T.C. Memo. 2009-55
UNITED STATES TAX COURT
STEPHEN G. AND SUZANNE Q. CHANEY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 4532-07. Filed March 12, 2009.
Kathryn Barnhill, for petitioners.
Catherine S. Tyson, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: Respondent determined a $19,108 deficiency
in and a $3,821.60 section 6662(a)1 penalty on petitioners’ 2003
Federal income tax.
1
All section references are to the Internal Revenue Code
in effect for the year in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
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Respondent concedes that petitioners conducted an active
trade or business as distributors of Shaklee products.
Respondent concedes that petitioners substantiated $1,245 of the
$1,526 of charitable contribution deductions claimed on their
return.
Petitioners concede the disallowance of $281 of charitable
contribution deductions (i.e., they only claim they substantiated
only $1,245 of the $1,526 of charitable contribution deductions).
Accordingly, this issue is resolved. Petitioners concede the
disallowance of their reported advertising expenses.
Accordingly, this issue is resolved. Petitioners concede
receiving income of $288 from Prudential Insurance Company of
America for 2003 and $600 from the National Institutes of Health
for 2003. These amounts were omitted from their 2003 Federal
income tax return. Accordingly, these issues are resolved.
At trial and on brief respondent failed to address the $500
deduction for the preparation of income taxes. Accordingly, we
find that respondent abandoned (waived) this issue. See Petzoldt
v. Commissioner, 92 T.C. 661, 683 (1989); Levert v. Commissioner,
T.C. Memo. 1989-333, affd. without published opinion 956 F.2d 264
(5th Cir. 1992).
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The following issues remain to be decided:
1. Rental Expenses
No concessions have been made. Accordingly, the entire
amount of rental expenses claimed remains at issue.
2. Utilities Expenses
Petitioners concede they did not substantiate $57 of the
$706 claimed on their return as utilities expenses.
Accordingly, $649 of utilities expenses remain at issue.
3. Repairs and Maintenance Expenses
Petitioners concede they did not substantiate $393 of the
$4,234 claimed on their return as repairs and maintenance
expenses. Accordingly, $3,841 of repairs and maintenance
expenses remain at issue.
4. Depreciation
Respondent allowed $3,540 in depreciation. Petitioners
concede they did not substantiate $637 of the $13,381 claimed on
their return as depreciation. Accordingly, $9,204 of
depreciation remains at issue.
5. Meetings and Convention Expenses
Respondent allowed $918 for meetings and convention
expenses. At trial petitioners conceded they did not
substantiate $1,183 of the $6,959 claimed on their return as
meetings and convention expenses--i.e., only $4,858 remained at
issue. On brief petitioners concede they did not substantiate
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$2,101 of the $6,959 claimed on their return as meetings and
convention expenses. Accordingly, $3,940 of meetings and
convention expenses remains at issue.
6. Cost of Goods Sold (COGS)
Petitioners concede they did not substantiate $4,943 of the
$70,018 claimed on their return as COGS and claim the correct
COGS was $65,075. Respondent concedes that petitioners’ COGS
totaled at least $58,045. Accordingly, $7,030 of COGS remains at
issue.
7. Meals and Entertainment Expenses
Petitioners concede they did not substantiate $961 of the
$2,280 claimed on their return as meals and entertainment
expenses. Accordingly, $1,319 of meals and entertainment
expenses remains at issue.
8. Car and Truck Expenses
Respondent allowed $2,023 as car and truck expenses.
Petitioners concede they did not substantiate $815 of the $6,922
claimed on their return as car and truck expenses. Accordingly,
$4,048 of car and truck expenses remains at issue.
9. Travel Expenses
Respondent allowed $594 as travel expenses. At trial,
petitioners conceded they did not substantiate $1,228 of the
$7,009 claimed on their return as travel expenses--i.e., only
$5,187 remained at issue. On brief petitioners concede they did
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not substantiate $1,822 of the $7,009 claimed on their return as
travel expenses. Accordingly, $4,593 of travel expenses remains
at issue.
