T.C. Memo. 2017-196
UNITED STATES TAX COURT
BRENDA K. SMILING AND A. MARK SMILING, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 18487-14. Filed October 3, 2017.
Edith Faye Moates, for petitioners.
G. Chad Barton, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARIS, Judge: With respect to petitioners’ Federal income tax for 2009, the
Internal Revenue Service (IRS or respondent) determined a deficiency of $24,251
and an accuracy-related penalty under section 6662(a) of $4,850.20.1 After
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the tax year at issue, and all Rule references are to the
(continued...)
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[*2] concessions,2 the issues remaining for decision are whether petitioners are:
(1) entitled to deduct settlement expenses of $331,455 reported on their Schedule
C, Profit or Loss from Business, or the additional settlement expenses of $168,900
asserted in their petition, (2) entitled to deduct legal and professional services
expenses in excess of the $49,549 respondent allowed, and (3) liable for the
accuracy-related penalty under section 6662(a). With one minor exception, the
Court resolves all issues in favor of respondent.
FINDINGS OF FACT
Some of the facts were stipulated and are so found. The first stipulation of
facts, the first supplemental stipulation of facts, and the respective accompanying
1
(...continued)
Tax Court Rules of Practice and Procedure.
2
Petitioners conceded the Schedule C reconciliation adjustment of $853, the
Schedule C wage adjustment of $30,007, the Schedule C taxes and license
adjustment of $2,510, and the Schedule C gross receipts adjustment of $107,366.
The parties agree that, for the purposes of computing self-employment tax, the
self-employment income on page 15 of the notice of deficiency should be
decreased by $154,988, as set forth in more detail in the stipulation of facts.
-3-
[*3] exhibits are incorporated by this reference.3 Petitioners resided in Oklahoma
when they timely petitioned this Court.
A. Mark Smiling (petitioner) is an experienced attorney and litigator, having
practiced law in Oklahoma for more than 30 years. He operates his law practice as
A. Mark Smiling, PLLC, offering representation in many areas of the law. Neither
petitioner nor any of the other attorneys in his law firm practice in the area of tax
law.
Petitioners’ Claimed Settlement Expense Deduction
The settlement expenses petitioners reported on their joint 2009 Form 1040,
U.S. Individual Income Tax Return, relate to an assignment of claim granted in a
divorce decree by the District Court of Tulsa County (divorce court) in 2009. The
underlying divorce proceedings, however, began as separation proceedings
between Drs. Lewis and Moon4 in 2005.5 It is helpful to begin with petitioner’s
3
Following the trial, the Court left the record open for petitioners to
introduce evidence of checks not in the record that were returned to Dr. Moon.
The parties filed a second supplemental stipulation of facts with attached exhibits.
Respondent objected to the admission of the exhibits, and petitioners “have no
problem with * * * [the exhibits’] not being admitted into evidence because they
are not in support of petitioners’ position on any issue before the Court.”
Accordingly, the Court sustains respondent’s objections with respect to the second
supplemental stipulation of facts.
4
Although Dr. Moon has multiple aliases, for consistency and simplicity, the
(continued...)
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[*4] involvement in Dr. Moon’s conflict to understand why the divorce court
awarded a claim of right against petitioner to Dr. Lewis (Dr. Moon’s former
spouse) and why petitioner’s settlement of that claim was deducted as a Schedule
C business expense.
In an effort to explain his financial relationship with Dr. Moon, petitioner
offered his testimony and limited documentary evidence. His documentary
evidence consisted of his IOLTA6 account statements for January and February of
2006, canceled checks, promissory notes, and receipts for funds received. Other
than petitioner’s testimony and selected divorce court records, there is no evidence
to support petitioner’s recitation of the financial trail of fund transfers between Dr.
Moon and petitioner.
Dr. Moon was an oncologist, licensed to practice medicine in the State of
Tennessee. Petitioner thought he first met Dr. Moon in the fall of 2005 to discuss
her potential investment in a business he owned. On December 12, 2005, Dr.
4
(...continued)
Court will refer to her only as Dr. Moon.
5
The separation proceedings were converted into divorce proceedings on
February 1, 2006. Because petitioner represented Dr. Moon through May 26,
2006--and for simplicity--the Court will refer to that case as the divorce
proceedings.
6
An IOLTA is a lawyer trust account for client funds held for short periods.
