The opinion
T.C. Memo. 2017-146
UNITED STATES TAX COURT
ALAN BROOKES AND CAROL BROOKES, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 30647-14. Filed July 26, 2017.
Mansoor H. Ansari, for petitioners.
Elizabeth S. McBrearty, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARIS, Judge: Respondent determined deficiencies in petitioners’ Federal
income tax and section 6662(a) accuracy-related penalties, as follows:1
1
All section references are to the Internal Revenue Code in effect for the
years in issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure, unless otherwise indicated.
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[*2] Penalty
Year Deficiency sec. 6662(a)
2010 $36,503 $7,300.60
2011 39,823 7,964.60
2012 45,376 9,075.20
After concessions,2 the issues remaining for decision are whether: (1) petitioners’
S corporation is entitled to deduct certain trade or business expenses for 2010,
2011, and 2012 and (2) petitioners are liable for section 6662(a) accuracy-related
penalties for those years.
2
Respondent determined in the notice of deficiency that payments to
petitioners from Brookes Financial Services, Inc. (Brookes Financial), totaling
$106,000 in 2010, $99,000 in 2011, and $101,000 in 2012 were wages to
petitioners. (Brookes Financial is petitioners’ wholly owned S corporation.)
Respondent allowed Brookes Financial corresponding deductions for wages paid
in 2010, 2011, and 2012. Additionally, the notice determined that amounts
deducted by Brookes Financial for insurance expenses in 2010, 2011, and 2012
were fringe benefits to petitioners; the notice of deficiency included these amounts
in petitioners’ wage income. Adding these fringe benefits to the aforementioned
payments, the total positive adjustments to wages for 2010, 2011, and 2012 were
$120,193, $111,234, and $111,297, respectively. Petitioners did not contest these
adjustments at trial or in their opening or answering briefs. Petitioners did not
present any evidence relating to these adjustments. Consequently, the Court finds
that petitioners have conceded all issues relating to these wage adjustments for
2010, 2011, and 2012 subject to the findings of this opinion.
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[*3] FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The first
stipulation of facts and the first supplemental stipulation of facts are incorporated
herein by this reference. Petitioners filed Forms 1040, U.S. Individual Income
Tax Return, for 2010, 2011, and 2012 as married individuals filing jointly.
Petitioners did not report any wage income on their Forms 1040 for those years.
Throughout 2010, 2011, and 2012 petitioners each owned half of Brookes
Financial, an S corporation incorporated since 1994. Brookes Financial filed
Forms 1120S, U.S. Income Tax Return for an S Corporation, for 2010, 2011, and
2012.
Brookes Financial carried on two lines of business during 2010, 2011, and
2012: Mr. Brookes’ business and financial consulting activities, which included
tax preparation services, and Mrs. Brookes’ art business.3 During the years in
issue Mr. Brookes provided services to fledgling businesses, including financial
and marketing advice and preparation of tax returns for clients.
3
Petitioners testified credibly that they ran both lines of business through
Brookes Financial. Corporate records they provided support their testimony.
Petitioners also claimed to have run a book publishing business of some kind
through Brookes Financial, but they have not provided any evidence to
substantiate any expenses or other tax items related to a book publishing business.
See infra note 12.
-4-
[*4] Mrs. Brookes is an artist. She holds bachelor’s and master’s degrees in fine
arts and has taught art at several colleges. Mrs. Brookes designed promotional
materials for some of Mr. Brookes’ clients. She also created “mixed media wall
sculptures” using sculpting epoxy, paint, and industrial materials, including nails
and bolts, ropes, and similar items. Mrs. Brookes offered these productions for
sale at various venues and out of her own studio.
Brookes Financial rented an art studio throughout 2010, 2011, and 2012
which Mrs. Brookes used for her art business. During the years in issue Mrs.
Brookes also displayed some of her art through Viridian Artists, Inc., and Brookes
Financial paid the gallery fees--$1,710, $3,055, and $2,180 in 2010, 2011, and
2012, respectively.
Petitioners traveled extensively--both domestically and internationally--in
2010, 2011, and 2012. Brookes Financial claimed a deduction for travel expenses
for each of those years.
