The opinion
T.C. Memo. 2010-17
UNITED STATES TAX COURT
MARC VIANELLO AND MICHELLE MULLARKEY VIANELLO, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15967-07. Filed February 1, 2010.
John A. Beam III and J. Matthew Sharp, for petitioners.
Dennis R. Onnen, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HAINES, Judge: Respondent determined deficiencies in
petitioners’ Federal income taxes of $9,013 and $157,486 and
penalties under section 6662(a) of $1,803 and $31,497 for 2002
and 2003, respectively.1 The issues for decision are: (1)
1
Unless otherwise indicated, section references are to the
(continued...)
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Whether Mr. Vianello (petitioner) was in the trade or business of
farming; (2) Whether petitioner was in the trade or business of
acquiring loans; (3) whether a debt for which a bad debt
deduction was claimed in 2003 became worthless in that year; and
(4) whether petitioners are liable for accuracy-related penalties
under section 6662(a).
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and the exhibits attached thereto are
incorporated herein by this reference. At the time they filed
their petition, petitioners resided in Kansas.
Notice of Deficiency and Procedural Background
On May 3, 2007, respondent issued a notice of deficiency to
petitioners determining deficiencies for 2002 and 2003 (years at
issue) of $9,013 and $157,486, respectively.2 Respondent also
determined penalties under section 6662(a) for 2002 and 2003 of
$1,803 and $31,497, respectively. The dispute arises over the
disallowance of petitioners’ farm losses for 2002 and 2003 of
$34,741 and $134,941, respectively; business expense “loan
1
(...continued)
Internal Revenue Code as amended. Rule references are to the Tax
Court Rules of Practice and Procedure. Amounts are rounded to
the nearest dollar.
2
Petitioners’ 2002 joint Form 1040X, Amended U.S. Individual
Income Tax Return, was filed on July 23, 2004. Petitioners’ 2003
joint Form 1040, U.S. Individual Income Tax Return, was filed on
Aug. 3, 2004.
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acquisition” losses for 2002 and 2003 of $18,723 and $302,007,
respectively; and a $269,622 bad debt deduction for 2003.
Personal Background
Both Mr. and Ms. Vianello are certified public accountants
(C.P.A.s). In 1997 petitioner formed Vianello & Leonard, L.L.C.,
(Vianello & Leonard), a two-member accounting firm that dissolved
in 2007. Petitioner specializes in forensic accounting and was
heavily involved in the business of forensic consulting during
the years at issue, billing 911 hours in 2002 and 1,409 hours in
2003. Ms. Vianello specializes in taxation and prepared
petitioners’ Federal income tax returns for the years at issue.
Ms. Vianello has been a CPA since 1980 and started her own
practice 25 years ago.
Conflicts With the DuPonts
As a member of Vianello & Leonard, petitioner was hired by
Robert J. DuPont (Mr. DuPont) to serve as an expert witness. Mr.
DuPont refused to pay the $75,000 he owed for petitioner’s
services, leading Vianello & Leonard to sue and obtain a judgment
against him that was later transferred to petitioner. Mr.
DuPont’s nonpayment was the first dispute in a series of
conflicts between petitioner and the DuPonts that form the
factual basis for the action at hand.
Although the DuPonts ultimately satisfied the Vianello &
Leonard judgment in 2001, petitioner wanted to put Mr. DuPont out
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of business because he was a “crook”. To that end, in December
2000 petitioner purchased another judgment (Dean judgment)
against the DuPonts from a third party and executed on it by
forcing a sheriff’s sale of the DuPonts’ residence and land at
22457 Mahogany Lane (Mahogany Lane property). On July 26, 2001,
using the Marc Vianello Revocable Trust (trust), petitioner won
the bid on the Mahogany Lane property and subsequently filed an
action against the DuPonts for unlawful detainer and other relief
on account of the DuPonts’ frustration of petitioner’s attempts
to take possession of the property.
The Mahogany Lane property was subject to a deed of trust
with a principal balance of $252,000 in favor of Bank of America
evidenced by a promissory note (note) executed by Mr. and Mrs.
DuPont. After petitioner’s winning bid on the Mahogany Lane
property and subsequent receipt of the sheriff’s deed, Bank of
America accelerated the indebtedness, demanding payment in full.
In August 2001 petitioner formed Land Purchase of Jasper County,
L.L.C. (Jasper LLC), a single-member LLC funded with money
derived from a mortgage secured by petitioner’s residence and
cash. On February 20, 2002, petitioner used Jasper LLC to
acquire the accelerated promissory note from Bank of America for
the unpaid principal balance of the note plus accrued interest
totaling $268,468. Petitioner believed that without a separate
entity to hold the collateral, State law would cause the legal
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title in the mortgage to merge into the equitable title he held
through the sheriff’s deed, essentially relieving Mr. DuPont of
liability under the promissory note.