-5-
[*5] Moon was convicted of Federal crimes associated with her dilution of life-
saving cancer drugs.7 Her then husband, Dr. Lewis, filed for separation on
December 16, 2005.
Sometime thereafter, Dr. Moon met with petitioner. During this meeting,
Dr. Moon requested that petitioner represent her in the divorce proceedings and in
proceedings before the Tennessee Board of Medical Examiners with respect to her
medical license. Although petitioner is not licensed to practice law in the State of
Tennessee, on December 22, 2005, he accepted a $200,000 retainer from Dr.
Moon for the medical-license-related representation. Petitioner also agreed to
represent Dr. Moon in the divorce proceedings. In addition petitioner accepted
cashier’s checks from Dr. Moon, the proceeds of which were to be used to invest
in a medical business he owned, Advantage Diagnostic & MRI, LLC (Advantage
Diagnostic), to purchase a PET scanner.8
7
The Court takes judicial notice of the docket entries in United States v.
Moon, No. 2:05-cr3 (M.D. Tenn. filed Mar. 2, 2005). See Fed. R. Evid. 201(a),
(c); Reyn’s Pasta Bella, LLC v. Visa USA, Inc., 442 F.3d 741, 746 n.6 (9th Cir.
2006) (stating that the court “may take judicial notice of court filings and other
matters of public record”); United States v. Harris, 331 F.2d 600, 601 (6th Cir.
1964) (explaining that a court may take judicial notice sua sponte).
8
Petitioner formed Advantage Diagnostic on March 21, 2005. During the
year at issue, petitioner owned 80% of Advantage Diagnostic. A positron
emission tomography or PET scanner is a nuclear medicine imaging device that
(continued...)
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[*6] The retainer and the investment came in the form of two checks and cash.
The checks totaled $306,000 and were received on December 22, 2005: one was
written for $103,517.91, the other for $202,482.09. Petitioner also received
$164,000 in cash from Dr. Moon the following day. Petitioner deposited the
checks into his IOLTA, keeping $200,000 in that account as a retainer for his
future representation of Dr. Moon in the Tennessee medical-license-related
proceeding, and writing a $106,000 check to Advantage Diagnostic.9 The same
day petitioner signed a receipt and a promissory note for $270,000--accounting for
$106,000 from the checks received on December 22 and $164,000 in cash
received on December 23--and promised to repay with interest this amount in
monthly installment payments beginning in February 2006.10
8
(...continued)
produces three-dimensional images.
9
Petitioner testified both that the $106,000 was invested in Advantage
Diagnostic and that $2,482.09 of the $202,482.09 check was payment for his
services in Dr. Moon’s divorce proceedings. There is no evidence of $2,482.09
being paid from petitioner’s IOLTA to his firm’s operating account.
10
There is no record that petitioner or Advantage Diagnostic made any of
these required installment payments. Petitioner repaid the $200,000 retainer to the
divorce court on June 30, 2006, and he--rather than Advantage Diagnostic--repaid
$103,517.91 to the divorce court on March 13, 2007.
-7-
[*7] On January 19, 2006, petitioner received a cash deposit of $60,000 from Dr.
Moon. This time he prepared a receipt acknowledging that he was holding the
cash until she directed him where to put the funds. There is no record of deposit,
investment, or use of these funds.
On January 27, 2006, petitioner received a $300,000 cashier’s check from
Dr. Moon for investment in a carwash. He deposited this check into his IOLTA
and promptly wrote a new check to TWB, LLC, the entity created to own and
operate the carwash.11
On February 27, 2006, petitioner received from Dr. Moon “$62,500 cash
and $107,500 * * * for loan for imaging center”. On March 7, 2006, petitioner
received $90,000 from Dr. Moon “to be invested or used as Mr. Smiling deems
appropriate.” On March 12, 2006, petitioner received from Dr. Moon “$200,000
checks and $110,000 cash to be invested or used as Mark Smiling deems
11
Petitioner owned 5% of TWB. TWB repaid the $300,000 to the divorce
court on August 28, 2007.
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[*8] appropriate.”12 There is no record of deposit, investment, or use of any of
these funds.