10. Mortgage Interest Expense
No concessions have been made. Accordingly, the entire
amount claimed as mortgage interest expense remains at issue.2
11. Residential Property Tax Expense
No concessions have been made. Accordingly, the entire
amount claimed as residential property tax expense remains at
issue.3
12. Office Depreciation
No concessions have been made. Accordingly, the entire
amount claimed as office depreciation expense remains at issue.
13. Royalty Income Expenses
No concessions have been made. Accordingly, the entire
amount claimed as royalty income expenses remains at issue.
14. Section 6662(a) Penalty
Petitioners’ liability for the penalty remains at issue.
2
If not deductible as a rental expense, this amount
normally would be allowable as itemized deductions on Schedule A,
Itemized Deductions.
3
If not deductible as a rental expense, this amount
normally would be allowable as itemized deductions on Schedule A.
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FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time they filed
the petition, petitioners resided in North Carolina.
Petitioners are the only partners of Becker & Chaney
Associates (BCA).4 During 2003 BCA sold, and trained others to
sell, nutritional and cleaning products from Shaklee Corporation
(Shaklee).
On its 2003 Form 1065, U.S. Return of Partnership Income,
BCA deducted (as detailed above) rental expenses, utilities
expenses, repairs and maintenance expenses, depreciation,
meetings and convention expenses, COGS, meals and entertainment
expenses, car and truck expenses, travel expenses, mortgage
interest expense, residential property tax expense, and office
depreciation.5 On their individual income tax return for 2003
petitioners also deducted royalty income expenses. As detailed
above, respondent disallowed varying amounts of the
aforementioned deductions.
4
BCA is not subject to the TEFRA partnership audit rules.
Sec. 6231(a)(1)(B) (the partnership BCA had 10 or fewer partners
and all partners were natural persons who were U.S. citizens).
5
The partnership claimed all of these expenses on its Form
1065. These deductions flowed through to petitioners, who
claimed the deductions on their joint return as their
distributive shares of the partnership’s items of income and
expense.
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OPINION
Deficiency
Generally, deductions are a matter of legislative grace, and
taxpayers have the burden of showing that they are entitled to
any deduction claimed. Rule 142(a); New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 (1934).
This is a substantiation case. Our resolution of this
dispute turns on the applicable law and our determination of the
credibility of the evidence presented. We determine the
credibility of each witness, weigh each piece of evidence, draw
appropriate inferences, and choose between conflicting
inferences. See Neonatology Associates, P.A. v. Commissioner,
115 T.C. 43, 84 (2000), affd. 299 F.3d 221 (3d Cir. 2002); see
also Gallick v. Balt. & Ohio R.R. Co., 372 U.S. 108, 114-115
(1963); Boehm v. Commissioner, 326 U.S. 287, 293 (1945);
Wilmington Trust Co. v. Helvering, 316 U.S. 164, 167-168 (1942).
We decide whether evidence is credible on the basis of objective
facts, the reasonableness of the testimony, and the demeanor of
the witness. Quock Ting v. United States, 140 U.S. 417, 420-421
(1891); Wood v. Commissioner, 338 F.2d 602, 605 (9th Cir. 1964),
affg. 41 T.C. 593 (1964); Pinder v. United States, 330 F.2d 119,
124-125 (5th Cir. 1964); Concord Consumers Hous. Coop. v.
Commissioner, 89 T.C. 105, 124 n.21 (1987).
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If the taxpayer fails to substantiate an item, the burden of
proof does not shift to the Commissioner. Sec. 7491(a)(2)(A);
Gagliardi v. Commissioner, T.C. Memo. 2008-10. If the taxpayer
substantiates the deductions claimed, this satisfies the
taxpayer’s burden of proof under Rule 142. Gagliardi v.
Commissioner, supra.
