T.C. Summary Opinion 2008-138
UNITED STATES TAX COURT
LADISLAU P. AND ANDREA HORVATH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 10782-06S. Filed October 30, 2008.
Ladislau P. and Andrea Horvath, pro sese.
John M. Tkacik, Jr., for respondent.
RUWE, Judge: This case was heard pursuant to the provisions
of section 7463 of the Internal Revenue Code in effect when the
petition was filed.1 Pursuant to 7463(b), the decision to be
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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entered is not reviewable by any other court, and this opinion
shall not be treated as precedent for any other case.
Respondent determined deficiencies in petitioners’ Federal
income taxes of $23,179 and $29,776 and accuracy-related
penalties under section 6662(a) of $4,636 and $5,955 for years
2002 and 2003 (years at issue), respectively.2 After
concessions, we must decide: (1) Whether petitioners have
unreported income for the years at issue; (2) whether petitioners
are entitled to deduct, under section 162, business expenses
related to both (a) the use of their automobiles for the years at
issue, and (b) their reported supplies expense for 2003; and (3)
whether petitioners are liable for section 6662(a) accuracy-
related penalties for the years at issue.
Background
Some of the facts have been stipulated and are so found.
At the time their petition was filed, petitioners resided in
Ohio.
Petitioners are husband and wife. They owned Transil Dental
Lab (Transil), which was operated out of their residence.
Petitioners’ business consisted of making dental molds, crowns,
dentures, and other related dental products for various dentists.
Mrs. Horvath worked both as the manager of the business and as
2
Where appropriate, figures have been rounded to the
nearest dollar.
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the delivery and pickup driver. During the years at issue,
petitioners owned several vehicles, which were used to make
deliveries for Transil. Petitioners maintained business records
which included a mileage log for the business use of each
vehicle. Shell credit card statements (gas receipts) entered
into evidence at trial showed the locations and amounts of
gasoline purchased by petitioners during the years at issue. The
gas receipts showed total expenses of $1,389 for 2002 and $1,383
for 2003. Petitioners also entered into evidence various
automobile repair receipts and vehicle registrations which showed
odometer readings for several of the vehicles for years before,
during, and after the years at issue. Further documentary
evidence entered at trial included an example of the number of
deliveries petitioners made on a weekly basis and a list of the
dentists and the distance between their home and the dentists’
offices.
Petitioners’ Schedules C, Profit or Loss From Business,
reported gross receipts of $71,000 and $75,2503 for 2002 and
2003, respectively. Petitioners’ reported expenses included,
among others, $21,900 and $10,800 of car and truck expenses,
calculated using the standard mileage rate, for 2002 and 2003,
3
While petitioners’ 2003 Schedule C shows gross receipts of
$75,250, the parties’ stipulation of facts indicates, without
further explanation, that petitioners’ gross receipts on their
2003 Schedule C were $75,190.
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respectively, and a supplies expense of $20,068 for 2003. After
deductions for returns and allowances and total expenses,
petitioners reported net profits/business income of $14,417 for
2002 and $13,079 for 2003. Petitioners’ business income was the
only income reported by petitioners for the years at issue.
After petitioners filed their tax returns for the years at
issue, their business records, including the mileage logs, were
destroyed when their basement flooded in 2004.
Respondent determined that petitioners had unreported income
on the basis of deposits into their bank accounts. For 2002,
petitioners deposited funds into two checking accounts at Ohio
Savings Bank.4 Total deposits into the two accounts during 2002
was $160,144. Respondent identified $53,027 in nontaxable
transfers between the two accounts in 2002 and concluded that
petitioners’ total income was $107,116. However, petitioners’
bank statements also showed a “DEBIT MEMO”5 of $4,271 on January
31, 2002, and a “DEBIT MEMO” of $9,000 on March 20, 2002.
Respondent’s bank deposits analysis arrived at net deposits by
subtracting transfers between petitioners’ accounts but did not
consider the two debit memos made by the bank. After subtracting
4
One of the Ohio Savings Bank checking accounts was in the
name of Transil, account no. xxxxxxx5493, while the other was in
petitioner Ladislau Horvath’s name, account no. xxxxxxx6660.