Intent on collecting from the DuPonts’ other assets, Jasper
LLC made a demand for payment and brought a collection action
against the DuPonts for breach of the note shortly after
acquiring it on February 20, 2002. Despite the loss of the
Mahogany Lane property the DuPonts continued to own 10 guest
homes for the mentally impaired and were also receiving payments
from a second deed of trust on a commercial building they had
sold.
On March 21, 2002, shortly after Jasper LLC purchased the
note from Bank of America, the Duponts formed a section 501(c)(3)
corporation, Joplin River of Life Ministries, Inc. (JROL).
Sometime thereafter, the DuPonts transferred five of the guest
homes to JROL and leased to JROL the remaining five guest homes
for $12,000 per month.3 During this time the DuPonts also
received an early discounted lump-sum payoff of a second deed of
trust from the buyer of the commercial building.
On November 24, 2003, a final judgment was entered in favor
of Jasper LLC against the DuPonts, requiring them to pay
$369,793, including attorney’s fees of $28,531 and expenses.
3
Mr. DuPont was one of the two incorporators, and the
DuPonts were two of the initial six directors.
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However, petitioners believed that the DuPonts’ transfer of the
guest homes to JROL and the lump-sum payoff of the commercial
building loan they had negotiated, in combination with Mr.
DuPont’s imprisonment for Medicare fraud with a projected release
date of September 28, 2004, reduced the value of the DuPonts’
remaining collectible assets. Thus, petitioners claimed a bad
debt deduction for 2003 of $269,622 shortly after receiving the
favorable judgment.
Farming Activities
The Mahogany Lane property consisted of 100 acres of higher
ground, containing pastures, woodlands, and the DuPonts’
residence; and 100 river-bottom acres planted in soybeans by
Charles Honey (Mr. Honey) pursuant to an oral agreement with Mr.
DuPont. Under the agreement Mr. Honey was to deduct the cost of
chemicals and fertilizer from the total sale proceeds of the
soybeans and pay Mr. DuPont one-third of the net proceeds of the
sale.
During the years at issue petitioner resided 150 miles from
the property and had never met Mr. Honey in person. On July 26,
2001, petitioner contacted Mr. Honey by phone, and they orally
agreed to continue the same arrangement with respect to a soybean
crop in 2002 under the same terms that Mr. Honey had had with Mr.
DuPont. Mr. Honey paid expenses with respect to the 2001 and
2002 soybean crops on the property, including the cost of seeds,
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and provided the equipment and labor with some assistance from
his grandson. Mr. Honey made all of the decisions with respect
to the crop, including what crop to plant, when to plant, what
equipment to use, when to spray for weeds, when to harvest, and
when and where to sell the soybeans. After harvesting the
soybean crops in 2001 and 2002 Mr. Honey marked petitioner’s name
on the scale tickets to identify the origin of the crops, sold
the crops, and paid petitioner $775 and $1,162 for 2001 and 2002,
respectively. The payments consisted of one-third of the net
proceeds after deducting the cost of chemicals to kill weeds and
grass.
Petitioner’s farm-related activities for 2002 consisted of
having Mr. Haskell, his tenant who rented the pastureland and
barn, mow the nearby pastures and tend the fences. Petitioner
also consulted with soil and horticultural experts, who advised
him to change from soybeans to Bermuda grass on the river-bottom
acres. Unbeknownst to petitioner, while harvesting the October
2002 soybean crop Mr. Honey had planted wheat on the property
under the assumption that the oral agreement he had with
petitioner carried over into 2003. A dispute arose between Mr.
Honey and petitioner with respect to whether Mr. Honey had
authority to plant the wheat, which led to a January 2003 letter
from petitioner demanding Mr. Honey stay off the property.
Petitioner subsequently chained the gate to the property and
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filed a suit against Mr. Honey that was pending at the time of
trial of the instant case. The wheat crop was never harvested.
In January 2003, after learning of the wheat Mr. Honey
planted in October 2002, petitioner entered into a contract with
Joe McCoy (Mr. McCoy) to plant Bermuda grass on the river-bottom
property in 2003, but the planting did not occur. In April 2003
petitioner also contacted Dennis Elbrader (Mr. Elbrader) about
planting Bermuda grass on the river-bottom property in 2003. Mr.
Elbrader determined that because of the property’s wet condition,
the weeds, and the weather, it was unlikely that he could plant
Bermuda grass in 2003. Petitioner did not tend to Mr. Honey’s
wheat crops, plant any crops on the Mahogany Lane property in
2003, or report any income on Schedule F, Profit or Loss From
Farming, for the year. Petitioner eventually had the wheat
plowed under in the spring of 2004, shortly before the first
planting of Bermuda grass in June 2004.
