The opinion
T.C. Memo. 2010-75
UNITED STATES TAX COURT
C. MICHAEL AND GWENDOLYN E. WILLOCK, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 25616-06. Filed April 14, 2010.
C. Michael and Gwendolyn E. Willock, pro se.
Jeanne Gramling, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARIS, Judge: On September 14, 2006, respondent mailed to
petitioners a notice of deficiency (notice) that determined
deficiencies in their Federal income tax of $140,135 and $154,888
for tax years 2002 and 2003, respectively, and penalties under
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section 66621 of $28,027 and $30,978 for 2002 and 2003,
respectively. Petitioners, then residing in the State of North
Carolina, timely petitioned this Court for redetermination of the
deficiencies and penalties.
The issues for decision as framed by the parties are:
(1) whether petitioners’ car and truck expenses were
ordinary and necessary business expenses, and whether petitioners
adequately substantiated those expenses;
(2) whether petitioners’ vehicle was placed in service
during taxable year 2003;
(3) whether petitioners adequately substantiated as dental
practice expenses their travel and entertainment expenses for
their trip to Hawaii, professional fees paid to an individual for
marketing and networking training, and fees for janitorial
services;
(4) whether petitioners’ losses from their dental equipment
leasing business are properly deductible from the income they
received from their condominium rental;
(5) whether petitioners’ participation in a multi-level
marketing company and an organic farming business was for profit;
(6) whether certain deposits made to petitioners’ joint
1
Section references are to the Internal Revenue Code of 1986
(Code), as amended. Rule references are to the Tax Court Rules
of Practice and Procedure.
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bank account are properly includable as income, or whether those
deposits repaid a loan made to their son; and
(7) whether petitioners are liable for accuracy-related
penalties.
FINDINGS OF FACT
Some of the facts have been stipulated and are found
accordingly. The stipulation of facts and the attached exhibits
are incorporated herein by this reference.
I. The Dental Practice Items
Petitioner husband is a dentist. In 2002 and 2003 he
operated his dental practice through an S corporation known as C.
Michael Willock, DDS, PA. For tax years 2002 and 2003 respondent
determined increases in the dental practice’s gross receipts by
reference to bank deposits and disallowed or reduced deductions
for some of the expenses claimed by the practice. The parties
agree that the amounts reported as the dental practice’s gross
receipts for 2002 and 2003 should be increased by $87,744 and
$7,271 respectively. However, what remains in dispute are
petitioners’ claimed deductions for car and truck expenses,
section 179 expenses, travel expenses, professional fees, and
cost of janitorial services. These expenses are flow-through
items incurred by the S corporation.
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A. Car and Truck Expenses
Respondent denied petitioners’ claimed deductions for car
and truck expenses of $23,705 and $22,899 for tax years 2002 and
2003, respectively. In 2002 petitioners drove an Audi and a Land
Rover, both of which were claimed by petitioners to have been
driven solely for business purposes. Petitioner wife had veneers
(cosmetic dental applications) applied to her teeth by petitioner
husband. Petitioners claim that any time petitioner wife drove
anywhere in one of the vehicles she was “a walking, talking
billboard for [the] dental office” because of the veneer work
petitioner husband had performed. Additionally, each vehicle had
a license plate holder that displayed the name of the dental
practice. Petitioner husband used the vehicles to perform
various tasks for the dental practice, such as purchasing office
supplies. During 2002 and 2003, petitioners owned four vehicles:
a GMC Envoy, an Audi, a Land Rover, and a Chevy Tahoe.
Petitioner wife testified that she drove the Audi until the lease
expired,2 after which she drove the Land Rover.
Petitioners started leasing the Land Rover on May 1, 2002,
and the dental practice claimed deductions for lease payments
with respect to both the Land Rover and the Audi during 2002.
Petitioners leased the Audi until February 10, 2003. During 2002
2
Petitioners leased the Audi and the Land Rover, and owned
the GMC Envoy and the Chevy Tahoe.
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and 2003 petitioners also reported a $750 monthly expense for
“GMAC”, which is reflected in their car and truck expenses for
2002 and 2003. It is unclear which vehicle these payments were
for. The vehicles were owned or leased by petitioners
individually, not by the dental practice; however, the dental
practice claimed the deductions.
B. Section 179 Expense Deduction
The dental practice claimed section 179 expense deductions
for tax years 2002 and 2003 in the respective amounts of $20,301
and $38,630. Respondent concedes the deduction of $20,301 for
tax year 2002. Respondent partially disallowed the section 179
expense deduction for 2003 claimed in regard to the GMC Envoy.
On the dental practice’s return, petitioners reported that the
GMC Envoy was placed in service on November 18, 2003, and that it
was used solely for business purposes. Petitioners purchased the
GMC Envoy after the lease for the Land Rover expired.
Petitioners’ lease on the Land Rover ended sometime after 2003,
i.e., in 2004. It therefore appears that petitioners retained
the Land Rover lease through 2003, and purchased the GMC Envoy
after 2003. The GMC Envoy bore a license plate holder with the
name of the dental practice. The GMC Envoy was titled in
petitioners’ names rather than in the name of the dental
practice, which claimed the deductions.
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C. Travel Expenses
Respondent disallowed travel expenses of $5,082 for 2002,
which petitioners claim they incurred during a business trip to
Hawaii for a dental conference. Petitioners were in Hawaii from
May 3 through 12, 2002. Petitioners testified that the dental
conference was held from May 7 through 10, 2002. Petitioners
presented the Court an invoice for the purchase of dental
equipment which they claim they purchased in Hawaii during the
dental conference. The invoice, however, states only when the
equipment was purchased, not where it was purchased.
