The opinion
T.C. Memo. 2009-118
UNITED STATES TAX COURT
KHAIRY E. AREF, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11164-06. Filed May 27, 2009.
Khairy E. Aref, pro se.
John D. Faucher, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: Respondent determined a $41,920 deficiency
in and a $8,384 section 6662(a)1 penalty on petitioner’s 2002
1
All section references are to the Internal Revenue Code
in effect for the year in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
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Federal income taxes. After a concession,2 the issues for
decision are: (1) Whether petitioner substantiated deductions
claimed on his Schedule C, Profit or Loss From Business; (2)
whether petitioner had unreported income; (3) whether petitioner
is entitled to claim head-of-household filing status; and (4)
whether petitioner is liable for the section 6662(a) penalty.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time he filed the
petition, petitioner resided in Egypt.
During 2002 petitioner worked for the California Department
of Corrections. He was the agency coordinator. Petitioner
developed and coordinated new programs for the State of
California Department of Corrections--which had 155,000
employees, 165,000 inmates, and a $6.7 billion budget. His
supervisor was a cabinet secretary, and his second level
supervisor was the Governor of California.
Petitioner is a licensed hazardous material specialist and a
certified instructor in hazardous materials. He also is a
registered professional engineer and an environmental specialist.
2
Respondent concedes that petitioner paid $30,000 in
deductible alimony during 2002.
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Additionally, during 2002 petitioner operated an
international consulting and training business that provided
training and technical services on handling hazardous materials
and toxic substances (Mr. Aref’s business). The training and
technical services were provided to private entity firefighters,
military personnel, and peace officers and for the operation of
correctional facilities, custody of inmates and prisoners,
handling and management of toxic substances, and emergency
response for spills and medical waste, as the case may be.
Mr. Aref’s business had over 400 videotapes available for
training purposes, covering topics such as correctional
facilities construction and administration, peace officers’
training, environmental impact statements and reports,
corrections officers training, fire protection and safety, and
health and safety plans. Petitioner oversaw the production
(including writing the narratives) and reproduction of the
videotapes. Petitioner met with clients in the United States,
including the Prime Minister and the Deputy Prime Minister of
Egypt.
Mr. Aref’s business operated in and had offices and business
equipment in Egypt. Mr. Aref’s business had equipment in Egypt
that included two leased cars, Toyota Land Cruisers. The cars
were used to get to training sessions and for pickups and
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deliveries related to Mr. Aref’s business. Mr. Aref’s business
also had an accountant in Egypt.
Petitioner leased office space in Egypt. The offices were
located at 17 Atbara Street and also at 64 Talmaneal Street in
Mohandeseen, Giza, Egypt. At 17 Atbara Street a sign outside the
building had the name of Mr. Aref’s business on it.
During the year in issue Mr. Aref’s business was marketed
and operated in Egypt by Ahmed Fadel. Petitioner had a written
contract with Mr. Fadel. The contract provided that petitioner
would establish training and technical services and that Mr.
Fadel would market them in Egypt. Mr. Fadel was responsible for
providing logistical support to petitioner necessary to provide
the training.
For 2002 petitioner deducted the following amounts as
business expenses: Depreciation $1,119; interest $8,699; rent or
lease of vehicles, machinery, and equipment $9,808; rent or lease
of other business property $9,755; wages $23,000; and other
expenses $6,309 (accounting $3,600 and telephone $2,709) for a
total of $58,690.
Mr. Fadel sent petitioner monthly invoices for the expenses
of Mr. Aref’s business. These invoices were delivered to
petitioner. Petitioner paid the invoices and had the payment
delivered directly to Mr. Fadel. The amounts on the invoices tie
into the amounts claimed on petitioner’s Schedule C.
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During 2002 petitioner received two separate loans3 of
$60,000 (a total of $120,000). One loan was from Jose Fawzia,
and the second loan was from the Gawish Medical Center.4
OPINION
I. Substantiation of Schedule C Deductions
Generally, deductions are a matter of legislative grace;
taxpayers have the burden of showing that they are entitled to
any deduction claimed. Rule 142(a); New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 (1934). Taxpayers are required to
maintain records that are sufficient to enable the Commissioner
to determine their correct tax liability. See sec. 6001; sec.
1.6001-1(a), Income Tax Regs.
Taxpayers are allowed a deduction for ordinary and necessary
expenses paid or incurred in carrying on a trade or business.
