T.C. Summary Opinion 2007-138
UNITED STATES TAX COURT
ROBERT D. AND CAROL A. BERRYMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15183-06S. Filed August 8, 2007.
Robert D. and Carol A. Berryman, pro se.
Ann L. Darnold, for respondent.
GOEKE, Judge: This case was heard pursuant to the
provisions of section 74631 of the Internal Revenue Code in
effect at the time the petition was filed. Pursuant to section
7463(b), the decision to be entered is not reviewable by any
1
All section references are to the Internal Revenue Code in
effect for the years at issue.
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other court, and this opinion shall not be treated as precedent
for any other case.
Petitioners operated a purported home-based business as
marketers for a direct marketing company. Respondent determined
deficiencies of tax of $11,824, $7,845, and $13,983 for tax years
2002, 2003, and 2004, respectively. Respondent also imposed
penalties of $2,364.80, $1,569, and $2,796.60 for 2002, 2003, and
2004, respectively. Because petitioners’ marketing activities
were not for profit, and because petitioners failed to
substantiate part of their 2002 home mortgage interest deduction,
we sustain respondent’s determinations.
Background
Some of the facts have been stipulated and are so found.
Petitioners are husband and wife and resided in Tulsa, Oklahoma
at the time their petition was filed. Petitioners are both
employed full time, Mr. Berryman with the Cimarron Telephone Co.
and Mrs. Berryman as a teacher in a local public school system.
Beginning in 1992, petitioners became involved with a
company called Melaleuca, Inc. Melaleuca is a direct marketing
company which sells a line of health and wellness products.
Melaleuca calls their distributors marketing executives. As
Melaleuca marketing executives, petitioners agreed to purchase a
certain volume of Melaleuca products which they received at a
discount. Petitioners could then earn commissions by recruiting
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others to join Melaleuca. The amount of commissions petitioners
would receive was determined by the number of individuals
recruited as well as the volume of products that these
individuals signed up to purchase from Melaleuca.
Prior to their involvement with Melaleuca, petitioners had
no experience in running a business. Despite this lack of
experience, petitioners did little to educate themselves in the
economics or logistics of operating a profitable business and
instead relied solely on the guidance provided by Melaleuca
insiders.
Petitioners hired their son to help set up and maintain an
accounting system on their home computer. Petitioners used this
system to track the income and expenses related to Melaleuca.
Petitioners did not, however, use this accounting system to help
evaluate their business or try to make it more profitable. In
addition, petitioners did not create or maintain any business
plan or budgets with respect to their Melaleuca marketing
activities.
Petitioners’ attempts to recruit other marketing executives
consisted of hosting gatherings of friends and acquaintances in
their home, where petitioners would present Melaleuca and try to
persuade these individuals to join. There is no evidence,
however, that petitioners advertised these gatherings by any
means other than word of mouth. Petitioners achieved limited
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success in actually recruiting others to join Melaleaca. For
each individual petitioners were able to recruit, petitioners
received a commission from $10 to $150.
Petitioners timely filed their Federal income tax returns
with attached Schedules C, Profit or Loss From Business, for the
years in issue. On their respective Schedules C for 2002, 2003,
and 2004, petitioners reported gross receipts from their
Melaleuca activities of $5,300, $3,674, and $3,030. Petitioners
then claimed losses of $49,590, $45,114, and $67,738 for 2002,
2003, and 2004, respectively. These losses included numerous
personal expenses claimed as business deductions. For instance,
petitioners claimed deductions for cat litter, golf balls,
tickets to Oklahoma State University football games, and a Dish
Network subscription. Petitioners also claimed a deduction for a
life insurance policy they purchased. Petitioners offset these
losses against combined wages of $95,824, $91,662, and $103,693
for 2002, 2003, and 2004, respectively.
In the notice of deficiency, respondent disallowed the
losses claimed on the Schedules C and asserted penalties under
section 6662(a). In addition, for 2002, respondent disallowed
$1,462 of petitioners’ claimed mortgage interest deduction, for
lack of substantiation.
