The opinion
T.C. Memo. 2017-38
UNITED STATES TAX COURT
GARY J. KAUFFMAN, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 23502-12. Filed February 22, 2017.
Gary J. Kauffman, pro se.
Kimberly A. Daigle, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: Respondent issued a notice of deficiency determining a
$52,680 deficiency in petitioner’s 2008 Federal income tax and an accuracy-
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[*2] related penalty under section 6662(a) of $11,592.80.1 After concessions,2 the
remaining issues for decision are whether petitioner: (1) is entitled to a deduction
for certain expenses paid from a disregarded entity to a controlled corporation;
(2) is entitled to a mortgage interest deduction in excess of the amount respondent
allowed; and (3) is liable for a section 6662(a) accuracy-related penalty.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulation of
facts and the attached exhibits are incorporated by this reference. At the time the
petition was timely filed, petitioner resided in Montana.
During the year at issue petitioner was a realtor and cinematographer.
Petitioner operated his business through several LLCs and a solely owned
C corporation. The LLCs were reported on petitioner’s Form 1040, U.S.
Individual Income Tax Return, as disregarded entities, and the C corporation filed
its own return.
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the year at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
2
Respondent concedes that petitioner is entitled to deduct $75,000 in costs
of sales on his Schedule C, Profit or Loss From Business, for Rocky Mountain
Habitats, LLC. Other concessions are discussed in the body of this opinion.
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[*3] Consulting Fees and Commission Expenses
One of petitioner’s LLCs, Rocky Mountain Habitats, LLC (RMH), reported
paying Rocky Mountain Habitats, Inc. (corporation), $191,000 in “consulting
fees” and $75,000 in “commissions and fees”. These expenses were actually
rental expenses--RMH allegedly rented and used a sophisticated camera that was
owned by the corporation.
Petitioner claimed a deduction for these expenses on his Form 1040
Schedule C for RMH, and the corporation included the corresponding amounts in
income on its Form 1120, U.S. Corporation Income Tax Return. Respondent
disallowed RMH’s claimed deduction for consulting fees and commissions in the
notice of deficiency. The record also shows that respondent made a corresponding
adjustment to the corporation’s income, reducing it by $266,000 ($191,000 plus
$75,000).
Interest Expense
Petitioner owned two homes during the year at issue. Petitioner’s primary
home was in West Glacier, Montana, and his second home was in San Diego,
California. Petitioner deducted interest expenses arising from loans secured by
both homes.
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[*4] Petitioner purchased the West Glacier property in 2003 for $225,143,
financing the purchase with a single loan. In October 2004 petitioner paid off the
first loan with a $326,500 loan from Countrywide. The balance on the first loan at
the time it was refinanced was $171,677.10. Two months later petitioner received
a home equity line of credit from Wells Fargo for $100,000. Both the
Countrywide loan and the Wells Fargo loan were secured by the West Glacier
property.
Petitioner purchased the San Diego property in 1999 for $350,000,
financing the purchase with loans of $280,000 and $35,000. Both loans were
secured by the San Diego property. In 2002 petitioner refinanced the two loans
with a single loan from Washington Mutual (now JP Morgan Chase) which was
also secured by the San Diego property. The balances on the loans at the time they
were refinanced were $273,108 and $34,138.50.
Petitioner deducted $16,381 of interest expenses related to the Countrywide
loan and the Wells Fargo loan (the loans secured by the West Glacier Property) on
his Form 1040 Schedule C for RMH. Respondent disallowed $16,261 of the
interest expense deduction on the Schedule C but reallocated $7,274.51 of that
amount to petitioner’s Schedule A, Itemized Deductions, as deductible mortgage
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[*5] interest.3 At trial respondent conceded that petitioner could deduct an
additional $2,490 on his Schedule A as mortgage interest. Respondent maintains
that the remaining $6,496.49 ($16,261 minus $7,274.51 and $2,490) is
nondeductible.
Petitioner timely filed a petition with this Court seeking redetermination.
OPINION
I. Burden of Proof
As a general rule, the Commissioner’s determinations in a notice of
deficiency are presumed correct, and the taxpayer bears the burden of proving that
those determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S.
