T.C. Memo. 2011-42
UNITED STATES TAX COURT
ROGER S. AND LISA G. CAMPBELL, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 22750-05. Filed February 17, 2011.
Roger S. and Lisa G. Campbell, pro se.
Robert V. Boeshaar, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GALE, Judge: Respondent determined deficiencies in
petitioners’ Federal income taxes for the taxable years 1998,
1999, and 2001 of $13,530, $7,013, and $751, respectively, as
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well as a $3,383 addition to tax under section 6651(a)(1)1 for
1998.
After concessions,2 the issues for decision are: (1)
Whether petitioners’ activity as Amway distributors was an
activity not engaged in for profit within the meaning of section
183 for taxable years 1998, 1999, 2000,3 and 2001; (2) whether
petitioners have substantiated claimed expenses from the Amway
activity for 1999 to the extent of gross profit from the
activity; (3) whether petitioners are entitled to deductions for
rental property expenses for 1998 and 1999; (4) whether
petitioners sustained a net operating loss in 2000 that may be
carried to one or more of the years in issue under section 172;
and (5) whether petitioners are liable for an addition to tax for
failure to timely file their 1998 Federal income tax return.
1
All section references are to the Internal Revenue Code of
1986, as in effect for the years in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
2
Petitioners concede that they are not entitled to deduct
$4,535 of expenses claimed with respect to their construction
business for 1998. Respondent concedes that petitioners are
entitled to a deduction for a wages expense of $2,699 for 1998.
Certain other adjustments are computational in nature.
3
Although respondent did not determine a deficiency for
2000, a determination under sec. 183 is necessary for 2000 in
order to determine the amount of any net operating loss
petitioners may carry back from that year.
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FINDINGS OF FACT
Some of the facts have been stipulated, and they are so
found. Petitioners resided in Washington when they filed the
petition.
During the years in issue petitioners operated two
businesses in addition to the Amway activity. Petitioner Lisa G.
Campbell (Mrs. Campbell) operated Preview Properties, a real
estate sales business. Mrs. Campbell spent significant time,
including weekends, conducting the real estate business. For
1998 and 1999 petitioners reported profits of $144,263 and
$43,189, respectively, from Preview Properties; they reported
losses from the business for 2000 and 2001 of $4,892 and $5,237,
respectively.
Also during the years in issue petitioner Roger S. Campbell
(Mr. Campbell) operated RC Construction, a general construction
business, which he had operated since 1988. Mr. Campbell spent
significant time during the years in issue managing his
construction business. For 1998 and 2000 petitioners reported
losses of $11,188 and $4,224, respectively, from RC Construction,
while for 1999 and 2001 they reported profits of $20,000 and
$8,933, respectively.
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Amway Activity
Beginning in 1995 and during the years in issue petitioners
operated an Amway4 distributorship under the name RLC
Enterprises. Amway is a supplier of household, cosmetic, and
nutritional products that are sold by individual distributors
through direct marketing. Petitioners had not been involved with
a direct marketing activity before becoming involved with Amway.
They began their distributorship after being recruited by another
Amway distributor in 1995.
An Amway distributor could generate revenue by selling Amway
merchandise directly to consumers at a retail markup or through
“performance bonuses” tied to the volume of products sold to
other Amway distributors he had recruited. The individuals
recruited by an Amway distributor were referred to as the
recruiting distributor’s “downline” distributors; the recruiting
distributor was referred to as the “upline” or “sponsor”
distributor of the downline distributor. A downline distributor
obtained his merchandise from his sponsor distributor, and the
sponsor distributor received performance bonuses from Amway based
on the volume of merchandise he sold to his downline
distributors. These performance bonuses created an incentive for
4
The servicing corporation for petitioners’ distributorship
was Amway in 1998 and Quixtar, Inc., thereafter. For
convenience, we refer to petitioners’ distributorship as their
Amway activity and to the servicing corporation as Amway
throughout this opinion.
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a sponsor distributor’s downline distributors to themselves
become sponsor distributors of additional downline distributors
in order to earn performance bonuses on the sales of distributors
who were downline to them--thus creating a pyramid of
distributors below a sponsor distributor that boosted the sponsor
distributor’s volume for purposes of performance bonuses.
Performance bonuses were computed as a percentage of sales volume
without regard to profitability. The percentage increased as
sales volume exceeded certain thresholds. Thus, Amway
distributors could maximize revenue by recruiting a large group
of downline distributors whom they in turn encouraged to sell or
distribute Amway merchandise and to make new recruits.
Any Amway merchandise that an Amway distributor purchased
for personal use was also counted as a sale for purposes of
computing volume for performance bonuses. Such merchandise could
be purchased by an Amway distributor at a discount below retail
price.
Finally, certain Amway distributors were eligible to
purchase, for their own use or for sale to their downline
distributors, various “business support” materials including
books, magazines, other printed materials, audiotapes,
videotapes, software, and other electronic media to assist
distributors with training and motivation of themselves or
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recruits.5 Petitioners purchased various business support
materials during the years in issue for their own use and for
resale to their downline distributors.
Amway promoted the performance-bonus-generated pyramid
structure of its distributors through its independent business
ownership plan. Petitioners focused on implementing the
independent business ownership plan and did not attempt to set up
a business plan of their own.
Petitioners did not obtain any independent advice before
beginning to operate their Amway distributorship, with the
exception of that of their stockbroker, who counseled against it.
Petitioners instead relied on the advice of other Amway
distributors, particularly their upline distributors.
Petitioners participated in Amway training functions
organized by Worldwide Group, L.L.C. (Worldwide Group).
Worldwide Group was operated by several Amway distributors
specifically to coordinate training and motivational seminars for
other Amway distributors. Petitioners participated in perhaps
three out-of-town seminars organized by Worldwide Group each
year, as well as local sessions monthly. The out-of-town
functions would generally take place over a weekend and would
5
According to Amway promotional materials, the purveyors of
these business support materials were independent of Amway or its
affiliates.
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typically include lectures and workshops as well as social
functions.