Sec. 162(a). Whether an expenditure is ordinary and necessary is
generally a question of fact. Commissioner v. Heininger, 320
U.S. 467, 475 (1943). Generally, for an expenditure to be an
ordinary and necessary business expense, the taxpayer must show a
bona fide business purpose for the expenditure; there must be a
proximate relationship between the expenditure and the business
3
The characterization of the amounts as loans is not in
dispute.
4
The testimony was somewhat unclear on whether this loan
was from the Gawish Medical Center or from Dr. Hassan Gawish.
Either way, it was a separate loan for $60,000.
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of the taxpayer. Challenge Manufacturing Co. v. Commissioner, 37
T.C. 650 (1962); Henry v. Commissioner, 36 T.C. 879 (1961).
To be “necessary” within the meaning of section 162, an
expense needs to be “appropriate and helpful” to the taxpayer’s
business. Welch v. Helvering, 290 U.S. 111, 113 (1933). The
requirement that an expense be “ordinary” connotes that “the
transaction which gives rise to it must be of common or frequent
occurrence in the type of business involved.” Deputy v. du Pont,
308 U.S. 488, 495 (1940) (citing Welch v. Helvering, supra at
114).
When taxpayers establish that they have incurred deductible
expenses but are unable to substantiate the exact amounts, we can
estimate the deductible amount in some circumstances, but only if
the taxpayers present sufficient evidence to establish a rational
basis for making the estimate. See Cohan v. Commissioner, 39
F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner, 85
T.C. 731, 742-743 (1985). In estimating the amount allowable, we
bear heavily upon taxpayers whose inexactitude is of their own
making. See Cohan v. Commissioner, supra at 544. There must be
sufficient evidence in the record, however, to permit us to
conclude that a deductible expense was paid or incurred.
Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957).
In addition to satisfying the criteria for deductibility
under section 162, certain categories of expenses must also
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satisfy the strict substantiation requirements of section 274(d)
in order for a deduction to be allowed. The expenses to which
section 274(d) applies include, among other things, those for
listed property, e.g., automobile expenses. Secs. 274(d)(4),
280F(d)(4)(A)(i) and (ii). We may not use the Cohan doctrine to
estimate expenses covered by section 274(d). See Sanford v.
Commissioner, 50 T.C. 823, 827 (1968), affd. 412 F.2d 201 (2d
Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax Regs., 50 Fed.
Reg. 46014 (Nov. 6, 1985). To substantiate a deduction
attributable to listed property, a taxpayer must maintain
adequate records or present corroborative evidence to show the
following: (1) The amount of the expense; (2) the time and place
of use of the listed property; and (3) the business purpose of
the use. Sec. 1.274-5T(b)(6), Temporary Income Tax Regs., 50
Fed. Reg. 46016 (Nov. 6, 1985).
Our resolution of the substantiation issue turns on the
applicable law and our determination of the credibility of the
evidence presented.
A. Depreciation
There is allowed as a depreciation deduction a reasonable
allowance for the exhaustion, wear and tear (including
obsolescence) of property used in a trade or business. Sec.
167(a). The basis on which exhaustion, wear and tear, and
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obsolescence are to be allowed in respect of any property is the
adjusted basis as provided in section 1011. Sec. 167(c).
The record does not establish what office furniture and/or
equipment was depreciated, what amount was paid for it, when it
was put in service, or who owned it. Accordingly, petitioner has
not substantiated the deduction for depreciation.
B. Interest
Petitioner testified that he gave his records regarding
interest to his accountant, the accountant arrived at the figure
on the return, and he trusted his accountant. There is
insufficient credible evidence to establish a rational basis for
making an estimate of the deductible amount of interest
petitioner paid during 2002. See Cohan v. Commissioner, supra at
543-544; Vanicek v. Commissioner, supra at 742-743. Accordingly,
we shall not allow petitioner a deduction for interest.
C. Rent or Lease of Vehicles, Machinery, and Equipment
Petitioner testified that he paid $818 per month to Mr.
Fadel to lease the two cars. This amount is corroborated by
invoices petitioner submitted.
Automobile expenses must also satisfy the strict
substantiation requirements of section 274(d) in order for a
deduction to be allowed because an automobile is listed property.
Secs. 274(d)(4), 280F(d)(4)(A)(i) and (ii).
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Petitioner did not keep a diary, log, trip sheet, or similar
record regarding the use of the cars, nor did he establish the
time and place of use of the cars (other than that the vehicles
were used in Egypt). See secs. 274(d)(4), 280F(d)(4)(A)(i) and
(ii); sec. 1.274-5T(c)(2), Temporary Income Tax Regs., 50 Fed.