111, 115 (1933). Section 7491(a) shifts the burden of proof to the Commissioner
as to any factual issue relevant to a taxpayer’s liability for tax if the taxpayer meets
certain conditions. Higbee v. Commissioner, 116 T.C. 438, 440-441 (2001).
Petitioner has not shown that he satisfied the requirements of section 7491(a) to
shift the burden of proof to respondent. Accordingly, petitioner bears the burden
of proof. See Rule 142(a).
3
Petitioner also deducted interest expenses attributable to the JP Morgan
Chase loan related to the San Diego property on his return, but none of it was
disallowed by respondent.
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[*6] II. Consulting Fees and Commission Expenses
Petitioner argues he is entitled to deduct $266,000 in consulting fees and
commission expenses (which should have been more appropriately labeled
“camera rental expenses”) because they were ordinary and necessary business
expenses of RMH.4 Respondent argues that petitioner failed to prove that the
expenses were ordinary and necessary business expenses. We agree with
respondent.
Taxpayers are allowed a deduction for ordinary and necessary expenses paid
or incurred in carrying on a trade or business. Sec. 162(a). Whether an
expenditure is ordinary and necessary is usually a question of fact. Commissioner
v. Heininger, 320 U.S. 467, 475 (1943). Generally, for an expenditure to be an
ordinary and necessary business expense, the taxpayer must show a bona fide
business purpose for the expenditure; there must be a proximate relationship
between the expenditure and the business of the taxpayer. Challenge Mfg. Co. v.
Commissioner, 37 T.C. 650, 659-660 (1962); Henry v. Commissioner, 36 T.C.
879, 884 (1961); sec. 1.162-1(a), Income Tax Regs. To be “necessary” within the
4
Petitioner changed course at trial and argued that the reported expenses
were actually intercompany loans deductible as bad debt losses. However,
petitioner abandoned this argument on brief and reiterated that the expenses were
ordinary and necessary business expenses.
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[*7] meaning of section 162, an expense needs to be “appropriate and helpful” to
the taxpayer’s business. Welch v. Helvering, 290 U.S. at 113. The requirement
that an expense be “ordinary” connotes that “the transaction which gives rise to it
must be of common or frequent occurrence in the type of business involved.”
Deputy v. du Pont, 308 U.S. 488, 495 (1940) (citing Welch v. Helvering, 290 U.S.
at 114).
Even if an expense is ordinary and necessary, it is deductible under section
162 only to the extent it is reasonable in amount. United States v. Haskel Eng’g &
Supply Co., 380 F.2d 786, 788-789 (9th Cir. 1967); Gill v. Commissioner, T.C.
Memo. 1994-92, aff’d without published opinion, 76 F.3d 378 (6th Cir. 1996);
Brallier v. Commissioner, T.C. Memo. 1986-42. The element of reasonableness is
inherent in the phrase “ordinary and necessary” in section 162. Haskel Eng’g &
Supply Co., 380 F.2d at 788-789.
While petitioner explains on brief that the expenses were ordinary and
necessary business expenses, he does not cite any credible testimony or other
relevant evidence in the record supporting his assertion. The only evidence
petitioner provided was accounting records and bank statements. However, these
items merely reflect expenses allegedly incurred by RMH; the accounting records
and bank statements do not show why the alleged expenses are ordinary and
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[*8] necessary. We also note that petitioner did not testify or offer other evidence
explaining how the expenses were calculated or whether the corporation charged
third parties the same amounts for similar services. Therefore, we are unable to
determine whether the expenses were reasonable in amount. Consequently, on the
basis of the record before us, we cannot find that the expenses were ordinary and
necessary business expenses. We therefore sustain respondent’s determination on
this issue.
III. Interest Expenses
We next address the extent to which petitioner is entitled to deductions for
interest expenses.
Taxpayers are generally allowed to deduct all interest paid or accrued within
the taxable year on indebtedness. Sec. 163(a). But in the case of a taxpayer other
than a corporation, no deduction is allowed for personal interest. Sec. 163(h)(1).