Petitioners concentrated on recruiting downline distributors
and marketing Amway merchandise to them, expending significant
time and effort for those purposes. In this connection,
petitioners would make presentations at which they provided free
samples of some of the Amway products and/or business support
materials. The distribution of the Amway products petitioners
sold to their downline distributors was time consuming,
consisting of taking and submitting distributors’ weekly orders,
collecting and remitting payments to petitioners’ upline
distributor, and distributing the merchandise to their downline
distributors. Each week Mrs. Campbell would also ship or deliver
any products she had sold directly to retail customers.
Petitioners also purchased Amway products for personal use;
as distributors, their purchases were often at a discount. Mr.
Campbell purchased a truck at a discount through a program
affiliated with Amway, and petitioners also purchased appliances,
electronics, clothing, office supplies, and nutritional products
through Amway. Petitioners also purchased Amway products for use
in their other businesses. Amway was a substantial source of
materials and supplies for Mr. Campbell’s construction business.
Petitioners’ records show that in 1999 $14,418 worth of their
Amway purchases was used in Mr. Campbell’s construction business.
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Mrs. Campbell used Amway products to furnish model houses in her
real estate business and for gift baskets for clients. While
some of the products petitioners purchased for personal use or
use in their other businesses were not eligible for discounts,
the purchases nonetheless augmented petitioners’ sales volume so
as to increase their performance bonuses.
Mrs. Campbell kept voluminous notes on petitioners’ Amway
activity, but petitioners made no written projections for profit,
loss, or break-even scenarios with regard to the Amway activity.
Petitioners would learn the extent of their profit or loss from
the Amway activity for any given year when they prepared the
year’s tax return. Their returns for 1998 and 2000 were filed
approximately 22 months after the close of the respective years;
their 1999 and 2001 returns were filed approximately 10 months
after the close of the respective years. Thus, petitioners were
generally not aware of the profitability of their Amway activity
for any given period until much later.
Petitioners experienced losses from their Amway activity in
every year from its inception through the years in issue. For
the years in issue and 2000, petitioners reported the following
gross receipts and claimed the following costs of goods sold,
expenses, and losses attributable to their Amway activity on
their Schedules C, Profit or Loss From Business:
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Gross Cost of Gross
Year Receipts Goods Sold Profit Expenses Net Profit
1998 $19,984 $44,745 ($24,761) $13,761 ($38,522)
1
1999 52,620 57,145 (4,525) 19,960 (24,485)
2000 74,690 83,372 (8,682) 16,795 (25,477)
2001 103,266 108,272 (5,006) 14,974 (19,980)
1
Petitioners now contend this figure is $54,999.
Respondent contends that petitioners had the following
amounts of gross receipts, costs of goods sold, expenses, and
losses attributable to their Amway activity:
Gross Cost of Gross
Year Receipts Goods Sold Profit Expenses Net Profit
1998 $19,984 $21,345 ($1,361) $11,095 ($12,456)
1999 52,620 38,311 14,309 9,941 4,368
2000 74,690 N/A N/A 18,528 N/A
1
2001 103,266 108,272 (5,006) 14,243 (19,249)
1
The notice of deficiency determined that petitioners had
substantiated $18,139 of expenses for 2001. Of this $5,884 was
attributable to a claimed expense for commissions and fees which
the parties now agree was already included in petitioners’ cost
of goods sold.
To summarize, respondent has allowed amounts for costs of
goods sold for both 1998 and 2001 that exceed petitioners’ gross
receipts from the Amway activity. Respondent also concedes that
petitioners have substantiated operating expenses that further
increase the losses generated by the Amway activity. However,
with respect to 1999, respondent’s disallowance of approximately
one-third of petitioners’ claimed cost of goods sold and one-half
of petitioners’ claimed operating expenses results in gross and
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net profits of $14,309 and $4,368, respectively, from the Amway
activity for that year.
At the time of trial petitioners continued to be involved in
the Amway activity and they had no intention of discontinuing it.
Rental Property Expenses
During the years at issue petitioners owned an unfinished
house in Montana, which was on land they leased from Mrs.
Campbell’s parents for $100 per year. In 1997 Mrs. Campbell and
her parents executed a document labeled a “purchase agreement”
which provided that Mrs. Campbell would purchase a horse from her
parents for $9,500. The document further provided that in lieu
of any cash payment for the horse, the unfinished house would be
rented to Mrs. Campbell’s parents for $500 annually, $300 of
which was to be credited against the purchase price of the horse
and $200 of which was for Mrs. Campbell’s parents’ care of the
horse.
With respect to the house, petitioners reported $500 in
rental income for both 1998 and 1999 on Schedules E, Supplemental
Income and Loss, and claimed thereon $4,299 and $4,481,
respectively, for rental property expenses.
Notice of Deficiency
After conducting an examination of petitioners’ 1998-2001
returns, respondent issued them a notice of deficiency. The
notice determined that petitioners did not engage in their Amway
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activity with a profit objective for 1998-2001 and made
adjustments for all 4 years, including 2000, but it did not
determine a deficiency for 2000 because the adjustments for that
year resulted in a loss.
The adjustments for 2000 included disallowance of the
$25,477 loss petitioners claimed with respect to their Amway
activity. However, respondent made no adjustment to the $4,892
loss petitioners claimed with respect to Mrs. Campbell’s real
estate business. With respect to the $4,224 loss petitioners
claimed from Mr. Campbell’s construction business, the notice
allowed an additional $3,614 depreciation expense, increasing the
loss by that amount. The aggregate result of the adjustments to
petitioners’ 2000 return was to reduce their claimed loss for the
year from $60,464 to $38,601.
OPINION
I. Burden of Proof
The Commissioner’s determinations in the notice of
deficiency are presumed correct, and the taxpayer generally bears
the burden of proving that the determinations are in error. See
Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
However, under section 7491(a), the burden of proof on any
factual issue relevant to a taxpayer’s liability for tax shifts
to the Commissioner if the taxpayer has introduced credible
evidence with respect to that issue and has satisfied certain
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other conditions, including compliance with the Internal Revenue
Code’s substantiation requirements. Sec. 7491(a)(1) and (2). As
discussed infra, petitioners have failed to provide
substantiation for required items. Accordingly, they are not
entitled to a shift in the burden of proof under 7491(a).