Petitioner purchased two tractors in 2002 and another
tractor and hay equipment on December 19, 2003. Petitioner also
purchased an additional 50 acres from a neighbor for Bermuda
grass cultivation in December 2003.
Loan Acquisition and Collection Activities
In December 2003, after receiving the $369,793 judgment on
the note acquired from Bank of America, Jasper LLC and petitioner
began negotiations with the DuPonts. In a letter dated December
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19, 2003, petitioner’s attorney contacted the attorney for the
DuPonts to determine their interest in setting up a payment
schedule. In similar correspondence on January 5, 2004,
petitioner’s attorney confirmed petitioner’s interest in
collecting via payments and requested a payment schedule. The
DuPonts’ attorney responded on January 14, 2004, stating that Mr.
DuPont suffered some heart trouble in January 2004. No more than
2 weeks of recovery were anticipated. In the light of the
circumstances, petitioner’s attorney advised him that further
collection efforts would be futile.
Nevertheless, during 2004 petitioner and Jasper LLC began
efforts to collect on the judgment against the DuPonts. Jasper
LLC issued three garnishment summonses to reach amounts owed by
JROL, the lessee of five of the guest homes, to the DuPonts. The
summonses resulted in payments of $868 to Jasper LLC. At the
time of the garnishments, petitioner did not know that the
DuPonts had retained ownership of any guest homes. In August
2004 Jasper LLC’s garnishment summons upon U.S. Bank resulted in
a payment of $66.
The DuPonts owned a personal residence purchased after
losing the Mahogany Lane property. On July 28, 2004, petitioner
authorized his attorney to initiate a levy on the personal
residence of the DuPonts despite the existence of a first
mortgage, a tax lien, and a restitution lien of $120,100 in favor
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of the Federal Government arising out of Mr. DuPont’s conviction
for Medicare fraud.4 On September 27, 2004, the DuPonts filed a
chapter 11 bankruptcy petition 1 day before the scheduled
sheriff’s sale of their residence. Jasper LLC filed a motion for
relief from the automatic stay or, in the alternative, adequate
protection on January 7, 2005. The Bankruptcy Court granted
petitioner’s motion on January 26, 2005, and the DuPonts
subsequently filed a motion to dismiss their bankruptcy case on
February 1, 2005, that was granted on February 25, 2005.
During the DuPonts’ bankruptcy proceeding, petitioners
learned that the DuPonts were still the owners of five of the
guest homes operated by JROL and that JROL had failed to report
lease payments owed to the DuPonts in the earlier garnishment
actions. Once JROL’s intentional misrepresentation came to
light, Missouri State law permitted Jasper LLC to obtain a
judgment against JROL on March 11, 2005, for the amounts JROL
paid to the DuPonts; i.e., $108,000, plus attorney’s fees of
$7,467.
On April 4, 2005, petitioner’s attorney sent a letter to Mr.
DuPont with an attached agreement to pay judgment and suspend
collection and release of garnishment (agreement). The agreement
covered both the final judgment obtained by Jasper LLC against
4
These liens also covered the five guest homes the DuPonts
retained.
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the DuPonts on November 24, 2003, on the promissory note acquired
from Bank of America, and the judgment obtained by Jasper LLC
against JROL in March 2005. The parties entered into the
agreement, and the DuPonts made all scheduled payments in 2005
totaling $81,392 (i.e., $44,928 of attorney’s fees accrued after
December 31, 2003, and $36,464 of interest accrued on the
judgment), which petitioners reported in Schedule C, Profit or
Loss From Business, of their 2005 Form 1040. The DuPonts made
payments for the first 11 months of 2006 totaling $44,568
(composed entirely of interest on the outstanding judgments), as
reflected in Schedule C of petitioners’ 2006 Form 1040. Jasper
LLC recovered $126,894 on the final judgment it obtained against
the DuPonts, consisting of $934 received from garnishments in
2004, $81,392 in payments received in 2005 representing
attorney’s fees and interest, and $44,568 in interest received in
2006. The payments made in 2004, 2005, and 2006 did not
represent recovery of the $369,793 principal amount but simply
attorney’s fees incurred by Jasper LLC and interest on the 2003
judgment. These payments continued until November 28, 2006, when
a fire at JROL caused the death of 10 people. Mr. DuPont was
again indicted for fraud, and the payments to petitioners ceased.
Accuracy-Related Penalties
Ms. Vianello prepared petitioners’ 2002 and 2003 income tax
returns. Before claiming the farm losses reported on Schedule F,
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Ms. Vianello used Internal Revenue Service (IRS) Publication 225,
Farmer’s Tax Guide, as the basis for conducting an interview with
petitioner to conclude that he materially participated in the
farm trade or business. In preparing Schedule C, Ms. Vianello
interviewed petitioner and determined that Jasper LLC was engaged
in the trade or business of acquiring and collecting the DuPonts’
debts.