Brookes Financial also had a medical reimbursement plan in place that
agreed to reimburse up to $5,000 of qualifying medical expenses incurred by
employees and their dependents; the plan does not provide any adjustment of the
$5,000 amount for inflation. Mrs. Brookes has severe scoliosis, and she requires
massage therapy as part of her treatment. Brookes Financial made payments to a
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[*5] massage therapist totaling $3,910.33 in 2010 and exceeding $5,000 in both
2011 and 2012.
On October 1, 2014, respondent issued a notice of deficiency to petitioners
for 2010, 2011, and 2012, disallowing deductions for certain trade or business
expenses claimed by Brookes Financial and determining that petitioners were
liable for accuracy-related penalties for the years in issue. On December 24, 2014,
while residing in Illinois, petitioners timely filed a petition.
OPINION
The Commissioner’s determinations in a notice of deficiency are generally
presumed correct, and the taxpayer bears the burden of proving those
determinations erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933). Petitioners do not contend, and the evidence does not establish, that the
burden of proof shifts to respondent under section 7491(a) as to any issue of fact.
I. Trade or Business Expenses
Section 162(a) allows the deduction of “all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or
business”. An expense is ordinary if it is customary or usual within a particular
trade, business, or industry or relates to a transaction “of common or frequent
occurrence in the type of business involved.” Deputy v. du Pont, 308 U.S. 488,
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[*6] 495 (1940). An expense is necessary if it is appropriate and helpful for the
development of the business. Commissioner v. Heininger, 320 U.S. 467, 471
(1943). Personal, living, and family expenses are generally not deductible. Sec.
262(a).
Deductions are a matter of legislative grace; taxpayers bear the burden of
substantiating their claimed deductions by keeping and producing records
sufficient to enable the Commissioner to determine the correct tax liability. Sec.
6001; INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a),
(e), Income Tax Regs.
A. Miscellaneous Expenses
The Court notes that petitioners’ exhibits provide little help explaining or
supporting their deductions.4 Petitioners provided corporate “Profit & Loss
4
The issue in this case is whether petitioners adequately substantiated that
the deductions Brookes Financial claimed were for ordinary and necessary
expenses paid during the taxable years in issue in connection with Brookes
Financial’s trades or businesses. Neither the notice of deficiency nor respondent’s
answer challenged Brookes Financial’s art business under sec. 183 as not for
profit. Respondent confirmed during the pretrial conference that petitioners’
deductions were not being challenged under sec. 183 but instead were being
challenged under secs. 162 and 262. The Court did not ask the parties to address
sec. 183. Respondent’s briefs did not address sec. 183. And yet the principal
issue addressed by petitioners’ counsel in the argument sections of his opening
and answering briefs was whether sec. 183 should apply to petitioners’ case.
Petitioners provided little meaningful guidance for the resolution of the actual
(continued...)
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[*7] Statement[s]” for 2010 and 2012, and a “Cash Flow” statement for 2011, but
these documents merely list total expenses in various categories. Petitioners also
provided itemized lists of expenses for each year, but the itemized lists are
generally not supported by receipts or other documentation demonstrating that the
expenses were actually paid or that the expenses had a business purpose. The
amounts in the itemized lists are generally lower than those appearing on the profit
and loss or cashflow statements (and lower than the amounts that appear on
Brookes Financial’s returns). Numerous discrepancies between the itemized lists,
the profit and loss or cashflow statements, and the deductions claimed on Brookes
Financial’s returns are not explained anywhere in the record. Petitioners also
provided credit card statements for personal credit cards, with handwritten notes in
the margins indicating that certain expenses were business expenses.5 Petitioners
4
(...continued)
issue in this case--whether petitioners have adequately substantiated the expenses
underlying the deductions claimed by Brookes Financial.
5
The handwritten notes in the margins of the credit card statements are terse:
for example, “Bus”, “Med”, “Art”, “Trav, “Auto”, and “Promo”. Petitioners
provided no testimony or other documentation, such as accompanying receipts, to
support deductions for the expenses listed on their credit card statements (with one
exception--as the Court will discuss below, petitioners provided supporting
documentation and testimony relating to credit card purchases of supplies for the
art business). The descriptions of credit card purchases on the credit card
statements are too vague for the Court to determine whether there was a business
(continued...)
