T.C. Memo. 2015-33
UNITED STATES TAX COURT
LEONARDO VILLEGAS, Petitioner v. COMMISSIONER OF
INTERNAL REVENUE, Respondent
GRACE VILLEGAS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 10600-12, 25070-13. Filed February 26, 2015.
Leonardo Villegas and Grace Villegas, pro sese.
Carolyn A. Schenck and Katherine Holmes Ankeny, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
NEGA, Judge: By separate notices, respondent determined deficiencies in
petitioners’ individual 2007 income tax and additions to tax as follows:1
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the year at issue. All Rule references are to the Tax
(continued...)
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[*2] Additions to tax
Sec. Sec. Sec.
Deficiency 6651(a)(1) 6651(a)(2) 6654(a)
Leonardo Villegas1 $132,912 $29,905 $33,228 $6,049
(Mr. Villegas)
Grace Villegas 134,008 30,152 33,502 6,099
(Mrs. Villegas)
1
Respondent originally determined a deficiency in Mr. Villegas’ income tax
of $187,146 and additions to tax totaling $91,797 for 2007. Respondent’s sub-
sequently revised position, shown above, reflects Mr. Villegas’ 50% community
property share in certain income items. Respondent prepared a second substitute
for return (SFR) to account for these changes.
After concessions, the issues for decision are: (1) whether petitioners are
entitled to exclude from gross income a portion of the gain realized from the sale
of their group home property in 2007; (2) whether petitioners are entitled to add
the cost of capital improvements to their basis in the group home property; (3)
whether petitioners are entitled to deduct expenses reported on Schedule C, Profit
or Loss from Business, of their 2007 tax returns for their group home business;
and (4) whether petitioners are liable for additions to tax for the 2007 tax year.2
1
(...continued)
Court Rules of Practice and Procedure. All monetary amounts are rounded to the
nearest dollar.
2
Petitioners’ self-employment tax is also at issue. Self-employment income
is subject to self-employment tax. Sec. 1401(a). A taxpayer’s self-employment
(continued...)
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[*3] FINDINGS OF FACT
Some of the facts have been deemed stipulated pursuant to Rule 91(f) by
reason of petitioners’ failure to respond to an order to show cause.3 The
stipulation of facts and the accompanying exhibits are incorporated herein by this
reference. Petitioners were married and resided in California, a community
property State, when their petitions were filed. Petitioners were both cash method
taxpayers for the year at issue. Their cases were consolidated for trial, briefing,
and decision.
In 1994 petitioners purchased a four-bedroom house in Diamond Bar,
California (Diamond Bar), for $200,000. The house included a kitchen, two
bathrooms, a living room, a family room, a garage, and an outdoor area with a
patio and a pool. That same year they decided to develop the Diamond Bar house
as a group home for the developmentally disabled and started doing business as
the L. Marillac Group Home (Marillac). Petitioners used the Diamond Bar house
2
(...continued)
income generally is equal to the gross income derived from business less any
business expenses which the taxpayer substantiates. Sec. 1402(a) and (b); sec.
1.1402(a)-1(a)(1), Income Tax Regs. Respondent’s determinations with respect to
petitioners’ self-employment tax and deductions are computational adjustments
that will be resolved by our decisions on the primary issues.
3
Proposed stipulations of fact were deemed established by the Court’s April
28, 2014, order.
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[*4] to accommodate and care for Marillac’s six clients. The clients used three
bedrooms, with two clients per bedroom. Petitioners used the fourth bedroom as
their office.
Marillac cared for its clients by attending to their personal hygiene,
providing meals, and organizing activities for them throughout the day. Marillac
was reimbursed for these services by the California Department of Health Care
Services (DHCS). In 2007 DHCS paid Marillac a total of $341,916 for its
services. That same year DHCS issued a Form 1099-MISC, Miscellaneous
Income, to Marillac to report its payments to petitioners in conjunction with these
services. Petitioners, as sole proprietors of Marillac, received this income.