Reg. 46017 (Nov. 6, 1985). Petitioner has failed to substantiate
the claimed automobile expenses in accordance with sections 162
and 274 and the regulations thereunder. Accordingly, we sustain
respondent’s determination on this issue.
D. Rent or Lease of Other Business Property
This expense was for the lease of office space in Egypt.
Office expenses may be “‘ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or
business’”. Schnell v. Commissioner, T.C. Memo. 2006-147
(quoting section 162(a)).
We find the invoices, corroborated by petitioner’s testimony
and the written contract with Mr. Fadel, to be credible evidence
of the amount that petitioner paid in 2002 for rent or lease of
office space used in Mr. Aref’s business. All of the invoices
bear a “paid” stamp from Mr. Fadel acknowledging that petitioner
paid the invoice. Accordingly, we conclude that petitioner has
substantiated this expense.
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E. Wages
This expense was for salary and wages for the people in
Egypt who provided or administered training and technical
services, for office staff, and for the drivers of the two cars.
Wages may be ordinary and necessary business expenses which
generally are deductible under section 162(a). Brown v.
Commissioner, T.C. Memo. 1992-40.
We find the invoices, corroborated by petitioner’s
testimony, to be credible evidence of the amount of the wage
expense of Mr. Aref’s business that petitioner paid in 2002. All
of the invoices bear a paid stamp from Mr. Fadel acknowledging
that petitioner paid the invoice. Accordingly, we conclude that
petitioner has substantiated this expense.
F. Accountant
The accountant did the accounting, invoicing, and list of
purchases and sales for Mr. Aref’s business. Accounting fees may
be ordinary and necessary business expenses which generally are
deductible under section 162(a). Smith v. Commissioner, T.C.
Memo. 1994-640.
We find the invoices, corroborated by petitioner’s testimony
and the written contract with Mr. Fadel, to be credible evidence
of the amount of the accountant expense of Mr. Aref’s business
that petitioner paid in 2002. All of the invoices bear a “paid”
stamp from Mr. Fadel acknowledging that petitioner paid the
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invoice. Accordingly, we conclude that petitioner has
substantiated this expense.
G. Telephone
Telephone expenses may be deductible under section 162(a) if
the expenses incurred are ordinary and necessary in carrying on a
trade or business. Weeldreyer v. Commissioner, T.C. Memo.
2003-324 (citing Vanicek v. Commissioner, 85 T.C. at 742,
Sengpiehl v. Commissioner, T.C. Memo. 1998-23, and Green v.
Commissioner, T.C. Memo. 1989-599).
Petitioner testified that he did not know the cost of a
basic telephone line in Egypt. According to the invoices,
petitioner paid $315 per month for telephone service.
When a taxpayer establishes that he has incurred deductible
expenses but is unable to substantiate the exact amounts, we can
estimate the deductible amount, but only if the taxpayer presents
sufficient evidence to establish a rational basis for making the
estimate. See Cohan v. Commissioner, 39 F.2d at 543-544; Vanicek
v. Commissioner, 85 T.C. at 742-743. In estimating the amounts
allowable, we bear heavily upon the taxpayer whose inexactitude
is of his own making. See Cohan v. Commissioner, supra at 544.
Upon the basis of the evidence presented, pursuant to Cohan, we
estimate that petitioner paid $150 per month for telephone
expenses and allow him a deduction of $1,800 for 2002.
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II. Unreported Income
Respondent determined that petitioner had $84,581 in
unreported gross income. At trial respondent conceded $6,000 of
this amount.5
Every individual liable for tax is required to maintain
books and records sufficient to establish the amount of his or
her gross income. Sec. 6001; DiLeo v. Commissioner, 96 T.C. 858,
867 (1991), affd. 959 F.2d 16 (2d Cir. 1992). Where a taxpayer
fails to maintain or produce adequate books and records, the
Commissioner is authorized to compute the taxpayer’s taxable
income by any method that clearly reflects income. Sec. 446(b);
Holland v. United States, 348 U.S. 121 (1954); Webb v.
Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1968), affg. T.C.
Memo. 1966-81. The reconstruction of income need only be
reasonable in the light of all surrounding facts and
circumstances. Giddio v. Commissioner, 54 T.C. 1530, 1533 (1970).