OPINION
I. Trade or Business of Farming
Respondent determined that petitioner was not in the trade
or business of farming in 2002 and 2003 and thus could not claim
his depreciation and expenses as Schedule F deductions.
Petitioner argues he was in the trade or business of farming
since he purchased a farm and shared in its production with Mr.
Honey. Petitioner further cites his involvement in major
management decisions and his risk of loss in the activity as
factors indicative of a trade or business.
Deductions are strictly a matter of legislative grace, and
taxpayers must satisfy the specific requirements for any
deduction claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S.
79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435,
440 (1934). Taxpayers bear the burden of substantiating the
amount and purpose of any claimed deduction. See Hradesky v.
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Commissioner, 65 T.C. 87 (1975), affd. 540 F.2d 821 (5th Cir.
1976).
Under section 162(a) a taxpayer may deduct all ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business. Although the term “trade or
business” is not precisely defined in section 162 or the
regulations promulgated thereunder, it is well established that
in order for an activity to be considered a taxpayer’s trade or
business for purposes relevant here, the activity must be
conducted “with continuity and regularity” and “the taxpayer’s
primary purpose for engaging in the activity must be for income
or profit.” Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987);
Wittstruck v. Commissioner, 645 F.2d 618, 619 (8th Cir. 1981),
affg. T.C. Memo. 1980-62. In addition, the taxpayer’s business
operations must have actually commenced. Goodwin v.
Commissioner, 75 T.C. 424, 433 (1980), affd. without published
opinion 691 F.2d 490 (3d Cir. 1982).
A. Trade or Business of Farming in 2002
Petitioner argues that he was in the trade or business of
farming because he claims he was involved in major farm
management decisions; provided and maintained fences, road
access, and security; and discussed row crop alternatives,
cockleburs, and Bermuda grass planting with Mr. Honey. In
further support of his involvement in 2002, petitioner argues
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that he purchased a farm and continued the agreement with Mr.
Honey, whereby each shared in the farm’s proceeds, with
petitioner treating it as income from the production of crops.
As proof of the arrangement petitioner cites Smith v. McNew, 381
S.W.2d 369 (Mo. Ct. App. 1964), which distinguishes a tenant’s
interest from that of a cropper, and offers a letter from the
U.S. Department of Agriculture (USDA) that states Mr. Honey and
petitioner’s revocable trust were producers and were actively
engaged in farming.
Despite petitioner’s claimed involvement, Mr. Honey paid all
expenses with respect to the 2002 soybean crop, including the
costs of seeds and pesticides, and provided the equipment and
labor. Mr. Honey also made all decisions with respect to the
crop, including what crop to plant, when to plant it, what
equipment to use, when to spray for weeds, when to harvest, and
when and where to sell the soybeans. Moreover, the USDA
determination that Mr. Honey and petitioner’s revocable trust
were actively engaged in farming and were coproducers for USDA
purposes has no bearing on whether petitioner was engaged in such
a trade or business for purposes of section 162(a), nor does it
permit petitioner to impute Mr. Honey’s farming activities to
himself for such purposes. It is clear to us that different
criteria are taken into account by the USDA in making such
determinations. See A.B.C.D. Lands, Inc. v. Commissioner, 41
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T.C. 840, 849 (1964); Hasbrouck v. Commissioner, T.C. Memo. 1998-
249, affd. without published opinion 189 F.3d 473 (9th Cir.
1999).5
As further evidence of the existence of a trade or business,
petitioners claim they had a risk of loss with regard to the
crops since an unsuccessful harvest would decrease the income
from the property and leave petitioners responsible for
reimbursing Mr. Honey for his one-third share of the cost of the
chemicals. However, it does not seem clear from the facts that
petitioners were responsible for any costs of chemicals and
fertilizer in the event of an unprofitable harvest as opposed to
Mr. Honey’s bearing the risk of his decisions’ failing to produce
a crop. Petitioner did not provide equipment or labor and was
not involved in the planting, spraying, harvesting, or selling of
5
Petitioner cites Mizell v. Commissioner, T.C. Memo. 1995-
571, and Estate of Sherrod v. Commissioner, 82 T.C. 523 (1984),
revd. on another issue 774 F.2d 1057 (11th Cir. 1985), inviting
us to look beyond the agreement between petitioner and Mr. Honey
to find that petitioner materially participated and was engaged
in the trade or business of farming. We decline petitioner’s
invitation and note that the issue of material participation, as
it arose in those cases, is a factor that we consider in the
context of net earnings from self-employment under sec. 1402(a)
and/or special use valuation under sec. 2032A. Sec. 1402(a)
requires a lessor or owner to include rental income in net
earnings from self-employment if it is received from a farm in
which he materially participates. Furthermore, the regulations
under sec. 1402(a) make it clear that petitioner’s efforts do not
constitute production or the management of the production as
required to meet the material participation standard. See sec.