D. Professional Fees
Petitioners deducted professional fees of $10,080.50 for tax
year 2002, which amount they claimed was paid to Ron Lewis, the
pastor of petitioners’ church. Petitioners hired Ron Lewis to
instruct petitioner wife in the areas of networking and marketing
so that she could be a more effective salesperson and marketer
for the dental practice. These instructional sessions
purportedly occurred in petitioners’ home and, for a brief period
of time, over the telephone. Petitioners presented copies of
Forms 1096, Annual Summary and Transmittal of U.S. Information
Returns, and 1099-MISC, Miscellaneous Income, in support of these
claimed expenses for consulting. No Social Security number is
listed for Ron Lewis on either form, and no evidence was offered
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to confirm that the tax forms were actually delivered to Ron
Lewis. Ron Lewis did not testify at trial.
E. Janitorial Expenses
Respondent disallowed some of the dental practice’s claimed
janitorial expenses for both 2002 and 2003, and a portion of
these expenses remains in dispute. With respect to 2002, the
dental practice claimed janitorial expenses of $20,226. The only
expenses remaining in dispute are certain expenses in connection
with payments claimed to have been made to the “Sotelos”, a
landscaping service, in the amount of $12,208. Petitioners
testified that these expenses were reported on their 2002 income
tax return and represent expenses incurred for landscaping
services provided for the dental practice. All of the invoices
from the Sotelos are addressed to petitioners at their home
address, and were not addressed to the dental practice or sent to
the dental practice address.
In tax year 2003, petitioners deducted janitorial expenses
of $11,648, of which amount respondent allowed $4,192. Of the
disallowed amount, $1,500 represents an amount petitioners claim
to have paid to their son Ryan Willock on behalf of the
condominium association where the dental office is located.
Petitioners testified that they paid their son to provide
landscaping upgrades to the dental practice. Petitioners claim
that the landscaping had not been updated in several years, and
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that such work was necessary to present a professional appearance
to new and existing dental practice patients. However,
petitioners presented no documentation supporting this claimed
expense. The remaining $6,0743 reflects a payment to Ryan
Willock, as evidenced by a Form W-2, Wage and Tax Statement, that
petitioners generated. Petitioners provided no evidence of the
services which their son purportedly provided for this amount,
nor any evidence that the Form W-2 was delivered to him.
II. Dental Practice Leases
Petitioners owned a condominium which they leased to
petitioner husband’s dental practice, which was operated as an S
corporation. In both 2002 and 2003, a profit was reported with
respect to this rental property. Petitioners also owned a
company known as Dental Equipment Leasing, L.L.C. (DEL), which
leased a CEREC milling machine4 to the dental practice. DEL did
not lease any other equipment to the dental practice, or lease
any equipment to any other individual or entity during the years
at issue. In 2002 and 2003, DEL reported a loss. On their 2002
3
The amount claimed, $11,648, less the amount allowed,
$4,192, leaves $7,456 disallowed by respondent. Respondent,
however, disallowed individual amounts of $1,500 and $6,074,
which total $7,574. This amount is $118 more than the total
amount claimed by petitioners. It is unclear what created this
discrepancy; however, respondent does not seek to disallow the
$118 difference between the total amount reported on the S
corporation’s return, and the total amount disallowed by
respondent.
4
This machine is used to make dental implants.
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and 2003 Federal income tax returns, petitioners deducted losses
from the lease of the dental equipment of $13,119 for 2002 and
$27,628 for 2003, from the income received from the rental of the
condominium. Respondent disallowed these claimed loss
deductions.
III. Nu-E World Lexxus International
During tax years 2002 and 2003, petitioners worked part-time
as salespersons and marketers with a company known as Nu-E World
Lexxus International (Nu-E World). Petitioners reported expenses
from their work with Nu-E World on Schedule C, Profit or Loss
From Business, on their 2002 and 2003 income tax returns. On
their 2002 income tax return, petitioners reported that their
work for Nu-E World caused them to incur expenses for travel,
meals and entertainment, sales aides, dues, and purchases. On
their 2003 income tax return, petitioners reported that their
work for Nu-E World caused them to incur expenses for
depreciation and dues. In the notice, respondent disallowed the
expense deductions claimed for both years on grounds that
petitioners failed to substantiate the amounts claimed, and
failed to establish that the amounts were ordinary and necessary
business expenses. After the notice was issued, petitioners
provided some receipts for meals as well as copies of credit card
statements. In light of these disclosures, respondent conceded
that petitioners may claim expenses to the extent of income
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reported. Petitioners reported sales income of $1,080 for 2002,
and zero income for 2003. There are no records indicating which
items were sold, or the volume or dates of sale.
On their 2002 income tax return, petitioners reported that
they incurred expenses in connection with their work for Nu-E
World for meals and travel, including hotel rooms for themselves
and their son and daughter-in-law, and meals for individuals who,
in the Nu-E World structure, ranked both above and below
petitioners. According to their list of expenses, petitioners
also purchased two computers to be used in their work for Nu-E
World; one from Dell in the amount of $1,497 on April 15, 2002,
and the other from Gateway in the amount of $902 in January of
2002. Petitioners claimed depreciation on their 2002 and 2003
returns for one of these computers, though it is impossible to
tell which computer from the evidence available to the Court.
Petitioners also purchased window blinds costing $541 for the
meeting room in their home. Petitioners claim that it was
necessary to purchase the blinds to make the meeting room look
more professional to potential Nu-E World clients. Petitioners’
records consist of summaries of expenses and receipts for meals
with handwritten notes with respect to the individuals whose
meals they paid for.
Petitioners thought that Nu-E World would be a good source
of income based upon their research of the history of the
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individuals running the company. According to petitioners, these
individuals had a proven record of success in very similar
industries, and thus petitioners believed that Nu-E World would
also be very successful.
Petitioners networked with people and attempted to sell them
products that Nu-E World marketed or produced, such as a product
called “Noni Juice”. Petitioners often gave out free samples of
products provided by Nu-E World, in the hope that the free
samples would generate purchases from customers. Petitioner wife
performed the role of salesperson for Nu-E World’s products. She
found individuals she believed might be interested in these
products, brought the individuals to her home’s meeting room, and
gave these individuals a sales-pitch on the benefits of various
Nu-E World products.
IV. Laurel Valley Properties, L.L.C.
In 2003, petitioners purchased 149 acres of land near
Stuart, Virginia for the purpose of starting an organic farm.