“Personal interest” includes any interest allowable as a deduction other than any
qualified residence interest. Sec. 163(h)(2)(D). “[Q]ualified residence interest”
means any interest that is paid or accrued during the taxable year on acquisition
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[*9] indebtedness5 or home equity indebtedness6 with respect to any qualified
residence of the taxpayer. Sec. 163(h)(3)(A). A taxpayer may have up to two
qualified residences. See sec. 163(h)(4)(A)(i).
Petitioner was liable in 2008 on three loans which were secured by his two
qualified residences. Respondent did not challenge the interest deduction arising
from the JP Morgan Chase loan securing the San Diego property and does not
assert that any portion of that loan is home equity indebtedness. Respondent does,
however, challenge a portion of the interest deduction attributable to the
Countrywide and Wells Fargo loans securing the West Glacier property.
Respondent argues that the $326,500 Countrywide loan consists of $171,677.10 in
5
“[A]cquisition indebtedness” means any indebtedness that is incurred in
acquiring, constructing, or substantially improving any qualified residence of the
taxpayer and is secured by the residence. Sec. 163(h)(3)(B)(i). Acquisition
indebtedness also includes any indebtedness secured by the residence resulting
from the refinancing of acquisition indebtedness but only to the extent the amount
of the indebtedness resulting from the refinancing does not exceed the amount of
the refinanced indebtedness. Id. And the aggregate amount treated as acquisition
indebtedness for any period must not exceed $1 million. Sec. 163(h)(3)(B)(ii).
6
“[H]ome equity indebtedness” means any indebtedness (other than
acquisition indebtedness) secured by a qualified residence to the extent the
aggregate amount of the indebtedness does not exceed the fair market value of the
qualified residence reduced by the amount of acquisition indebtedness with
respect to the residence. Sec. 163(h)(3)(C)(i). And the aggregate amount treated
as home equity indebtedness for any period must not exceed $100,000. Sec.
163(h)(3)(C)(ii).
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[*10] qualified home acquisition indebtedness and that the remaining $154,822.90
balance of the loan is home equity indebtedness. Respondent also asserts that the
entire $100,000 Wells Fargo loan is home equity indebtedness. Under that
premise, respondent argues that the disallowed interest deduction should be
sustained because petitioner’s total home equity indebtedness during the year at
issue was $254,822.90, which exceeds the $100,000 home equity indebtedness
limit in section 163(h)(3)(C)(ii).
Petitioner argues that the entire amount of the Countrywide loan consists of
home acquisition indebtedness. Petitioner maintains that he purchased the West
Glacier property with a $225,143 loan and began financing over $150,000 in
improvements to the property by using credit cards. The record shows that
petitioner later refinanced the first loan (which then had a balance of $171,677.10)
with a new loan of $326,500 from Countrywide. The Countrywide loan was
clearly used to pay off the first loan, but the record shows that the balance of the
loan was distributed to petitioner in his individual capacity. This is not fatal, and
in fact, the remaining balance of the loan distributed to petitioner could be
considered acquisition indebtedness if he were able to prove that he did actually
incur expenses to improve the qualified residence during the 24 months before the
date the house was complete and that the Countrywide loan was secured within 90
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[*11] days of the completion of construction. See Notice 88-74, Example 1, 1988-
2 C.B. 385, 386.
Petitioner, however, did not produce credible evidence showing that
expenses were incurred to improve the property. Petitioner’s only evidence
offered in support of his argument is his uncorroborated accounting records. In
the absence of the actual credit card statements, bank records, receipts, or other
documents showing that he incurred improvement expenditures, we find
petitioner’s uncorroborated accounting records insufficient and we sustain
respondent’s determination that petitioner is limited to $171,677.10 in home
acquisition indebtedness on the Countrywide loan. We also find that the interest
attributable to the home equity portion of the Countrywide loan and the interest
attributable to the Wells Fargo loan are subject to the $100,000 limit provided by
section 163(h)(3)(C)(ii).