We begin our analysis by noting that Mr. Chaney’s testimony
was consistent and forthright. His testimony was not one sided:
he admitted to facts that were not in petitioners’ interest. For
example, Mr. Chaney noted that the original business records for
BCA contained some minor errors that needed to be corrected
before submission to the return preparer, that Mrs. Chaney
occasionally puts items in the wrong categories of the business
records, that petitioners did not have receipts for the alleged
rent payments or a written lease agreement with BCA for renting
the office space, that petitioners deducted care for their dogs
as business (travel and meetings) expenses, and that petitioners
confined one of their dogs in the office space because the dog
sheds and Mrs. Chaney prefers that the dog not be in the other
part of the house, and petitioners’ two other dogs sleep in the
office space. Accordingly, having had the opportunity to observe
Mr. Chaney and evaluate his candor, we rely on his testimony to
resolve the amounts that remain at issue.
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Taxpayers are allowed a deduction for ordinary and necessary
expenses paid or incurred in carrying on a trade or business.
Sec. 162(a). Whether an expenditure is ordinary and necessary is
generally a question of fact. Commissioner v. Heininger, 320
U.S. 467, 475 (1943). Generally, for an expenditure to be an
ordinary and necessary business expense the taxpayer must show a
bona fide business purpose for the expenditure; there must be a
proximate relationship between the expenditure and the business
of the taxpayer. Challenge Manufacturing Co. v. Commissioner, 37
T.C. 650 (1962); Henry v. Commissioner, 36 T.C. 879 (1961).
To be “necessary” within the meaning of section 162, an
expense need be “appropriate and helpful” to the taxpayer’s
business. Welch v. Helvering, 290 U.S. 111, 113 (1933). The
requirement that an expense be “ordinary” connotes that “the
transaction which gives rise to it must be of common or frequent
occurrence in the type of business involved.” Deputy v. du Pont,
308 U.S. 488, 495 (1940) (citing Welch v. Helvering, supra at
114).
In addition to satisfying the criteria for deductibility
under section 162, certain categories of expenses must also
satisfy the strict substantiation requirements of section 274(d)
in order for a deduction to be allowed. The expenses to which
section 274(d) applies include, among other things, listed
property (e.g., automobile expenses and cellular telephones) and
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travel expenses (including meals and lodging while away from
home). Secs. 274(d)(4), 280F(d)(4)(A)(i), (ii), (v). We may not
use the Cohan doctrine to estimate expenses covered by section
274(d). See Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930);
Sanford v. Commissioner, 50 T.C. 823, 827 (1968), affd. 412 F.2d
201 (2d Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax Regs.,
50 Fed. Reg. 46014 (Nov. 6, 1985). To substantiate a deduction
attributable to listed property, a taxpayer must maintain
adequate records or present corroborative evidence to show the
following: (1) The amount of the expense; (2) the time and place
of use of the listed property; and (3) the business purpose of
the use. Sec. 1.274-5T(b)(6), Temporary Income Tax Regs., 50
Fed. Reg. 46016 (Nov. 6, 1985).
Section 280A(a) generally does not allow a deduction with
respect to the use of a residence by a taxpayer who is an
individual or an S corporation. A pass-through entity such as a
partnership is considered to have made personal use of a dwelling
unit on any day which a partner would be considered to have made
personal use of the dwelling. Holmes v. United States, 85 F.3d
956 (2d Cir. 1996), on remand 79 AFTR 2d 97-1292, 9701 USTC par.
50,265 (W.D.N.Y. 1997); sec. 1.280A-1(e)(5)(ii), Proposed Income
Tax Regs., 48 Fed. Reg. 33323 (July 21, 1983).
Ultimately, the Court believes Mr. Chaney’s testimony and
accepts petitioners’ documentation, which satisfied applicable
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law. We hold that petitioners are entitled to deduct the amounts
that remained at issue for depreciation (other than depreciation
for the portion of the dwelling unit used for Shaklee business),
meetings and convention expenses, COGS, meals and entertainment
expenses, car and truck expenses, travel expenses, and royalty
income expenses. However, petitioners are not entitled to deduct
the costs of dog care, clothes for a meeting, personal birthday
gifts, and a wedding gift. See sec. 262 (no deduction allowed
for personal, living, or family expenses).
