Cunningham v. Comm'r

T.C. Summary Opinion 2013-27

UNITED STATES TAX COURT

SUSAN KATHLEEN CUNNINGHAM, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 1389-09S. Filed April 1, 2013.

Susan Kathleen Cunningham, pro se.

Timothy A. Froehle and Audra Dineen, for respondent.

SUMMARY OPINION

DEAN, Special Trial Judge: This case was heard pursuant to the provisions

of section 7463 of the Internal Revenue Code in effect when the petition was filed.

Pursuant to section 7463(b), the decision to be entered is not reviewable by any

other court, and this opinion shall not be treated as precedent for any other case.

Unless otherwise indicated, subsequent section references are to the Internal
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Revenue Code in effect for the years at issue, and Rule references are to the Tax

Court Rules of Practice and Procedure.

Respondent issued a statutory notice of deficiency1 to petitioner in which he

determined deficiencies and additions to tax as follows:

Additions to tax
Year Deficiency Sec. 6651(a)(1) Sec. 6651(a)(2) Sec. 6654

2002 $17,708 $3,984 $4,427 $591
2003 17,713 3,985 4,428 457
2004 17,132 3,854 (1) 490
2005 16,928 3,808 (1) 679
2006 16,683 3,753 (1) 789

1
The amount for this year has yet to be determined.

Petitioner concedes the adjustments in the notice of deficiency for interest

income and “rents received” income from Comerica Bank reported on Schedules

E, Supplemental Income and Loss, for each of the years 2002 through 2006.

Petitioner concedes that she received and failed to report alimony of $24,000 in

each of the years 2002 through 2006, but the notices of deficiency do not adjust

this item and respondent has not asserted an increased deficiency. Petitioner

concedes that she had a short-term capital gain of $138 in 2003 and a long-term

1
Respondent also issued a separate statutory notice of deficiency to petitioner
for 2001, but that case at docket No. 21358-08S was dismissed for lack of
jurisdiction.
 -3-

capital gain of $17,754 in 2004; respondent made no adjustment for the long-term

capital gain of $17,754 in 2004 and failed to assert an increased deficiency.

Petitioner concedes that she failed to file returns for 2002 through 2006. The issues

remaining for decision are whether for 2002 through 2006 petitioner is: (1) entitled

to itemized deductions in excess of the standard deduction; (2) entitled to

deductions reportable on Schedule C, Profit or Loss From Business; (3) entitled to

deductions reportable on Schedule E; (4) liable for the addition to tax for failure to

file timely Federal income tax returns without reasonable cause and due to willful

neglect; (5) liable for the addition to tax for failure to pay timely the tax due without

reasonable cause and due to willful neglect; and (6) liable for the addition to tax

under section 6654(a) for failure to pay estimated income tax.

Some of the facts have been stipulated and are so found. The stipulation, the

supplemental stipulation, and the second supplemental stipulation of facts and the

exhibits received in evidence are incorporated herein by reference. Petitioner

resided in California when the petition was filed.

Background

Petitioner filed her Federal income tax return for 2001 in April 2006,

reporting zero tax. Petitioner was issued a notice of deficiency for 2001 and

petitioned the Court, which entered a dismissal for lack of jurisdiction because the
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tax year was the subject of a prior notice and petition for which the Court

determined there was no deficiency. Petitioner failed to file tax returns or pay any

Federal income tax for 2002 through 2006. In July 2008 respondent prepared

Forms 13496, IRC Section 6020(b) Certification, signed by his delegate identifying

petitioner by name and taxpayer identification number, containing sufficient

information from which to compute petitioner’s tax liabilities and filed returns for

petitioner for 2002 through 2006. Each of the section 6020(b) returns was for a

single individual, included interest income and rental income, and allowed the

standard deduction and a personal exemption. The 2003 return respondent prepared

also included $138 of capital gain income.

Respondent issued the notice of deficiency for 2002 through 2006 on

October 21, 2008. In June 2011 petitioner hand delivered to respondent’s counsel

professionally prepared Forms 1040, U.S. Individual Income Tax Return, for the

years at issue. Petitioner claimed on the forms provided to respondent deductions

on Schedules A, Itemized Deductions, and Schedules C and E for each year at

issue. The Schedules C claimed deductions for a “consulting, marketing and

promotions” activity under the name of “Access”. The Schedules E reported

income and expense deductions for one property, 14401 Big Basin Way, for 2002
 -5-

through 2006 and for two other properties at 3936/3944 Peoria Road for 2002

through 2004.

Petitioner reported on the Forms 1040 zero taxable income for all the years at

issue, 2002 through 2006.

It was not until the case was called for trial, however, that petitioner gave

respondent copies of substantial documentation (documentation) attempting to

evidence her entitlement to the deductions she had shown on the Forms 1040

submitted the previous year. The documentation is a collection of items, including

copies of checks, receipts, and schedules with little organization or explanation. It

was with difficulty that the Court analyzed the record. Unfortunately for petitioner,

the record does not support the same results as the timely filing of petitioner’s tax

returns and the coherent, systematic, and timely production of substantiation of the

items on the returns might have produced.