1.1402(a)-4(b), Income Tax Regs.
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the crop. Petitioner’s services in connection with production of
the crop in 2002 seemingly consisted of asking Mr. Haskell to mow
the grassy areas of petitioner’s adjacent pastures and tend the
fences. Such services are not integrally related to the income-
producing activity of growing soybeans during the years at issue
inasmuch as Mr. Honey testified that he has never met Mr. Haskell
or petitioner. Furthermore, petitioner resided 150 miles from
the property and was primarily engaged in the business of
forensic consulting, billing substantial hours during the years
at issue. Thus, we hold that petitioners were not engaged in the
trade or business of farming in 2002.
B. Trade or Business of Farming in 2003
During the 2002 harvest Mr. Honey planted wheat and was
informed in January 2003 that he was not permitted to enter the
property. During 2003 petitioner did not tend to Mr. Honey’s
wheat crop or plant any crops of his own. Nor did he report any
income on Schedule F for the year. Mr. Elbrader testified that
petitioners intended but were unable to plant in 2003 because the
property was covered by unharvested wheat and was also too wet
and muddy. In December 2003 petitioner purchased 50 additional
acres from a neighbor. On December 19, 2003, petitioner
purchased a tractor, a loader, a mower, and a baler for use with
Bermuda grass, despite the fact that it would not have been
possible to plant Bermuda grass on the property until spring 2004
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at the earliest. On the basis of the absence of farm-related
activities during 2003, we find that petitioner’s purchases of
the tractor and attachments were not ordinary and necessary
expenses incurred in connection with the trade or business of
farming in 2003.6
Petitioner’s farm-related activities in 2002 and 2003 were
not sufficient to constitute a trade or business. During 2003
petitioner did not plant, cultivate, or tend a crop of any kind,
and his farm-related activities were not continuous or regular.
Moreover, petitioner has not established that a trade or business
with respect to soybeans, Bermuda grass, or any other crop
commenced during the years at issue. Finally, petitioner has
failed to show how the claimed Schedule C expenses would
constitute ordinary and necessary expenses of a farm trade or
business or that such expenses were not preproduction expenses
incurred in anticipation of a trade or business in farming.
Section 195, in effect for the years at issue, provides that no
deduction shall be allowed for startup expenditures, except that
a taxpayer may elect to treat such expenditures as deferred
expenses deductible over a period of not less than 60 months,
beginning with the month in which the active trade or business
6
Petitioner argues that 1 year of no sales of crops such as
occurred in 2003 should not remove him from the trade or business
of farming. However, petitioner was not regularly and actively
involved in farming activity until at least 2004.
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begins. Petitioners failed to make such an election for the
years at issue but later filed a “Protective Election to Amortize
Start-Up Expenses”, citing section 195(b), with their 2004
Federal income tax return. For the above reasons, the Schedule F
depreciation and expenses petitioners claimed in 2002 and 2003
may not be deducted and must be capitalized.
II. The Trade or Business of Loan Acquisition in 2002 and 2003
Respondent determined that neither petitioner nor the solely
owned Jasper LLC was in the trade or business of loan acquisition
and thus could not claim Schedule C loss deductions for the years
2002 and 2003 of $18,723 and $302,007, respectively.7 Petitioners
assert that the Vianello & Leonard suit for nonpayment and the
subsequent judgment, the purchase of the Dean judgment, the suit
against the DuPonts for unlawful detainer, and the purchase of
the note from Bank of America constitute a trade or business of
engaging in profitable litigation against the DuPonts.
These four actions do not constitute the type of activity
that rises to the level of a trade or business. In Green v.
Commissioner, T.C. Memo. 2005-250, affd. 507 F.3d 857 (5th Cir.
2007), cited by petitioners, we rejected the taxpayer’s argument
that his repeated attempts to collect a judgment against the
State of Texas constituted a trade or business, stating:
7
Jasper LLC was a disregarded entity and did not make an
election to be treated as a corporation under the regulations.
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Though petitioner continuously and regularly
engaged in the activity of attempting to recover his
judgment between 1991 and 1995, we cannot conclude that
petitioner was in a trade or business in the customary
use of those terms. Petitioner did not perform
services for others, he had no customers, and he was
not in the business of trading securities or gambling
on a regular and continuous basis. See id.