II. Applicability of Section 183 to Petitioners’ Amway Activity
A. In General
Under section 183(a), if an activity is not engaged in for
profit, then no deduction attributable to that activity is
allowed except to the extent provided by section 183(b). In
pertinent part, section 183(b) allows those deductions that would
have been allowable had the activity been engaged in for profit
only to the extent of gross income derived from the activity
(reduced by deductions attributable to the activity that are
allowable without regard to whether the activity was engaged in
for profit).
Section 183(c) defines an activity not engaged in for profit
as “any activity other than one with respect to which deductions
are allowable for the taxable year under section 162 or under
paragraph (1) or (2) of section 212.” Deductions are allowable
under section 162 or under section 212(1) or (2) if the taxpayer
is engaged in the activity with the “actual and honest objective
of making a profit”. Dreicer v. Commissioner, 78 T.C. 642, 645
(1982), affd. without published opinion 702 F.2d 1205 (D.C. Cir.
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1983); Golanty v. Commissioner, 72 T.C. 411, 426-427 (1979),
affd. without published opinion 647 F.2d 170 (9th Cir. 1981).
The taxpayer need not, however, establish that his or her
expectation of profit was reasonable. See Dreicer v.
Commissioner, supra at 644-645; sec. 1.183-2(a), Income Tax Regs.
The existence of the requisite profit objective is a
question of fact that must be decided on the basis of the entire
record. Elliott v. Commissioner, 84 T.C. 227, 236 (1985), affd.
without published opinion 782 F.2d 1027 (3d Cir. 1986); Dreicer
v. Commissioner, supra at 645; sec. 1.183-2(b), Income Tax Regs.
In resolving this factual question, greater weight is given to
objective facts than to a taxpayer’s statement of intent. See
Westbrook v. Commissioner, 68 F.3d 868, 875-876 (5th Cir. 1995),
affg. T.C. Memo. 1993-634; sec. 1.183-2(a), Income Tax Regs.
The regulations set forth a nonexhaustive list of factors
that may be considered in deciding whether a profit objective
exists. These factors are: (1) The manner in which the taxpayer
carries on the activity; (2) the expertise of the taxpayer or his
advisers; (3) the time and effort expended by the taxpayer in
carrying on the activity; (4) the expectation that the assets
used in the activity may appreciate in value; (5) the success of
the taxpayer in carrying on other similar or dissimilar
activities; (6) the taxpayer’s history of income or losses with
respect to the activity; (7) the amount of occasional profits, if
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any, which are earned; (8) the financial status of the taxpayer;
and (9) any elements indicating personal pleasure or recreation.
Sec. 1.183-2(b), Income Tax Regs.
No single factor, nor even the existence of a majority of
factors supporting or rebutting the existence of a profit
objective, is controlling. Id. Rather, all facts and
circumstances with respect to the activity are to be taken into
account. Id.
The parties agree that the appreciation of assets has no
meaningful application as a factor with respect to determining
petitioners’ profit motivation in pursuing their Amway activity.
The parties disagree whether the other regulatory factors are
indicative of a profit objective.
B. Manner in Which Petitioners Carried On the Amway
Activity
If a taxpayer carries on the activity in a businesslike
manner and maintains complete and accurate books and records, it
may indicate a profit objective. Sec. 1.183-2(b)(1), Income Tax
Regs. However, if there is a lack of evidence that the
taxpayer’s records were used to improve the performance of a
losing operation, such records generally do not indicate a profit
objective. Golanty v. Commissioner, supra at 430; see also
Sullivan v. Commissioner, T.C. Memo. 1998-367, affd. without
published opinion 202 F.3d 264 (5th Cir. 1999). In particular,
keeping records that are used only for purposes of preparing tax
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returns is not indicative of a profit objective. See Rowden v.
Commissioner, T.C. Memo. 2009-41; Kinney v. Commissioner, T.C.
Memo. 2008-287.
Petitioners did not conduct the Amway activity in a
businesslike manner. Although they maintained a separate bank
account for the activity and maintained records for certain
aspects of it, petitioners never used these records as an
analytical tool for improving profitability. Mrs. Campbell
testified that she did not know whether the Amway activity was
profitable in any given year until she completed petitioners’ tax
return for that year which, for 2 of the taxable years in issue,
did not occur until almost 2 years later. It is a fair inference
that petitioners’ recordkeeping was directed more towards
substantiating deductions on a tax return than assessing the
profitability of the Amway activity.
Moreover, petitioners’ Amway records were incomplete and
unreliable. Petitioners’ recordkeeping made it impossible to
distinguish between Amway product purchases that were properly
includible in costs of goods sold and those that were withdrawn
from the business for personal consumption, leading respondent to
disallow a substantial portion of petitioners’ claimed costs of
goods sold. At the examination the revenue agent determined that
she needed to reconstruct petitioners’ costs of goods sold for
1998 and 1999 to ascertain the extent to which the Amway products
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purchased by petitioners and included by them in costs of goods
sold had in fact not been resold to downline distributors. The
revenue agent compared petitioners’ total Amway product purchases
with the deposits into their Amway account of checks written to
them by individuals, treating all such checks as payments for
Amway products from downline distributors. The revenue agent
treated the difference between the total Amway products purchased
and the amounts received from downline distributors as
representing the value of Amway products that had been withdrawn
from inventory by petitioners for personal use. The computation
made by the revenue agent was as follows:
1998 1999
Purchases $58,402 $72,384
Less payments from distributors (19,665) (38,311)
38,737 34,073
Less inventory at end of year (2,732) (4,220)
Personal use items1 36,005 29,853
1
The revenue agent’s calculation did not take into account
petitioners’ opening inventory in each year, thus understating
her computation of petitioners’ personal use items by $1,680 and
$2,732 for 1998 and 1999, respectively.