During the years at issue petitioner initially lived in Scottsdale, Arizona, in

a home (Scottsdale home) she had purchased for her eventual retirement. The

Scottsdale home purchase was financed with a first mortgage loan from

Washington Mutual (WaMu) and a second mortgage loan from Steven Michael

Miller, Trustee of the Steven Michael Miller 1997 Revocable Trust (Steven
 -6-

Miller).2 Petitioner, however, spent so much time going back and forth to California

to see her children that she decided to purchase a home in Paso Robles, California

(Paso Robles home), in May 2003 for a total cost of $892,142. The “Buyer Final

Closing Statement” indicates that there was a first deed of trust evidencing a loan

with Wells Fargo Home Mortgage of $615,300 and a second deed of trust for a loan

with Wells Fargo Home Equity of $150,000. Petitioner continued to hold the

Scottsdale home as a second residence with the intent of selling it. She began living

in the Paso Robles home as her “main residence” in 2003. Petitioner refinanced the

Paso Robles home for $840,000 in September 2005 with Countrywide Home Loans

and placed a second deed of trust on the house for a loan of $174,000 with

Countrywide Home Loans in November 2005. Petitioner also refinanced the

Scottsdale home on December 8, 2006.

During the years at issue petitioner maintained a “business address” at

144073 Big Basin Way in Saratoga, California, but her mailing address for

business and personal mail was in Cupertino, California. Petitioner refinanced the

2
Petitioner described Steven Miller as an “investor”.
3
The property at 14407 Big Basin Way was owned by petitioner’s former
husband, Dennis Cunningham.
 -7-

property at 144014 Big Basin Way, obtaining three successive loans from Steven

Miller in February 2002, May 2003, and September 2004. The first loan was for

$550,000, the second for $225,000, and the third for $450,000. On May 18, 2005,

petitioner filed a fictitious business name statement with the Santa Clara County

Clerk Recorder’s Office stating the address of the fictitious business name, Access,

was 14510 Big Basin Way #290.5 The statement indicates that petitioner began

transacting business under the fictitious name in 1991 and that the statement is being

refiled.

In April 2001 petitioner purchased properties at 3936/3944 Peoria Road in

Springfield, Illinois, for $86,500, and this amount was financed by a loan with

First Guaranty Mortgage Corp. On the Schedules E that petitioner provided to

respondent properties B and C correspond to the addresses at 3936/3944 Peoria

Road. Petitioner reported rents received from both properties in 2002,

2003, and 2004. The rent reported for property C in all three years represents

payments petitioner made from her checking account in the name of “Access” to

herself for “rental” of the property for storage of what she described as business

4
Petitioner owned property at 14401 Big Basin Way.
5
The record does not offer any evidence as to the ownership of property at
14510 Big Basin Way.
 -8-

materials. She deducted the “rental” payments on her Schedules C. Petitioner was

the only “tenant” in property C. Although petitioner testified that she had a tenant

in property B, she provided no other evidence that the property at 3936 Peoria was

actually rented during the relevant period. In May 2004 petitioner sold the

property at 3936/3944 Peoria Road for $107,500.

Discussion

Generally, the Commissioner’s determinations are presumed correct, and the

taxpayer bears the burden of proving that those determinations are erroneous.

Rule 142(a); see INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992);

Welch v. Helvering, 290 U.S. 111, 115 (1933). In some cases the burden of proof

with respect to relevant factual issues may shift to the Commissioner under section

7491(a). Petitioner did not argue or present evidence to show that she satisfied the

requirements of section 7491(a). Therefore, petitioner bears the burden of proof

with respect to the issues in the notice of deficiency.

When a taxpayer fails to file a return, as did petitioner, it is as if she filed a

return “showing a zero amount” for purposes of determining a deficiency. Schiff v.

United States, 919 F.2d 830, 832 (2d Cir. 1990); Roat v. Commissioner, 847

F.2d 1379, 1381 (9th Cir. 1988); sec. 301.6211-1(a), Proced. & Admin. Regs.
 -9-

In determining the deficiencies, respondent allowed petitioner only the

standard deduction because, in the absence of returns filed by petitioner, respondent

had no evidence that there were any other deductions allowable to her. Implicit in

the determination is the disallowance of any deductions other than the standard

deduction. When petitioner subsequently submitted to respondent’s counsel Forms

1040 for 2002 through 2006, she claimed for the first time itemized deductions and

deductions for expenses on Schedules C and E.

Respondent’s repeated requests for substantiation of items that petitioner

belatedly claimed on the Forms 1040 submitted after the notice of deficiency was

issued were consistent with respondent’s original determination. It was, however,

only at the call of the case from the trial calendar that petitioner appeared with a

stack of copies of documents intended to substantiate the various expenses she had

listed on the Schedules C and E for 2002 through 2006 that she had given to

respondent six months previously.

Itemized Deductions

With the exception of matters pertaining to real estate, almost all of the

documents were copies of checks, some bearing tiny, and occasionally elaborate,

notations on their faces. Respondent raised objections to the checks. Respondent

objects to the admission of the checks on the basis of “lack of foundation”,
 - 10 -

hearsay, and lack of authentication. The Court assumes that, if asked, petitioner

would say that the documents are what they purport to be, checks that she wrote to

pay her expenses. Checks are commercial paper and self-authenticating. Fed. R.

Evid. 902. Checks are “verbal acts” and not hearsay statements. United States v.

Pang, 362 F.3d 1187, 1192 (9th Cir. 2004). The Court overrules respondent’s

objections and admits the checks as evidence.

Medical and Dental Expenses

Petitioner deducted medical and dental expenses of $1,104 for 2002 but

provided no substantiation. She is not entitled to a deduction for medical and dental

expenses for 2002.