On late-submitted returns for the 2007 tax year, petitioners reported total
expenses of $239,258 for Marillac on their respective Schedules C. This total
included, among other items, wage expenses of $89,621, repair and maintenance
expenses of $6,604, tax and license expenses of $12,010, home office expenses of
$25,708, and “other expenses” of $84,095. These “other expenses” included
$2,548 in “Bank Service Charges” and the same $6,604 for “Facility
Maintenance” that petitioners reported under repair and maintenance expenses.
Petitioners also deducted $2,083 for depreciation. To substantiate these expenses,
petitioners produced to respondent 636 pages of records including invoices, bank
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[*5] records, a payroll register, and receipts. The records contained information
pertaining to total taxable wages paid by Marillac to its employees, license fees
incurred by Marillac, and evidence that Marillac’s business bank accounts were
used at times for petitioners’ personal foreign travel. The records also contained a
summary spreadsheet of operating expenses by category for January through
November 2007. These categories, however, did not correspond to the categories
of expenses listed on petitioners’ 2007 tax returns, and petitioners did not explain
how this spreadsheet correlated with the expenses reported on their returns. The
other records produced to respondent did not contain useful information for
determining the amounts of petitioners’ remaining reported expenses.
In order to deduct home office expenses, petitioners claimed the Diamond
Bar house was their personal residence. Mrs. Villegas’ slept at the Diamond Bar
house from time to time, but petitioners did not live at the Diamond Bar house and
in fact lived at a house on Mulvane Street in La Puente, California (Mulvane),
with their three children, one nephew, and Mr. Villegas’ parents. Petitioners’
checks, bank records, payroll records, tax preparation documents, and children’s
school records indicated that they used the Mulvane address. Marillac’s former
bookkeeper also traveled to Mulvane to work on Marillac’s cost reports for DHCS
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[*6] with Mrs. Villegas. Another former employee went to Mulvane for social
gatherings with petitioners.
After receiving petitioners’ documentation, respondent reviewed this
integrated data retrieval system (IDRS) and compared it with the payroll register
and bank statements petitioners produced to reconcile the expenses they reported
on their tax returns. Through this analysis respondent determined that petitioners
could deduct only $57,392 in wage expenses and $5,605 in tax and license
expenses.
Petitioners claim they made numerous home improvements during the more-
than-10-year period they owned the Diamond Bar house to operate Marillac’s
group home. However, the only record of costs of improvements they submitted
was a two-page handwritten table listing various examples of improvements. On
the table, petitioners wrote amounts for costs next to improvements they thought
pertained to the Diamond Bar house with the respective years they incurred these
costs. No other evidence was provided to substantiate the amounts listed on this
document.
In 2007 petitioners sold the Diamond Bar house for $600,000, and they
received a Form 1099-S, Proceeds From Real Estate Transactions, from Coast City
Escrow reporting the sale. In order to exclude from gross income a portion of the
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[*7] gain from the sale under section 121, petitioners claimed the house was their
principal residence. Petitioners each excluded more than $250,000 of gain from
the sale on their separate returns for 2007.
In August of 2007 petitioners sold the Marillac group home business to their
former bookkeeper for $180,000. In 2008 petitioners received a Form 1099-
MISC, from the buyer reporting the sale of Marillac from the prior year.
Petitioners did not timely file returns for 2006 and 2007. The IRS prepared
substitutes for returns (SFRs) for 2007 based on information returns that it
received. In its calculations the IRS allowed a standard deduction for a single filer
and one exemption for each of petitioners’ returns. The IRS used the SFRs to
prepare petitioners’ notices of deficiency. After respondent mailed the notices of
deficiency, petitioners submitted returns for 2006 and 2007 and timely sought
redetermination in this Court.
OPINION
I. Petitioners’ Tax Liabilities
The Commissioner’s determinations in a notice of deficiency are generally
presumed correct, and the taxpayer bears the burden of proving those
determinations erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
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[*8] (1933). Petitioners do not contend, and the evidence does not establish, that
the burden of proof shifts to respondent under section 7491(a) as to any issue of
fact.