IV. Accuracy-Related Penalty
We next determine whether petitioner is liable for an accuracy-related
penalty. Pursuant to section 6662(a) and (b)(1) and (2), a taxpayer may be liable
for a penalty of 20% on the portion of an underpayment of tax due to:
(1) negligence or disregard of rules or regulations or (2) a substantial
understatement of income tax. “Negligence” is defined as any failure to make a
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[*12] reasonable attempt to comply with the provisions of the Code; this includes
a failure to keep adequate books and records or to substantiate items properly.
Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs. Negligence has also been
defined as the failure to exercise due care or the failure to do what a reasonable
person would do under the circumstances. See Allen v. Commissioner, 92 T.C. 1,
12 (1989), aff’d, 925 F.2d 348, 353 (9th Cir. 1991); Neely v. Commissioner, 85
T.C. 934, 947 (1985). “Disregard” means any careless, reckless, or intentional
disregard. Sec. 6662(c). “Understatement” means the excess of the amount of the
tax required to be shown on the return over the amount of the tax imposed which
is shown on the return, reduced by any rebate. Sec. 6662(d)(2)(A). A “substantial
understatement” of income tax is defined as an understatement of tax that exceeds
the greater of 10% of the tax required to be shown on the tax return or $5,000.
Sec. 6662(d)(1)(A).
The accuracy-related penalty does not apply with respect to any portion of
the underpayment for which the taxpayer shows that there was reasonable cause
and that he or she acted in good faith. See sec. 6664(c)(1). The decision as to
whether a taxpayer acted with reasonable cause and in good faith is made on a
case-by-case basis, taking into account all of the pertinent facts and circumstances.
See sec. 1.6664-4(b)(1), Income Tax Regs. “Circumstances that may indicate
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[*13] reasonable cause and good faith include an honest misunderstanding of fact
or law that is reasonable in light of all of the facts and circumstances, including
the experience, knowledge, and education of the taxpayer.” Id. Reliance on a tax
professional demonstrates reasonable cause when a taxpayer (1) selects a
competent tax adviser, (2) supplies the adviser with all relevant information, and
(3) relies in good faith on the adviser’s professional judgment. See Neonatology
Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d
Cir. 2002).
The Commissioner bears the burden of production with respect to the
taxpayer’s liability for the section 6662(a) penalty and must produce sufficient
evidence indicating that it is appropriate to impose the penalty. See sec. 7491(c);
Higbee v. Commissioner, 116 T.C. at 446-447. Once the Commissioner meets his
burden of production, the taxpayer must come forward with persuasive evidence
that the Commissioner’s determination is incorrect or that the taxpayer had
reasonable cause or substantial authority for the position. See Higbee v.
Commissioner, 116 T.C. at 446-447.
Respondent satisfied his burden of production in establishing the
appropriateness of the penalty. Petitioner did not maintain sufficient records to
substantiate most of the expenses underlying his deductions, and the disallowed
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[*14] deductions in this case are directly attributable to petitioner’s failure to
maintain adequate records. Furthermore, petitioner has not proven he had
reasonable cause for his return positions and his failure to maintain adequate
business records. Although petitioner argues he relied on a return preparer, there
is no evidence in the record that his return preparer was provided all relevant
information. Petitioner testified that he provided his return preparer with his
accounting records (which we find unreliable), but the record does not show that
he provided his return preparer with the supporting evidence (or that the
supporting evidence ever existed). It is also unclear from the record whether
petitioner adequately explained the nature of the transactions his related business
entities were purportedly engaged in (i.e., that “consulting fees” and “commissions
and fees” were actually camera rental expenses). We therefore hold that petitioner
is liable for a section 6662(a) accuracy-related penalty on the ground of
negligence.7
In reaching our holding, we have considered all arguments made, and to the
extent not mentioned, we consider them irrelevant, moot, or without merit.
7
In the event the Rule 155 computations demonstrate that petitioner’s
understatement of income tax for the year at issue exceeds the greater of $5,000 or
10% of the amount of tax required to be shown on the return, we conclude that the
underpayment for the year will also be attributable to a substantial understatement
of income tax for which petitioner has not shown reasonable cause.
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[*15] To reflect the foregoing,
Decision will be entered
under Rule 155.