The revenue agent then determined the appropriate costs of goods
sold by making the following computation:
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1998 1999
Beginning inventory $1,680 $2,732
Purchases less withdrawals 22,397 42,531
24,077 45,263
Less end of year inventory (2,732) (4,220)
Cost of goods sold1 21,345 41,043
1
The revenue agent’s failure to account for opening
inventory in the calculation of items withdrawn for personal use
carried over onto her computation of costs of goods sold, causing
the figure to be overstated by $1,680 and $2,732 in 1998 and
1999, respectively.
As a result of the examination respondent determined that
petitioners had substantially overstated the costs of goods on
their Amway Schedules C for 1998 and 1999. Respondent’s
examination revealed that, of the $44,745 claimed as cost of
goods sold for 1998, only $21,345 could be traced to the
generation of receipts from the resale of Amway products, leaving
$23,400 in Amway product purchases claimed as cost of goods sold
for which there was no record of any proceeds from resale. For
1999, of petitioners’ claimed cost of good sold of $57,145, only
$41,043 could be traced to the generation of resale receipts,
leaving $16,102 in claimed cost of goods sold for which there was
no record of any proceeds from resale.6 After a painstaking
6
As noted, the revenue agent’s computations actually
understated the value of items withdrawn for personal use in 1998
and 1999. On brief, respondent makes a correction for the
revenue agent’s corresponding overstatement of cost of goods sold
for 1999 (from $41,043 to $38,311) but he does not do so for
(continued...)
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review of petitioners’ records, including additional
substantiation we permitted petitioners to submit after trial, we
agree with respondent’s position that petitioners substantially
overstated costs of goods sold for each year.
Petitioners’ response appears to be that the $23,400 and
$16,102 in 1998 and 1999, respectively, of their Amway product
purchases for which there are no corresponding resale proceeds
represent Amway products that were given away for promotional or
training purposes; i.e., as free samples or as “business support”
(motivational) materials for their downline distributor recruits,
prospective recruits, and/or retail customers. Petitioners also
accounted for personal use by excluding $14,800 and $14,418 in
1998 and 1999, respectively, of Amway product purchases from
their computation of costs of goods sold, as reflected in the
posttrial substantiation they submitted.
We are not persuaded by petitioners’ explanation. First, we
note that the exclusion of $14,800 for 1998 and $14,418 for 1999
of personal products that petitioners document in their posttrial
substantiation is already accounted for in the revenue agent’s
computation. The revenue agent’s starting figures for Amway
purchases, $58,402 for 1998 and $72,384 for 1999, closely
approximate the results petitioners show in their posttrial
6
(...continued)
1998.
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substantiation for Amway product purchases before exclusion of
personal use products, $59,063 for 1998 and $71,024 for 1999.
Recognizing the foregoing, we find it difficult to believe that
petitioners gave away Amway products totaling $23,400 in 1998 and
$16,102 in 1999 (i.e., each year’s Amway product purchases that
could not be traced to a resale). Accepting petitioners’
explanation requires the Court to believe, for example, that they
gave away Amway products in excess of gross receipts in 1998.
Second, petitioners introduced expense summaries (Exhibit 23-P)
indicating that substantial amounts of Amway “business support”
materials were sold to their downline distributors, not given
away (i.e., $4,680 in 1998 and $14,197 in 1999). Third, Mrs.
Campbell admitted in her testimony that she used Amway products
in her real estate business to stock model homes and to give in
gift baskets to clients, yet the only non-Amway use of Amway
product purchases in 1999 that is reflected in petitioners’
posttrial substantiation is use in Mr. Campbell’s construction
business. In sum, while we are persuaded that some portion of
the Amway product purchases for which there are no corresponding
resale proceeds were given away for promotional or training
purposes during the years at issue,7 we believe such use fell
7
We account for promotional expenses in 1999 by allowing as
a promotional expense $4,000 of petitioners’ claimed “supplies”
expense (which they also explain as attributable to the giveaway
of Amway products as free samples or promotional materials for
(continued...)
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considerably short of $23,400 and $16,102 in 1998 and 1999,
respectively.
Considering all the facts and circumstances, including
especially the confusing state of petitioners’ Amway records, we
conclude that a substantial portion of the costs of goods sold
respondent disallowed for 1998 and 1999 represents Amway
purchases that petitioners withdrew from inventory for personal
use or use in their other businesses. This commingling of the
Amway merchandise, resulting in substantial inaccuracies in
reported costs of good sold, is further evidence that
petitioners’ Amway activity was not conducted in a businesslike
fashion. It also resulted in petitioners’ claiming business
deductions for personal expenditures.
Finally, in the face of reporting consistent losses from
their Amway activity, petitioners did little to change how they
operated the business--except, apparently, reducing the size of
free samples given to prospective downline distributors and
attempting to increase retail sales. Petitioners had no business
plan other than the plan Amway provided. While it is true that
petitioners’ reported gross receipts grew dramatically during the
years at issue, suggesting success in recruiting downline
7
(...continued)
existing or prospective distributors). We note in this regard
that “selling expenses” are accounted for in the regulations as
business expenses rather than as cost of goods sold. Sec. 1.162-
1(a), Income Tax Regs.
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distributors,8 this trend had no significant impact on
profitability. Petitioners’ reported gross receipts almost
doubled between 1999 and 2001, yet their reported losses remained
around $20,000 annually. See Ogden v. Commissioner, T.C. Memo.
1999-397 (annual increases in gross income from Amway activity
not indicative of businesslike conduct of activity where exceeded
by claimed deductions), affd. 244 F.3d 970 (5th Cir. 2001). Mr.
Campbell testified that petitioners would stick with the Amway
activity even if it never returned a profit. Under these
circumstances, it is clear that petitioners did not operate their
Amway activity in a businesslike manner. Accordingly, this
factor weighs heavily against petitioners.
C. Expertise of Petitioners or Their Advisers
Preparation for the activity by extensive study of its
accepted business practices, or consultation with those who are
expert therein, may indicate a profit objective where the
taxpayer carries on the activity in accordance with such
practices. Sec. 1.183-2(b)(2), Income Tax Regs.