Collectively, between December 22, 2005, and March 12, 2006, petitioner
received $1.4 million from Dr. Moon.13 Soon after, on March 15, 2006, in his
capacity as Dr. Moon’s divorce attorney, petitioner defended Dr. Moon in a
deposition where she was accused of hiding assets from Dr. Lewis.14
On April 11, 2006, petitioner completed and signed a life insurance change
of beneficiary form he had requested from his insurance agent. The witnessed
form listed petitioner’s relationship with Dr. Moon as business partners and
designated Dr. Moon as beneficiary of a life insurance policy on petitioner of $1.4
12
Petitioner suggested that by this time Dr. Moon had decided not to pursue
the proceeding related to her medical license. This might be true; Dr. Moon,
represented by counsel other than petitioner, filed an agreed order with the
Tennessee Board of Medical Examiners on March 15, 2006, agreeing to the
revocation of her medical license. Petitioner also suggested that he returned the
$200,000 retainer and that the “$200,000 checks” was that same amount. The
Court finds that the record does not support his explanation as credible.
13
Although the divorce court found that petitioner received “at a minimum”
$1.4 million, the record in this case supports this Court’s finding that he received
exactly $1.4 million.
14
The decree of dissolution of marriage set forth the divorce court’s findings
that Dr. Moon pursued a malicious, fraudulent, and deceitful scheme designed to
deny Dr. Lewis his right to an equitable division of the marital assets.
-9-
[*9] million with proceeds payable upon his death.15 Petitioner and Dr. Moon also
executed a document titled “Modification of Agreement”, pursuant to which
petitioner promised to repay a loan of $1.1 million with interest over the course of
five years.16 This document, signed by both petitioner and Dr. Moon, was
accompanied by a mortgage securing the entire loan amount. The mortgage was
collateralized by property owned by petitioner and signed by both petitioner and
Dr. Moon, and their signatures were notarized.17
On April 18, 2006, petitioner filed with the divorce court an application to
withdraw from his representation of Dr. Moon; that application was granted on
15
This form lists petitioner and Dr. Moon as business partners, ostensibly
covering the transfers of funds occurring between December 22, 2005, and March
12, 2006. And petitioner represented Dr. Moon in the divorce proceedings until
his April 18, 2006, application to withdraw was granted on May 26, 2006. Rule
1.8(a) of the Oklahoma Rules of Professional Conduct prohibits business
transactions between an attorney and his client without the client’s properly
waiving their conflict of interest. Nothing in the record suggests that Dr. Moon
waived the conflict; the Court finds that petitioner and Dr. Moon were not
business partners.
16
The balance after $300,000 was given directly to TWB was $1.1 million.
17
Dr. Moon mailed copies of these documents to herself later that day. The
envelope containing these copies was found inside a storage locker rented on
behalf of Dr. Moon. The envelope was addressed to Advantage Diagnostic’s
mailbox, physically located at Hunter’s Glen Self Storage. Hunter’s Glen Self
Storage was owned by GTB Properties, which was owned by petitioner.
Excepting the facility manager, petitioner had the only key to the mailbox.
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[*10] May 26, 2006. Between then and June 30, 2006, petitioner terminated his
legal representation of Dr. Moon and returned her legal file without first making
copies of any of the documents therein.18 There is no evidence that petitioner
returned any funds to Dr. Moon other than those paid to the divorce court.19
With respect to the funds petitioner received from Dr. Moon, upon the order
of the divorce court he paid into the court on June 30, 2006, the initial retainer of
$200,000 and on March 13, 2007, $103,517.91 of Dr. Moon’s Advantage
Diagnostic investment. TWB paid to the divorce court the $300,000 it received.
Of the remaining $796,482.09,20 petitioner paid to the divorce court $300,000 on
April 30, 2007. This left $496,482.09 petitioner had previously received from Dr.
Moon unaccounted for.
18
Petitioner testified that the change of beneficiary form, the Modification of
Agreement, and the mortgage were all “pro forma” without adequate explanation.
His testimony was not persuasive. Each of the three documents was fully
executed.
19
Petitioner wrote receipts for the large sums of money received from Dr.
Moon. His testimony that he returned these large sums of cash and checks to Dr.
Moon and failed to document their return is not credible.
20
This amount comprised $396,500 in cash ($60,000 + $164,000 + $62,500
+ $110,000), $202,482.09 in checks ($2,482.09 + $200,000), and $197,500 of
other funds ($107,500 + $90,000).
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[*11] In its lengthy and deliberative factual division of the marital assets of Drs.
Lewis and Moon, the divorce court treated as assets Dr. Moon’s rights under the
April 11, 2006, modification of agreement and mortgage, noting in its decree of
dissolution of marriage that “Mr. Smiling has testified that he does not owe any
obligation under these agreements-- * * * [Dr.] Lewis should be permitted to test
that assertion.” The divorce court awarded to Dr. Lewis “[a]ny and all rights or
claims to recover funds held or deposited by Young Moon with Mark Smiling”.