The property was titled in petitioners’ names; however, the
farming operation was operated as a limited liability company
called Laurel Valley Properties, L.L.C. (Laurel Valley). Laurel
Valley filed a Form 1065, U.S. Return of Partnership Income, for
2003. Petitioners were each issued a Schedule K-1, Partner’s
Share of Income, Credits, Deductions, etc., from Laurel Valley
for 2003. Petitioners reported on their individual 2003 income
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tax return a flowthrough loss from Laurel Valley, of $68,660.
Of that amount, $42,684 was for depreciation on two all-terrain
vehicles petitioners purchased, and $19,417 was for mortgage
interest on the farm. Respondent disallowed the claimed loss on
the ground that this endeavor was not entered into as a business
activity engaged in for profit.
Laurel Valley had no bank account in 2003, and some of the
expenditures for which petitioners claimed deductions were made
with checks from petitioner husband’s dental practice, while
others were made with petitioners’ personal checks.
In 2003, petitioners purchased chickens that were to be used
for egg production and sale, but the chickens were eaten by
predators. Petitioners have since built a chicken coop to house
the chickens. Petitioners determined that they would be able to
sell the chicken eggs to a nearby restaurant as well as to local
individuals. Petitioners devoted all of their weekends,
holidays, and vacation time to working on the farm. Petitioners
made improvements to the farm such as building a storage shed.
Petitioner wife was born on a farm, and lived on a farm
until she was 38 years old. She had owned a farm with her
father, and had owned cows, tractors, and milking equipment in
the past. Petitioner wife’s father was a dairy farmer.
Petitioner husband worked on petitioner wife’s father’s farm
after petitioners married. Petitioner husband worked
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continuously on the farm until the farm was sold, at which point
petitioner husband went to dental school. Petitioner wife has
been a member of the North Carolina Farm Bureau, an independent
farming trade group, since 1965.
V. Banks Deposits (Loan to Ryan Willock)
Respondent analyzed petitioners’ bank deposits and
determined that petitioners had understated their 2002 and 2003
income of $61,899 and $184,537 respectively. After respondent
issued the notice, petitioners presented respondent with certain
documentation in an attempt to justify the understatement.5
Based upon these documents, respondent conceded all but $8,500
for 2002, and the entire amount for 2003. Petitioners claim that
the bank deposits of $8,500 remaining in dispute for 2002 were
received in repayment of a loan they made to their son, Ryan
Willock, so that he could purchase a used pickup truck from
Michael Hickman, a used car salesman. Petitioners therefore
claim that the bank deposits of $8,500, which respondent included
in their income, had a nontaxable source, i.e., loan repayments
from their son. Petitioners’ documentary evidence supporting
this claim consists of (1) a carbon copy of a check for $7,200
from the bank account of “M. Ryan Willock” dated April 16, 2002,
(2) a copy of a deposit slip for petitioners’ bank account which
5
The Court is not privy to the reason petitioners did not
present this information to respondent before the notice was
issued.
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reflects a $7,200 deposit on April 17, 2002, and (3) copies of
two checks, one for $8,000 and the other for $500, both dated
April 16, 2002, and both made payable to Michael Hickman.
Petitioners did not present any documentation to support their
claim that the additional deposit of $1,300 into their bank
account was from their son in satisfaction of his loan debt.
Petitioners lent $8,500 to their son Ryan Willock so that he
could purchase a used pickup truck. The truck was offered for
sale by Michael Hickman for $8,500. Petitioner wife happened
upon the sale of the vehicle and asked her son whether he was
interested in purchasing it for the sale price. Her son informed
her that he was interested, but could not come to the vehicle’s
location at that time because of his work schedule. Petitioner
wife asked Hickman to hold the vehicle for her son. Hickman
agreed to do so only after receiving a $500 deposit check from
petitioner wife. Petitioner wife paid the remaining $8,000 to
Hickman by check upon sale.
OPINION
I. Dental Practice Items
Respondent determined that the returns underreported the
dental practice’s gross receipts by reference to bank deposits,
and disallowed or reduced some of the deductions claimed by the
practice for tax years 2002 and 2003. The parties agree that the
dental practice’s gross receipts for 2002 and 2003 should be
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increased by $87,744 and $7,271, respectively. However,
remaining in dispute are petitioners claimed deductions for car
and truck expenses, section 179 expenses, travel expenses,
professional fees, and fees for janitorial services.
A. Car and Truck Expenses
Section 162(a) allows deductions for all ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business, including operating expenses
of automobiles used in the trade or business. Sec. 1.162-1(a),
Income Tax Regs. A taxpayer is entitled to deduct transportation
expenses incurred in carrying on a trade or business. Commuting
expenses, however, incurred in going from a taxpayer’s residence
to his or her place of business and returning are nondeductible
personal expenses. See, e.g., Fausner v. Commissioner, 413 U.S.
838 (1973). When a taxpayer uses a car for personal as well as
for business purposes, he or she must allocate expenses between
personal and business use. See sec. 1.274-5T(d)(2)(i), Temporary
Income Tax Regs., 50 Fed. Reg. 46025 (Nov. 6, 1985). Petitioners
did not allocate their expenses.
The Code and the regulations thereunder require that
sufficient records be maintained to establish the amount of any
deduction claimed. See sec. 6001; sec. 1.6001-1(a), Income Tax
Regs. Any taxpayer seeking to deduct expenses related to the
business use of a car must provide the Commissioner with certain
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information. A taxpayer must indicate mileage, including total
business, commuting, and other personal mileage, percentage of
business use, date placed in service, use of other vehicles,
after-work use, whether the taxpayer has evidence supporting
claimed business use, and whether or not the evidence is written.
Sec. 1.274-5T(d)(2)(i), Temporary Income Tax Regs., supra.
Petitioners have not provided this information to respondent or
the Court.
