T.C. Memo. 2007-320
UNITED STATES TAX COURT
ROBERT L. AND BRENDA J. TARTER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 20688-05. Filed October 25, 2007.
Eric Johnson, for petitioners.
Christian A. Speck, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Petitioners petitioned the Court to
redetermine respondent’s determination of a 2001 income tax
deficiency of $457,491, a section 6662(a)1 accuracy-related
1
Rule references are to the Tax Court Rules of Practice and
Procedure. Unless otherwise noted, section references are to the
applicable versions of the Internal Revenue Code (Code).
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penalty of $91,498.20, and a section 6651(a)(1) addition to tax
of $22,693.10 for failure to file timely. With regard to the
income tax deficiency, we decide whether petitioners’ claimed
trade or business expense deductions are allowable. We hold they
are not. We also decide whether petitioners are liable for the
accuracy-related penalty. We hold that they are. Petitioners do
not dispute that their income tax return was filed untimely and
do not assert that a reasonable basis existed for their late
filing. We sustain the addition to tax without further comment.
FINDINGS OF FACT
The parties have filed with the Court stipulated facts and
exhibits. The stipulated facts are found accordingly.
Petitioners are husband and wife, and they jointly filed a 2001
Form 1040, U.S. Individual Income Tax Return. They resided in
Lincoln, California, when their petition was filed with the
Court.
A. Petitioner’s Business History
Robert Tarter (petitioner) went into business for himself in
approximately 1991, beginning B & B Construction (B&B). B&B was
engaged in the business of preparing and pouring concrete
foundations and flatwork for residential projects.
B&B operated as a sole proprietorship at its inception and
was still operating as a sole proprietorship at the beginning of
2001. On December 15, 2000, petitioner formed BBT Enterprises,
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Limited (BBT), a limited partnership. The partners of BBT were
petitioner and B & B Complex Trust, with petitioner having a
1-percent interest and B & B Complex Trust having a 99-percent
interest. By at least June 2001, B&B began to operate as BBT.
No Form 1065, U.S. Return of Partnership Income, was filed for
BBT for 2001. No Form 1041, U.S. Income Tax Return for Estates
and Trusts, was filed for the B & B Complex Trust for 2001.
Petitioner reported all claimed income and deductions of the
concrete business for 2001 as those of a sole proprietorship on
their Schedule C, Profit or Loss From Business.
A checking account for BBT, d.b.a. B&B, was opened on
May 17, 2001 (BBT account). At that time, a checking account
existed in the name of B&B and petitioners (B&B account).
Sometime after August or September 2001, operating expenses for
the concrete construction business were paid out of the BBT
account. After September 2001, funds represented by checks from
the BBT account were not funds that came from the B&B account.
B. Additional Entities
On September 15, 2000, petitioner set up the entity V & E
Leasing, Ltd., a California limited partnership (V&E Leasing).
The partners of V&E Leasing were petitioner and Granite Bay
Complex Trust. Upon formation of V&E Leasing, petitioner held a
1-percent interest, and Granite Bay Complex Estate Trust held a
99-percent interest. The depreciable vehicles and smaller
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equipment assets that petitioner used for the concrete
construction business were transferred to V&E Leasing during
2001. No Form 1065 was filed for V&E Leasing for 2001.
Also on September 15, 2000, petitioner set up the entity
B & B Concrete Pumping, Ltd., a California limited partnership
(B&B Concrete Pumping). The partners of B&B Concrete Pumping
were petitioner and Granite Bay Complex Trust. Upon formation of
B&B Concrete Pumping, petitioner held a 1-percent interest and
Granite Bay Complex Estate Trust held a 99-percent interest in
B&B Concrete Pumping. The bigger, more expensive concrete pumps
that petitioner used for the concrete construction business were
transferred to B&B Concrete Pumping during 2001. No Form 1065
was filed for B&B Concrete Pumping for 2001.
C. Payments to Workers
Beginning in October 2000, petitioner began to use a payroll
system under which B&B’s approximately 100 to 200 employees were
leased to an employee leasing company, Labor Force Partners, Ltd.
(payroll company). Through this leasing arrangement, the payroll
company became the primary legal employer of record.
The individuals who originally presented and promoted
the payroll system to petitioner were David Clancy and Ray
Vallejo. In September 2000, petitioner arranged for an
all-employee meeting for B&B workers. At that meeting, Clancy
and Vallejo told the employees about the new payroll system.