Taxes

Section 164(a) allows taxpayers to deduct taxes for the year within which

paid, including State and local real estate, general sales,6 personal property, and

income taxes. Petitioner indicated on the Forms 1040 that she provided in 2011 that

6
Taxpayers may, under sec. 164(b)(5), deduct for tax years beginning after
December 2003 State and local sales taxes in lieu of State and local income taxes.
American Jobs Creation Act of 2004, Pub. L. No. 108-357, sec. 501, 118 Stat. at
1520; Tax Relief and Health Care Act of 2006, Pub. L. No. 109-432, sec. 103, 120
Stat. at 2934. Emergency Economic Stabilization Act of 2008, Pub. L. No. 110-
343, sec. 201, 122 Stat. at 3864; Tax Relief, Unemployment Insurance
Reauthorization, and Job Creation Act of 2010, Pub. L. No. 111-312, sec. 722, 124
Stat. at 3316; American Taxpayer Relief Act of 2012, Pub. L. No. 112-240, sec.
205, 126 Stat. at 2323.
 - 11 -

she is entitled to deduct: for 2002 State and local income taxes of $7,094 and real

estate taxes of $4,369; for 2003 State and local income taxes of $10,287 and real

estate taxes of $9,777; for 2004 State and local general sales taxes of $828, personal

property taxes of $3, and real estate taxes of $17,315; for 2005 State and local

income taxes of $9,416 and real estate taxes of $8,741; and for 2006 State and local

income taxes of $13,079 and real estate taxes of $13,894.

Petitioner provided copies of two checks payable to the County of Maricopa,

Arizona Treasurer for 2002. The check dated March 1, 2002, is for $1,405.64, and

the check dated October 1, 2002, is for $2,963.58. Small notations on the faces of

the checks reference property taxes for the Scottsdale, Arizona, property for 2001

and 2002. The magnetic ink character recognition (MICR) numbers7 match the

amounts for which the checks were written.

Petitioner for 2003 introduced copies of two checks payable to the State of

California Franchise Tax Board, one for $7,370.39 and one for $7,074.49, both

dated July 8, 2003. A very small notation on the lower left face of each check

indicates that the check for the larger amount is for the payment of income tax for

2000 and the smaller amount is for income tax for 2001. The MICR numbers at the

7
See 12 U.S.C. sec. 5002(12) (2006); see also First Union Nat’l Bank v.
Bank One, N.A., No. 01-CV-1204, 2002 WL 501145 (E.D. Pa. Mar. 20, 2002).
 - 12 -

bottom right of the checks indicate that the checks were processed in the amounts

for which they were written. Petitioner also provided checks showing the payment

of property taxes for 2003 of $3,229.12 to Maricopa County and of $5,790.84 to the

County of San Luis Obispo in 2003.

For 2004 petitioner introduced copies of checks to Maricopa County for 2004

property taxes of $3,355.70 and to the County of San Luis Obispo for 2003-04

property taxes of $3,799.40, delinquent 2002-03 property taxes of $313.14, and

2004-05 property taxes of $9,847.03. On the Form 1040 for 2004 that she provided

to respondent she also deducted in lieu of State income tax $828 of general State

sales tax.8 The total amount of property taxes represented by the checks comports

with the amount shown on the Form 1040 for 2004. On the basis of the adjusted

gross income shown on petitioner’s Form 1040 for 2004, she correctly reported the

deduction for sales tax for her State of residence for that year. See IRS Pub. 600,

Optional State Sales Tax Tables (2004). Any adjustment to this item will be

computational and will be resolved by the Court’s decision on the other issues.

Petitioner’s check copies for 2005 included one to the County of San Luis

Obispo for property taxes of $5,021.96 for 2005-06 and one to Maricopa County for

8
See supra note 6.
 - 13 -

property taxes of $3,718.84 for 2005. Petitioner did not substantiate the payment of

any State and local income taxes for the year.

Petitioner’s check copies for property taxes for 2006 are to the County of San

Luis Obispo for $5,021.96 and $5,122.35 and to Maricopa County for $3,750.16.

Petitioner did not substantiate the payment of any State and local income taxes for

the year.

Petitioner is entitled to deduct real estate and State and local income taxes

paid for 2002 through 2006 as described in the previous discussion.

Home Mortgage Interest

Section 163(a) allows a deduction for interest paid or accrued within the

taxable year on indebtedness. Taxpayers other than corporations are not allowed to

deduct “personal” interest. Sec. 163(h)(1). Individuals, however, are allowed a

deduction for “qualified residence interest”. Sec. 163(h)(3). A qualified residence

is the taxpayer’s primary residence and one other residence of the taxpayer. Sec.

163(h)(4)(A). Qualified residence interest includes interest on “acquisition

indebtedness” or “home equity indebtedness”. Acquisition indebtedness is debt,

limited to $1 million, incurred to acquire, construct or substantially improve a

qualified residence of the taxpayer that is secured by the qualified residence. Home

equity indebtedness is certain indebtedness, not in excess of $100,000, secured by a
 - 14 -

qualified residence. Sec. 163(h)(3)(C). Acquisition indebtedness also includes the

refinancing of acquisition indebtedness. Sec. 163(h)(3)(B) (flush language). Debt is

secured by a qualified residence if there is an instrument that in the event of default

subjects the residence to satisfaction of the debt in the same way as would a

mortgage or deed of trust. Sec. 1.163-10T(o)(1), Temporary Income Tax Regs., 52

Fed. Reg. 48417 (Dec. 22, 1987).

Home equity indebtedness is limited in amount to the fair market value of the

qualified residence reduced by any “acquisition indebtedness” and may not exceed

$100,000. Sec. 163(h)(3)(C). Respondent argues that petitioner has failed to

provide adequate substantiation for her claimed mortgage interest expense

deductions. For 2001, no longer at issue, petitioner presented a copy of a Form

1098, Mortgage Interest Statement, addressed to her from WaMu. The statement

computed “total interest applied” for the year of $20,587.80 “less deferred interest -

added to your principal balance” of $718.83 “plus payments applied to previously

deferred interest” of $1,463.43 for a total mortgage interest received from payer of

$21,332.40. The ending WaMu loan balance for 2001 is stated to be $262,633.70.