On November 20, 2009, petitioner entered into a settlement agreement with
Dr. Lewis on behalf of himself; A. Mark Smiling, PLLC; Smiling Bender &
Rounds, P.A.; “any other law firm with whom Mr. Smiling has also affiliated”;
Hunter’s Glen Self Storage; and all of the listed entities’ employees, attorneys, and
paralegals. Although petitioner’s position was that the obligation documents
assigned in the decree were merely pro forma, pursuant to the settlement
agreement petitioner paid Dr. Lewis a total of $500,000 as follows: $31,100 on
September 25, 2009; $168,900 on September 25, 2009; and $300,000 on
November 13, 2009. The settlement released the above-listed individuals and
entities from liability for a number of things
[i]ncluding all claims or rights reserved in the Agreement dated
January 15 and 16, 2009 * * * including, without limitation, Lewis’
rights awarded him under paragraph 16 at page 27 of the Decree of
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[*12] Dissolution of Marriage, filed August 11, 2009, * * * this
Settlement Agreement and Release settles and satisfies any
contractual claims Lewis has or was awarded against Smiling * * *
and as to any marital cash or other holdings which may have been
placed in the possession of Smiling by * * * Moon.
In preparation of petitioners’ 2009 Form 1040,21 petitioner gave his
accountant copies of the $31,100 and $300,000 checks, telling his accountant only
that the amounts were for the “protection of the reputation and integrity of the law
business”. The facts relating to Drs. Lewis and Moon were not shared with the
accountant. The accountant concluded that the settlement expenses were
deductible as ordinary and necessary business expenses of petitioner’s business as
an attorney and relied on Jenkins v. Commissioner, T.C. Memo. 1983-667, for his
conclusion.
Petitioner’s Legal Expenses
At some point a complaint was filed against petitioner with the Oklahoma
Bar Association. Petitioner hired an attorney to represent him before the bar
association. As a result of the services rendered by petitioner’s attorney, petitioner
21
Petitioners used the services of an accountant and a CPA. Petitioner
provided expense-related documentation to his accountant, who compiled various
schedules of expenses. The accountant gave the schedules to petitioner’s CPA,
who used them to prepare petitioners’ 2009 Form 1040.
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[*13] received invoices, and he made payments with respect to those invoices.22
Petitioner showed those checks to his accountant, but the canceled checks are not
part of this record.
Notice of Deficiency
In the notice of deficiency respondent disallowed the entirety of petitioners’
claimed Schedule C settlement expense deduction--$331,455. The Schedule C
expenses omitted $168,900 previously paid to Dr. Lewis on September 25, 2009.
(Respondent opposes this claim for a deduction for additional settlement expenses
of $168,900.) Petitioners also claimed legal and professional fee expenses of
$69,830. Respondent disallowed $20,281, which petitioner claims is the amount
paid to his attorney with respect to the Oklahoma Bar Association complaint.
OPINION
The Commissioner’s determinations in a notice of deficiency are generally
presumed correct, and the taxpayers bear the burden of proving those
determinations erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933). Deductions are a matter of legislative grace. The taxpayers bear the
burden of proving that reported business expenses were actually paid and were
22
Petitioner’s attorney did not testify in this case. Instead, petitioner
introduced an affidavit dated March 17, 2014. The petition in this case was not
filed with the Court until August 2014.
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[*14] “ordinary and necessary”. Sec. 162(a); Rule 142(a). Necessary expenses are
those that are “appropriate and helpful” to the taxpayers’ business; ordinary
expenses are those that are common or frequent in 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.
The taxpayers also bear the burden of substantiating the expenses
underlying their claimed deductions by keeping and producing records sufficient
to enable the Commissioner to determine the correct tax liability.23 Sec. 6001;
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a), (e),
Income Tax Regs. The failure to keep and present accurate records counts heavily
against the taxpayers’ attempted proof. Rogers v. Commissioner, T.C. Memo.
2014-141, at *17.
In the event that the taxpayers establish that they paid a deductible expense
but are unable to substantiate the precise amount, the Court may approximate the
amount of the deduction, bearing heavily against the taxpayers whose inexactitude
is of their own making. Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930). The
Court must, however, have evidence sufficient to provide a basis upon which
23
Petitioners do not contend, and the evidence does not establish, that the
burden of proof shifts to respondent under sec. 7491(a) as to any issue of fact.