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Petitioner did not recall ever telling the employees they were
“fired”.
The payroll company did not make any of the decisions
regarding the employees, for example who would be hired or fired
and how much they would be paid, or otherwise supervise the
day-to-day activities of the workers. After the fall of 2000,
petitioner continued to make all the hiring and firing decisions
with respect to employees of the concrete business. Similarly,
after the fall of 2000, petitioner or supervisors of B&B
continued to give the day-to-day instructions to employees of the
concrete business. In general, employees were the same
individuals, performed the same type of work, were supervised the
same way, and were paid the same amounts both before and after
petitioner began paying the employees through the payroll
company.
The payroll company set up two payroll accounts with
Paychex, a large processing company. Pursuant to this new
payroll system, instead of receiving one paycheck, each employee
received two. The first paycheck covered the minimum wage that
State law required. The balance due an employee, called a
“dividend” payment, was paid in a second check from an account
under the name of Labor Force Partners Trust. Petitioner did not
pay employment taxes or workers compensation on the portion of
the wages greater than the minimum wage.
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Shortly after the new payroll system began, petitioners’
return preparer, Shannon Perez (Perez), assumed bookkeeping for
the concrete business. Perez also prepared petitioners’ 2001
Form 1040. That Form 1040 was prepared in haste in order for
petitioners to satisfy a requirement to close on a new home.
Neither petitioners nor Perez thought the 2001 return was
accurate when prepared and filed, and they anticipated its
amendment. On the Form 1040, petitioners reported approximately
$15 million in receipts and slightly more in expenses, resulting
in a net Schedule C loss of approximately $157,000.
Perez kept track of the expenses of the concrete business by
categorizing and entering those expenses into a computer
Quickbooks data file using bank statements, check stubs, and
canceled checks that petitioner provided. To prepare
petitioners’ return, Perez ran reports from the Quickbooks
database.
D. Disallowed Deductions
Petitioners’ 2001 Form 1040 was selected for audit, and
respondent, in the notice of deficiency mailed to petitioners on
August 29, 2005, determined that petitioner failed to
substantiate five categories of expenses on Schedule C:
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(1) Employee benefits $97,212
(2) Payroll taxes 578,441
(3) Outside services 104,592
(4) Rent/lease
Vehicles/machinery/equipment 187,004
(5) Depreciation and
sec. 179 expense 407,075
These disallowed amounts are the amounts that petitioner claimed
in the referenced categories on his Schedule C.
E. Substantiation
Perez, no later than September 11, 2006, acknowledged errors
in every category of expense claimed on petitioner’s Schedule C
with the possible exception of depreciation. Neither Perez nor
petitioners kept books and records of expenses of the concrete
business for 2001 that reflected the deduction amounts claimed in
the categories listed on petitioner’s 2001 Schedule C.
F. Financial Statements
Perez prepared financial statements that she knew were
inconsistent with petitioners’ 2001 tax return, which she had
prepared. The financial statements made petitioner’s business
look more profitable than it appeared on his Schedule C. The
2001 profit and loss statement purporting to show petitioners’
2001 net income from the concrete business was intended to be
used to obtain a license in Nevada and showed $999,648 more in
net income than the net income reflected on petitioner’s
Schedule C.
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G. Discovery
Before trial, on July 7, 2006, respondent served
interrogatories on petitioners, asking them to list every item
claimed as an expense deduction on the 2001 Schedule C. Perez
prepared petitioners’ responses to those interrogatories. For
every item except depreciation that respondent disallowed in the
notice of deficiency, petitioners’ interrogatory responses
reflected deduction amounts greater than the amounts reported on
the Schedule C.
H. The Seizures
On November 30, 2005, agents of respondent’s Criminal
Investigation Division (CID) executed simultaneous search
warrants at petitioner’s business and at the payroll company.
From November 30, 2005, through the trial in this case, CID has
retained originals or copies of all electronic or paper records
seized pursuant to the search warrants. At the time of the
seizures, CID created an inventory of the seized paper documents.
The seized paper records consist of approximately 85 boxes of
materials seized from B&B Construction and 40 boxes of materials
seized from the payroll company.