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Discussion
A. Petitioners’ Direct Marketing Activities
Section 183 restricts taxpayers from deducting losses from
an activity that is not “engaged in for profit”. Sec. 183(a).
An activity is engaged in for profit if the taxpayer entertained
an actual and honest profit objective in engaging in the
activity. Surloff v. Commissioner, 81 T.C. 210, 233 (1983);
Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), affd. without
opinion 702 F.2d 1205 (D.C. Cir. 1983); sec. 1.183-2(a), Income
Tax Regs. The taxpayer’s expectation of profit must be in good
faith. Allen v. Commissioner, 72 T.C. 28, 33 (1979) (citing sec.
1.183-2(a), Income Tax Regs.).
In deciding whether petitioners operated their direct
marketing activities for profit, we consider the following nine
factors: (1) The manner in which they carried on the activity;
(2) their expertise or that of their advisers; (3) the time and
effort they expended in carrying on the activity; (4) the
expectation that the assets they used in the activity may
appreciate in value; (5) their success in carrying on other
similar or dissimilar activities; (6) their history of income or
loss with respect to the activity; (7) the amount of occasional
profits, if any, which they earned; (8) their financial status;
and (9) whether elements of personal pleasure or recreation are
involved. See sec. 1.183-2(b)(1) through (9), Income Tax Regs.
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No single factor, nor even the existence of a majority of
factors favoring or disfavoring the existence of a profit
objective, is controlling. Brannen v. Commissioner, 722 F.2d
695, 704 (11th Cir. 1984), affg. 78 T.C. 471 (1982); sec.
1.183-2(b), Income Tax Regs. Rather, the relevant facts and
circumstances of the case are determinative. See Golanty v.
Commissioner, 72 T.C. 411, 426 (1979), affd. without published
opinion 647 F.2d 170 (9th Cir. 1981).
After careful consideration, we are satisfied that
petitioners did not engage in the marketing of Melaleuca products
with a profit objective.2 Petitioners did not prepare or
maintain any business plans, financial projections, or budgets
with respect to their Melaleuca activities. While petitioners
used a computerized accounting program to track income and
expenses, there is no evidence that petitioners used that
information to try to make their activities profitable. See id.
at 430.
Before becoming Melaleuca marketing executives, petitioners
had no experience in running a business. Nevertheless, they did
not seek independent business advice at the outset nor after
sustaining year after year losses. Instead, at most, petitioners
2
We note that petitioners did not argue to shift the burden
of proof under sec. 7491(a). Regardless, the outcome of this
case is determined on the preponderance of the evidence after
trial and is unaffected by sec. 7491(a). See Estate of Bongard
v. Commissioner, 124 T.C. 95, 111 (2005).
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relied upon Melaleuca insiders. This failure to become educated
in the economics of operating a profitable home-based business
strongly suggests that petitioners were using and marketing
Melaleuca products for purposes other than profit. See Ogden v.
Commissioner, T.C. Memo. 1999-397, affd. 244 F.3d 970 (5th Cir.
2001).
Petitioners’ Melaleuca activities have resulted in
substantial losses. While losses that are incurred in the
initial stages of an activity do not necessarily suggest the
absence of an honest profit objective, losses that continue
without explanation may indicate the lack of a profit objective.
See Golanty v. Commissioner, supra at 427. Petitioners reported
losses of $49,590, $45,114, and $67,738, for the years at issue.
This after having already been involved with Melaleuca since
1992. Further, despite these year after year losses, there is no
evidence that petitioners changed tactics to increase the
likelihood of earning a profit.
Both petitioners worked full-time jobs. This left little
time for petitioners to spend on their Melaleuca activities.
Despite this apparent lack of time, Mr. Berryman testified that
on as many as five nights a week, petitioners would host
gatherings of between 1 and 25 prospective customers. We find
Mr. Berryman’s testimony lacked credibility, especially in the
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absence of any efforts on the part of Mr. Berryman to locate
these prospective customers other than by word of mouth.