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[*15] an estimate can be made. Vanicek v. Commissioner, 85 T.C. 731, 742-743
(1985).
There is no doubt that petitioner carried on a business and incurred expenses
pertaining to it during 2009. But petitioners must show that the reported expenses
were ordinary and necessary expenses to that business; they must also substantiate
their expenses. The Court summarizes its findings in the following paragraphs.
A. Settlement-Agreement-Related Expenses
Petitioners argue that the settlement payments were made to protect Mr.
Smiling’s professional reputation and his ability to represent some of his current
clients, who require that he maintain a certain professional rating. Petitioners
contend that because Mr. Smiling made the settlement payments to Dr. Lewis, they
could not have been repayments. Respondent disagrees, arguing that the
settlement expenses were merely a repayment of Dr. Moon’s funds received by
petitioner. The Court agrees with respondent.
Petitioners are correct that an amount paid for protection of one’s
professional reputation can be an ordinary and necessary expense. See Milbank v.
Commissioner, 51 T.C. 805, 818 (1969). However, it is a non sequitur to jump to
a conclusion regarding whether the $500,000 paid to Dr. Lewis pursuant to the
settlement agreement was a repayment. Generally “[d]eductions are not permitted
- 16 -
[*16] on account of the repayment of loans.” Crawford v. Commissioner, 11
B.T.A. 1299, 1302 (1928). But outside the framework of bona fide loans,
repayments can--in limited circumstances--be deductible. See, e.g., Jenkins v.
Commissioner, T.C. Memo. 1983-667 (addressing the deductibility of payments
made by a taxpayer on behalf of another person for amounts the taxpayer was not
obligated to repay). As a prerequisite to deducting repayments to customers,
taxpayers bear the burden of proving that the amounts repaid were reported as
income. See Patel v. Commissioner, T.C. Memo. 2012-9.
Petitioner received $1.4 million from Dr. Moon.24 Petitioners have not
shown or suggested that they reported any of this money as income. Petitioners
have shown, however, that petitioner paid $300,000 directly to TWB and that
TWB repaid those funds to the divorce court. What is left to evaluate is the
remaining $1.1 million petitioner received.
It was not a coincidence that on the same day petitioner completed the
change of beneficiary form, he and Dr. Moon executed two other documents. The
first was a modification of agreement, pursuant to which petitioner agreed to repay
a loan of $1.1 million with interest over the course of five years. This document
24
Petitioner properly completed a change of life insurance beneficiary form
in that exact amount, had his and Dr. Moon’s signatures witnessed, and gave the
only copies to Dr. Moon.
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[*17] was accompanied by a notarized mortgage, securing the entire loan amount,
and collateralized by property petitioner owned.
Petitioners suggest that these documents were merely pro forma--they were
mock documents not intended to be enforceable.25 They further suggest that all of
the remaining funds received from Dr. Moon were repaid--either directly to Dr.
Moon or through the divorce court. But they ask this Court to find as fact that
petitioner, a seasoned and knowledgeable attorney, prepared and executed
“pretend” documents which, if filed, would actually make him liable to Dr. Moon
for $1.1 million; they ask the Court to find that notwithstanding this fact,
petitioner gave to Dr. Moon every copy of these documents and retained no
records whatsoever; and they ask the Court to find that when returning hundreds
of thousands of dollars to Dr. Moon, petitioner neither prepared nor requested
receipts of any kind.
These explanations are incredible. It cannot be coincidence that the funds
under petitioner’s control and the amount of indebtedness listed in the
modification of agreement and mortgage are identical--$1.1 million. Of this
amount, petitioner paid $603,517.91 to the divorce court, leaving $496,482.09
25
To support this assertion, petitioner testified that the property securing the
mortgage was worth only $6,000, but he offered no support for this valuation.
- 18 -
[*18] unaccounted for. The divorce court recognized this fact and awarded Dr.
Moon’s right to sue petitioner for the $496,482.09 balance to Dr. Lewis. Rather
than attempt to prove that the modification of agreement and mortgage were pro
forma or worthless, petitioner decided to settle the issue privately with Dr. Lewis.
The settlement agreement contains plenty of legalese and formal boilerplate,
but it is easy to connect the settlement amount of $500,000 with the unaccounted-
for $496,482.09.26 Petitioners suggest that because the funds belonged to Dr.