Petitioner also provided copies of adding machine tapes, an untitled payment

schedule showing, among other items, total monthly payments of $2,010.51 and an
 - 15 -

ending balance of $206,116.60, and copies of 12 monthly checks to Steven Miller

for $2,010.51. According to the adding machine tapes and the payment schedule,

apparently for the Steven Miller loan, petitioner paid interest of $23,242.89 in

2001.

For 2002 petitioner provided copies of checks to WaMu and Steven Miller

but no Form 1098 or any other home-mortgage-related documentation. The WaMu

checks show a monthly payment of $1,841.95, until the check dated July 1, 2002,

which was for $1,603.60. The checks for the remaining months of 2002 following

July are in varying amounts approximating $1,600. The untitled payment schedule

shows for 2002 monthly payments of $2,010.51 and an ending balance of

$205,128.88. The 12 monthly checks written to Steven Miller are all for $2,010.51.

All the MICR numbers match the amounts for which the checks are written.

Where a taxpayer has established that he has incurred an expense, failure to

prove the exact amount of the otherwise deductible item may not be fatal.

Generally, unless precluded by section 274, the Court may estimate the amount of

such an expense and allow the deduction to that extent. See Finley v.

Commissioner, 255 F.2d 128, 133 (10th Cir. 1958), aff’g 27 T.C. 413 (1956);

Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). Any inexactitude in
 - 16 -

the estimate by the Court is of petitioner’s own making due to her failure to maintain

proper business records. See Cohan v. Commissioner, 39 F.2d at 544. In order for

the Court to estimate the amount of an expense there must be some basis upon

which an estimate may be made. Vanicek v. Commissioner, 85 T.C. 731, 742-743

(1985). Without such a basis, an allowance would amount to unguided largesse.

Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957).

The Court, having examined the documents petitioner submitted as evidence

of her home mortgage interest expense, concludes that she is entitled to deduct

$30,000 as home mortgage interest for 2002.

For 2003 petitioner provided copies of checks to WaMu, Steven Miller, and

Wells Fargo but no Form 1098 or any other home-mortgage-related documentation.

The Court cannot determine accurately from the checks alone how much of

petitioner’s payments is for interest. Further complicating the Court’s consideration

of petitioner’s claim of home mortgage interest expenses for 2003 through 2006 is

the amount of the outstanding acquisition indebtedness.

The opening balance (the ending balance from 2001) for 2002 on the WaMu

mortgage was $262,633.70, and the opening balance (the ending balance from

2002) on the mortgage to Steven Miller for 2003 was $205,128. Petitioner owed

well over $400,000 in mortgage debt on the Scottsdale home in 2003 when she
 - 17 -

incurred an additional $766,300 in mortgage debt to purchase the Paso Robles

home. Petitioner exceeded the $1 million limit on deductible acquisition

indebtedness in 2003. The problem was exacerbated in 2005 when she refinanced

the Paso Robles home with an $840,000 loan followed closely by a $174,000 loan

from Countrywide Home Loans.

Although petitioner has failed to keep appropriate records which would

enable the Court to make an accurate determination of her home mortgage interest

expenses for 2003 through 2006, there is some basis upon which an estimate may be

made. The Court, having examined the documents petitioner submitted as evidence

of her home mortgage interest expenses for 2003 through 2006, concludes that she

is entitled to home mortgage interest expense deductions of $35,000, $40,000,

$38,000, and $35,000 for those years, respectively. Any inexactitude in the

estimate by the Court is of petitioner’s own making because of her failure to

maintain proper records. See Cohan v. Commissioner, 39 F.2d 540.

Gifts to Charity

Taxpayers are allowed a deduction for any charitable contribution made

within the year if verified under regulations prescribed by the Secretary. Sec.

170(a). Petitioner claimed deductions for charitable contributions of cash of $150

for 2002, $200 for 2003, $350 for 2004, $225 for 2005, and $175 for 2006 on the
 - 18 -

Forms 1040 that she submitted to respondent in 2011. Charitable contributions of

money may be verified by maintaining a canceled check for the contribution. Sec.

1.170A-13(a)(1), Income Tax Regs. Charitable contributions of more than $250

must be verified by a written acknowledgment of the of the contribution by the

donee organization. Sec. 170(f)(8)(A).

Among the records petitioner provided are copies of three checks, each of

which is written for $50 to Our Lady of Peace Church in 2002. The MICR numbers

match the amounts for which the checks were written. Respondent’s objection to

the admission of the checks is overruled. Petitioner is entitled to a charitable

contribution deduction of $150 for 2002. The Court can find no other substantiation

for charitable contributions for any year, and petitioner is not entitled to deduct the

amounts claimed for the other years at issue.

Claims of Schedule C and E Deductions

Deductions are strictly a matter of legislative grace, and a taxpayer bears the

burden of proving entitlement to any deduction claimed. Rule 142(a); New Colonial

Ice Co. v. Helvering, 292 U.S. 435 (1934); Welch v. Helvering, 290 U.S. at 115.

Moreover, taxpayers are required to maintain records that are sufficient to

substantiate their deductions. Sec. 6001. Deductions are allowed under section 162

for the ordinary and necessary expenses of carrying on an activity that constitutes
 - 19 -

the taxpayer’s trade or business. Deductions are allowed under section 212(1) and

(2) for expenses paid or incurred in connection with an activity engaged in for the

production or collection of income, or for the management, conservation, or

maintenance of property held for the production of income.