Although petitioners have prior entrepreneurial experience
and both operated other businesses concurrently, they had no
8
Some of the growth in gross receipts may also be
attributable to the fact that petitioners processed through their
Amway activity the purchase of supplies and materials for Mr.
Campbell’s construction business and Mrs. Campbell’s real estate
business. For example, in 1999 petitioners purchased at least
$14,418 of Amway products for the construction business alone.
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experience with operating a direct marketing distributorship
before they were recruited as Amway distributors. Petitioners
obtained advice only from their upline distributors and other
interested Amway individuals, persons who had a direct financial
interest in the maximization of petitioners’ sales volume,
without regard to petitioners’ profitability. See Ogden v.
Commissioner, supra (Amway upline distributors’ advice biased in
view of financial interest in downline distributor’s sales
volume). The only disinterested third party with whom
petitioners consulted was their stockbroker, who advised them not
to become involved in Amway. This factor weighs against
petitioners.
D. The Time and Effort Expended by Petitioners in Carrying
On the Activity
The fact that the taxpayer devotes much of his personal time
and effort to carry on an activity may indicate an intention to
derive a profit. Sec. 1.183-2(b)(3), Income Tax Regs.
Both petitioners spent extensive time and effort carrying on
the Amway activity. Petitioners went to Amway training
functions, participated in counseling sessions with upline
distributors, and expended substantial time attempting to recruit
new downline distributors. Mrs. Campbell credibly testified that
she spent approximately 25 hours on average per week taking and
organizing orders from her retail customers and downline
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distributors, placing these orders, and distributing the
merchandise.
This factor favors petitioners.
E. Petitioners’ Success in Carrying Out Other Similar or
Dissimilar Activities
The fact that the taxpayer has engaged in similar activities
in the past and converted them from unprofitable to profitable
enterprises may indicate that he is engaged in the present
activity for profit, even though the activity is presently
unprofitable. Sec. 1.183-2(b)(5), Income Tax Regs.
Petitioners had no prior history of engaging in a direct
marketing distributorship. However, both petitioners
successfully operated other businesses. During the years in
issue, both Mr. Campbell’s construction business and Mrs.
Campbell’s real estate business had profitable years and loss
years. While the real estate and construction businesses are not
similar to an Amway distributorship, we conclude that
petitioners’ record of at least moderate success in other
business activities makes this factor favor petitioners.
F. Petitioners’ History of Income or Loss
A series of losses during the initial or startup stage of an
activity may not necessarily be an indication that the activity
is not engaged in for profit. Sec. 1.183-2(b)(6), Income Tax
Regs.; see Golanty v. Commissioner, 72 T.C. at 427. However,
where losses continue to be sustained beyond the period which
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customarily is necessary to bring the operation to profitable
status, such continued losses, if not explainable, may be
indicative that the activity is not engaged in for profit. Sec.
1.183-2(b)(6), Income Tax Regs. The “goal must be to realize a
profit on the entire operation, which presupposes not only future
net earnings but also sufficient net earnings to recoup the
losses which have meanwhile been sustained in the intervening
years.” Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965),
affd. 379 F.2d 252 (2d Cir. 1967); see also Nissley v.
Commissioner, T.C. Memo. 2000-178.
Petitioners’ gross receipts from their Amway activity
increased significantly each year in issue, from $19,984 in 1998
to $103,266 in 2001. Nonetheless, if we use petitioners’
reported results, their cost of goods sold always exceeded their
gross receipts, and after accounting for operating expenses,
petitioners’ Amway activity generated annual losses that
generally exceeded $20,000, notwithstanding the growth in gross
receipts.9 Petitioners in this respect are similar to the
9
Petitioners claimed that they had a small profit from their
Amway activity in 2002, and they submitted a copy of a Federal
income tax return they had submitted to respondent for that year.
Because the return was filed late and close to the time of trial,
respondent had not yet processed the return. The return was
prepared during the pendency of this proceeding. We are
therefore mindful that petitioners had an incentive to show a
profit from Amway for that year in order to bolster their
position in this proceeding. Nothing in the record, other than
petitioners’ testimony, enables us to determine whether
(continued...)
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taxpayers in Ogden v. Commissioner, T.C. Memo. 1999-397. In
Ogden, the taxpayers’ Amway activity showed substantial and
increasing gross revenue for a period of 3 consecutive years and,
in contrast to petitioners’ activity, generated small amounts of
gross profit (i.e., gross revenue less cost of goods sold).
After the Ogden taxpayers’ claimed expenses, however, their Amway
activity produced losses each year of approximately $20,000, a
magnitude similar to petitioners’ claimed losses. We concluded
in Ogden that the growth in gross receipts did not support a
finding of a profit objective in view of the sustained pattern of
losses. We reach the same conclusion here. Petitioners’
sustained period of losses favors respondent.
Moreover, some of the growth in petitioners’ gross receipts
is illusory. Petitioners’ Amway gross receipts included their
bonus payments, which were boosted by product sales that
reflected petitioners’ purchase of Amway products for use in
their other businesses.10 Thus, some of petitioners’ increase in
gross receipts was due not to their efforts at building their
9
(...continued)
petitioners’ claimed profit in 2002 is genuine or whether it is a
result of their decision to claim fewer expenses. We therefore
decline to make any finding that petitioners’ Amway activity was
profitable in 2002.
10
As noted, petitioners recorded $14,418 of Amway purchases
for Mr. Campbell’s construction business in 1999.
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Amway activity but to their decision to use Amway as a supplier
of the construction business.
G. Petitioners’ Financial Status
The fact that the taxpayer does not have substantial income
or capital from sources other than the activity may indicate that
an activity is engaged in for profit. Sec. 1.183-2(b)(8), Income
Tax Regs. Substantial income from sources other than the
activity, particularly if the losses from the activity generate
substantial tax benefits, may indicate that the activity is not
engaged in for profit. Id.
