UNITED STATES TAX COURT
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T.C. Memo.
2010-282
UNITED STATES TAX COURT
EDWARD AND ODETTE DAOUD, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No.
12070-04.
Joseph E. Mudd,
Filed December 22,
2010.
for petitioners.
Laura A. McKenna, for respondent.
MEMORANDUM OPINION
HOLMES, Judge:
The Daouds owned two Wienerschnitzel
franchises in Southern California, both of which gobbled up
unusually large amounts of money.
These expenses grabbed the
Commissioner's attention and during his audit of the Daouds' 2000
and 2001 returns, he found that they had reported a large loss on
kitchen equipment they never owned, and lacked substantiation for
SERVED DEC 2 22010
- 2 many of the other deductions that they claimed.
The Commissioner
determined a large deficiency for each year, and wants to add
fraud or at least accuracy-related penalties.
We make our way
through the resulting menu of possibilities to determine the
correct taxes and penalties .
Background
Edward and Odette Daoud are both highly educated.
Mr. Daoud
has a Ph.D. in engineering and an M.B.A., and he worked as the
director of engineering for Ameritech (the telecommunications
company) in 2000 and part of 2001.
business savvy.
By his own account he was
He claimed to have anticipated the downturn in
the telecommunication market, causing him to look for a new job
even before he was laid off in April 2001.
Mrs. Daoud has a
bachelor's degree in physical science and has taken classes
toward a master's degree in psychology.
She also managed the
day-to-day operations of the couple's two Wienerschnitzel
franchises in Southern California:
one in Cypress and the other
in Irvine .
In addition to wage and business income, the couple earned
rent on a house they owned in Austin, Texas .
Yet despite their
many sources of income, the Daouds reported zero taxable income
in both 2000 and 2001 after claiming a combination of losses and
deductions.
The largest of all were business expenses from their
Wienerschnitzel operations.
These claimed expenses reduced the
- 3 more than $1 million in combined yearly saless the restaurants
produced to $22,000 of income in 2000 and a $7,000 loss in 2001.
The Commissioner sent the Daouds a notice of deficiency.
We
tried the case in Los Angeles, where the Daouds lived when they
filed their petition.
I.
The Deficiency and the Amounts at Issue
Our first task was to determine what expenses are at issue
and in what amounts.
This was complicated by the way the
Commissioner made adjustments to the Daouds' returns, and by how
I
Mr. Daoud prepared the returns in the first place.
According to Mr. Daoud's testimony, his wife kept the
Wienerschnitzels' books on handwritten daily logs.
He would then
take these daily logs and transfer the information onto his
Quicken software program.
Once all the information was entered,
he was able to use the program to generate reports.
He claims
that it- was from his Quicken reports that he prepared the
couple's tax returns.
The curious thing about this claim is that many of the
amounts on the Quicken reports do not match the amounts listed on
the Daouds' returns.
The revenue agent nevertheless allowed the
Daouds to substantiate their expenses with these Quicken reports.
She made a few exceptions, but if an expense was documented on
the Quicken reports, she generally allowed it--even if the amount
was greater . than the Daouds reported on their returns .1
A
1 consequence of allowing the Daouds amounts for certain expenses
greater than those which they reported on their returns is that
if they can substantiate all the expenses still in dispute, their
net income would be even less than what they originally reported.
We also had difficulty determining the amounts in dispute
because the revenue agent inadvertently increased the Daouds'
Schedule C income by sometimes disallowing the same expense
twice.
She first disallowed the expenses under -an adjustment
labeled "Other Expenses, " which included her changes to the
stores' 2000 and 2001 Schedule Cs.
She then disallowed some of
the same expenses in other parts of the notice of deficiency.
We
have corrected her mistakes in making our calculations and
constructing our tables .
A.
Schedule C Income and Deductions
The following tables summarize the adjustments made to the
Daouds' Schedule C income:
From the "Explanation of Items" prepared by the revenue
agent it appears that she used this examination method for both
2000 and 2001, but neither party introduced the 2001.Quicken
eports into evidence .
- 5 -
Summary of Cypress' s Schedule C Adjustments
2000
2001
Per Return
Per IRS
Re
rn
Per IRS .
$648,071
336,998
38,885
14,719
32,404
9,018
4,633
10,029
$647,462
316,090
38,885
-032,404
-02,314
-0-
$664,827
320,996
39,890
5,317
33,241
6,482
4,994
5,324
$664,820
320,996
39,890
-033,241
-01,875'
-0-
Other interest
-0- .
2,0671
---
---
Legal & professional fees
Pension/profit sharing
3,965
-0-
-0-0-
Office expenses
14,309
-0-
5,880
2,250
17,692
Rent or lease: Auto'
machine & equipment
11,075
-0-
21,075
-0-
Rent or lease: Other
71,308
73,957
88,640
72,000
Repairs & maintenance
Supplies
Taxes & licenses
Travel
Meals & entertainment
Utilities
Charitable contributions
Contracted services
Laundry
Pest control
Trash
Uniforms
6,706
7,692
25,829
6,710
1,752
24,019
3,189
2,360
490
480
2,194
1,604
3,072
15,736
5,088
-0-018,9802
-02,701
-0-02,045
727
16,451
2,307
27,581
3,238
1,383
24,201
3,890
2,418
583
600
2,183
2,116
975
833
25
-0-024,201
-02,433
-0504
2,320
1,310
.133,396
26,095
164,217
Net gross receipts
COGS
Advertising
Car & truck
Commissions/fees
Depreciation
Insurance
.