With respect to either section, however, the taxpayer must demonstrate a

profit objective for the activity in order to deduct associated expenses. See

Jasionowski v. Commissioner, 66 T.C. 312, 320-322 (1976); sec. 1.183-2(a),

Income Tax Regs. The profit standards applicable for section 212 are the same as

those used for section 162. See Agro Sci. Co. v. Commissioner, 934 F.2d 573, 576

(5th Cir. 1991), aff’g T.C. Memo. 1989-687; Antonides v. Commissioner, 893 F.2d

656, 659 (4th Cir. 1990), aff’g 91 T.C. 686 (1988); Allen v. Commissioner, 72 T.C.

28, 33 (1979); Rand v. Commissioner, 34 T.C. 1146, 1149 (1960).

Schedule C

Petitioner, however, must show not only that her primary purpose for

engaging in the activity was for income or profit but also that she engaged in the

activity with “continuity and regularity” in order to show that she was engaged in a

trade or business during the years at issue. See Commissioner v. Groetzinger, 480

U.S. 23, 35 (1987).
 - 20 -

Petitioner attached to the Forms 1040 that she gave respondent in 2011

Schedules C reporting a “Consulting, Marketing, Promotions” business named

“Access”. She claimed deductions for expenses resulting in net losses from her

activity as Access for each of the years at issue. Included in the documents

petitioner provided was an undated and untitled document stating that Access

“provides business development services” that include designing marketing

materials, event planning and scheduling, and attending trade shows. At the bottom

of the document is the handwritten notation: “Prepared Prior To Business

Collapse”.

The parties also stipulated a copy of the fictitious business name statement for

Access petitioner filed on May 18, 2005, with the Santa Clara County Clerk

Recorder’s Office. Petitioner showed that she maintained a checking account in the

name of Access from which she wrote checks to various payees. Petitioner,

however, has offered no other documentary or any detailed oral evidence that she

conducted a trade or business, a profit-motivated activity engaged in with continuity

and regularity, during the years at issue. Access had no employees; and though

petitioner claimed expenses for advertising, she produced no evidence of any

advertising. Petitioner offered no evidence of any Access work product or any

correspondence between Access and a client. Petitioner produced no books of
 - 21 -

account, client list, bank statement, or check register showing the receipt of any

payment from a client, any invoice to a client, or any other evidence of any amount

she ever received in payment from a client for her services as Access.

Because petitioner has not shown that she was engaged in a trade or business

during any of the years at issue, she is not entitled to deduct any trade or business

expenses on Schedule C.

Schedule E

Respondent does not dispute petitioner’s profit objective with respect to the

properties listed on Schedule E. In fact, the parties agree that petitioner received

substantial rental income from Comerica Bank for the use of the property at 14401

Big Basin Way for the years at issue, $95,355 in 2002, $98,975 in 2003, $91,425 in

2004, $88,225 in 2005, and $88,225 in 2006. Petitioner’s Schedules E report the

income received from property A as the rental of 14401 Big Basin Way. For 2002

through 2004 petitioner reported on Schedules E net losses from properties B and C,

3936/3944 Peoria Road. Petitioner testified that she purchased the Peoria Road

properties as “investment property”.

Petitioner testified that in 2004 she had a tenant in property B, but she

provided no other evidence that the property at 3936 Peoria was actually rented or

held out for rental during the relevant period. The Court concludes that because
 - 22 -

petitioner did not receive rental income for the year or show that she held the

property for rental during the year, she incurred no rental expenses with respect to

property B during 2002 through 2006.

Petitioner also testified that property C at 3944 Peoria was “rented” to

Access throughout her ownership of the property, which ended in 2004. Petitioner

alleges that she paid herself rent for using her own property. The “income” reported

on Schedule E is the “rent” that she paid herself as Access. Petitioner, however,

failed to show that Access was in fact a business during the years at issue.

Petitioner also fails to have considered that under section 451, cash basis taxpayers

include in income only the amounts “received” during the year and sections 162 and

212 limit the expenses that a cash basis taxpayer can deduct to those that are “paid”

during the year. Petitioner neither paid nor received any amount involving property

C; she possessed the relevant funds before the “transactions”, and she possessed

them after the transactions. There was no economic gain or loss. It is as if she

moved money from one of her pockets to the other. Property C was not rented or

held out for rental from 2002 through 2004, and petitioner neither received rental

income nor incurred rental expenses with respect to the property.
 - 23 -

The holding of property for rental purposes is generally treated as the use of

property in a trade or business. Alvary v. United States, 302 F.2d 790, 796 (2d Cir.

1962); Mendes v. Commissioner, 121 T.C. 308, 317 (2003). The Court concludes

from the record that while property A was property used in a trade or business,

properties B and C were purchased and held for investment purposes.9

Petitioner claimed entitlement to a number of deductions for property A for

all the years at issue and for properties B and C for 2002 through 2004. Most of

petitioner’s substantiation of claimed expenses is in the form of checks. The MICR

numbers at the bottom right of the check copies indicate that the checks were

processed in the amounts for which they were written.

Advertising Expenses

Petitioner failed to point the Court to, and the Court was unable to find, any

evidence of advertising expenses for 2002 and 2003, and she did not report any

advertising expenses for 2004, 2005, and 2006.

Auto and Travel Expenses

Petitioner failed to provide any evidence of automobile or travel expenses that

meets the stringent substantiation requirements of section 274.

9
Unlike expense deductions for rental property, any allowable expense
deductions associated with investment properties B and C are itemized deductions
subject to the 2% floor of sec. 67(a). See sec. 62(a)(4).
 - 24 -

Cleaning and Maintenance

Petitioner points to copies of checks made out to Kevin Cunningham, her son,

and to Terry W. Eckenfels “DBA Terry’s Lawn Service” as evidence of cleaning

and maintenance expenses for properties B and C. Petitioner changed the dates of

several of the checks payable to her son in 2002 that bear notations indicating

“landscape maintenance”, and two of the checks with an October date indicate they

were written for multiple months.