Although the profitability of Mr. Campbell’s construction
business and Mrs. Campbell’s real estate business fluctuated,
petitioners reported combined profits from the two businesses of
$133,075, $63,189, and $3,696 for 1998, 1999, and 2001,
respectively, and a combined reported loss of $9,116 for 2000.11
Petitioners were able to use the reported losses from the Amway
activity to offset 29 percent, 38 percent, and 100 percent of
their combined income from the real estate and construction
businesses in 1998, 1999, and 2001, respectively. Thus, the tax
benefits generated from their reported Amway losses were
substantial. Petitioners’ financial status enabled them to
11
As discussed infra, in the notice of deficiency respondent
allowed additional depreciation expense for petitioners’
construction business for 2000, increasing the combined loss from
the construction and real estate businesses to $12,730.
- 27 -
exploit significant tax benefits from the losses generated by the
Amway activity. Therefore, this factor favors respondent.
H. Elements of Personal Pleasure or Recreation
The presence of personal motives in carrying on an activity
may indicate that the activity is not engaged in for profit,
especially where there are recreational or personal elements
involved. Sec. 1.183-2(b)(9), Income Tax Regs.
This Court has observed that “there are significant elements
of personal pleasure attached to the activities of an Amway
distributorship” and that “an Amway distributorship presents
taxpayers with opportunities to generate business deductions for
essentially personal expenditures.” Brennan v. Commissioner,
T.C. Memo. 1997-60. We accept petitioners’ testimony that they
did not engage in the Amway activity for its social aspects or
because their Amway activities afforded them recreational
opportunities. Nonetheless, petitioners used their Amway
distributorship as a means to generate business deductions for
essentially personal expenditures and as a source of discounts on
items for personal consumption or use in their other businesses,
as illustrated by the extensive disallowances of their claimed
deductions, many of which they now concede. For 1999
petitioners’ proffered substantiation shows that they deducted,
as “legal and professional” expenses of the Amway activity, hay
and shoes for their horses. Petitioners concede that the meals
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and entertainment expenses they claimed with respect to the Amway
activity were overstated by $602 and $803 for 1998 and 1999,
respectively. We have discussed previously the inadequate
bookkeeping that resulted in petitioners’ claiming cost of goods
sold for Amway products used for personal consumption or in
petitioners’ other businesses.
Petitioners’ Amway activity enabled them to obtain an
extensive range of consumer products for personal use (or other
business use) at a discount, including a truck and household
appliances. Petitioners were entitled to discounts at several
national chain retailers through Amway, including Barnes & Noble,
OfficeMax, Craftsman Tools, Circuit City, and Sur La Table.
Petitioners’ own recordkeeping reflects that $14,800 and $14,418
of Amway products in 1998 and 1999, respectively, was purchased
for personal use or use in their other businesses, and we have
concluded that additional amounts were used for this purpose and
improperly reported as costs of goods sold in those years.
Petitioners obtained a further effective discount on these
purchases because they boosted petitioners’ Amway sales volume
for the year, generating additional bonuses. The availability of
consumer product discounts for personal use merchandise is a
factor supporting the conclusion that Amway distributors lacked a
profit objective. See Nissley v. Commissioner, T.C. Memo. 2000-
178; Ogden v. Commissioner, T.C. Memo. 1999-397.
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These personal aspects are further underscored by Mr.
Campbell’s testimony that petitioners expected to continue their
Amway activity, even if it never returned a profit. See Nissley
v. Commissioner, supra (personal dimensions of Amway activity
underscored by admission that taxpayers had no intention of
getting out of Amway even if it did not turn profitable).
Accordingly, we find that petitioners derived substantial
personal benefits from their Amway activity. This factor favors
respondent.
I. Conclusion
Petitioners spent significant time carrying on their Amway
activity. Furthermore, petitioners achieved substantial
increases in gross receipts from the Amway activity during the
years in issue, reflecting some success in recruiting downline
distributors, though some of the increase was illusory because it
was attributable to their acquisition of Amway products for use
in their other businesses and for personal consumption.
However, petitioners did not conduct their Amway activity in
a businesslike manner. They usually had no notion of whether the
Amway activity had been profitable for a given year until they
completed their tax return for that year many months later. They
also deducted personal expenses as Amway business expenses.
Their recordkeeping commingled costs of Amway products used for
personal purposes and in their other businesses with those of
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products used in their Amway distributorship to such an extent
that their cost of goods sold for each year, and operational
results, for the Amway activity were substantially misstated.
Petitioners’ substantial use of discounted Amway products in
their other businesses and for personal consumption persuades us
that the discounts were a principal motivation for petitioners’
involvement in the Amway activity. We are likewise persuaded
that petitioners’ substantial use of the discounts and their
commingling of the Amway merchandise in their records indicates
that they were largely indifferent to whether the Amway activity,
standing alone, produced a profit. We conclude that the benefits
of the discounts to their other businesses and of the reduction
in their effective tax burden from the Amway losses made
petitioners willing to accept losses from the Amway activity
indefinitely (as Mr. Campbell testified). In view of the
foregoing, petitioners have failed to prove that they carried on
their Amway activity with the requisite objective of making a
profit. Consequently, their deductions arising from the Amway
activity are limited by section 183.
III. Substantiation of Petitioners’ Amway Expenses
A. In General
The parties dispute whether petitioners have substantiated
many of the expenses claimed for the Amway activity, including
cost of goods sold.
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For 1998 and 2001 respondent concedes that petitioners have
substantiated expenses that exceed their gross income derived
from the Amway activity. We therefore need not address whether
petitioners have substantiated any expenses beyond those
respondent conceded for those years, because our holding that
petitioners’ Amway activity was not engaged in for profit
precludes any such deductions in excess of gross income derived
from the Amway activity. However, petitioners’ claimed Amway
expenses that respondent concedes for 1999 are less than
petitioners’ gross income from Amway in that year. Accordingly,
we must decide whether petitioners have substantiated any Amway
expenses for 1999 beyond those respondent conceded.
Petitioners and respondent agree that petitioners had
$52,620 of gross receipts from their Amway activity in 1999.