The one financial success, at least before respondent caught
on, that petitioners enjoyed with their Melaleuca activities was
offsetting their losses against wages of $95,824, $91,662, and
$103,693 for 2002, 2003, and 2004, respectively, to create
substantial tax savings. Of course, this itself is an indication
that petitioners were more interested in the tax savings realized
by converting personal expenses into tax deductions than they
were with operating a business for profit.
In sum, we are satisfied that petitioners’ primary purpose
for engaging in the promotion of Melaleuca products was not to
profit. Accordingly, petitioners are not entitled to the
deductions here in dispute beyond those allowed by respondent
under section 183(b).
B. Petitioners’ 2002 Home Mortgage Interest Deduction
Respondent also adjusted the home mortgage interest
deduction claimed by petitioners in 2002 by $1,462 for lack of
substantiation that they paid such interest. Section 163(h)
allows a deduction for interest paid on a qualified residence.
Sec. 163(h)(2)(D). “Qualified residence” within the meaning of
section 163 may be either the taxpayer’s principal residence or
another residence selected by the taxpayer and used as a
residence. Sec. 163(h)(4)(A)(i). As with any deduction,
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petitioners must be able to substantiate the amount claimed. See
sec. 6001; sec. 1.6001-1(a), Income Tax Regs.
Petitioners provided no documentation before, during, or
after trial, such as canceled checks, that would substantiate
their claim that they made payments of home mortgage interest in
excess of the $10,123 allowed by respondent for 2002. At trial,
Mr. Berryman did not testify as to any specific payments of home
mortgage interest and included as an exhibit the Forms 1098,
Mortgage Interest Statement, only for taxable years 2003 and
2004. Accordingly, without any evidence that petitioners
actually paid the $1,462, we sustain respondent’s adjustment with
respect to petitioners’ 2002 itemized mortgage interest
deduction.
C. Section 6662(a) Accuracy-Related Penalties
Finally, we address respondent’s assertion of penalties
under section 6662(a) and (b).3 Section 6662(a) and (b)(1)
provides that if any portion of an underpayment of tax is
attributable to negligence or disregard of rules or regulations,
there shall be added to the tax an amount equal to 20 percent of
the amount of the underpayment that is so attributable. The term
3
Respondent bears the burden of production with respect to
the accuracy-related penalties. Sec. 7491(c). In order to meet
this burden of production, respondent must produce sufficient
evidence that it is appropriate to impose the accuracy-related
penalties. Once respondent has done so, the burden of proof is
upon petitioners. Higbee v. Commissioner, 116 T.C. 438, 449
(2001).
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“negligence” includes any failure to make a reasonable attempt to
comply with the provisions of the Internal Revenue Code, and any
failure to keep adequate books and records or to substantiate
items properly, and the term “disregard” includes any careless,
reckless, or intentional disregard. Sec. 6662(c); sec.
1.6662-3(b)(1) and (2), Income Tax Regs. No penalty shall be
imposed if it is shown that there was reasonable cause for the
underpayment and the taxpayer acted in good faith with respect to
the underpayment. Sec. 6664(c).
While petitioners are by no means sophisticated in matters
related to tax, the manner in which petitioners operated their
purported business and the character of the deductions claimed as
part of that purported business, convince us that the
underpayment of tax for each year was attributable to a disregard
of the rules and regulations. For instance, petitioners claimed
deductions for the cost of cat litter, a Dish Network
subscription, and a life insurance policy.
Petitioners rely on Nitschke v. Commissioner, T.C. Memo.
2000-230, for support that Melaleuca is a business. In Nitschke,
the Commissioner challenged whether certain claimed expenses of
the taxpayer, related to Melaleuca activities, were ordinary and
necessary under section 162(a) and did not challenge whether the
taxpayer was operating their Melaleuca activities for profit.
Thus, our decision in Nitschke is of no relevance to whether
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petitioners here were carrying on their Melaleuca activities for
profit. Accordingly, respondent’s determination that petitioners
are liable for accuracy-related penalties under section 6662(a)
is sustained.
To reflect the foregoing,
Decision will be entered for
respondent.