Generally, no deduction is allowed for personal, living, or family expenses.

See sec. 262. Petitioner must show that any claimed expenses were incurred

primarily for business or for investment rather than personal reasons. See Rule

142(a); Walliser v. Commissioner, 72 T.C. 433, 437 (1979); sec. 1.212-1(d) and (e),

Income Tax Regs. To show that the expense was not personal, petitioner must

show that the expense was incurred primarily to benefit her business or was for the

production or collection of income or for the management, conservation or

maintenance of property held for the production of income. There must also have

been a proximate relationship between the claimed expense and the business or the

section 212 activity. See Walliser v. Commissioner, 72 T.C. at 437; sec. 1.212-

1(d). Petitioner’s checks to her son for 2002 through 2004 do not meet this

standard.
 - 25 -

The Court concludes that four checks dated in 2003 each written for $125 to

Terry W. Eckenfels “DBA Terry’s Lawn Service” (noted to be for properties B and

C) , a 2003 check to Tom’s Plumbing and Heating (noted to be for furnace repair at

property B), and a 2004 check for $297.22 written to “Avenue Glass and Repair

Shop Inc.” (noted to be for property B) are adequate substantiation of cleaning and

maintenance expenses.

Insurance

Petitioner produced copies of two 2002 checks to State Farm Insurance Co.,

one for $230 for property B and one for $327 for property C. She provided copies

of two checks for 2003 to State Farm, one for $282 and one for $401. She also

provided two checks showing payments to State Farm in 2004, one for $363 for

property B and one for $500 for property C. The Court can find no evidence of

insurance payments with respect to property A for any year. Petitioner is entitled to

insurance expense deductions for amounts shown on the previously discussed

checks.

Mortgage Interest

Petitioner claimed deductions on the Schedules E for relatively modest

amounts of mortgage interest expenses. She claimed for property A $2,302 for

2002, $1,478 for 2003, $2,230 for 2004, $2,687 for 2005, and $2,687 for 2006.
 - 26 -

Petitioner, however, offered as evidence to prove her entitlement to mortgage

interest expense deductions for property A copies of settlement documents showing

the details of financing from Steven Miller, copies of notated checks to Steven

Miller, and copies of Steven Miller payment books10 she maintained showing the

dates of payment, the total amount paid, the amount of interest paid, and the

outstanding balance due for amounts much larger than those she claimed. The

Steven Miller payment books bear the legend “BENEFICIARY: Please initial each

payment and return book.” There are initials following each payment entry. The

settlement documents for the three refinancing events for property A during the

years at issue show that the loans were each independent of the other and used by

petitioner to obtain cash.

Petitioner proffered check copies for the February 2002 loan of $550,000

from Steven Miller showing, with a few exceptions, monthly payments during the

period at issue beginning in April 2002. Petitioner presented copies of nine checks

to Steven Miller in 2002 for $4,927.08 bearing notations indicating they were for the

February 2002 loan. The payment book associated with the loan indicates the

interest rate to be 10.75% per annum (.1075 x $550,000 / 12 = $4,927.08). Judging

10
The Court overrules respondent’s objections to the payment books. See
Rule 174(b); Fed. R. Evid. 803(6); Keogh v. Commissioner, 713 F.2d 496, 500 (9th
Cir. 1983), aff’g Davies v. Commissioner, T.C. Memo. 1981-438.
 - 27 -

by the payment book the loan was an interest-only loan; the principal was not

amortized, and all payments went to interest. Petitioner paid interest of $44,343.72

in 2002 on the $550,000 loan from Steven Miller. Petitioner made 12 monthly

payments of $4,927.08 in each of the years 2003, 2004, 2005 and 2006, $59,124.96

a year in interest.11

Petitioner provided similar evidence with respect to the May 2003 loan from

Steven Miller of $225,000 at a rate of 12%. The evidence indicates monthly

payments of $2,250, applied to interest only from July 2003 through August 2004.

Petitioner incurred interest expenses of $13,500 in 2003 and $18,000 in 2004 due to

the May 2003 loan. Similarly, petitioner’s evidence shows monthly payments of

$4,031.25 on the Steven Miller loan in September 2004 of $450,000 at 10.75%.

Petitioner made three payments in 2004 for a total of $12,093 and twelve payments

in 2005 and 2006 totaling $48,372 for each year.

The Court has analyzed the evidence and finds the relevant dates and

amounts to be internally consistent and consistent with the surrounding facts and

circumstances. Petitioner is entitled to Schedule E interest deductions for property

11
The payment book indicates that the payments continued through September
2007.
 - 28 -

A of $44,343.72 for 2002, $72,624.96 for 2003, $89,217.96 for 2004, $107,496.96

for 2005, and $107,496.96 for 2006.

If a taxpayer is an individual, however, the “passive activity loss” for the

taxable year shall not be allowed. Sec. 469(a). The term “passive activity loss”

means the amount by which “the aggregate losses from all passive activities”

exceeds “the aggregate income from all passive activities” for the taxable year. Sec.

469(d)(1). For purposes of section 469(a), “passive activities” are, with certain

exceptions, activities involving a trade or business in which the taxpayer does not

“materially participate”. Sec. 469(c)(1). The term “passive activity” generally

includes any rental activity. Sec. 469(c)(2). Rental activity is any activity “where

payments are principally for the use of tangible property.” Sec. 469(j)(8).

Petitioner has not shown that her property A rental activity is excepted from

treatment as a passive activity.