Petitioners claimed a total of $86,662 in cost of goods sold and
operating expenses for their Amway activity for 1999,12 but
respondent has disallowed $38,410 of the total. Respondent’s
disallowances, if sustained in full, would cause petitioners’
gross income from their Amway activity to exceed the expenses
respondent allowed by $4,368 ($52,620 gross receipts less $48,252
in cost of goods sold and expenses allowed by respondent). We
12
As compared to the amounts petitioners claimed on their
1999 return, petitioners at trial conceded $2,146 in cost of
goods sold and claimed an additional $1,759 and $9,944 in office
and supply expenses, respectively.
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must therefore decide whether petitioners are entitled to any
Amway expenses for 1999 in excess of those respondent allowed.
As discussed below, we find that petitioners are entitled to
$1,000 in office expense and at least $4,000 in promotional or
marketing expense deductions for 1999. We therefore need not
address the other disputed items.
Generally, a taxpayer must keep records sufficient to
establish the amounts of the items reported on his Federal income
tax return. Sec. 6001; sec. 1.6001-1(a), Income Tax Regs. In
the event that a taxpayer establishes that a deductible expense
has been paid but is unable to substantiate the precise amount,
we generally may estimate the amount of the deductible expense,
bearing heavily against the taxpayer whose inexactitude in
substantiating the amount of the expense is of his own making.
Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930).
B. Office Expenses
For 1999 petitioners claimed $4,048 of office expenses,
$2,289 on their return and an additional $1,759 at trial.
Respondent determined that no office expenses were allowable for
that year.
Petitioners have offered substantiation of approximately
$2,074 of office expenses. They have introduced an exhibit
titled “1999 New + original office expense additional”, which
consists of a handwritten ledger and a summary spreadsheet
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purporting to record their Amway office expenses for 1999.
Petitioners provided no invoices for any of the listed entries.
Consequently, we find petitioners’ proffered substantiation
insufficient.
Nonetheless, we are persuaded by petitioners’ testimony and
the record as a whole that their Amway activities, including
especially Mrs. Campbell’s distribution tasks, were extensive.
We are further persuaded that petitioners necessarily incurred
office expenses to execute these tasks in 1999. Given the extent
of petitioners’ distribution network and sales volume, we find a
reasonable estimate of their office expenses for 1999 to be
$1,000 (approximately $83 per month), and we accordingly allow
$1,000 of office expenses for 1999.
C. Promotional Expenses
Petitioners claimed $9,944 of expenses attributable to
“supplies” for their Amway activity, all of which respondent
disputes. Petitioners contend that the supplies expense
represents free samples and “business support” materials given to
their existing or prospective downline distributors.
Petitioners’ proffered substantiation of the supplies
expense consists of handwritten and computer-generated ledgers
purporting to record $6,040 and $3,898, respectively, of Amway
products, including training and motivational books, audiotapes,
and videotapes, given away as promotional or training materials
- 34 -
in 1999. In many instances, these ledgers record multiple
purchases of the same item (which tends to rebut the notion that
the items were for personal use). In these circumstances, we
find credible petitioners’ claim that they gave away at least
some significant portion of the items on these ledgers in an
effort to recruit downline distributors and encourage existing
downline distributors to purchase products and engage in further
recruiting. Moreover, respondent has conceded that $16,688 of
Amway products was purchased by petitioners in 1999 but not
resold. While we have previously concluded that some portion of
this $16,688 in Amway products purchased in 1999 represents
personal use, we are persuaded that petitioners also gave away a
portion for promotional purposes. Considering that petitioners
generated $52,620 of Amway gross receipts for 1999, we find that
at least $4,000 (approximately 7.5 percent of 1999 gross
receipts) constitutes a reasonable estimate of petitioners’
promotional expenses for the Amway activity for 1999.
As a consequence of the office and promotional expenses we
are persuaded petitioners incurred in their Amway activity for
1999, they have substantiated expenses that are at least equal to
their gross income from Amway in that year.
IV. Deductions for Rental Expenses in 1998 and 1999
Petitioners claimed deductions for Schedule E rental
expenses of $4,299 and $4,481 for 1998 and 1999, respectively,
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for expenses purportedly incurred in renting their unfinished
Montana house to Mrs. Campbell’s parents.
Section 212 allows a deduction for ordinary and necessary
business expenses paid for the production of income or for the
management or maintenance of property held for the production of
income. An expense is ordinary if it is customary or usual
within a particular trade business, or industry. Deputy v. du
Pont, 308 U.S. 488, 495 (1940). It is necessary if it is
appropriate and helpful for the business. Commissioner v.
Heininger, 320 U.S. 467, 471 (1943).
Petitioners reported $500 of annual rental income in 1998
and 1999 from the Montana house. Petitioners allowed Mrs.
Campbell’s parents to use the house for various purposes.
Petitioners claim that their rental expenses consisted of
cleaning and maintenance of the house, depreciation, and property
taxes paid on the house.
Petitioners are not entitled to the claimed deductions.
Petitioners provided no documentary evidence to substantiate
their claimed expenses. There is no evidence of their basis in
the house to support a depreciation deduction, no evidence of a
local tax bill, and no invoice for maintenance or cleaning.
Respondent’s disallowance of petitioners’ claimed rental expense
for 1998 and 1999 is sustained.
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V. Net Operating Loss Deduction
Section 172(a) authorizes a net operating loss (NOL)
deduction. An NOL is defined as the excess of allowable
deductions over gross income, with specified modifications. Sec.
172(c) and (d). The modifications for purposes of computing an
NOL include an exclusion of personal exemptions and nonbusiness
deductions of taxpayers other than corporations (except to the
extent of income that is not derived from a trade or business).
Sec. 172(d)(3) and (4). Section 172(a) allows an NOL deduction
for the aggregate of NOL carrybacks and carryovers to the taxable
year. Section 172(b)(1)(A) generally provides that the period
for a carryback is 2 years and that the period for a carryover is
20 years. A taxpayer may elect to waive the carryback period,
but only if he files an election to do so by the due date
(including extensions) of the return for the year in which the
carryback NOL is generated. Sec. 172(b)(3). Otherwise, the NOL
must be carried to the earliest of the taxable years to which it
may be carried, and it offsets taxable income for that year.
Sec. 172(b)(2).