Section 274(d)(4) provides that no deduction is allowed for
listed property as defined by section 280F(d)(4) unless the
taxpayer substantiates by adequate records or corroborative
evidence (1) the amount of such expense, (2) the time and place
of use, (3) the business purpose of the expense, and (4) the
business relationship of the taxpayer to the persons using the
property. Pursuant to section 280F(d)(4) listed property
includes, with certain exceptions, “any passenger automobile” or
“other property used as a means of transportation”. Sec.
280F(d)(4)(A)(i) and (ii).
Petitioners deducted car and truck expenses $23,705 and
$22,899 for 2002 and 2003, respectively. Respondent denied
these deductions, claiming that petitioners failed to adequately
substantiate the expenses or provide information that the amounts
were incurred as ordinary and necessary business expenses. In
order to substantiate the expenses petitioners offered cancelled
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checks and credit card bills for various items such as repairs
and gas. Additionally, petitioners offered a series of
handwritten calendars that detail their daily work schedules, but
not the particular use of the vehicles for which expenses were
claimed. Petitioners used their cars for personal as well as
business purposes; however, petitioners claim all use was
business related because each vehicle had a license plate holder
that displayed the name of the dental practice. Petitioners
contend that even when the vehicles were being used for personal
reasons they provided a valuable advertising service to the
dental practice. Petitioners did not maintain records allocating
personal and business use of their cars. Petitioners also
commuted to the dental practice from their home daily, but did
not make an allocation for any commuting to and from the dental
practice.
Petitioners failed to prove that the vehicles were used in
the conduct of a trade or business as defined under section 162.
Further, petitioners failed to maintain adequate records to
substantiate the use of their vehicles under section 274.
Respondent’s determination is sustained.
B. Section 179 Expense Deductions
A taxpayer may elect to deduct as a current expense the cost
of any section 179 property, with certain dollar limitations,
that is acquired by purchase in the active conduct of a trade or
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business and placed in service during the taxable year. Sec.
179(a), (b), (d)(1); sec. 1.179-4(a), Income Tax Regs. Placed in
service is defined to mean “the time that property is first
placed by the taxpayer in a condition or state of readiness and
availability for a specifically assigned function, whether for
use in a trade or business, for the production of income, in a
tax-exempt activity, or in a personal activity.” Sec. 1.179-
4(e), Income Tax Regs.
The dental practice claimed section 179 deductions for tax
years 2002 and 2003 of $20,301 and $38,630, respectively.
Respondent concedes petitioners may deduct $20,301 for tax year
2002. However, respondent disallowed the section 179 deduction
claimed in 2003 for the GMC Envoy petitioners claim was used
solely for business purposes for the dental practice. On the
dental practice’s return, petitioners reported that the GMC Envoy
was placed in service on November 18, 2003, and that it was used
solely for business purposes. Petitioner wife testified that
petitioners purchased the GMC Envoy after the lease for the Land
Rover expired. However, petitioner wife also testified that
petitioners’ lease on the Land Rover ended sometime after 2003.
It therefore appears that petitioners retained the Land Rover
lease through 2003 and thus purchased the GMC Envoy after 2003.
It is unclear whether petitioners placed the item in service
in 2003 or in 2004 after the lease on the Land Rover expired.
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Petitioners have not offered any other evidence to corroborate
their claimed placed-in-service date. Under section 179 and the
regulations thereunder, the Court must sustain respondent’s
determination as to the GMC Envoy.
C. Travel and Entertainment Expenses
A taxpayer may claim a deduction for travel and
entertainment expenses if the taxpayer establishes, among other
things, that the expenditure was directly related to the active
conduct of the taxpayer’s trade or business or, in the case of an
expenditure directly preceding or following a substantial and
bona fide business discussion, that the expenditure was
associated with the active conduct of the taxpayer’s trade or
business. Sec. 1.274-2(a)(1), Income Tax Regs. Petitioners
claimed travel expenses of $10,196 for tax year 2002, of which
$5,082 remains in dispute after respondent’s partial concession.
Petitioners claim they incurred these expenses for a trip to
Hawaii for a dental seminar. Petitioners have not offered any
probative evidence to substantiate their attendance at the
seminar, nor have they offered any probative evidence to support
the business purpose of the trip. Petitioners presented the
Court an invoice for the purchase of dental equipment which they
claim was made in Hawaii during the dental conference. The
invoice, however, states only when the equipment was purchased,
not where it was purchased. Petitioners produced no evidence
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supporting any of the expenses claimed, which include meals,
first-class airline tickets, and taxi fees. Petitioners have
failed to substantiate that their claimed expenses were in any
way related to their dental practice.
Respondent’s determination is sustained as to the amount of
the travel expenses remaining in dispute and not conceded by
respondent.
D. Professional Fees Expense
Petitioners claimed a deduction for professional fees for
tax year 2002 of $10,080.50, which they claimed was paid to Ron
Lewis for consulting services in the form of networking and
marketing instruction to petitioner wife. Petitioners presented
to the Court copies of Forms 1096 and 1099-MISC, which
petitioners prepared, in support of these claimed expenses for
consulting. No Social Security number is listed for Ron Lewis on
either form, nor is there any proof that these forms were ever
delivered to him. Petitioner wife initially testified that she
borrowed the money used to pay Ron Lewis by issuing to him checks
written against a Chase line of credit, thus incurring finance
charges. She later testified that she paid Ron Lewis with
“mostly cash”. It is unclear from the evidence whether Ron Lewis
was ever paid any amount by petitioners.
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Because petitioners have not met their burden of
substantiating these expenditures, respondent’s determination
must be sustained.
E. Janitorial Services Expense
Respondent reduced the dental practice’s claimed janitorial
expenses for both 2002 and 2003, and a portion of these
expenses remains in dispute. With respect to 2002, the dental
practice claimed janitorial expenses of $20,226. The only
expenses remaining in dispute are certain expenses of $12,208 in
connection with payments claimed to have been made to the
“Sotelos”, a landscaping service. Petitioners testified that
these expenses were reported on their 2002 income tax return, and
represented expenses incurred for landscaping services provided
to the dental practice. All of the invoices from the Sotelos
were addressed to petitioners at their home address, and were not
addressed to the dental practice, or sent to the dental practice
address.