Moon, the payments to Dr. Lewis could not be a “repayment”. This semantic
argument fails because the funds were actually repaid as modified by the divorce
court in the equitable distribution of marital assets. Accordingly, $496,482.09 was
clearly a repayment that is not deductible. The remaining $3,517.91 of the
settlement payments might have been an ordinary and necessary business expense
for protecting his reputation, but petitioner failed to show whether and to what
26
There is no record of interest being paid with respect to the promissory
note from Advantage Diagnostic or with respect to the modification of agreement
between 2005 when the funds were placed under petitioner’s control and 2009
when petitioner gave them to Dr. Lewis.
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[*19] extent he was entitled to deduct any of that amount.27 The balance is not
deductible either.
Petitioners have further failed to explain or substantiate in any way the
remaining $355 of reported settlement expenses.28 Accordingly, respondent’s
disallowance of petitioners’ 2009 claimed settlement expense deduction is
sustained; petitioners’ request for additional settlement expense deductions is
denied.
B. Legal Fees
Irrespective of whether petitioner’s legal fees were ordinary and necessary,
those expenses--to be deductible--must have been paid during the year in issue,
and they must be properly substantiated. For 2009 petitioner reported on the
Schedule C legal and professional fees of $69,830; respondent disallowed any
deduction for $20,281 of that amount.
27
The settlement agreement includes the rights of petitioner; A. Mark
Smiling, PLLC; Smiling Bender & Rounds, P.A.; “any other law firm with whom
Mr. Smiling has also affiliated”; Hunter’s Glen Self Storage; and all of the listed
entities’ employees, attorneys, and paralegals.
28
Petitioners claimed deductions of $331,455 on their 2009 Form 1040; they
claim additional deductions of $168,900 in their petition, which represents one of
the settlement payments made by petitioner. But the sum of these amounts--
$500,355--exceeds the total paid to Dr. Lewis by $355.
- 20 -
[*20] Petitioner credibly testified that he incurred legal fees as a result of a
complaint filed against him with the Oklahoma Bar Association. The record
includes an affidavit from his attorney corroborating the existence and scope of
their relationship. It states in pertinent part: “All invoices submitted by my office
and payments made by A. Mark Smiling, PLLC, were for professional services
rendered in connection with Mr. Smiling maintaining his practice of law and
operation of his law firm, A. Mark Smiling, PLLC.” Conspicuously missing are
details surrounding the timing and amounts of those invoices and payments. Also
absent from the record in this case are the invoices, the canceled checks,
accounting records relating to these amounts, and bank statements of petitioner’s
law firm.29
Petitioners suggest that showing canceled checks to their accountant, who
provided a summary schedule to their tax return preparer, is sufficient to
substantiate the amounts paid for the disallowed portion of the deduction for legal
fees. They are incorrect. A trial before this Court is a proceeding de novo; the
determination of petitioners’ tax liability must be based on the record before this
Court and not on any records used at the administrative level. Davis v.
29
The record contains only two bank statements. Both are of petitioner’s
IOLTA account; neither is for the year at issue.
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[*21] Commissioner, 65 T.C. 1014, 1022 (1976). And whether petitioners
provided documents to their accountant to prepare their tax return is immaterial.
Missing from the record in this case are any books and records containing mention
of these legal fees, copies of canceled checks, or any other specific reference to
dates and amounts paid with respect to petitioner’s representation before the
Oklahoma Bar Association.
Since the record includes no corroboration of the amounts or dates of
payment of petitioner’s legal expenses, the Court finds that petitioner’s
uncorroborated testimony is insufficient to substantiate the $20,281 respondent
disallowed.30 See Higbee v. Commissioner, 116 T.C. 438, 445 (2001).
C. Penalty
The Code imposes a 20% penalty on the portion of any underpayment of tax
attributable to “[n]egligence or disregard of rules and regulations” or “[a]ny
substantial understatement of income tax.” Sec. 6662(a) and (b)(1) and (2).
Negligence includes “any failure to make a reasonable attempt to comply” with the
internal revenue laws. Sec. 6662(c). An understatement of income tax is
“substantial” if it exceeds the greater of $5,000 or 10% of the tax required to be
30
Even with the Cohan rule, petitioners have provided no evidence upon
which to approximate allowable expenses beyond the amount respondent allowed.
See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930).