Petitioner’s passive activity losses exceed her aggregate income from all

passive activities for the years 2005 and 2006; rental income of $88,225 less interest

expenses of $107,496.96 generates a passive loss of $19,271.96 for both years.12

Section 469(i) provides an exception to the general rule that passive activity losses

12
Other expenses petitioner claimed with respect to property A are affected by
sec. 469(a) to the extent the aggregate losses exceed aggregate income.
 - 29 -

are disallowed. A taxpayer who “actively [participates]” in a rental real estate

activity can take advantage of an offset, a deduction of a maximum loss of $25,000

per year, as an exception to the disallowance of passive activity losses. Sec.

469(i)(1) and (2). But petitioner has not demonstrated that she actively participated

in the rental activity and therefore cannot qualify for the offset.13 See Madler v.

Commissioner, T.C. Memo. 1998-112.

Petitioner also claimed deductions for interest expenses associated with the

Schedule E properties B and C at 3936/3944 Peoria Road that First Guaranty

Mortgage Corp. financed. The Court has found that those properties were held for

investment. In the case of a taxpayer other than a corporation, interest deductions

may not exceed the taxpayer’s net investment income for the taxable year. Sec.

163(d)(1). The Court has found that petitioner had no investment income from

renting the properties.

The term “investment income” can include the net gain from the disposition

of investment property, and petitioner experienced such a gain upon the disposition

of the Peoria Road properties in 2004. See sec.163(d)(4)(B)(iii). Petitioner’s

evidence of her interest expenses for properties B and C, however, is meager. The

13
Losses disallowed under sec. 469(a) may be carried to the next year. Sec.
469(b).
 - 30 -

evidence consists of copies of settlement documents showing the purchase in April

2001 of the Peoria Road properties First Guaranty Mortgage Corp. financed and

copies of checks drawn in favor of City Mortgage Inc., beginning in March 2002.

The checks bear the notation: “Loan Originating Lender First Guaranty Mortgage

Corporation”. Petitioner failed to explain why there were payments to an institution

other than the one that financed the purchase. Petitioner also failed to provide any

substantiation of how much interest she was paying. In order for the Court to

estimate the amount of an expense there must be some basis upon which an estimate

may be made. Vanicek v. Commissioner, 85 T.C. at 742-743. Without such a

basis, an allowance would amount to unguided largesse. Williams, 245 F.2d at 560.

The Court finds that petitioner has not provided sufficient evidence from which to

make an estimate of her interest expenses associated with the Peoria Road

properties.

Supplies Expenses

The Court could find no substantiation of expenses for supplies that could be

identified as being associated with properties A, B, or C.

Taxes

Petitioner’s 2002 Form 1040 as submitted to respondent claims a deduction

for taxes for property A of $6,121. She has provided copies of checks to the
 - 31 -

County of Santa Clara Tax Collector (Santa Clara County) dated in 2002 that total

$6,121.16. Petitioner has a copy of a 2003 check to Santa Clara County for

$4,322.94, having claimed a deduction for taxes of $4,323 for property A for 2003.

Petitioner for 2004 has provided for property A a copy of a check to Santa Clara

County for $4,400.98, having claimed a deduction for taxes paid of $4,401.

Petitioner’s checks substantiate taxes paid to Santa Clara County of $2,343.29 in

2005 and $6,973.17 ($2,343.29 and $4,629.88) in 2006.

Petitioner claimed a deduction of $1,042 for taxes in 2002 for each of

properties B and C. She submitted a copy of a 2002 check to the Township of

Springfield, Illinois Tax Collector (Town of Springfield) for $1,042 with a notation

that the payment was for both properties B and C. Although she claimed this

amount once for each of properties B and C as taxes paid, petitioner has a copy of

one 2003 check to the Town of Springfield, Illinois Tax Collector for $1,062.72 for

both properties. Petitioner provided no substantiation for any 2004 taxes paid on

properties B and C and is therefore not entitled to deduct expenses for taxes

associated with the properties for 2004.

Petitioner is entitled to deduct the taxes associated with properties A, B, and

C for which she provided checks to substantiate her payments as discussed above.
 - 32 -

Utilities

Petitioner claimed deductions for utilities expenses on Schedules E of her

Forms 1040 for property A for 2002 and 2003 and for property B for 2002, 2003,

and 2004. She substantiated utilities expenses only for property B, $1,058 for

utilities expenses in 2002, $737 for 2003, and $453.83 for 2004 as claimed on the

Forms 1040. She is entitled to deduct substantiated utilities expenses.

Bank Service Charges

Petitioner claimed a deduction for “Bank Service Charges” for properties A,

B, and C but failed to offer sufficient evidence to substantiate the item for any year

or property.

Depreciation

The Court finds that petitioner is entitled to depreciation deductions for

property A for 2002 through 2006 and for properties B and C for 2002 through 2004

as determined by the computations of the parties.

Additions to Tax Under Section 6651(a)(1) and (2)

Section 7491(c) imposes on the Commissioner the burden of production in

any court proceeding with respect to the liability of any individual for penalties and

additions to tax. Higbee v. Commissioner, 116 T.C. 438, 446 (2001); Trowbridge

v. Commissioner, T.C. Memo. 2003-164, aff’d, 378 F.3d 432 (5th Cir. 2004). In
 - 33 -

order to meet the burden of production under section 7491(c), the Commissioner

need only make a prima facie case that imposition of the penalty or the addition to

tax is appropriate. Higbee v. Commissioner, 116 T.C. at 446.

Section 6651(a)(1) provides for an addition to tax of 5% of the tax required to

be shown on the return for each month or fraction thereof for which there is a failure

to file, not to exceed 25%. The addition to tax for failure to file a timely return will

be imposed if a return is not timely filed, unless the taxpayer shows that the delay

was due to reasonable cause and not willful neglect. See sec. 6651(a)(1). The

section 6651(a)(1) addition to tax is reduced by the amount of the section

6651(a)(2) addition to tax for any month (or fraction thereof) to which an addition to

tax applies under section 6651(a)(1) and (2). See sec. 6651(c)(1).