[Commissioner v. Groetzinger] at 33-34. Petitioner’s
asserted purpose was to secure the compensation to
which he was entitled. Although a trade or business
requires continuous and regular activity, continuity
and regularity, do not, standing alone, constitute a
trade or business. * * *
Despite their claim, neither petitioners nor the LLC
performed services for others, had customers, or were in the
business of trading notes or loans. Furthermore, there is no
evidence that petitioners ever considered the Vianello & Leonard
judgment or the suit for unlawful detainer to be part of a trade
or business. Of the remaining actions, petitioners used Jasper
LLC to purchase the note from Bank of America to prevent merger
of title instead of purchasing the note themselves. That action
establishes petitioners’ interest, not in establishing a trade or
business of acquiring loans, but in preserving the opportunity to
collect against other property owned by the DuPonts. Thus,
petitioner’s four actions against the DuPonts do not establish
the continuous and regular activity needed to prove the existence
of a trade or business but highlight his attempts to “secure the
compensation to which he was entitled.” See id.
Under such circumstances we find that petitioners have
failed to prove petitioner’s or Jasper LLC’s involvement in the
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trade or business of acquiring loans, the ongoing business of
collecting debts, or of farming during the years at issue.
Therefore, we disallow the disputed Schedule C deductions for the
years at issue.
III. Treatment of the Bad Debt Deduction
Most of the $302,007 Schedule C loss petitioners claimed in
2003 consists of a claimed bad debt of $269,622 arising from the
worthlessness of the promissory note against the DuPonts Jasper
LLC acquired on February 20, 2002. The issue we must address is
whether that debt became worthless in 2003.
An individual taxpayer may deduct as a short-term capital
loss a nonbusiness debt that becomes wholly worthless during the
taxable year. Sec. 166(d). However, the taxpayer has the burden
of proving that he or she is entitled to any claimed deductions.
INDOPCO, Inc. v. Commissioner, 503 U.S. at 84. Thus, petitioners
have the burden of proving that the $269,622 note became wholly
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worthless in 2003.8 See Rule 142(a); Crown v. Commissioner, 77
T.C. 582, 598 (1981).
There is no standard test or formula for determining
worthlessness, and the determination depends upon the particular
facts and circumstances of the case. Lucas v. Am. Code Co., 280
U.S. 445, 449 (1930); Crown v. Commissioner, supra at 598. A
taxpayer usually must show identifiable events to prove
worthlessness in the year claimed. Crown v. Commissioner, supra;
Dallmeyer v. Commissioner, 14 T.C. 1282, 1291-1292 (1950). The
taxpayer must demonstrate that the debt had value at the
beginning of the year in which the taxpayer claimed worthlessness
and that the debt became worthless in that year. Am. Offshore,
Inc. v. Commissioner, 97 T.C. 579, 593 (1991); Dustin v.
Commissioner, 53 T.C. 491, 501 (1969), affd. 467 F.2d 47 (9th
Cir. 1972).
8
Petitioners argue that the burden of proof with respect to
the issue of worthlessness of the note should shift to respondent
pursuant to Rule 142(a)(1) on the grounds that it constitutes a
new matter. We disagree. In SDI Netherlands B.V. v.
Commissioner, 107 T.C. 161, 168 (1996) (quoting Zarin v.
Commissioner, 92 T.C. 1084 (1989), revd. on other grounds 916
F.2d 110 (3d Cir. 1990)), we stated that: “‘A new position taken
by respondent is not necessarily a “new matter” if it merely
clarifies or develops respondent’s original determination without
requiring the presentation of different evidence, being
inconsistent with respondent’s original determination, or
increasing the amount of the deficiency.’” Here, respondent has
not increased the deficiency, the issue of worthlessness is not
inconsistent with respondent’s original determination, the issue
does not require new evidence, and it develops respondent’s
original determination.
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Debts become wholly worthless when the taxpayer has no
reasonable expectation of repayment. Crown v. Commissioner,
supra. The worthlessness of the debt must be determined as of
the time the deduction is claimed. Estate of Scofield v.
Commissioner, 266 F.2d 154, 163 (6th Cir. 1959), affg. in part
and revg. in part 25 T.C. 774 (1956). However, subsequent events
may be considered to test the soundness of the decision. Am.
Offshore, Inc. v. Commissioner, supra at 597.
A. Absence of an Identifiable Event Causing Worthlessness
Petitioners contend the judgment became worthless during
2003 and subsequent collection attempts in 2004 were made to
confirm its worthlessness. In characterizing the judgment as
worthless, petitioners point to the fact that the DuPonts
transferred their business assets to JROL and liquidated a second
mortgage on a commercial building, which were the targets of
petitioners’ collection action. Petitioners note that Mr. DuPont
was incarcerated and, as part of his sentence, the Federal
Government obtained a restitution lien and Mr. DuPont was barred
from participating in any business associated with insured
healthcare benefits. Petitioners further claim that Mr. DuPont
suffered a severe heart attack, that the IRS filed an NFTL
against the DuPonts’ property, and the DuPonts’ residence was
subject to a first mortgage.