- 22 -
[*22] shown on the return. Sec. 6662(d)(1)(A). Under section 7491(c), the
Commissioner bears the burden of production with respect to the liability for any
penalty. See Higbee v. Commissioner, 116 T.C. at 446. Once the Commissioner
satisfies his burden, the burden shifts to the taxpayers to prove that the penalty
does not apply. Id. at 447.
Respondent met his burden of production for the substantial understatement
penalty31 here by showing that petitioners (1) claimed a deduction for settlement
expenses to which they were not entitled and (2) were unable to substantiate the
legal expenses underlying the disallowed deduction.32 The burden of proof thus
shifts to petitioners.
31
Although respondent asserted negligence in the alternative, the Court need
not address it with respect to the settlement expenses. Respondent did not make a
negligence argument with respect to the claimed deduction for legal fees. That
argument is deemed conceded. See Mendes v. Commissioner, 121 T.C. 308,
312-313 (2003) (holding that arguments not addressed in posttrial brief may be
considered abandoned); Leahy v. Commissioner, 87 T.C. 56, 73-74 (1986)
(finding concession by failure to argue).
32
With respect to the amounts petitioners conceded, see supra note 2,
respondent has also met his burden of production. Petitioners do not address the
portion of the sec. 6662 penalty attributable to these amounts. That argument is
deemed conceded. See Mendes v. Commissioner, 121 T.C. at 312-313 (holding
that arguments not addressed in posttrial brief may be considered abandoned);
Leahy v. Commissioner, 87 T.C. at 73-74 (finding concession by failure to argue).
Therefore the sec. 6662 penalty applies to the portion of petitioners’ underpayment
attributable to these concessions.
- 23 -
[*23] The section 6662 penalty does not apply to any portion of an underpayment
if the taxpayers acted with reasonable cause and in good faith with respect thereto.
The taxpayers bear the burden of proving reasonable cause and good faith. Id. at
444-447. The decision whether the taxpayers acted with reasonable cause and in
good faith is made on a case-by-case basis, taking into account all pertinent facts
and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Reasonable cause and
good faith can be shown by reasonable, good-faith reliance on the advice of a
qualified tax professional. See id. But generally, the most important factor is the
taxpayer’s effort to assess his or her correct tax liability; other factors include the
taxpayer’s experience, knowledge, and education. Id.
In determining whether a taxpayer reasonably relied on professional advice
for this purpose, the Court applies a three-prong test which asks whether: (1) the
adviser was a competent professional who had sufficient expertise to justify the
reliance;33 (2) the taxpayer provided necessary and accurate information to the
adviser; and (3) the taxpayer actually relied in good faith on the adviser’s
judgment. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000),
33
Respondent did not dispute the qualifications of petitioners’ accountant.
This issue is deemed conceded. See Mendes v. Commissioner, 121 T.C. at
312-313 (holding that arguments not addressed in post-trial brief may be
considered abandoned); Leahy v. Commissioner, 87 T.C. at 73-74 (finding
concession by failure to argue).
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[*24] aff’d, 299 F.3d 221 (3d Cir. 2002); Van der Lee v. Commissioner, T.C.
Memo. 2011-234, slip op. at 33 (citing Neonatology’s test and finding that the
taxpayers “failed to provide * * * [their accountant] with all relevant information”
necessary to accurately report their charitable contributions), aff’d, 501 F. App’x
30 (2d Cir. 2012). Reliance on professional advice may constitute reasonable
cause and good faith, but “it must be established that the reliance was reasonable.”
Freytag v. Commissioner, 89 T.C. 849, 888 (1987), aff’d on another issue, 904
F.2d 1011 (5th Cir. 1990), aff’d, 501 U.S. 868 (1991).
Petitioners argue that they reasonably relied on their accountant to prepare
the schedules for their CPA, who prepared their return for the year in issue and
that this reliance constitutes reasonable cause and good faith.34 As it relates to the
34
Petitioners argue in the alternative that they made adequate disclosure of
the settlement expenses by claiming the deduction on their Schedule C. To satisfy
the adequate disclosure standard of sec. 6662(d)(2)(B)(ii), taxpayers must disclose
the relevant facts on a properly completed form attached to the return or to a
qualified amended return. Sec. 1.6662-4(f)(1), Income Tax Regs. For disclosure
to be adequate, it “must be sufficiently detailed to alert the Commissioner and his
agents as to the nature of the transaction so that the decision as to whether to select
the return for audit may be a reasonably informed one.” Estate of Fry v.