Section 6651(a)(2) provides for an addition to tax of 0.5% per month up to

25% for failure to pay timely the amount shown on a return unless it is shown that

the failure is due to reasonable cause and not due to willful neglect.

Petitioner submitted by hand Forms 1040 to respondent’s counsel three years

after the issuance of the notice of deficiency, an action that may not qualify as the

“filing” of the returns. See Allnutt v. Commissioner, 523 F.3d 406, 412-413 (4th

Cir. 2008), aff’g T.C. Memo. 2002-311. But cf. Dingman v. Commissioner, T.C.

Memo. 2011-116 (2004 amendments to section 1.6091-2 (d)(1), Income Tax Regs.
 - 34 -

may have changed what constitutes filing by hand). Petitioner, however conceded

that she failed to file Federal income tax returns or to pay any income tax.14 In

any event, respondent has met his burden of production under section 7491(c)

with respect to imposing the addition to tax under section 6651(a)(1) and

(2).

It is petitioner’s burden to prove that she had reasonable cause and lacked

willful neglect in not filing or paying timely. See United States v. Boyle, 469 U.S.

241, 245 (1985); Higbee v. Commissioner, 116 T.C. 438; sec. 301.6651-1(a)(2),

Proced. & Admin. Regs. Petitioner testified that she did not file or pay timely

because she “didn’t owe any tax” on the basis of her “running log” in “her head”,

and “then life took a turn for the worse”. The mistaken belief on the part of a

taxpayer that no return was required under the statute does not constitute reasonable

cause for noncompliance. Shomaker v. Commissioner, 38 T.C. 192, 202 (1962).

To prove reasonable cause for a failure to pay her tax liability, the taxpayer

must show that she exercised ordinary business care and prudence in providing for

14
Respondent prepared returns for petitioner meeting the requirements of sec.
6020(b). See sec. 301.6020-1(b)(2), Proced. & Admin. Regs. The returns made by
respondent under sec. 6020(b) are to be disregarded for purposes of sec. 6651(a)(1)
but treated as returns filed by petitioner for purposes of sec. 6651(a)(2). Sec.
6651(g).
 - 35 -

payment of her tax liability and nevertheless was either unable to pay the tax or

would suffer undue hardship if she paid the tax on the due date. Sec. 301.6651-

1(c)(1), Proced. & Admin. Regs. Although the Court believes that petitioner is

presently in financial difficulty, she lived far beyond her means during the years at

issue. She purchased a second residence, a rental property, and two investment

properties during the years at issue. A taxpayer who makes lavish or extravagant

purchases so that her assets and income will be insufficient to pay her taxes has not

exercised ordinary business care and prudence in providing for the payment of her

tax liability. Id.

Because petitioner failed to offer any evidence of reasonable cause and lack

of willful neglect for her failure to file or pay timely, respondent’s determination that

she is liable for the additions to tax under section 6651(a)(1) and (2) is sustained.

Section 6654(a) Addition to Tax

Section 6654 imposes an addition to tax for failure to make timely and

sufficient payments for estimated taxes. In order for respondent to satisfy his

burden of production under section 7491(c), he must produce evidence necessary to

enable the Court to conclude that petitioner had an obligation to make estimated tax

payments for 2002 through 2006. See Wheeler v. Commissioner, 127 T.C. 200,
 - 36 -

211 (2006), aff’d, 521 F.3d 1289 (10th Cir. 2008). Specifically, respondent must

produce evidence showing that petitioner had a “required annual payment” as

defined by section 6654(d)(1)(B) for 2002 through 2006. See id.

The section 6654 addition to tax is calculated with reference to four required

installment payments of the taxpayer’s estimated tax liability. Sec. 6654(c)(1).

Each required installment of estimated tax is equal to 25% of the “required annual

payment”. Sec. 6654(d)(1)(A).

Under section 6654(d)(1)(B), “required annual payment” means the lesser
of:

(i) 90 percent of the tax shown on the return for the taxable
year (or, if no return is filed, 90 percent of the tax for such year), or

(ii) 100 percent of the tax shown on the return of the individual
for the preceding taxable year.

Clause (ii) shall not apply if the preceding taxable year was not a taxable
year of 12 months or if the individual did not file a return for such
preceding taxable year.

Petitioner filed a return for 2001, and the Court has sufficient evidence to

make a determination with respect to 2002 under section 6654(d)(1)(B)(i). Because

petitioner had no tax liability for 2001, no addition to tax for failure to make

estimated income tax payments may be imposed on her for 2002. See sec.

6654(e)(2).
 - 37 -

Petitioner failed to file a return for 2002, 2003, 2004, 2005, or 2006.15 The

evidence is again sufficient for the Court to make the analysis required by section

6654(d)(1)(B)(i). Because of petitioner’s failure to file in the relevant years, her

required annual payment for 2003 through 2006 was 90% of the tax due for each of

those years. See sec. 6654(d)(1)(B)(i).

Petitioner for each of the years 2003 through 2006 failed to make a required

annual payment equal to 90% of the tax due. Accordingly, petitioner is liable for the

addition to tax under section 6654 for 2003, 2004, 2005, and 2006.

To reflect the foregoing,

Decision will be entered

under Rule 155.

15
Even if petitioner “filed” the returns she submitted to respondent’s counsel
in 2011 and the Court ignores her concession that she failed to file returns, the
returns will be disregarded for purposes of sec. 6654(d)(1)(B)(i). See Mendes v.
Commissioner, 121 T.C. 308, 325 (2003).