The Commissioner is given latitude in determining which method of
5
At the May 15, 2007, recall of this case before Judge
Cohen, respondent conceded the unreported income issue on the
record. (At that time respondent had also conceded the issue in
his pretrial memorandum.) Apparently, respondent revoked or
withdrew this concession before the trial in the case (although
when asked in the case at bar whether the unreported income issue
was still at issue, respondent’s counsel initially answered
“No”). Petitioner did not object to the trial of the unreported
income issue or assert that the unreported income was no longer
at issue.
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reconstruction to apply when a taxpayer fails to maintain
records. Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989).
Respondent used the source and application of funds method
(also known as the cash expenditures in excess of reported income
method) to reconstruct petitioner’s income. Respondent failed to
include in his calculation the $120,000 in loans petitioner
received during 2002.6 When these loans are included in the
source and application of funds calculation, petitioner does not
have any unreported income for 2002 (the $120,000 of loans that
were not included as income exceeds the $78,581 ($84,581 minus
the $6,000 respondent conceded) determined to be unreported
income). Accordingly, we find for petitioner on this issue.
III. Head of Household
An individual qualifies as a head of household if the
individual is not married at the close of the taxable year and
maintains as his home a household that constitutes for more than
one-half of the taxable year the principal place of abode of an
individual who qualifies as the taxpayer’s dependent within the
meaning of section 151. Sec. 2(b)(1)(A).
Respondent did not raise the issue of head-of-household
filing status in the notice of deficiency. Respondent raised it
6
See supra note 3. Respondent disputed that petitioner
received the loans. We found as a fact that petitioner received
the $120,000 in loans.
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as a new matter at trial. Accordingly, respondent bears the
burden of proof on this issue. See Rule 142(a).
Petitioner was not married at the close of the taxable year.
Respondent has not established that petitioner did not maintain
as his home a household that constituted for more than one-half
of the taxable year the principal place of abode of an individual
who qualified as petitioner’s dependent within the meaning of
section 151. Petitioner claimed two dependents on his 2002 tax
return. Furthermore respondent’s reconstruction of petitioner’s
income using the source and application of funds method was based
on petitioner’s having a family of three. Respondent has not
established the total cost of maintaining the household in 2002
or that petitioner did not provide over half of the cost.
Accordingly, respondent has failed to prove that petitioner is
not entitled to head-of-household status.
IV. Section 6662(a)
Section 7491(c) provides that the Commissioner will bear the
burden of production with respect to the liability of any
individual for additions to tax and penalties. “The
Commissioner’s burden of production under section 7491(c) is to
produce evidence that it is appropriate to impose the relevant
penalty, addition to tax, or additional amount”. Swain v.
Commissioner, 118 T.C. 358, 363 (2002); see also Higbee v.
Commissioner, 116 T.C. 438, 446 (2001). However, the
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Commissioner does not have the obligation to introduce evidence
regarding reasonable cause or substantial authority. Higbee v.
Commissioner, supra at 446-447.
Respondent determined that petitioner is liable for the
section 6662(a) penalty for 2002. Pursuant to section 6662(a)
and (b)(1) and (2), a taxpayer may be liable for a penalty of 20
percent on the portion of an underpayment of tax due to
negligence or disregard of rules or regulations or a substantial
understatement of income tax. “Negligence” includes any failure
by the taxpayer to keep adequate books and records or to
substantiate items properly. Sec. 1.6662-3(b)(1), Income Tax
Regs. An “understatement” is the difference between the amount
of tax required to be shown on the return and the amount of tax
actually shown on the return. Sec. 6662(d)(2)(A). A
“substantial understatement” exists if the understatement exceeds
the greater of (1) 10 percent of the tax required to be shown on
the return for a taxable year, or (2) $5,000. See sec.
6662(d)(1)(A). Respondent met his burden of production as there
was a substantial understatement.
The accuracy-related penalty is not imposed with respect to
any portion of the underpayment as to which the taxpayer acted
with reasonable cause and in good faith. Sec. 6664(c)(1). The
decision as to whether the taxpayer acted with reasonable cause
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and in good faith depends upon all the pertinent facts and
circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
Petitioner maintained business records to substantiate his
expenses. In total the invoices hardly deviated from the
expenses claimed by more than a few dollars (with the exception
of the telephone costs which were off by approximately $100). We
conclude that petitioner acted with reasonable cause and in good
faith with respect to the substantiation of his business
expenses.
To reflect the foregoing,
Decision will be entered
under Rule 155.