Commissioner, 88 T.C. 1020, 1023 (1987). Although adequacy of disclosure is
judged using a reasonable person standard, Highwood Partners v. Commissioner,
133 T.C. 1, 21-22 (2009), petitioners did nothing more than report the settlement
expenses on their Schedule C. This does not rise to the level of adequately
apprising the Commissioner of the nature of the settlement. See id. at 21 (“The
disclosure must be more substantial than providing a clue that would intrigue the
(continued...)
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[*25] reported settlement expenses, their argument fails because there is no
credible evidence in the record that petitioners provided to their accountant
documents relating to Dr. Moon’s divorce, the receipts and promissory notes, or
the information underlying any of these documents. With respect to the reported
legal expenses, the Court finds that petitioners have shown reasonable cause and
good faith. These conclusions are discussed in more detail below.
Although preparation of a taxpayer’s return by an accountant does not
provide absolute protection against substantial understatement or negligence
penalties, in some circumstances a taxpayer’s reliance on a competent and
experienced accountant in the preparation of the taxpayer’s return may constitute
reasonable cause and good faith. To show good faith reliance, however, “the
taxpayer must establish that the return preparer was supplied with all necessary
information and the incorrect return was a result of the preparer’s mistakes.” Weis
v. Commissioner, 94 T.C. 473, 487 (1990); see also Westbrook v. Commissioner,
68 F.3d 868, 881 (5th Cir. 1995), aff’g T.C. Memo. 1993-634; Enoch v.
Commissioner, 57 T.C. 781, 802 (1972) (“The ultimate responsibility for a correct
34
(...continued)
likes of Sherlock Holmes but need not recite every underlying fact.”).
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[*26] return lies with the taxpayer, who must at least furnish the necessary
information to his agent who prepared the return.”).
Petitioner did not provide to his accountant any documents or information
relating to Dr. Moon’s money; he did not discuss the modification of agreement or
the mortgage; and he did not discuss Dr. Moon’s divorce proceedings. And there
is no evidence that petitioner’s accountant discussed the impact of these types of
facts upon the deductibility of the claimed settlement expense deduction.
Accordingly, the Court concludes that petitioners have failed to show that they
provided their accountant necessary and accurate information. See Neonatology
Assocs., P.A. v. Commissioner, 115 T.C. at 100. For this reason alone, petitioners
have failed to show that they had reasonable cause for claiming the settlement
expense deduction.35
35
This alone is sufficient to disqualify petitioners from the reasonable cause
and good faith defense to the sec. 6662 penalty. But even if the Court were to
assume (as it does not) that petitioners provided to their accountant all of these
documents and evidence, there is nothing in the record showing that their
accountant considered or advised them of the implications of their particular
situation. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 100 (2000)
(“The mere fact that a certified public accountant has prepared a tax return does
not mean that he or she has opined on any or all of the items reported therein.”).
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[*27] With respect to the claimed legal fees, however, the Court is faced with a
different situation. Petitioners contend that they had reasonable cause and good
faith for their claimed legal and professional services expense deduction.
“[T]he most important factor” in determining whether taxpayers have
reasonable cause for their tax treatment and whether they act in good faith “is the
extent of the taxpayer[s’] effort to assess the taxpayer[s’] proper tax liability.”
Sec. 1.6664-4(b)(1), Income Tax Regs. Petitioners have provided sufficient
evidence to show that at the time they filed their 2009 Form 1040, they had
reasonable cause and good faith with respect to this deduction.
It is clear that a complaint was filed against petitioner with the Oklahoma
Bar Association. Petitioner retained counsel, and the canceled checks for the
attorney’s fees were provided to petitioner’s accountant. Petitioner also provided
documents to his accountant supporting the rest of his claimed legal and
professional services expenses. And petitioners’ 2009 Form 1040 reflected those
legal and professional services expense receipts shown to petitioners’ accountant.
Although petitioner failed to substantiate to this Court the amounts paid, his
credible testimony on this point--combined with the credible testimony of his
accountant and the affidavit of petitioner’s attorney--convinces the Court that at
the time they filed their 2009 Form 1040, petitioners had reasonable cause and
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[*28] good faith for the legal and professional services expense deduction
claimed. Therefore the section 6662(a) penalty does not apply to the portion of
petitioners’ underpayment attributable to the disallowed legal and professional
services deduction.
To reflect the foregoing,
Decision will be entered
under Rule 155.