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[*8] have not provided any meaningful explanation of how all these various
documents fit together as substantiation for their deductions. The Court will,
nevertheless, review petitioners’ poorly organized evidence and proceed to the
merits of the case.
After carefully reviewing the entire record, the Court finds that either no or
inadequate evidence was provided to substantiate expenses petitioners deducted
for 2010, 2011, and 2012 for “Purchases - Cost of Goods Sold”,6 “Bank Charges”,7
“Legal and Professional Fees”,8 “Maintenance”, “Net Operating Loss”, “Office
5
(...continued)
purpose for any of the credit card purchases. For example, expense descriptions
include “Walgreens”, “Shell Oil”, and “AT&T Data”--any of these expenses could
have been personal to petitioners. Because no other evidence corroborates (or
even explains) these expenses, the Court finds that no deductions are allowed for
expenses listed on their personal credit card statements, other than the deductions
the Court allows below for purchases of art supplies.
6
Respondent contends that the amount of “Purchases - Cost of Goods Sold”
disallowed for 2011 consisted of payments for “personal condo assessments” and
that the amount of “Purchases - Cost of Goods Sold” disallowed for 2012
consisted of payments to purchase gold bullion or was entirely unsubstantiated.
Petitioners did not respond to these arguments.
7
Respondent determined that the charges disallowed either were
unsubstantiated or were for a personal line of credit. Petitioners did not argue
otherwise.
8
Respondent determined that “Legal and Professional Fees” consisted of
“investment fees” and a payment to petitioners’ condo association. Petitioners did
(continued...)
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[*9] Expenses”,9 “Shareholder Distribution K-1”, “Organizational Expenses”,
“Reimbursed Expenses”, “Storage”, “Telephone”, and “Utilities”,10 beyond what
respondent allowed. Therefore the Court sustains respondent’s determinations
with regard to these deductions.
The Court may estimate the amounts of certain deductible expenses under
the so-called Cohan rule. See Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir.
1930); see also Lerch v. Commissioner, 877 F.2d 624 (7th Cir. 1989), aff’g T.C.
Memo. 1987-295. While it is true that “a court should allow the taxpayer some
deductions if the taxpayer proves he is entitled to the deduction but cannot
establish the full amount claimed”, Edelson v. Commissioner, 829 F.2d 828, 831
(9th Cir. 1987), aff’g T.C. Memo. 1986-223, “the Cohan rule does not ‘require that
8
(...continued)
not respond to this argument.
9
The Court will recharacterize a portion of the reported office expenses for
2011 as “Fees”, which will be discussed infra p. 18. The disallowance of the
deductions for the remaining office expenses is sustained.
10
Respondent disallowed the deductions claimed for telephone and utilities
expenses because some of them appear to be personal expenses, and petitioners
failed to provide any information regarding the allocation of these expenses
between business and personal. Because petitioners have likewise failed to
provide the Court with any evidence regarding allocation of these expenses
between business and personal, the Court sustains respondent’s determination
regarding the deductions for telephone and utilities expenses.
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[*10] such latitude be employed’”, Norgaard v. Commissioner, 939 F.2d 874, 879
(9th Cir. 1991) (quoting Williams v. United States, 245 F.2d 559, 560 (5th Cir.
1957)), aff’g in part, rev’g in part T.C. Memo. 1989-390.
“[T]o qualify for the estimation treatment under Cohan, the taxpayer must
establish that he is entitled to some deduction.” Id. (citing Edelson v.
Commissioner, 829 F.2d at 831). As Cohan v. Commissioner, 39 F.2d at 543-544,
puts it: “Absolute certainty in such matters is usually impossible and is not
necessary”, but a court “should make as close an approximation as it can, bearing
heavily if it chooses upon the taxpayer whose inexactitude is of his own making.”