With respect to tax year 2003, petitioners claimed
janitorial expenses of $11,648, of which respondent allowed
$4,192. Of the disallowed amount, $1,500 represents an amount
petitioners claim to have paid to their son Ryan Willock on
behalf of the condominium association where the dental office is
located. Petitioners testified that they paid their son to
provide landscaping upgrades to the dental practice. Petitioners
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claim that the landscaping had not been updated in several years,
and that such work was necessary to present a professional
appearance to new and existing dental practice patients.
However, petitioners presented no documentation supporting this
claimed expense. The remaining $6,074 reflects a payment to Ryan
Willock, as evidenced by a Form W-2 petitioners generated.
Petitioners provided no evidence of the services which their son
purportedly provided for this amount.
Petitioners have failed to substantiate that these claimed
expenses had a business purpose or that the services were even
provided to their business, rather than to them personally.
Respondent’s determination is sustained.
II. Dental Practice Leases
DEL leased one CEREC milling machine to the dental practice,
but did not lease any other equipment to any other individual or
entity during the years at issue. DEL reported losses for 2002
and 2003. Petitioners, on their 2002 and 2003 income tax
returns, attempted to deduct the passive losses of DEL from the
income derived from their rental of the condominium to the dental
practice, claiming both were passive activities. Respondent
disallowed the deduction on the grounds that the rental activity
was not passive because petitioner husband actively participated
in the dental practice. Petitioners argued during the trial that
the equipment leasing and condominium leasing were both
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nonpassive activities, thus allowing for the loss of one to
offset the income of the other.
Generally, under section 469, an individual, closely held C
corporation, or personal services corporation may not deduct
losses from passive activities against nonpassive income.
Passive activity is defined to include (1) a trade or business in
which the taxpayer is not a material participant or, (2) any
rental activity. See sec. 469(c). Though section 469(c)(2)
generally includes rental activities in the definition of passive
activity, the “self-rental rule” provides that a taxpayer’s net
income from a rental of property to a trade or business activity
in which the taxpayer materially participates is treated as
nonpassive income, whereas a loss from such rental is treated as
a passive loss. See sec. 1.469-2(f)(6), Income Tax Regs.; see
also Krukowski v. Commissioner, 114 T.C. 366, 369 (2000) (holding
that the Secretary was authorized to prescribe section
1.469-2(f)(6), Income Tax Regs., and that the regulation is valid
law), affd. 279 F.3d 547 (7th Cir. 2002). Therefore, if
petitioner husband’s dental practice constitutes a trade or
business activity in which he materially participates, under the
self-rental rule any income from the condominium rental or
equipment rental would be nonpassive and any losses from these
activities would be treated as passive. If this is the case,
then respondent’s determination would be sustained because losses
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from one passive activity can be deducted against income from
other passive activities, but passive losses may not be deducted
from nonpassive income. See sec. 469(a).
An individual participates materially in a trade or business
if his or her involvement “in the operations of the activity” is
“regular”, “continuous”, and “substantial”. Sec. 469(h)(1). In
an effort to make the material participation test objective, the
regulations identify seven situations in which an individual’s
participation in a trade or business is material. See sec.
1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb.
25, 1988). Fulfilling the criteria in any of the seven will
cause the participation to be deemed active. Id. Petitioner
husband may meet the criteria for several of the situations, but
most notably meets the “500 hour test”. Under this test an
individual who participates in an activity for more than 500
hours during a taxable year is a material participant in the
activity for the year. Id. “Participation” generally means any
work done in an activity by an individual who owns an interest in
the activity. Sec. 1.469-5(f)(1), Income Tax Regs. Generally,
all hours of work in connection with the activity are counted as
participation. Id.
Petitioner husband worked full-time at the dental practice
during 2002 and 2003. By petitioner husband’s own admission he
worked more than 500 hours at the dental practice each year. The
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dental practice was clearly materially participated in by
petitioner husband during 2002 and 2003. Under the self-rental
property rule, the income petitioners received from the rental of
the condominium is nonpassive income. Moreover, under this rule,
the losses petitioners may have incurred from the rental of the
CEREC machine to the dental practice are passive.
Under section 469, petitioners are prohibited from deducting
the passive losses of DEL from the nonpassive income of the
condominium rental. The Court sustains respondent’s
determination.
III. Section 183 and Activities Engaged in for Profit
The Court must determine whether petitioners’ Nu-E World
sales and marketing activities and Laurel Valley farming
activities were “engaged in for profit” within the meaning of
section 183. Section 183(a) provides that if an activity engaged
in by an individual is not engaged in for profit, no deduction
attributable to that activity shall be allowed except as provided
in section 183(b). Section 183(b) allows in the case of
activities not engaged in for profit: (1) Deductions which would
be allowable under the Code without regard to whether such
activity was engaged in for profit; and (2) a deduction equal to
the amount of the deductions which would be allowable under the
Code only if such activity were engaged in for profit, but “only
to the extent that the gross income derived from such activity
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for the taxable year exceeds the deductions allowable by reason
of [the first exception]”. Section 183(c) defines an activity
not engaged in for profit as “any activity other than one with
respect to which deductions are allowable for the taxable year
under section 162 or under paragraph (1) or (2) of section 212.”
Section 162 allows a deduction for all ordinary and
necessary expenses paid or incurred in carrying on any trade or
business. Section 212 allows a deduction for all ordinary and
necessary expenses paid or incurred for the production or
collection of income, or for the management, conservation, or
maintenance of property held for the production of income.
Whether deductions are allowable under section 162 or 212
depends, inter alia, on whether the taxpayer engaged in the
activity with the objective of making a profit. See sec. 183(a).