A. Petitioners’ Principal Residence
Section 121 excludes from gross income gain from the sale of a principal
residence. Generally, the property being sold must be a principal residence for an
aggregate of at least two years during the five-year period preceding the date of
the sale. A principal residence is “the primary dwelling or house that a taxpayer
occupied as his principal residence.” Gates v. Commissioner, 135 T.C. 1, 10
(2010). If taxpayers own two residences, they can satisfy the section 121
requirements with regard to only one. See sec. 1.121-1(b)(2), Income Tax Regs.
Petitioners did not live or reside at the Diamond Bar house at any time while
operating the Marillac group home at this site. First, none of Marillac’s employees
saw petitioners live at this address, and two former employees testified at trial that
petitioners lived on Mulvane. Second, none of the school records for petitioners’
children indicate that petitioners lived at the Diamond Bar address but instead
show that petitioners lived at Mulvane. Third, Mrs. Villegas’ sister told an IRS
agent that petitioners lived at Mulvane. Finally, we are not persuaded by Mrs.
Villegas’ claim that she stayed overnight at the Diamond Bar house because the
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[*9] room that Mrs. Villegas claimed to use as her bedroom was known to
Marillac employees as an office. Moreover, Mrs. Villegas’ credibility is
diminished by her testimony at trial and her conduct during a hearing with the
Court.
We conclude that under section 121 petitioners’ Diamond Bar house was
not petitioners’ principal residence for two of the five years preceding its sale. We
accordingly sustain respondent’s determination that the section 121 exclusion does
not apply.
B. Adjusted Basis in the Diamond Bar property
Generally, a taxpayer must recognize gain from the sale or exchange of
property. Sec. 1001(c); see also sec. 1.61-6(a), Income Tax Regs. (providing,
generally, that gain realized on the sale of property is included in gross income).
Section 1001(a) defines gain from the sale of property as the excess of the amount
realized on the sale of property over the adjusted basis of the property sold or
exchanged. Section 1011(a) provides that a taxpayer’s adjusted basis for
determining the gain from the sale or other disposition of property shall be its cost,
adjusted to the extent permitted by section 1016. See sec. 1016(a)(1); sec. 1.1016-
2(a), Income Tax Regs. (providing that the cost basis is increased by additional
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[*10] costs properly chargeable to capital account, including the cost of
improvements and betterments made to the property).
Petitioners purchased the Diamond Bar house in 1994 for $200,000, and this
is their cost basis in the property. Petitioners argue that they are entitled to an
increased basis in the property because of costs incurred for various improve-
ments. The only evidence petitioners offer to substantiate their costs for improve-
ments is their two-page table that generally lists various home improvements. The
table contains handwritten amounts next to those improvements pertaining to the
Diamond Bar property with the year each improvement was made. No other
documentation was submitted to substantiate costs of petitioners’ improvements or
to verify the amounts listed on the handwritten table. We hold that petitioners
have failed to establish that any of the handwritten amounts on their table were in
fact paid in connection with the Diamond Bar property. We accordingly find that
petitioners’ basis in the Diamond Bar property is their cost basis of $200,000.
C. Schedule C Expenses
Section 162(a) allows a taxpayer to deduct “all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or
business.” A necessary expense is one that is “appropriate and helpful” to the
taxpayer’s business; ordinary expenses are those that are common or frequent in
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[*11] the type of business in which the taxpayer is engaged. Deputy v. du Pont,
308 U.S. 488, 495 (1940); Welch v. Helvering, 290 U.S. at 113. Personal, living,
and family expenses are generally not deductible. Sec. 262.
Petitioners provided no credible evidence of any business expenses paid or
incurred during 2007 in excess of the amounts respondent conceded and allowed.
In an attempt to substantiate their expenses, petitioners submitted a disorganized
assortment of invoices, receipts, and bank records to respondent. Some of these
documents relate to personal expenses, such as foreign travel, instead of business
expenses, and many of the documents do not appear to correspond to the
categories of expenses listed on the table petitioners submitted as a summary of
their expenses. Petitioners admit that one category of expenses, “Repairs and
Maintenance”, was counted twice on their return. At trial petitioners failed to
clarify how the documents they produced related to their reported expenses or
establish that these expenses were in fact incurred. Petitioners ignored our
specific instructions to link their evidence to respondent’s adjustments. We need
not (and will not) undertake the task of sorting through the voluminous evidence
petitioners have provided in an attempt to see what is, and what is not, adequate
substantiation of the items on their returns. See Hale v. Commissioner, T.C.