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Despite their characterization of the facts, petitioners
failed to point to an identifiable event that demonstrated the
debt was worthless at the end of 2003. Contrary to petitioners’
allegations, the DuPonts did not transfer all of their business
assets to JROL, and the substantial rental income the DuPonts
received from the five retained guest homes could continue
despite Mr. DuPont’s imprisonment. Mr. DuPont’s imprisonment
does not establish that the debt was worthless, and petitioners
were aware of his indictment in January 2001 before they
purchased the Mahogany Lane property or acquired the note against
the DuPonts. See Tower Loan of Miss., Inc. v. Commissioner, T.C.
Memo. 1996-152. Nonetheless, petitioners made numerous attempts
to collect the judgment during Mr. DuPont’s imprisonment.
Furthermore, despite petitioner’s allegation that Mr. DuPont
suffered a severe heart attack, the record indicates that the
heart problem did not arise until January 2004 and that no more
than 2 weeks of recovery were anticipated.
B. Attempts at Settlement
Respondent argues that the debt owed to petitioners was not
worthless at the end of 2003 and cites the parties’ postjudgment
settlement attempts as evidence of its perceived value. The
judgment was not obtained until November 24, 2003, and in
December 2003 negotiations began between Jasper LLC and the
DuPonts to enter into a payment schedule to satisfy the judgment.
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The negotiations were ongoing as of December 31, 2003, and
continued into 2004 as evidenced by correspondence between the
attorneys for petitioners and the DuPonts. We find that these
ongoing negotiations detail petitioners’ intention to continue
collection efforts into 2004 and beyond and highlight the absence
of an identifiable event showing worthlessness of the debt at the
end of 2003.
C. Payments Received on the Judgment
Petitioners received $126,894 in payments from the DuPonts
on the judgment in the 3 years after 2003. Petitioners argue
that the $934 collected through garnishments in 2004 was paltry
and inconsequential while the $81,392 received in 2005 and the
$44,568 in 2006 pursuant to the April 2005 agreement with the
DuPonts were related not to the 2003 judgment but the JROL
judgment from 2005. The fact that a claimed bad debt is paid in
a subsequent year does not necessarily bar a deduction in a prior
year. However, the fact that substantial payments were made in
2004 through 2006 further suggests that the debt held by Jasper
LLC against the DuPonts had value as of the end of 2003. See
Buchanan v. United States, 87 F.3d 197 (7th Cir. 1996).
Moreover, the 2005 agreement between petitioners and the DuPonts
to pay the judgment and suspend collection clearly indicates that
the 2005 and 2006 payments were made in satisfaction of the
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judgment against the DuPonts entered on November 23, 2004, and
the one against JROL entered on March 11, 2005.
D. Petitioners’ Subsequent Collection Efforts
Respondent further emphasizes petitioners’ substantial
collection efforts in 2004 through 2006 to demonstrate the value
of the judgments to petitioners and Jasper LLC. Beginning in
2002 Jasper LLC pursued the suit against the DuPonts on the note
for more than a year, incurring $28,531 in attorney’s fees and
expenses before being awarded a judgment on November 24, 2003.
Jasper LLC subsequently incurred legal fees and expenses of
$44,928 over the next few years, primarily in connection with the
attempted collection of the judgment. On July 28, 2004,
petitioner authorized his attorney to initiate the costly process
of levying on the personal residence of the DuPonts to collect on
the judgment. We are not persuaded that petitioners, through
Jasper LLC, incurred such substantial attorney’s fees and
expenses to obtain and collect on the judgment against the
DuPonts without any reasonable expectation of repayment.
After carefully considering all the facts and circumstances,
we find that petitioners have failed to prove that the $269,622
nonbusiness debt became wholly worthless in 2003. See sec.
166(d). Petitioners failed to demonstrate an identifiable event
causing the debt to become worthless in 2003, their settlement
negotiations carried over beyond 2003, they ultimately recovered
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a significant amount on the judgment in the subsequent 3 years,
and they incurred extensive costs in attempting to collect.
Thus, we sustain respondent’s determination on this issue.9
IV. Section 6662(a) Penalty
Section 6662(a) and (b)(2) imposes a 20-percent accuracy-
related penalty on the portion of any underpayment that is
attributable to a substantial understatement of income tax. An
understatement is substantial if it exceeds the greater of 10
percent of the tax required to be shown on the return or $5,000.
Sec. 6662(d)(1)(A). The Commissioner bears the burden of
production with respect to penalties. Sec. 7491(c); Higbee v.