The regulations under section 183 establish an objective
test for determining whether a taxpayer is engaging in an
activity for profit. The regulations state:
The determination whether an activity is
engaged in for profit is to be made by
reference to objective standards, taking into
account all of the facts and circumstances of
each case. Although a reasonable expectation of
profit is not required, the facts and
circumstances must indicate that the taxpayer
entered into the activity, or continued the
activity, with the objective of making a
profit. * * * In determining whether an
activity is engaged in for profit, greater
weight is given to objective facts than to the
taxpayer’s mere statement of his intent.
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Sec. 1.183-2(a), Income Tax Regs. The regulations provide a
nonexclusive list of nine factors that “should normally be taken
into account” when making the determination whether the activity
was engaged in for profit. Sec. 1.183-2(b), Income Tax Regs.
The nine factors are: (1) The manner in which the taxpayer
carried on the activity; (2) the expertise of the taxpayer or his
advisors; (3) the time and effort spent by the taxpayer on the
activity; (4) the expectation that assets used in the activity
might appreciate in value; (5) the taxpayer’s success in carrying
on similar or dissimilar activities; (6) the taxpayer’s record of
income or losses attributable to the activity; (7) the amount of
profits earned; (8) the taxpayer’s financial status; and (9) the
personal pleasure or recreation derived from the activity by the
taxpayer. Id.
As explained by the regulations, no single factor is
controlling. Sec. 1.183-2(b), Income Tax Regs. To simplify the
analysis, several factors can be grouped together for purposes of
analyzing the facts and circumstances applicable to this case.
The first factor involving whether the taxpayer acted in a
businesslike manner in connection with the undertaking is defined
under section 1.183-2(b)(1), Income Tax Regs., as follows:
The fact that the taxpayer carries on the
activity in a businesslike manner and maintains
complete and accurate books and records may
indicate that the activity is engaged in for
profit. Similarly, where an activity is carried
on in a manner substantially similar to other
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activities of the same nature which are
profitable, a profit motive may be indicated. A
change of operating methods, adoption of new
techniques or abandonment of unprofitable
methods in a manner consistent with an intent
to improve profitability may also indicate a
profit motive.
Section 1.183-2(b)(2), Income Tax Regs., explains the second
factor regarding the expertise of the taxpayer and his advisors:
Preparation for the activity by extensive study
of its accepted business, economic, and
scientific practices, or consultation with
those who are expert therein, may indicate that
the taxpayer has a profit motive where the
taxpayer carries on the activity in accordance
with such practices. Where a taxpayer has such
preparation or procures such expert advice, but
does not carry on the activity in accordance
with such practices, a lack of intent to derive
profit may be indicated unless it appears that
the taxpayer is attempting to develop new or
superior techniques which may result in profits
from the activity.
The time and effort expended by the taxpayer in carrying on
the activity, which is the third factor, is defined by section
1.183-2(b)(3), Income Tax Regs., as follows:
The fact that the taxpayer devotes much of his
personal time and effort to carrying on an
activity, particularly if the activity does not
have substantial personal or recreational
aspects, may indicate an intention to derive a
profit. A taxpayer’s withdrawal from another
occupation to devote most of his energies to
the activity may also be evidence that the
activity is engaged in for profit. The fact
that the taxpayer devotes a limited amount of
time to an activity does not necessarily
indicate a lack of profit motive where the
taxpayer employs competent and qualified
persons to carry on such activity.
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With respect to the fifth factor dealing with the success of
the taxpayer in carrying on other similar or dissimilar
activities, section 1.183-2(b)(5), Income Tax Regs., provides:
The fact that the taxpayer has engaged in
similar activities in the past and converted
them from unprofitable to profitable
enterprises may indicate that he is engaged in
the present activity for profit, even though
the activity is presently unprofitable.
A. Nu-E World
The Court is not convinced that petitioners conducted this
activity in a businesslike manner. See sec. 1.183-2(b)(1),
Income Tax Regs. Petitioners purchased two computers supposedly
for use in this activity; however, there is no evidence before
the Court of what purpose these computers served. Additionally,
petitioners’ records consist of summaries of expenses and
receipts for meals with handwritten notes with respect to the
individuals whose meals they paid. Petitioners claim that they
served as salespersons for Nu-E World. Nu-E World sells consumer
products such as “Noni Juice”. Petitioners claim that they did
in fact sell some Nu-E World products. Petitioners, however, did
not maintain any records indicating which, if any, items they
sold on behalf of Nu-E World or the volume or dates of such
sales. Petitioners similarly did not use certain fundamental
business practices that would be expected of individuals
undertaking an activity for profit, such as keeping detailed
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records of business telephone charges, commercial bank account
records, detailed invoices of products received from Nu-E World,
and postage expenses records. See Ogden v. Commissioner, T.C.
Memo. 1999-397, affd. 244 F.3d 970 (5th Cir. 2001). To the
Court’s knowledge, petitioners did not maintain a written
business plan or a projected profit and loss statement.
Petitioners have no prior experience in selling or maintaining an
inventory of retail products.
The Court determines that petitioners are not entitled to
deduct the losses from their Nu-E World activity for the years at
issue.
B. Laurel Valley
Petitioners purchased a parcel of land in Virginia with the
goal of transforming it into an organic farm. Petitioners
operated the farm in a businesslike manner consistent with that
of farms being operated for profit. See sec. 1.183-2(b)(1),
Income Tax Regs. To this end, petitioners made improvements to
the land, such as building a storage shed, purchasing farming
machinery to clear and work the land, and building a chicken
coop. Petitioners purchased chickens that were to be used for
egg production and sale. Through research, petitioners
determined that the eggs could be sold to a nearby winery and
restaurant, as well as to other local consumers. These are
activities conducted in any successful farming activity.
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Petitioners devoted all of their weekends, holidays, and vacation
time to working on the farm. See sec. 1.183-2(b)(3), Income Tax
Regs.
Petitioner wife was born on a farm and lived on a farm until
she was 38 years old. She had at one time owned a profitable
farm with her father and had also owned livestock and farming
equipment. Petitioner husband worked on petitioner wife’s
father’s farm after petitioners were married. Petitioner husband
worked continuously on that farm until the farm was sold.