The Court has sustained respondent’s determination with regard to these
deductions because petitioners have failed to offer any evidence that certain
expenses were in fact paid and because petitioners’ lack of receipts, confusing and
inconsistent accounting techniques, and vague testimony leave the Court with no
reasonable means of differentiating or estimating which of the reported expenses
Brookes Financial paid as ordinary and necessary business expenses. After a
thorough review of the record, the Court concludes that there is no basis for
allowing an estimated amount of the aforementioned deductions in addition to the
amounts respondent already allowed.
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[*11] B. Expenses Subject to Section 274(d)
Section 274(d) imposes more rigorous substantiation requirements for
certain expenses, including those pertaining to travel, meals and entertainment,
and passenger automobiles. Petitioners’ “Travel”, “Meals and entertainment”,
“Auto”, and “Repairs” expenses are all subject to the heightened substantiation
requirements of section 274(d).11
To satisfy the requirements of section 274(d), the taxpayer must prove with
specificity the amount, time, place, and business purpose of the expense; for
entertainment expenses, the business relationship of the person or persons
entertained must also be proved. Sec. 1.274-5T(b)(2) and (3), Temporary Income
Tax Regs., 50 Fed. Reg. 46014-46015 (Nov. 6, 1985). The taxpayer also generally
must maintain adequate records or documentary evidence corroborating the
taxpayer’s own statement which, in combination, is sufficient to establish each
element of an expenditure or use. Id. para. (c), 50 Fed. Reg. 46016. Adequate
records generally consist of an account book, a diary, a log, a statement of
11
Brookes Financial claimed a deduction of $1,621 for “Repairs” for 2011.
As respondent points out, there is an expense of $1,620.95 listed in Brookes
Financial’s 2011 credit card expense report, which is labeled “Auto”. The Court
has reviewed the cashflow, credit card expense, and register reports petitioners
provided for 2011; there is no other expense in that amount. The Court concludes
that the “Repairs” expense was a passenger automobile expense.
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[*12] expense, trip sheets, or a similar record made at or near the time of the
expenditure or use, along with supporting documentary evidence. Id. para. (c)(2).
A taxpayer lacking a contemporaneous log is generally expected to maintain a
record created as near in time as possible to the particular expenditure or business
use (including the elements outlined above), supported by corroborative
documentary evidence that carries with it a high degree of probative value. Id.
para. (c)(1). Expenses subject to section 274(d) must be substantiated; they cannot
be estimated. See Sanford v. Commissioner, 50 T.C. 823, 828 (1968), aff’d, 412
F.2d 201 (2d Cir. 1969).
1. Deduction for Travel Expenses
To deduct travel expenses, a taxpayer must substantiate with adequate
records or by sufficient evidence corroborating his own statement: (1) the
“[a]mount of each separate expenditure for traveling away from home * * * except
that the daily cost of the traveler’s own breakfast, lunch, and dinner and of
expenditures incidental to such travel may be aggregated, if set forth in reasonable
categories, such as for meals, for gasoline and oil, and for taxi fares”; (2) “[d]ates
of departure and return for each trip away from home, and number of days away
from home spent on business”; (3) “[d]estinations or locality of travel, described
by name of city or town or other similar designation”; and (4) the “[b]usiness
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[*13] reason for travel or nature of the business benefit derived or expected to be
derived as a result of travel”. Sec. 274(d); sec. 1.274-5T(b)(2), (c)(1), Temporary
Income Tax Regs., supra.
Petitioners have utterly failed to substantiate their deductions for travel
expenses.12 Petitioners did not provide contemporaneous or near
contemporaneous logs for any of their travel, nor did they articulate with
specificity the business reasons for each of their travel expenses. Mr. Brookes
12
Petitioners claim to have taken three or four business trips in each year in
issue. Mr. Brookes testified that they traveled each year to their “Corporate
Annual Meeting” at Wisconsin Dells to discuss for a week or more “how the past
year went”and “how the future events are” and to elect corporate officers.
Petitioners provided “Minutes of Annual Meeting” for each of the years in issue,
but the minutes merely list a single date and time for the meeting (April 20 at 1
p.m. in all three years), with no additional detail other than notes that (1) Mr. and
Mrs. Brookes were elected as officers of the corporation and (2) Brookes Financial
would continue to rent an art studio (in 2012 they also resolved to find a new
office space to rent). The Court finds that Mr. Brookes’ testimony with respect to
the Wisconsin Dells trips and the “Minutes of Annual Meeting” documents is not
credible because the minutes list a single date and time and only two items of
business even though the meeting supposedly went on for several days.