OPINION
The burden of proof is on petitioners to show that
respondent’s determinations set forth in the notice of deficiency
are incorrect. See Rule 142(a)(1); See Welch v. Helvering, 290
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U.S. 111, 115 (1933). Deductions are strictly a matter of
legislative grace, and petitioners must show that their claimed
deductions are allowed by the Code. Petitioners must also keep
sufficient records to substantiate any deduction that would
otherwise be allowed by the Code. See sec. 6001; New Colonial
Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). In order to meet
their burden of proof, petitioners must introduce sufficient
evidence to: (1) Make a prima facie case establishing that
respondent committed the errors alleged in the petition and (2)
overcome the evidence submitted by (or otherwise favorable to)
respondent. See Lyon v. Commissioner, 1 B.T.A. 378, 379 (1925).
For the burden to shift to respondent, petitioners must comply
with the substantiation and record-keeping requirements of the
Code. See sec. 7491(a)(2)(A) and (B). We conclude that the
burden of proof has not shifted to respondent with respect to any
of the issues affecting petitioners’ tax liability because we
find that petitioners failed to comply with substantiation
requirements of the Code.
A. Employee Benefits and Payroll Taxes
Respondent’s notice of deficiency disallowed the amounts
petitioner claimed on his Schedule C for employee benefits and
payroll taxes, $97,212 and $578,441, respectively. Respondent
determined that the expenses were disallowed because petitioners
did not provide information to support the deductions and did not
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establish that the expenses were ordinary and necessary.
Respondent argues on brief that petitioners have never
established that these costs were not claimed on the 2001
Schedule C as labor costs under cost of goods sold.
In support of their benefits and payroll tax deductions,
petitioners detailed amounts paid to Kaiser for medical insurance
invoices and amounts paid to the payroll company for disability
insurance. From the evidence presented, it appears that payments
were made for medical and disability benefits; however, these
proofs of payment in no way address nor negate respondent’s
argument that those items may already be included in petitioner’s
Schedule C as labor costs under cost of goods sold. We sustain
respondent’s determination on this issue.
B. Outside Services
Respondent’s notice of deficiency disallowed the amount
petitioner claimed on his Schedule C for “Outside services”,
$104,592. Respondent claims that petitioners did not provide
information to support the deductions and that petitioners did
not establish that the expenses were ordinary and necessary. In
support of their outside services deduction, petitioners explain
on brief that the amount represents legal and engineering fees.
Perez tried to substantiate the expenses for “outside
services” with a list that included several payments to
“Operating Engineers”. Perez claimed Operating Engineers
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belonged in that category because they provided engineering
services or certifications as shown in their invoices; however,
Operating Engineers was the union for the concrete pump truck
operators. In the check registers, the payments to Operating
Engineers were categorized as “Subcontractors”. According to the
interrogatory responses, items categorized as “Subcontractors”
were part of the cost of goods sold.
Although we find it likely that the payments claimed by
petitioners were in fact made for legal and engineering costs,
those fees may already be included in petitioner’s Schedule C as
a part of cost of goods sold. Also, to the extent that those
fees were for services performed for BBT and not B&B, they are
not deductible by petitioners.2 Petitioners provide no
information on those components that make up the cost of goods
sold amount claimed on the Schedule C, nor do they distinguish
fees paid by B&B from those paid by BBT. In the light of this
absence of evidence, the credible evidence in the record does not
permit us to find that the outside services deduction is
supportable as an independent Schedule C deduction.
2
For example, a fee for legal services, dated June 1, 2001,
is directed to “BBT Enterprises dba B & B Construction”,
indicating that BBT had already set itself forth as a business
entity by that date.
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C. Rent/Lease Vehicles/Machinery/Equipment
Respondent’s notice of deficiency disallowed the amount
petitioner claimed on his Schedule C for renting or leasing of
vehicles, machinery, and equipment, $187,004. The notice of
deficiency stated that this cost was disallowed because
petitioners did not provide information to support the deductions
and did not establish that the expenses were ordinary and
necessary. Petitioners support this deduction with a stipulation
listing checks and a record of check stubs.
We note that the checks paid from the beginning of the year
through July 21, 2001, were paid out of the B&B account while the
checks paid after that date were paid out of the BBT account.
All checks dated from July 31, 2001, through the end of 2001 were
issued from the BBT account. BBT did not file a Form 1065 for
2001, nor did B&B Complex Trust, the 99-percent partner of BBT,
file a Form 1041 for 2001. Petitioner cannot claim a deduction
on his Schedule C for the rent/lease of vehicles, machinery, and
equipment if those expenses were in fact incurred by BBT. In the
light of all the evidence, we hold that the deductions on
Schedule C are limited to only those expenses stipulated by the
parties to have been paid out of the B&B account.