5
On the basis of the bank statements, we interpret the
“DEBIT MEMO” as a nontaxable transaction reversing the
corresponding deposit from petitioners’ bank account.
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the two debit memos the net deposits into petitioners’ bank
accounts in 2002 were $93,845.
For 2003, petitioners deposited funds into four checking
accounts, two at Ohio Savings Bank and two at Charter One Bank.6
Respondent determined total deposits into the four accounts of
$167,286 and identified $60,257 of nontaxable transfers between
the accounts. After allowing for transfers, respondent concluded
that petitioners’ total income was $107,028. One of petitioners’
bank statements, however, showed a “DEBIT MEMO” of $241 on
January 21, 2003, which respondent did not consider. After
subtracting the debit memo, the net deposits into petitioners’
bank accounts were $106,788 in 2003.
Discussion
I. Unreported Income
As a general rule, the Commissioner’s determinations set
forth in a notice of deficiency are presumed correct, and the
taxpayer bears the burden of proving that these determinations
are in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933).
6
The two Ohio Savings Bank checking accounts are the same
two identified previously. See supra note 4. These two accounts
were closed on Aug. 31, 2003. The two checking accounts at
Charter One Bank were opened on Aug. 27, 2003, one in the name of
Transil, account no. xxx-xxx313-0, and the other in petitioners’
names, account no. xxx-xxx070-2.
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Where taxpayers are unable to produce substantiating
business records of their income, the Commissioner may use the
bank deposits method to reconstruct and compute the taxpayers’
income. See Estate of Mason v. Commissioner, 64 T.C. 651, 656
(1975), affd. 566 F.2d 2 (6th Cir. 1977). A bank deposit is
prima facie evidence of income. Tokarski v. Commissioner, 87
T.C. 74, 77 (1986). The bank deposits method of reconstruction
assumes that all of the money deposited into the taxpayers’
accounts is includable in gross income unless the taxpayers show
that the deposits are not taxable. DiLeo v. Commissioner, 96
T.C. 858, 868 (1991), affd. 959 F.2d 16 (2d Cir. 1992). The
Commissioner, however, must take into account any nontaxable
items and deductible expenses of which the Commissioner has
knowledge. Id.
For 2002, respondent argues that petitioners had total
deposits of $160,144 and nontaxable transfers of $53,027. For
2003, respondent argues that petitioners had total deposits of
$167,286 and nontaxable transfers of $60,257. Respondent argues
that his bank deposits analysis supports a finding that
petitioners had net deposits of $107,116 for 2002 and $107,029
for 2003. Because petitioners’ Schedules C reported gross
receipts of only $71,000 for 2002 and $75,250 for 2003,
respondent contends that the difference between these figures
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amounts to unreported income of $36,116 for 2002 and $31,779 for
2003.7
Petitioners do not dispute respondent’s use of the bank
deposits method of reconstruction and do not allege any specific
error in respondent’s computations. Rather, petitioners contend
that they maintained business records during the years at issue
that were destroyed, that their tax returns for those years
accurately reported their income and expenses, and that
respondent’s determinations are therefore erroneous.
After reviewing petitioners’ bank statements, it appears
that respondent erroneously included $13,271 for 2002 and $241
for 2003 in petitioners’ total net deposits. The bank statements
indicate that respondent’s bank deposits calculations included a
$4,271 deposit on January 31, 2002, a $9,000 deposit on March 20,
2002, and a $241 deposit on January 21, 2003, without considering
the corresponding debit memos. Each of these deposits appears to
be attributable to transactional errors reflected in the bank
statements. The bank statements indicate that each of the
“deposits” was corrected with a same-day “DEBIT MEMO” removing
the “deposit” from petitioners’ account. On the basis of the
foregoing, we find that petitioners understated their gross
receipts by $22,845 in 2002 and by $31,538 in 2003.
7
The statutory notice of deficiency originally determined
unreported income of $37,677 for 2002 and $50,593 for 2003. At
trial, respondent reduced his allegation of unreported income to
$36,116 for 2002 and $31,779 for 2003.