Petitioners also claim to have traveled to New York City for the Annual
Meeting of Viridian Artists, Inc. (an art gallery through which some of Mrs.
Brookes’ art was displayed), in each of the years in issue. Petitioners also claim to
have traveled to Hawaii in 2010 to (1) help a client establish an advertising
business, (2) do research related to Mrs. Brookes’ art business, and (3) research a
travel book on which Mr. Brookes was working. Petitioners claim to have made
similar art and book research trips to Panama in 2011 and to Southeast Asia in
2012. Finally, they claim to have made trips to Santa Fe, New Mexico, and San
Francisco, California, for the purpose of displaying and selling Mrs. Brookes’
artwork, though the record does not reflect any art sales related to these trips.
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[*14] testified in a vague and general way that some amount of business-related
activity occurred on each of the various trips he and his wife took together, but he
admitted, for example, that a principal purpose of his annual trip to the Wisconsin
Dells was to “rest” and “unwind” after tax season.
Petitioners submitted a “Travel Log” for each year in issue, but these logs
are wholly insufficient to substantiate petitioners’ travel expenses. The logs are
not contemporaneous and do not detail amounts of separate expenditures or even
set forth expenses in appropriate categories. The dates of departure and return are
not clearly set out, and there is no differentiation of business from personal
expenses, even though some of the expenses are clearly personal. Consequently,
the Court sustains respondent’s determination to disallow the deductions for travel
expenses.
2. Deduction for “Meals and Expenses”
The Court has reviewed the entire record and has found no evidence
substantiating the deduction for “Meals and Expenses” claimed for 2011.
Consequently, the Court finds that this deduction was properly disallowed.
3. Deductions Related to a Passenger Automobile
To support a deduction for expenses related to the use of a passenger
automobile, a taxpayer must substantiate with adequate records or by sufficient
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[*15] evidence corroborating his own statement: (1) the “amount of each separate
expenditure” with respect to the passenger automobile; (2) the “amount of each
business/investment use * * * based on the appropriate measure (i.e., mileage for
automobiles * * * ), and the total use of the * * * [passenger automobile] for the
taxable period”; (3) the “[d]ate of the expenditure or use” with respect to the
passenger automobile; and (4) the “business purpose for an expenditure or use”
with respect to the passenger automobile. Secs. 274(d), 280F(d)(4); sec. 1.274-
5T(b)(6) and (c)(1), Temporary Income Tax Regs., supra.
Alternatively, a taxpayer may calculate his deductible passenger automobile
expenses by multiplying his business miles by the standard mileage rate for the
year and then adding allowable tolls and parking fees. Under this alternate
method, however, the taxpayer is not relieved of the requirement to substantiate
the amount of each business use (i.e., the business mileage), or the time and
business purpose of each use. Sec. 1.274-5(j)(2), Income Tax Regs.
Consequently, substantiation of miles and business purpose is a prerequisite to
claiming a deduction for mileage whether petitioners meant to claim their actual
automobile expenses or meant to use the alternative standard mileage rate method
for 2012.
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[*16] Petitioners provided no evidence to substantiate business purpose or miles
driven. Consequently, they have failed to substantiate their deductions for “Auto”
and “Repairs”.13
C. Deductions Related to the Art Business
Respondent disallowed all or some of the deductions claimed for
“Advertising”, “Rents”, “Fees”, and “Supplies” expenses due to his determination
that the art business was not run through Brookes Financial and that, therefore, it
was inappropriate for Brookes Financial to claim deductions for that line of
business. The Court has found, however, that the art business was run through
Brookes Financial. Consequently, the aforementioned deductions will be allowed
in the following amounts, as explained more fully below:
Item 2010 2011 2012
Advertising $2,141 -0- $6,411
Rents 27,579 $30,053 30,961
Fees 1,710 3,055 2,180
Supplies 5,295 10,000 9,581
Respondent allowed deductions for advertising expenses related to Mr.