Memo. 2010-229; Patterson v. Commissioner, T.C. Memo. 1979-362. Because
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[*12] petitioners failed to link the invoices, receipts, and bank records that they
produced with the amounts of expenses they reported, we hold that petitioners are
not entitled to any deduction for business expenses for the 2007 tax year beyond
the amounts respondent conceded and allowed.4
II. Additions to Tax
Respondent bears the burden of production for the additions to tax. See sec.
7491(c). Once respondent meets the burden of production, petitioners bear the
burden of proof, including the burden of proving reasonable cause for their late
payment or late filing. See Rule 142(a); Higbee v. Commissioner, 116 T.C. 438,
446-447 (2001).
A. Failure To Timely File a Tax Return
Section 6651(a)(1) provides for an addition to tax when a taxpayer fails to
file a return timely, unless the taxpayer proves that the failure was due to
reasonable cause and not due to willful neglect. Late filing of a return is due to
reasonable cause “[i]f the taxpayer exercised ordinary business care and prudence
and was nevertheless unable to file the return within the prescribed time.” Sec.
4
Petitioners also claimed $25,709 in home office expense deductions. As
we stated earlier, petitioners did not use the Diamond Bar property as their
principal residence. See sec. 280A. Therefore, we conclude that no home office
deduction is allowable.
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[*13] 301.6651-1(c)(1), Proced. & Admin. Regs. For each month or fraction
thereof for which such failure continues, section 6651(a)(1) adds 5% of the tax
required to be shown on such return, up to a maximum addition of 25%.
It was deemed stipulated that petitioners did not file timely returns for 2007,
but petitioners advance two explanations for their failure to file timely: (1) they
thought they owed no tax at the time and (2) they were confused as to when to
report income from the sale of Marillac because the buyer did not issue them a
Form 1099-MISC for the sale of the business until after the time to file had passed.
Further, Mr. Brown, petitioners’ accountant, whom they relied on in 2012 to
prepare and file their 2007 returns, claimed he needed additional time to gather
information about the cost basis of petitioners’ Diamond Bar property and the
expenses related to Marillac.
First, petitioners’ belief that returns for 2007, if prepared, would show no
payments due provides no justification for neglecting to prepare and file those
returns because petitioners’ gross income for 2007 far exceeded the threshold for
nonfilers. A taxpayer’s mistaken belief that he or she need not file a return is not
reasonable cause. See Henningsen v. Commissioner, 26 T.C. 528, 536 (1956),
aff’d, 243 F.2d 954 (4th Cir. 1957); Ruggeri v. Commissioner, T.C. Memo. 2008-
300.
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[*14] Second, petitioners’ assertion that the buyer’s late issuance of a Form 1099-
MISC pertaining to the sale of Marillac was somehow responsible for their failure
to timely file 2007 returns is both unconvincing and misguided. Although
petitioners did not receive a Form 1099-MISC from the buyer until 2008, the sale
of the business took place in 2007 and petitioners received money from the sale in
2007. As cash method taxpayers, petitioners had a responsibility to report this
income for 2007--the year they received it. Furthermore, in 2008 petitioners
received a Form 1099-MISC for income received from DHCS in 2007 and a Form
1099-S for the sale of the Diamond Bar property in 2007 and still neglected to
submit tax returns for 2007 before respondent prepared SFRs. Finally, petitioners’
reliance on Mr. Brown does not justify their failure to timely file. See, e.g., United
States v. Boyle, 469 U.S. 241, 252 (1985).
We hold that petitioners lacked reasonable cause for failing to file their
returns timely and accordingly sustain the section 6651(a)(1) additions to tax for
2007.
B. Failure To Timely Pay Tax
Section 6651(a)(2) provides for an addition to tax when a taxpayer fails to
timely pay the tax shown on a return, unless the taxpayer proves that the failure
was due to reasonable cause and not due to willful neglect. Reasonable cause for
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[*15] purposes of section 6651(a)(2) depends upon whether the taxpayer, notwith-
standing the exercise of ordinary business care and prudence, was in fact unable to
pay or would suffer undue hardship if payment were made. See Ruggeri v.