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II. Disallowed Deductions
Deductions are a matter of legislative grace, and the
taxpayer bears the burden of proving he is entitled to the
deductions claimed. Rule 142(a); INDOPCO, Inc. v. Commissioner,
503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292
U.S. 435, 440 (1934). Section 162(a) allows a taxpayer to deduct
all the ordinary and necessary expenses paid or incurred in
carrying on a trade or business. Petitioners claimed business
deductions for the use of their personal vehicles and for
supplies used in their business. Respondent disallowed these
deductions due to petitioners’ lack of substantiation.
a. Car and Truck Expenses
Section 274(d) provides:
SEC. 274. DISALLOWANCE OF CERTAIN ENTERTAINMENT, ETC.,
EXPENSES.
(d) Substantiation Required.--No deduction or
credit shall be allowed--
* * * * * * *
(4) with respect to any listed property
(as defined in section 280F(d)(4)),
unless the taxpayer substantiates by adequate records
or by sufficient evidence corroborating the taxpayer’s
own statement (A) the amount of such expense or other
item, (B) the time and place of the travel,
entertainment, amusement, recreation, or use of the
facility or property, or the date and description of
the gift, (C) the business purpose of the expense or
other item, and (D) the business relationship to the
taxpayer of persons entertained, using the facility or
property, or receiving the gift. * * *
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Section 280F(d)(4)(A)(i) provides that passenger automobiles are
“listed property”. Thus, the heightened substantiation
requirements of section 274(d) are applicable to petitioners’
claimed car and truck expense deductions.
Substantiation is to be made by either “adequate records” or
“sufficient evidence corroborating the taxpayer’s own statement”.
Sec. 274(d); sec. 1.274-5T(c)(1), Temporary Income Tax Regs., 50
Fed. Reg. 46016 (Nov. 6, 1985). “To meet the ‘adequate records’
requirements of section 274(d), a taxpayer shall maintain an
account book, diary, log, statement of expense, trip sheets, or
similar record * * *, and documentary evidence”. Sec. 1.274-
5T(c)(2)(i), Temporary Income Tax Regs., 50 Fed. Reg. 46017 (Nov.
6, 1985). In lieu of substantiating the actual amount of an
expenditure related to the business use of a passenger
automobile, a taxpayer may use the standard mileage rate
established by the Commissioner.8 Sec. 1.274-5(j)(2), Income Tax
Regs.
Petitioners kept a log of their business use of their
automobiles that would have provided the required information.
However, petitioners testified and provided documentation to
prove that these records were lost as a result of flood damage in
8
The optional standard mileage rate for business use of a
passenger automobile was 36.5 cents and 36 cents per mile for
2002 and 2003, respectively. See Rev. Proc. 2001-54, sec. 5,
2001-2 C.B. 530, 531; Rev. Proc. 2002-61, sec. 5, 2002-2 C.B.
616, 618.
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2004. Where, as here, the taxpayer establishes that the failure
to produce adequate records is due to the loss of the records
through circumstances beyond the taxpayer’s control, such as
destruction by flood, the taxpayer may substantiate a deduction
by reasonable reconstruction of his expenditures or use. Sec.
1.274-5T(c)(5), Temporary Income Tax Regs., 50 Fed. Reg. 46022
(Nov. 6, 1985); see also Malinowski v. Commissioner, 71 T.C.
1120, 1125 (1979); Schneider v. Commissioner, T.C. Memo. 1978-
447. Where documentation is unavailable “the Court may, although
it is not required to do so, accept the taxpayer’s testimony to
substantiate the deduction.” Davis v. Commissioner, T.C. Memo.
2006-272; see also Boyd v. Commissioner, 122 T.C. 305, 320
(2004); Watson v. Commissioner, T.C. Memo. 1988-29.
Petitioners have presented credible testimony and evidence
sufficient to reconstruct a portion of their car and truck
expenses. It is clear that petitioners used their vehicles for
deliveries in their business. They testified that their vehicles
were used primarily for business purposes. Petitioners also
testified and presented documentary evidence of the locations of
and the frequency with which they traveled to the various
dentists’ offices.