Mortgage interest
.
business property
Total net income
17,703
.
-0-
I The Daouds incorrectly categorized "Other Interest" as "Mortgage
Interest." The Commissioner disallowed this entire amount--it wasn't interest
on a mortgage--but then allowed-the amount the Daouds could substantiate as
"Other Interest."
2 The Commissioner at first gave the Daouds an increased deduction for
utilities of $27,252 but then reduced it by $8,372.
- 6 Summary of Irvine' s Schedule C Adjustments
Net gross receipts
COGS
Advertising
Car & truck
•
2000
Per Return
Per IRS
$464 , 856
$463, 401
260,352
258,1021
27,892
27,905
12,951
1,201
-
2001
Per Return
Per IRS
$431, 320
$431, 320
250,825
250,825
26,047
26,047
15,586
-0-
I
Commissions/fees
23, 243
23, 251
21, 566
21, 566
Depreciation
Insurance
1,882
, 1, 222
-02, 614
1,466
1, 222
-01, 222
Mortgage interest
4,465
-0-
3.,220
-0-
Other interest
---
---
---
---
Legal & professional fees
Office expenses
2, 760
5,614
-0 4,918
2, 988
3,938
-0.-0-
Rent or lease: Auto,
machine & equipment
9, 744
1, 980
2, 794
-0 -
Rent or lease: Other
46,879
50,532
72,000
72,000
4, 286
990
5, 065
1, OO0
business property
Repairs & maintenance
Supplies
---
---
1,625
-0-
Taxes & licenses
30,483
-
2,497
26,915
-0-0-
Travel
2,072
-0-
1,989
Meals & entertainment
---
---
1, 172
-0 -
Utilities
19, 681
20, 362
19, 782
19, 782
Charitable contributions
Contracted services
1,960
931
-0-0-
-0-0-
Laundry
Pest control
Trash
Uni forms
Misc. materials
Total net income
490
438
1, 4 92
1, 524
-04,495
-0-01, 260
-0 • 10,053
57,736
788
. 1,932
49Ò
458
1, 512
1, 689
-0(33,749)
.
-0458
1, 408
88
827
36,097
The Commissioner at first increased Irvine's COGS by $304, but then
adjusted it downward by $2, 590 . The net amount is listed.
Total Schedule C Adjustments
Cypress
' I
Irvine
2000
2001
2000
2001
$115,693
$138,122
$53,241
$69,846
The parties compromised or conceded some of these
adjustments.
What's left for us to decide are the following
amounts (in each instance the difference between the parties'
f inal positions) :
Schedule C Expenses Still at Isst e
Cost of goods sold
Cypress
2000
2001
$20,908
---
Car & truck
Depreciation
Insurance
Mortgage interest & other interest:
14,719
9,018
2,319
7,962
$5,317
6,482
3,119
5,324
4,465
3,220
Legal. & professional services
Pension/profit sharing
3, 965
---
5, 880
2,250
2, 760
2, 988
Office expenses
Re.nt or lease: Auto, machine &
14,309
11,075
17,692
21,075
696
7,764
3,938
2,794
---
16,640
---
---
3,634
15,476
3,-296
4,065
equipment
Rent or lease: Other business
property
Repairs & maintenance
Supplies
Ir ine
2001
--11,750
$15,586
1.,882
1,466
2000
$2,250
---
1,474
---
1,625
Taxes/licenses
Travel
Meals & entertainment
20,741
6,710
1,752
27,556
3,238
1,383
27,986
2,072.
---
26,915
1,989
1,172
Utilities Contracted services
5,039
---
-----
931
1,932
490
480
149
877
124,147
583
96
--806
134,391
490
438
232
1,524
68,536
490
--104
1,601
69,885
Laundry
Pest control
Trash collection
Uniforms
Total
.
The parties did stipulate that the Daouds are not entitled to any
of the deductions claimed for charitable contributions.
B. -
Schedule A Deductions
The Commissioner challenged two of the Daouds' Schedule A
deductions from 2000: $3,640 in claimed gift/jewelry expenses and
$10,183 for mileage.
The Daouds conceded after trial that they
aren't entitled to any Schedule A deductions beyond those already
1.
- 8 |
allowed by the Commissioner, but they are still relevant for our
determination of penalties .
The Daouds also concede that they
failed to report a $2,565 state-income-tax refund received in
2000.
The Daouds were required to include this amount because
their 1999 Schedule A claimed a deduction for all of the state
income taxes paid, including the amount that they overpaid.
C.