Brookes’ financial services business of $2,141 and $5,286 for 2010 and 2012,
13
It is not entirely clear from the record, but it also appears that Brookes
Financial improperly claimed deductions for both actual expenses and standard
mileage rate expenses.
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[*17] respectively. Petitioners have not met their burden of proof to support any
additional deduction for 2010 for advertising expenses related to the art business
because there was too little evidence to support a business purpose for those
expenses. Petitioners provided several 2010 receipts labeled “Promo” and a credit
card statement for 2010, some entries of which have also been labeled “Promo”.
But the descriptions of what was purchased are too vague and general for the
Court to determine whether these purchases might have been used in the art
business. On the other hand, petitioners have met their burden to substantiate the
full $6,411 deduction they claimed for advertising for 2012. Petitioners provided
receipts showing information sufficient to determine the date of purchase, amount
paid, and business purpose for the expenses underlying the advertising deduction
they claimed for 2012.
Respondent allowed deductions for rent paid for the office Mr. Brookes
used for his financial services business of $21,279, $23,753, and $24,661 for
2010, 2011, and 2012, respectively. The documentation provided to substantiate
rent paid for the art studio is inconsistent, but after reviewing petitioners’
testimony as a whole in conjunction with the documents provided, the Court is
satisfied that Brookes Financial did rent an art studio throughout 2010, 2011, and
2012. Petitioners failed to properly substantiate rent paid in that they did not
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[*18] provide adequate proof of payment, but it is clear from the record that
Brookes Financial paid rent of at least $525 per month throughout 2010, 2011, and
2012. Therefore, the Court will allow added deductions of $6,300 per year for
estimated rent paid, for total “Rents” deductions of $27,579, $30,053, and $30,961
for 2010, 2011, and 2012, respectively. See Cohan v. Commissioner, 39 F.2d 540.
During the years in issue Mrs. Brookes displayed some of her art through
Viridian Artists, Inc., and Brookes Financial paid gallery fees of $1,710, $3,055,
and $2,180 in 2010, 2011, and 2012, respectively. The Court allows deductions in
these amounts.14
Brookes Financial claimed deductions for supplies used in the financial and
art businesses. Respondent allowed deductions of $2,295 for 2010, zero for 2011,
and $2,581 for 2012 for supplies related to the financial business. The Court has
carefully reviewed the receipts petitioners provided that relate to the art business.
Several receipts are illegible or list a date of payment outside of the years in issue;
several merely show an unpaid balance, rather than an amount paid. Some receipts
do not adequately describe what was purchased. The Court is satisfied, however,
that petitioners have provided sufficient information for the Court to estimate art
14
Brookes Financial reported these fees for 2011 under the heading “Office
Expenses”. The Court now recharacterizes these expenses as fees for the sake of
consistency across all three years in issue. See supra note 9.
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[*19] supplies expenses in addition to what respondent allowed of at least $3,000,
$10,000, and $7,000 for 2010, 2011, and 2012, respectively. Altogether,
therefore, the Court allows total supplies deductions of $5,295 for 2010, $10,000
for 2011, and $9,581 for 2012.
D. Deductions Related to Health Expenses
Brookes Financial claimed deductions for “Cost of Labor - Cost of Goods
Sold” and for “Benefits”. Respondent disallowed portions of the deductions for
“Cost of Labor” and all of the deductions for “Benefits” for lack of substantiation
or because both deductions appear to have been for Brookes Financial’s
reimbursement of various personal medical expenses. The amounts claimed by
Brookes Financial, as well as the amounts respondent has allowed, are:
Cost of labor Benefits
Year Claimed Allowed Claimed Allowed
2010 $29,584 $22,501 $12,720 -0-
2011 42,212 20,493 9,466 -0-
2012 40,452 18,694 38,737 -0-
Petitioners’ only argument against these adjustments is that Brookes
Financial is entitled to deduct amounts paid for massage therapy for Mrs. Brookes.