Petitioner wife has been a member of the North Carolina Farm
Bureau since 1965. See sec. 1.183-2(b)(5), Income Tax Regs.
It is important to note that the year at issue, 2003, was
the very first year petitioners engaged in this activity. This
fact makes the determination whether the activity was engaged in
for profit more difficult. Though petitioners’ recordkeeping
certainly could be improved, and no profit was made, by all
indications petitioners were working hard to make this a
successful farm from which goods could be sold to local
restaurants and individuals.
The Court determines that petitioners engaged in the farming
activity with the motivation of making a profit and are entitled
to the claimed deductions.
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IV. Loan to Ryan Willock
Section 61(a) specifies that “Except as otherwise provided”,
gross income includes “all income from whatever source derived”.
Respondent used the bank deposits method of proof to reconstruct
petitioners’ income and determined that unexplained deposits
totaling $8,500 should be included as income. “Deposits in a
taxpayer’s bank account are prima facie evidence of income, and
the taxpayer bears the burden of showing that the deposits were
not taxable income but were derived from a nontaxable source.”
Welch v. Commissioner, 204 F.3d 1228, 1230 (9th Cir. 2000), affg.
T.C. Memo. 1998-121. “The bank deposits method assumes that all
money deposited in a taxpayer’s bank account during a given
period constitutes taxable income, but the Government must take
into account any nontaxable source or deductible expense of which
it has knowledge.” Clayton v. Commissioner, 102 T.C. 632,
645-646 (1994) (citing DiLeo v. Commissioner, 96 T.C. 858, 868
(1991), affd. 959 F.2d 16 (2d Cir. 1992)).
Petitioners claim that the $8,500 deposited in their bank
account for 2002 is not income but instead the repayment of a
loan made to their son, Ryan Willock, so that he could purchase a
used pickup truck. Petitioners further claim that the $8,500
comprises two deposits; one of $7,200, and the other of $1,300.
In support of their claim that the deposited amounts were loan
repayments and not income, petitioners submitted to the Court (1)
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a carbon copy of a check for $7,200 from the bank account of “M.
Ryan Willock” dated April 16, 2002, (2) a copy of a deposit slip
for petitioners’ bank account which reflects a $7,200 deposit on
April 17, 2002, and (3) copies of two checks, one for $8,000 and
the other for $500, both dated April 16, 2002, and both made
payable to Michael Hickman, a used car salesman. Petitioners did
not present any documentation to support their claim that the
additional deposit of $1,300 into their bank account was from
their son in satisfaction of his loan debt. Instead, petitioners
presented copies of two statements from a Charles Schwab
custodial account for Michael R. Willock which do not seem to
address this deposit at all.
Petitioner wife testified that she lent $8,500 to her son
Ryan Willock so that he could purchase a used pickup truck. The
truck was offered for sale by Michael Hickman for $8,500.
Petitioner wife testified that she happened upon the sale of the
vehicle and asked her son whether he was interested in purchasing
it for the sale price. Her son informed her that he was
interested but could not come to the vehicle’s location at that
time because of his work schedule. Petitioner wife asked Hickman
to hold the vehicle for her son. Hickman agreed to do so only
after receiving a check for $500 as a deposit from petitioner
wife. Petitioner wife testified that the remaining $8,000 was
paid to Michael Hickman by check upon sale.
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Petitioners claim that the deposits of $7,200 and $1,300
were from their son in repayment of the loan. Petitioners claim
that Ryan Willock asked to repay the loan in two separate
installments because he could not afford to immediately pay the
loan principal in its entirety.
The Court finds petitioners’ explanation of this matter to
be credible. Petitioners offered to the Court a carbon copy of a
check for $7,200 from the bank account of “M. Ryan Willock” dated
April 16, 2002. This amount appears to be contemporaneous with
petitioners’ April 17, 2002, deposit slip in the amount of
$7,200. Petitioners argue that their son paid the balance of the
loan on November 3, 2002. Petitioners’ banking records reflect a
deposit to their account made on November 3, 2002, in the amount
of $1,300.
The Court determines that the two deposits at issue were
loan repayments made by petitioners’ son, and are not includable
as income.
V. Accuracy-Related Penalty
Respondent determined that petitioners are liable for each
of their taxable years for the accuracy-related penalty under
section 6662(a) because of: (1) Negligence or disregard of rules
or regulations under section 6662(b)(1); or (2) a substantial
understatement of tax under section 6662(b)(2).
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Section 6662(a) imposes an accuracy-related penalty equal to
20 percent of the underpayment to which section 6662 applies.
Section 6662 applies to the portion of any underpayment which is
attributable to, inter alia, (1) negligence or disregard of rules
or regulations, sec. 6662(b)(1), or (2) a substantial
understatement of income tax, sec. 6662(b)(2).
The term “negligence” in section 6662(b)(1) includes any
failure to make a reasonable attempt to comply with the Code.
See sec. 6662(c). Negligence has also been defined as a failure
to do what a reasonable and prudent person would do under the
circumstances. See Leuhsler v. Commissioner, 963 F.2d 907, 910
(6th Cir. 1992), affg. T.C. Memo. 1991-179; Antonides v.
Commissioner, 91 T.C. 686, 699 (1988), affd. 893 F.2d 656 (4th
Cir. 1990). The regulations further state that negligence is
strongly indicated where there is a tax treatment of an item that
a reasonable and prudent person would find “too good to be true”
under the circumstances. Sec. 1.6662-3(b)(1)(ii), Income Tax
Regs. “‘Negligence’ also 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. The term
“disregard” includes any careless, reckless, or intentional
disregard. Sec. 6662(c).
An understatement of income tax exists if the actual tax
exceeds the tax reported on the return, sec. 6662(d)(2)(A), and
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an understatement will be treated as substantial in the case of
an individual if it exceeds the greater of $5,000 or 10 percent
of the tax required to be shown on the return, sec.
6662(d)(1)(A).
