Wickert v. Commissioner, 842 F.2d 1005 (8th Cir. 1988), affg.

T.C. Memo. 1986-277.

II. The “Deferred Income” Issue

In the notice of deficiency and in his answer, respondent

takes the position that $195,000 of licensing fees received by

ISOA, Inc., are includable in its income in the year received.

According to petitioners, respondent has failed to establish that

his position has a reasonable basis in law. Petitioners argue

that respondent’s position is, therefore, not substantially

justified.
 - 48 -

For the taxable years in issue, ISOA, Inc., was an S

corporation that prepared its tax returns on the cash basis

method of accounting. On its 1995 return, ISOA, Inc., treated

$195,000 of licensing fees received during the taxable year as

“Unearned Income (Escrow)”. Petitioners claimed that ISOA, Inc.,

did not include the $195,000 of licensing fees it received in

taxable income due to the fact that the royalties the corporation

owed would not ultimately be paid until a final agreement was

reached with the University. Therefore, petitioners argued, the

full amount of the licensing fees which ISOA, Inc., would retain

could not be determined at the time of receipt.

Once again, respondent’s position on this issue calls into

play fundamental principles of Federal income taxation. As a

general rule, a cash basis taxpayer recognizes income in the year

of receipt. Sec. 451(a); sec. 1.451-1(a), Income Tax Regs.

Exceptions to this general rule exist for amounts properly

characterized as deposits or amounts held in trust that might

have to be returned. See, e.g., Commissioner v. Indianapolis

Power & Light Co., 493 U.S. 203, 207-208 (1990); Johnson v.

Commissioner, 108 T.C. 448, 467-475 (1997), affd. in part, revd.

in part and remanded on another ground 184 F.3d 786 (8th Cir.

1999). Unless received under a claim of right, “a taxpayer need

not treat as income moneys * * * which were not his to keep, and

which he was required to transmit to someone else as a mere
 - 49 -

conduit.” Diamond v. Commissioner, 56 T.C. 530, 541 (1971),

affd. 492 F.2d 286 (7th Cir. 1974). Receipts subject to the

taxpayer’s claim of right are includable in the taxpayer’s income

in the year of receipt. N. Am. Oil Consol. v. Burnet, 286 U.S.

417, 424 (1932). A taxpayer has a claim of right to income if

the taxpayer: (1) Receives the income; (2) has control over the

utilization and disposition of the income; and (3) asserts a

“claim of right” or entitlement to the income. Id. at 424.

Over the course of the examination, petitioners maintained

several different positions with respect to ISOA, Inc.’s

treatment of the licensing fees as “deferred income”. In 1997,

petitioners’ original position with respect to the “deferred

income” was that the amount was being “held for payment of $1.5

million buyout of intellectual property” from the University.

Later, in August 2000, petitioners maintained the position that

the “deferred income” represented accumulated royalties owed to

the inventors of the underlying intellectual property. At trial,

Ms. Stephenson also testified that the licensing fees were

treated as “deferred income” because they were subject to being

refunded to the licensees. We also note that, on August 1, 2000,

just prior to respondent’s notice of deficiency sent on October

19, 2000, Ms. Stephenson stated that ISOA, Inc., was actually an

accrual basis taxpayer and that the proper accounting treatment
 - 50 -

of the “deferred income” would have been “to recognize the

royalty income when received and set up a corresponding payable

to the inventors for the same amount.”

Given petitioners’ explanations, it was reasonable for

respondent to take the position that ISOA, Inc., was not merely a

conduit and that the $195,000 received by the corporation in 1995

was includable in taxable income in the year received. There was

no question that the licensing fees were received by ISOA, Inc.,

in 1995 and deposited into the corporation’s bank account. ISOA,

Inc., had control over the utilization and disposition of these

licensing fees and, in fact, paid related expenses from these

licensing fees. There is no indication in the record that the

licensing fees were ever deposited or segregated into any

separate account. While ISOA, Inc., may have had an unfixed

obligation to pay royalties to the inventors, the licensing fees

were not required to be held until that time.

Accordingly, it was reasonable for respondent to take the

position that ISOA, Inc., had dominion and control over the

licensing fees and that such amounts were not held by the

corporation merely as an agent or conduit. We find that

respondent’s position that the $195,000 of “deferred income”

should have been included in ISOA, Inc.’s 1995 taxable income was

a reasonable application of the law given the available facts and

circumstances at the time that respondent took his position.
 - 51 -

Because respondent’s positions in the administrative and

court proceedings were substantially justified, we need not

decide whether petitioners unreasonably protracted the

proceedings, or whether the administrative and litigation costs

claimed by petitioners are reasonable.

We find that respondent’s positions on the disputed issues

were substantially justified. Therefore, we hold that

petitioners are not prevailing parties within the meaning of

section 7430 and are not entitled to an award of administrative

and litigation costs.

To reflect the foregoing,

An appropriate order

and decision will be entered.