In general, the taxpayer bears the burden of establishing
both the actual existence of an NOL in another year and the
amount of that NOL that may be carried to the years in issue.
Keith v. Commissioner, 115 T.C. 605, 621 (2000). We have
jurisdiction to consider such facts related to years not in issue
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as may be necessary for redetermination of the tax liability for
any period before the Court. See sec. 6214(b).
In the notice of deficiency respondent made a series of
determinations concerning petitioners’ 2000 taxable year, the
result of which was a loss for that year of $38,601, rather than
the $60,464 claimed on the return. The notice determined that,
pursuant to section 183, the losses arising from petitioners’
Amway activity in excess of the gross income derived therefrom
were not allowable, resulting in the elimination of a $25,477
loss claimed. The notice made no adjustment, however, to the
$4,892 loss petitioners claimed with respect to Mrs. Campbell’s
real estate business. With respect to Mr. Campbell’s
construction business, the notice determined that petitioners’
claimed loss of $4,224 should be increased by an additional
$3,614 depreciation expense that was not claimed on the return.
Respondent made no other adjustments, accepting petitioners’
claimed itemized deductions and personal exemptions.
The adjustments respondent made in the notice of deficiency
concerning petitioners’ 2000 taxable year, wherein respondent
concedes a $38,601 loss for the year, indicate that petitioners’
2000 taxable year may give rise to an NOL carryback or
carryforward to one or more of the years at issue. Neither party
has addressed this issue on brief. In view of petitioners’ pro
se status, however, we conclude that it is appropriate, and is a
- 38 -
necessary part of our jurisdiction to redetermine the
deficiencies for the years before us, to resolve whether
petitioners are entitled to an NOL deduction for any year at
issue. We will accordingly direct the parties to address
petitioners’ entitlement to any NOL from 2000 as part of their
Rule 155 computations.
For purposes of the Rule 155 computations, we sustain
respondent’s determination that the loss petitioners claimed for
2000 from the Amway activity is limited by section 183. For the
same reasons discussed in relation to the other years at issue,
we conclude that petitioners did not engage in their Amway
activity in 2000 with the requisite profit objective and that
their deductions are therefore limited to their gross income
derived from the activity. Since respondent concedes that
petitioners had $83,372 of cost of goods sold in 2000, which
exceeded their gross income in that year, it follows that
petitioners are not entitled to the $25,477 loss they claimed for
2000 arising from the Amway activity.
In making no adjustment to petitioners’ claimed $4,892 loss
from Mrs. Campbell’s real estate business, and in allowing an
additional depreciation deduction of $3,614 on top of the $4,224
loss claimed for Mr. Campbell’s construction business, respondent
appears to have conceded that petitioners had aggregate Schedule
C losses of $12,730 for 2000. Similarly, respondent appears to
- 39 -
have conceded that petitioners had itemized deductions of $20,303
and personal exemptions of $5,600 for 2000. Together, the
foregoing would generate a loss totaling $38,601 for 2000, before
the necessary adjustments under section 172(d).
VI. Section 6651(a)(1) Addition to Tax
Respondent determined that petitioners are liable for an
addition to tax for failure to timely file their 1998 return.
Under section 7491(c), the Commissioner has the burden of
production with respect to a taxpayer’s liability for the section
6651(a)(1) addition to tax. In order to meet that burden, the
Commissioner must offer sufficient evidence to indicate that it
is appropriate to impose the relevant penalty. Higbee v.
Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner
meets his burden of production, the taxpayer bears the burden of
proving error in the determination, including evidence of
reasonable cause or other exculpatory factors. Id. at 446-447.
Section 6651(a)(1) provides for an addition to tax for a
taxpayer’s failure to file a required return on or before the due
date, including extensions. The addition to tax may be avoided
if the failure to file was due to reasonable cause and not
willful neglect. United States v. Boyle, 469 U.S. 241, 245-246
(1985). Reasonable cause exists for late filing if the taxpayer
exercised ordinary care and prudence but was nevertheless unable
to file on time. Sec. 301.6651-1(c)(1), Proced. & Admin. Regs.
- 40 -
Illness or incapacity may constitute reasonable cause if the
illness causes an inability to file. Joseph v. Commissioner,
T.C. Memo. 2003-19. However, illness or incapacity does not
constitute reasonable cause where the taxpayer has the capacity
to attend to other responsibilities. Wright v. Commissioner,
T.C. Memo. 1998-224 (“‘selective inability’ to file tax returns
while attending to other responsibilities does not demonstrate
reasonable cause”), affd. without published opinion 173 F.3d 848
(2d Cir. 1999).
Petitioners concede that they filed their 1998 return on
October 18, 2000. Accordingly, respondent has met his burden of
production, and in order to avoid the addition to tax,
petitioners must show that reasonable cause existed for their
failure to timely file their return. Petitioners argue that they
had reasonable cause because their daughter was extremely ill and
was giving birth to a child at the time the 1998 return was due.
They contend that their care for their daughter was so time
consuming that it was reasonable for petitioners not to file
their 1998 return when due.
Petitioners did not testify as to the length of their
daughter’s illness and did not provide medical records. However,
even accepting that petitioners’ daughter was severely ill and
that petitioners had to care for her, petitioners have not
established that their daughter’s illness provided reasonable
- 41 -
cause for not timely filing the 1998 return. During 1999, the
year in which petitioners’ 1998 return was due, they generated
significant income from their construction business and their
real estate business. Concurrently, they spent significant time
in their Amway activity. Because petitioners were able, despite
their daughter’s illness, to carry on extensive business
activities with significant success, petitioners’ contention that
they simply did not have time to file their 1998 returns is
implausible. See Coury v. Commissioner, T.C. Memo. 2010-132; see
also Wright v. Commissioner, supra; Bear v. Commissioner, T.C.
Memo. 1992-690, affd. without published opinion 19 F.3d 26 (9th
Cir. 1994). We accordingly conclude that petitioners did not
have reasonable cause for the failure to timely file their 1998
return. The addition to tax under section 6651(a)(1) determined
by respondent is sustained.
To reflect the foregoing,
Decision will be entered
under Rule 155.