The accuracy-related penalty under section 6662(a) does not
apply to any portion of an underpayment if it is shown that there
was reasonable cause for, and that the taxpayer acted in good
faith with respect to, such portion. Sec. 6664(c)(1). The
determination of whether the taxpayer acted with reasonable cause
and in good faith depends on the pertinent facts and
circumstances, including the taxpayer’s effort to assess the
proper tax liability, the knowledge and experience of the
taxpayer, and the reliance on the advice of a professional, such
as an accountant. Sec. 1.6664-4(b)(1), Income Tax Regs.
Respondent has the burden of production under section
7491(c) with respect to the accuracy-related penalty under
section 6662. To meet that burden, respondent must come forward
with sufficient evidence showing that it is appropriate to impose
the accuracy-related penalty. See Higbee v. Commissioner, 116
T.C. 438, 446 (2001). Although respondent bears the burden of
production with respect to the accuracy-related penalty that
respondent determined for each of petitioners’ taxable years,
respondent “need not introduce evidence regarding reasonable
cause, substantial authority, or similar provisions[,] * * *
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[because] the taxpayer bears the burden of proof with regard to
those issues.” Id.
The parties made substantial concessions prior to the start
of trial, and the Court did not sustain some of the items in the
notice of deficiency. The Court finds that in the event the
computations under Rule 155 establish that there is an
understatement of income tax as a result of the Court’s holding
and the parties’ concessions that is greater than 10 percent of
the tax required to be shown in petitioners’ joint returns or
$5,000, see sec. 6662(d)(1)(A), then petitioners have
substantially understated their income tax and are liable for
such penalty under section 6662(d).
Petitioners were negligent in their treatment of the
remaining items in the notice of deficiency that the Court
sustained, as described below. Generally, the Court finds that
petitioners failed to show that they (1) made a reasonable
attempt to comply with, and did not intentionally disregard, the
Code and the regulations thereunder, and (2) acted with due care
and did what reasonable people would do under the circumstances.6
6
For example, petitioners’ claimed deductions for the dental
practice items, i.e., the license plate advertisements, are
reminiscent of those claimed by the taxpayer in Henry v.
Commissioner, 36 T.C. 879 (1961), which treatment was similarly
“too good to be true”. See sec. 1.6662-3(b)(1)(ii), Income Tax
Regs. In Henry, the taxpayer, a tax lawyer and accountant,
allocated 100 percent of expenses incurred in maintaining his
yacht as a business deduction on his Federal income tax return.
(continued...)
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1. Car and Truck Expenses
The crux of petitioners’ argument is that all use of their
vehicles, whether otherwise personal or not, may be claimed as
business use because of the license plate holders on each vehicle
that advertise the dental practice. Petitioners have offered no
authority to support this position, nor could the Court find any
supportive law. The idea that a license plate holder somehow
transforms all personal use into business use is clearly “too
good to be true”.
2. Section 179 Expense
Petitioners failed to substantiate that the GMC Envoy was
purchased and placed in service in 2003, the year for which the
expense deduction was claimed under section 179. Petitioners are
negligent in failing to keep adequate books and records to
substantiate this deduction. See sec. 1.6662-3(b)(1), Income Tax
Regs.
3. Travel Expenses
Petitioners failed to provide any probative evidence to the
Court that their trip to Hawaii related to petitioner husband’s
dental practice or otherwise served a business purpose.
6
(...continued)
The taxpayer purchased a yacht on which he flew a pennant with
the numerals “1040” on it, purportedly to provoke inquiries and
thus promote his business by giving him contacts with people in
yachting circles who might become clients. The Commissioner
disallowed the deduction, and the Court upheld the Commissioner’s
determination.
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4. Professional Fees Expenses
Petitioners failed to substantiate that the amount claimed
as an expense was a legitimate business expense or was ever paid.
5. Janitorial Services
Petitioners failed to substantiate that these claimed
expenses had a business purpose or that the services were even
provided to their business, rather than to them personally.
6. Nu-E World
Petitioners failed to substantiate that the amounts deducted
as expenses were legitimate business expenses.
Petitioners maintain that they are not liable for any
penalties under section 6662(a) and (b)(1) because they had
reasonable cause for, and acted in good faith in taking, their
reported positions because they relied on the advice of their tax
preparer.
The decision as to whether the taxpayer acted with
reasonable cause and in good faith depends upon all the pertinent
facts and circumstances. See sec. 1.6664-4(b)(1), Income Tax
Regs. Relevant factors include the taxpayer’s efforts to assess
his proper tax liability, including the taxpayer’s reasonable and
good-faith reliance on the advice of a professional, such as an
accountant. See id. “[A]n honest misunderstanding of fact or
law that is reasonable in light of all of the facts and
circumstances, including the experience, knowledge and education
- 40 -
of the taxpayer” may indicate reasonable cause and good faith.
See id.
The Court sustained respondent’s determination regarding the
dental leasing equipment largely because of the “self-rental
rule”. See sec. 1.469-2(f)(6), Income Tax Regs. This rule is
complex and could very easily perplex even a sophisticated
taxpayer. The Court does not find petitioners’ treatment of both
leasing activities as passive for income and loss to be “too good
to be true”. The Court finds that under section 6662(c)
petitioners did make “a reasonable attempt to comply with the
provisions of [the Code]”. Petitioners were not negligent in
their reporting of this item and have met the reasonable cause
exception for the portion of the underpayment relating to this
item. See sec. 6664(c)(1).
Petitioners have failed to carry their burden of
establishing that they acted with reasonable cause and in good
faith on all the other items sustained by the Court. Petitioners
have failed to provide the Court with any evidence that they
received advice from a tax preparer or that they followed such
advice. Petitioners have fallen short of convincing the Court
that they are entitled to relief under section 6664(c).
Accordingly, with the exception of the dental equipment
leasing item, petitioners are liable for a 20-percent
- 41 -
accuracy-related penalty on underpayments relating to the notice
of deficiency items that the Court sustained.
Conclusion
In reaching the conclusions stated herein, the Court has
considered all arguments made, and, to the extent not mentioned
above, finds them to be moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.