Commissioner, T.C. Memo. 2008-300.
A substitute for return prepared by the IRS pursuant to section 6020(b) is
treated as the “return” filed by the taxpayer for purposes of section 6651(a)(2).
See sec. 6651(g). For each month or fraction thereof for which a failure to pay
continues, section 6651(a)(2) adds 0.5% of the amount shown as tax on the return
but not paid, up to a maximum addition of 25%.
It was deemed stipulated that petitioners did not file their 2007 returns
timely. Respondent prepared SFRs for 2007 that met the requirements of section
6020(b), and petitioners did not pay the amounts shown as due. See sec. 6651(g);
Cabirac v. Commissioner, 120 T.C. 163, 170-173 (2003). Petitioners assert that
their failure to pay was due to reasonable cause, and the excuses they offer for late
payment are the same excuses they offered for late filing. Petitioners offered no
evidence to show that they were unable to timely pay their tax liabilities or would
suffer undue hardship if they did. We accordingly sustain respondent’s
determinations with respect to the section 6651(a)(2) additions to tax for 2007.
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[*16] C. Failure To Pay Estimated Tax
Respondent also determined that petitioners are liable for additions to tax
for failure to pay estimated tax under section 6654. Section 6654 imposes an
addition to tax on an individual who underpays his estimated tax.5 The addition to
tax is calculated with reference to four required installment payments of the
taxpayer’s estimated tax liability. Sec. 6654(c) and (d). In general, each required
installment of estimated tax is equal to 25% of the “required annual payment”.
Sec. 6654(d). A taxpayer has an obligation to pay estimated tax only if he has a
“required annual payment”. Wheeler v. Commissioner, 127 T.C. 200, 212 (2006),
aff’d, 521 F.3d 1289 (10th Cir. 2008); see also Mendes v. Commissioner, 121 T.C.
308, 324 (2003). The “required annual payment” is equal to the lesser of (1) 90%
of the tax shown on the taxpayer’s return for that year (or, if no return is filed,
90% of his or her tax for such year) or (2) 100% of the tax shown on the
taxpayer’s return for the immediately preceding taxable year. Sec. 6654(d)(1)(A)
and (B). Returns submitted after the IRS has issued a notice of deficiency for a
5
Unless a statutory exception applies, the sec. 6654(a) addition to tax is
mandatory. See sec. 6654(a), (e); Recklitis v. Commissioner, 91 T.C. 874, 913
(1988). Sec. 6654 does not contain a general exception for reasonable cause or
absence of willful neglect. See Grosshandler v. Commissioner, 75 T.C. 1, 21
(1980). Petitioners do not contend that any of the statutory exceptions under sec.
6654(e) is applicable.
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[*17] particular year are not considered filed returns for purposes of section
6654(d)(1)(B)(i) and (ii). See Mendes v. Commissioner, 121 T.C. at 324-325;
Wolfgram v. Commissioner, T.C. Memo. 2010-69; Lenihan v. Commissioner, T.C.
Memo. 2006-259.
It was deemed stipulated that petitioners did not timely file Federal income
tax returns for 2006 and 2007. Although petitioners eventually submitted returns
for the 2006 and 2007 tax years, we disregard these returns for the purposes of
section 6654 because they were submitted after respondent mailed a notice of
deficiency for the 2007 tax year to each petitioner. Mendes v. Commissioner, 121
T.C. at 324-325. Respondent produced sufficient evidence to demonstrate that
petitioners had required annual payments for 2007 equal to 90% of their tax for
the year, that petitioners did not make any estimated tax payments for 2007, and
that petitioners are liable for their respective section 6654 additions to tax for
2007. Accordingly, we hold that petitioners are liable for the section 6654(a)
additions to tax for 2007. See sec. 6654(e)(1).
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[*18] We have considered all the other arguments made by the parties, and to the
extent not discussed above, find those arguments to be irrelevant, moot, or without
merit.
To reflect the foregoing,
Decisions will be entered
under Rule 155.