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Petitioners produced partial gasoline receipts totaling
$1,389 for 2002 and $1,383 for 2003.9 The Energy Information
Administration reports that the average price of gasoline in the
Midwestern United States was 136.5 cents per gallon and 154.8
cents per gallon in 2002 and 2003, respectively. The U.S.
Department of Transportation reports the average fuel efficiency
of U.S. passenger cars as 22 miles per gallon in 2002 and 22.2
miles per gallon in 2003. On this basis, we conclude that
petitioners’ business use of their vehicles totaled at least
20,000 miles in 2002 and 18,000 miles in 2003 and that
petitioners are entitled to deductions for business use of their
vehicles using the standard mileage rate. See sec. 1.274-
5(j)(2), Income Tax Regs.; Rev. Proc. 2001-54, sec. 5, 2001-2
C.B. 530, 531; Rev. Proc. 2002-61, sec. 5, 2002-2 C.B. 616, 618.
b. Business Supplies Expense
Petitioners’ 2003 Schedule C reported a supplies expense of
$20,068. Respondent allowed $6,216 and disallowed the remaining
$13,852 (disallowed portion).
Both petitioners and respondent indicated at trial that the
disallowed portion of the supplies expense deduction remained at
issue; however, neither party offered any evidence. Because
petitioners bear the burden of proof, we find that petitioners
are not entitled to a deduction for business supplies expenses in
9
For some of the months in each year there were no
receipts.
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excess of the amount allowed by respondent for 2003. Rule
142(a); Levin v. Commissioner, 87 T.C. 698, 722-723 (1986), affd.
832 F.2d 403 (7th Cir. 1987).
III. Section 6662(a) Accuracy-Related Penalty
Section 6662(a) provides that a taxpayer is liable for a 20-
percent accuracy-related penalty on any portion of an
underpayment of tax required to be shown on a return attributable
to, inter alia, (1) negligence or disregard of the rules or
regulations or (2) a substantial understatement of income tax.
See sec. 6662(b).
Respondent’s position with respect to the accuracy-related
penalties is unclear. The notice of deficiency sent to
petitioners included accuracy-related penalties under section
6662(a). At the beginning of trial the parties indicated that
the only issues remaining in dispute for 2002 were unreported
income and a car and truck expense deduction and for 2003 were
unreported income, a car and truck expense deduction, and a
supplies expense deduction.
In any event, the penalty under section 6662(a) shall not be
imposed upon any portion of an underpayment where the taxpayer
shows that he or she acted with reasonable cause and in good
faith with respect to such portion. See sec. 6664(c)(1); Higbee
v. Commissioner, 116 T.C. 438, 448 (2001). The determination of
whether a taxpayer acted with reasonable cause and in good faith
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is made on a case-by-case basis, taking into account all the
pertinent facts and circumstances. Higbee v. Commissioner, supra
at 448; Sec. 1.6664-4(b)(1), Income Tax Regs. The most
important factor is the extent of the taxpayer’s effort to assess
his proper tax liability for the year. Sec. 1.6664-4(b)(1),
Income Tax Regs. “Circumstances that may indicate reasonable
cause and good faith include * * * the experience, knowledge, and
education of the taxpayer.” Id.
On the basis of petitioners’ testimony, we are satisfied
that petitioners maintained business records to the best of their
ability and that information reported on their 2002 and 2003 tax
returns reflected a good faith effort to assess their correct tax
liabilities. As previously noted, petitioners’ business records
for the years at issue were destroyed by flood in 2004. Even
though petitioners have been unable to completely reconstruct
their records, we are persuaded and conclude that petitioners
made a substantial effort to assess their proper tax liabilities
for the years at issue, and, consequently, that petitioners acted
with reasonable cause and in good faith as required under section
6664(c)(1). Accordingly, we hold that petitioners are not liable
for section 6662(a) accuracy-related penalties for 2002 and 2003.
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In reaching our holdings herein, we have considered all
arguments made, and to the extent not mentioned above, we find
them to be moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.