Brookes Financial had a medical reimbursement plan in place under which it
agreed to reimburse up to $5,000 of qualifying medical expenses incurred by
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[*20] employees and dependents of employees. Mrs. Brookes has severe
scoliosis. Mrs. Brookes testified credibly regarding her scoliosis, and petitioners
also provided a note from her doctor describing the treatment recommended for
her, which includes deep tissue massage therapy.
Respondent has not challenged the validity of the plan or that Brookes
Financial made certain payments in relation to a massage therapist’s treatment of
Mrs. Brookes. The payments totaled $3,910.33 in 2010 and exceeded $5,000 in
both 2011 and 2012. Neither has respondent argued that Brookes Financial paid
amounts that were otherwise reimbursed by petitioners’ health insurance or that
the medical expenses reimbursed did not qualify for reimbursement or deduction
as appropriate medical expenses.
The sole issue at trial was whether the $5,000 limitation in the plan should
be adjusted for inflation. Because the plan contains no clause providing for
adjustments for inflation, no adjustment for inflation is permitted. Therefore, in
addition to what respondent has already allowed, Brookes Financial is entitled to
deduct $3,910.33 for 2010, $5,000 for 2011, and $5,000 for 2012. Otherwise,
respondent’s adjustments are sustained because petitioners failed to substantiate
any further expenses and also failed to articulate any reason further medical
expenses would be deductible by Brookes Financial.
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[*21] II. Accuracy-Related Penalties
Respondent determined that petitioners were liable for accuracy-related
penalties for either: (1) disregard of rules or regulations or (2) substantial
understatements of income tax for the years in issue.15 Section 6662(a) and (b)
imposes an accuracy-related penalty of 20% of the portion of an underpayment
attributable to any one of various factors, including “[n]egligence or disregard of
rules or regulations” and “any substantial understatement of income tax”.
Respondent has the burden of production with respect to the penalties. See sec.
7491(c).
Negligence includes any failure to make a reasonable attempt to comply
with the provisions of the Internal Revenue Code, and “‘disregard’ [of rules or
regulations] includes any careless, reckless, or intentional disregard.” Sec.
6662(c). Negligence is determined by testing a taxpayer’s conduct against that of
a reasonable, prudent person. Zmuda v. Commissioner, 731 F.2d 1417, 1422 (9th
Cir. 1984), aff’g 79 T.C. 714 (1982). A taxpayer is required to substantiate
expenses underlying claimed deductions by keeping and producing records
15
Respondent’s determination of accuracy-related penalties in the notice of
deficiency includes the factors “[s]ubstantial valuation misstatement
(overstatement)” and “[t]ransaction lacking economic substance” as possible
reasons for the penalties, neither of which is in issue here.
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[*22] sufficient to enable the Commissioner to determine the correct tax liability.
Sec. 6001; INDOPCO, Inc. v. Commissioner, 503 U.S. at 84; sec. 1.6001-1(a), (e),
Income Tax Regs.
Insofar as the Court has sustained respondent’s disallowance of deductions,
the Court has done so because petitioners did not produce records sufficient to
substantiate their deductions. Respondent has therefore met his burden of
production to show that petitioners were negligent and disregarded the applicable
rules or regulations.16
A penalty under section 6662(a) does not apply to any portion of an
underpayment of tax if there was reasonable cause for such portion and the
taxpayer acted in good faith with respect to such portion. Sec. 6664(c)(1).
Petitioners bear the burden of proving reasonable cause and good faith. See
Higbee v. Commissioner, 116 T.C. 438, 449 (2001). Petitioners do not contend--
16
Although only one accuracy-related penalty may be applied to any given
portion of an underpayment, see sec. 1.6662-2(c), Income Tax Regs., if
computations under Rule 155 show that petitioners have substantially understated
their income tax for any year in issue, respondent has also met his burden of
production for that factor.
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[*23] nor does the record demonstrate--that they had reasonable cause or acted in
good faith with respect to the portions of the underpayments sustained above.17
Therefore, petitioners are liable for accuracy-related penalties for the years in
issue.
The Court has considered all of the arguments made by the parties, and to
the extent they are not addressed herein, they are considered unnecessary, moot,
irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered
under Rule 155.
17
The Court notes that Mr. Brookes prepares tax returns for his clients. See
supra p. 3.