D. Depreciation
Respondent’s notice of deficiency disallowed the amount
claimed on Schedule C for depreciation, $407,075. The notice
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stated that the depreciation was disallowed because petitioners
did not provide information to support the deductions and did not
establish that the expense was ordinary and necessary. In
support of the depreciation expense, petitioners offer a one-page
depreciation schedule that includes the bases of certain stated
assets, the method of depreciation, and the 2001 deprecation
claimed.
Section 167(a) allows a deduction for a reasonable allowance
for the exhaustion, wear and tear, and obsolescence of property
used in a trade or business or held for the production of income.
The basis on which a depreciation deduction is allowable with
respect to any property under section 167(a) is the adjusted
basis of the property, determined under section 1011 for the
purpose of determining gain on the sale or other disposition of
the property. See sec. 167(c).
Petitioners’ depreciation schedule lacks an essential piece
of information, the owner of the assets. For 2001, possible
asset owners include petitioners, BBT, V&E Leasing, B&B Concrete
Pumping, or perhaps one of the partners of one of these
partnerships, and it is certainly possible, if not likely, that
ownership of the itemized assets changed throughout 2001.
Although we are satisfied that a concrete business would have
depreciable assets, we cannot find evidence in the record by
which we can determine the amount of the depreciation expense for
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petitioner’s Schedule C; therefore, we sustain respondent’s
determination with respect to depreciation.3
E. Accuracy-Related Penalty
Respondent determined that petitioners are liable for an
accuracy-related penalty under section 6662(a). Section 6662(a)
imposes an accuracy-related penalty equal to 20 percent of the
portion of an underpayment that is attributable to, among other
things, negligence. Petitioners will avoid this penalty if the
record shows that they were not negligent; i.e., they made a
reasonable attempt to comply with the provisions of the Code and
they were not careless, reckless, or in intentional disregard of
rules or regulations. See sec. 6662(c); Keeler v. Commissioner,
243 F.3d 1212, 1221 (10th Cir. 2001), affg. Leema Enters., Inc.
v. Commissioner, T.C. Memo. 1999-18. Negligence connotes a lack
of due care or failure to do what a reasonable and prudent person
would do under the circumstances. See Allen v. Commissioner, 92
T.C. 1 (1989), affd. 925 F.2d 348 (9th Cir. 1991). An
3
As noted above, on Nov. 30, 2005, CID agents executed
simultaneous search warrants at petitioner’s business and the
payroll company, and respondent has remained in possession of
those materials through the date of trial. The record does not
provide support that this circumstance impaired petitioners’
preparations for and offering of evidence at trial. In fact,
after this case was set for trial, respondent moved for
continuance, but petitioners opposed that motion; and the request
for continuance was denied. Further, Perez testified that the
information she had used to prepare petitioner’s Schedule C came
from the Quickbooks accounting system that she used and that she
had been able to restore that information from Quickbooks files
backups that had not been seized.
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accuracy-related penalty is not applicable to any portion of an
underpayment to the extent that a taxpayer has reasonable cause
for that portion and acts in good faith with respect thereto.
See sec. 6664(c)(1).
Respondent bears the burden of production with respect to
the accuracy-related penalty. Sec. 7491(c). To meet this burden
of production, respondent must produce sufficient evidence that
it is appropriate to impose an accuracy-related penalty. Once
respondent has produced sufficient evidence, the burden of proof
is upon petitioners. See Higbee v. Commissioner, 116 T.C. 438,
449 (2001). Petitioners may carry their burden by proving that
with respect to their underpayment there existed reasonable cause
and they acted in good faith. Sec. 6664(c)(1).
Respondent has satisfied the burden of production in that
the record establishes that petitioners failed to substantiate
their claimed deductions. Section 6001 imposes on petitioners a
duty to maintain books and records sufficient to support items
reported on their returns, and petitioners’ breach of that duty
is contrary to what a prudent and responsible taxpayer would have
done under the circumstances. See sec. 1.6662-3(b)(1), Income
Tax Regs. Further, petitioners have failed to persuade us that
their failure to maintain the requisite substantiation was
excused by reasonable cause and good faith; therefore, we sustain
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respondent’s determination that petitioners are liable for the
accuracy-related penalty under section 6662(a).
We have considered all arguments by petitioners for holdings
contrary to those which we reach herein. To the extent not
discussed, we conclude that those arguments are irrelevant or
without merit.
Decision will be entered
under Rule 155.