There is a lack of proof of a bona fide rental. There was
no written rental agreement. The purported rental agreement has
little reality beyond tax planning. The purported rental was not
at arm’s length, and we disregard it for a lack of economic
substance.6 Accordingly, pursuant to section 280A, petitioners
are not entitled to deduct rental expenses, utilities expenses,
repairs and maintenance expenses, mortgage interest expense, a
residential property tax expense, and office depreciation.7
6
Additionally, Mr. and Mrs. Chaney made personal use of
the alleged rental space. One of petitioners’ dogs is confined
all day to the Shaklee office space. Mrs. Chaney prefers this
dog “not be in the other part of the house” to prevent it from
shedding in other parts of the house. Two other dogs stay in the
other parts of petitioners’ house during the day, but the Shaklee
office space is where the two other dogs sleep at night.
7
Pursuant to sec. 1402(a), “net earnings from self-
employment” include gross income derived by an individual from
any trade or business carried on by a partnership of which the
individual is a member. Disallowance of these expenses and
(continued...)
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Section 6662(a) Penalty
Section 7491(c) provides that the Commissioner bears the
burden of production with respect to the liability of any
individual for additions to tax and penalties. “The
Commissioner’s burden of production under section 7491(c) is to
produce evidence that it is appropriate to impose the relevant
penalty, addition to tax, or additional amount”. Swain v.
Commissioner, 118 T.C. 358, 363 (2002); see also Higbee v.
Commissioner, 116 T.C. 438, 446 (2001). The Commissioner,
however, does not have an obligation to introduce evidence
regarding reasonable cause or substantial authority. Higbee v.
Commissioner, supra at 446-447.
Respondent determined that petitioners are liable for the
section 6662(a) penalty for 2003. Pursuant to section 6662(a)
and (b)(1) and (2), a taxpayer may be liable for a penalty of 20
percent on the portion of an underpayment of tax due to
negligence or disregard of rules or regulations or a substantial
understatement of income tax. An “understatement” is the
difference between the amount of tax required to be shown on the
return and the amount of tax actually shown on the return. Sec.
6662(d)(2)(A). A “substantial understatement” exists if the
7
(...continued)
concessions of other expenses by petitioners will result in
increased income flowing from BCA to petitioners. Pursuant to
sec. 1402(a), this income is self-employment income.
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understatement exceeds the greater of (1) 10 percent of the tax
required to be shown on the return for a taxable year or (2)
$5,000. See sec. 6662(d)(1)(A). Respondent has met his burden
of production as he determined a substantial understatement of
income tax in the notice of deficiency.
The accuracy-related penalty is not imposed with respect to
any portion of the underpayment as to which the taxpayer acted
with reasonable cause and in good faith. Sec. 6664(c)(1). The
decision as to whether the taxpayer acted with reasonable cause
and in good faith depends upon all the pertinent facts and
circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
Among other things, petitioners failed to report income from
Prudential Insurance Company of America and the National
Institutes of Health for 2003. Additionally, they deducted the
costs of dog care, clothes for a meeting, personal birthday
gifts, and a wedding gift. These facts establish that
petitioners did not act with reasonable cause and in good faith.
We note that petitioners’ tax return preparer was not called
as a witness. We infer that his testimony would not have been
favorable to petitioners. See Wichita Terminal Elevator Co. v.
Commissioner, 6 T.C. 1158, 1165 (1946), affd. 162 F.2d 513 (10th
Cir. 1947).
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Accordingly, we sustain the section 6662(a) penalty.
In reaching our holdings herein, we have considered all
arguments made by the parties, and to the extent not mentioned
above, we find them to be irrelevant or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.