Commissioner, 116 T.C. 438, 446-447 (2001). Once the burden of
production is met, the taxpayer must come forward with evidence
sufficient to show that the penalty does not apply. Higbee v.
Commissioner, supra at 447.
According to our determinations above, the tax required to
be shown on petitioners’ return was $18,391 and $226,357 for 2002
and 2003, respectively. Ten percent of the amount of tax
required to be shown in 2002 and 2003 is $1,839 and $22,635,
respectively. Consequently, petitioners’ understatements are
substantial only if they exceeded $5,000 for 2002 and $22,635 for
2003. Petitioners’ understatements for 2002 and 2003 were $9,013
9
Because of our holding herein, we do not address the
question of whether the debt involved was a business or
nonbusiness bad debt.
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and $157,486, respectively. Thus, respondent has satisfied his
burden of production by showing that petitioners’ understatements
of tax were substantial in both of the years at issue.
Respondent determined petitioners are liable for accuracy-
related penalties under section 6662(a) of $1,803 and $31,497 for
2002 and 2003, respectively. For purposes of determining the
accuracy-related penalty, the amount of the understatement is
reduced by the portion of the understatement that was
attributable to the tax treatment of an item where: (1) The
taxpayer had substantial authority for his position; or (2) the
taxpayer adequately disclosed his or her position and has a
reasonable basis for such position. Sec. 6662(d)(2)(B).
Petitioners argue that they had substantial authority for
claiming the deductions and that they made adequate disclosures
and had a reasonable basis for their position. Respondent
disagrees.
A. Substantial Authority and Adequate Disclosure
There is substantial authority for a specific tax treatment
only if the weight of the authorities supporting the treatment is
substantial in relation to the weight of those supporting
contrary treatment. See sec. 1.6662-4(d)(3)(i), Income Tax Regs.
Moreover, the substantial authority standard is an objective one,
and the taxpayer’s belief that there is substantial authority for
the tax treatment of an item is not relevant. Id. Petitioners
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have not met this objective standard. As we found above, the
cases petitioners cited are distinguishable and do not stand for
the proposition that the expenses petitioners incurred before
engaging in the trade or business of farming are deductible or
that Jasper LLC’s purchase of a single loan qualifies as a trade
or business for tax purposes.
Petitioners argue that they adequately disclosed the
relevant information in a footnote to Schedule C and had a
reasonable basis for their position. Adequate disclosure
generally requires the inclusion of Form 8275, Disclosure
Statement, with the return. See sec. 1.6662-4(f), Income Tax
Regs. Petitioners did not include that form. Moreover,
reasonable basis “is a relatively high standard of tax reporting,
that is, significantly higher than not frivolous or not patently
improper. The reasonable basis standard is not satisfied by a
return position that is merely arguable or that is merely a
colorable claim”. Sec. 1.6662-3(b)(3), Income Tax Regs. Thus,
we find petitioners did not have a reasonable basis for their tax
treatment.
B. Reasonable Cause and Good Faith
The accuracy-related penalty is not imposed with respect to
any portion of the underpayment if the taxpayer can establish he
acted with reasonable cause and in good faith. Sec. 6664(c)(1).
The determination of whether a taxpayer acted with reasonable
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cause and in good faith is made on a case-by-case basis, taking
into account all pertinent facts and circumstances, including the
extent of the taxpayer’s efforts to assess his or her proper tax
liability and the taxpayer’s education, knowledge, and
experience. Sec. 1.6664-4(b)(1), Income Tax Regs. The extent of
the taxpayer’s efforts to assess the proper tax liability is
generally the most important factor. Id.
Both petitioners were certified public accountants in 2002
and 2003. The returns for the years at issue were prepared by
Ms. Vianello, who has been a CPA since 1980, who started her own
practice 25 years ago, and who is a tax specialist. Despite this
background and her admitted lack of experience in farm matters,
there is no evidence that she did any research with respect to
the deductibility of the claimed Schedule F losses other than
consulting an IRS publication and related forms. There is no
evidence that she did any research with respect to the claimed
Schedule C losses. Rather, she merely interviewed petitioner to
assess the proper tax liability. Petitioners have extensive
knowledge and experience in tax law but did not make a
significant effort to determine their eligibility for the claimed
losses under Schedule C or F or properly evaluate the facts
regarding the worthlessness of the DuPonts’ debt in 2003. Under
the circumstances, petitioners have not shown they acted with
reasonable cause and good faith.
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For the above reasons, we find petitioners are liable for
accuracy-related penalties under section 6662(a) of $1,803 and
$31,497 for 2002 and 2003, respectively.
In reaching our holdings, we have considered all arguments
made, and, to the extent not mentioned, we conclude that they are
moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered for
respondent.