Gain' on the Sale of the Irvine Wienerschnitzel
In the notice of deficiency, the Commissioner adopted the
calculations of the revenue agent and determined that there was
unreported gain realized on the sale of the Irvine business in
2001.
The Daouds purchased the Irvine Wienerschnitzel in 1994
for approximately $200,000, and sold it for about $350,000.
The
IRS determined that the adjusted basis in the business was
$236,166.55, which included the cost of improvements made by the
Daouds ~in 2001.
In addition, it was determined that the Daouds
häd an available,net capital loss of $88,896 that could offset
some of the gain realized on the sale.
Out of the $54,866 gain subject to tax, he also determined
that $38, 848 was ordinary income under section 12502 and the rest
was capital gain.-
He arrived at these numbers by starting with
the amount paid by the Daouds for the Irvine Wienerschnitzel in
1994, about $200, 000, and divided it by 39 years--the recovery
2 ;Unless otherwise noted, all section references are to the
Internal Revenue Code; all Rule references are to the Tax Court
Rules of Practice and "Procedure.
- 9 period for nonresidential real property under section 168.
From
that calculation he concluded that the depreciation allowed per
year under a straight-line method was $5,128.
He then multiplied
$5,128 by the number of years the Daouds owned the Irvine
franchise, coming to $38,848.
Because $38,848 was found to be
"section 1250 income,"3 he presumed that the remaining $16,018
was capital gain.
Eventually the parties agreed that the Daouds
realized only a $12,325 capital gain, but the Commissioner's
determination of section 1250 income is still at issue.
D.
Penalties
On their 2000 return, the Daouds reported a $110,015 loss on
the sale of kitchen equipment.
As a result, the revenue agent
requested documentation from the Daouds substantiating this loss;
and Mr. Daoud gave the agent a document titled "CONTRACT" that
was written son SILVA/MBA II Restaurant Equipment letterhead.
The
document was a bid from SILVA listing new equipment and equipment
upgrades that the Däouds would have to buy before they could sell
the Irvine Wienerschnitzel.
The total amount of SILVA's bid was
$110,015.
When the revenue agent received the bid she noticed a couple
of odd things about it.
The document was signed by Edward Daoud
but the line for Michael Freed, one of the contractor's partners,
3 The terms "section 1250 gain," "section 1250 recapture,"
and "section 1250 income" refer to the amount of ordinary income
required to be recognized under section 1250.
- 10 was blank.
It also appeared as though the date on the document
had been altered to read March 1, 2000.
her to issue a summons to SILVA.
Her suspicions prompted
SILVA quickly sent her a list
of bids it had made for the Daouds' Irvine Wienerschnitzel, and
three canceled checks totaling $31,241 written by the Daouds.
One of the bids on the list was for $110,015 and was made on
March 1, 2001.
From this the revenue agent determined that the
document provided by Mr. Daoud had been altered, causing her to
disallow the kitchen-equipment loss and apply a civil-fraud
penalty under section 6663 for the amount of the deficiency
attributable to the kitchen equipment loss, and accuracy-related
penalties under section 6662 for the rest.
At the end of trial, however, the Commissioner orally moved
under Rule 41(b) to conform the pleadings to the evidence
presented.
He now wants us to attach the civil-fraud penalty to
the full amount of the underpayment for both tax years.
And, as
n alternative, he asks us at least to apply the accuracy-related
penalty under section 6662 to whatever amount we determine is not
subject to the civil-fraud penalty.
The Daouds did not object to
the Commissioner's motion, and both parties have specifically
addressed the merits of the issue in their briefs.
I.
The Trial
The Daouds were unable to substantiate many of their
eductions at trial, and Mr. Daoud's testimony-did not help their
case.
Mr. Daoud conceded that he and his wife were not entitled
~
11
-
to the loss on the sale of kitchen equipment, but he tried to
explain why he reported a loss for equipment he had neither
bought nor sold.
He testified that he was unsure how the
$110,015 loss got on his return, but he speculated that the bid
was mixed up with all the other paperwork on his desk, which
caused him to enter it into Turbo Tax by mistake.
He also
testified that the date he recorded on the Form 4797, Sales of
Business Property, as the date that he sold the equipment was
simply one that he chose at random after Turbo Tax prompted him
to enter a date.
He went on to explain that he gave the altered
document to the revenue agent "out of panic."
During the remainder of Mr. Daoud's direct examination, he
proffered numerous bits of evidence and explained how each piece
substantiated the Daouds' deductions and expenses.
One of these
exhibits included two mileage logs and various receipts from
. airline, hotel, and car rental companies.
Mr. Daoud offered this
exhibit to substantiate the travel-expense deductions he claimed
for his job search and for the Wienerschnitzel restaurants.
The two mileage logs--especially the dates on them--are
particularly interesting.
On the first entry of the first log,
Mr. Daoud filled in 1/7/00 ,for the date, wrote his destination,
the business purpose, and the miles driven.
The log continues
sequentially until 12/18 when just the day and month are noted.
On the second log the dates start over with 1/5/00 and the log
again continues sequentially, with just the day and month written
1
l •
- 12 -
from 1/9 until 11/27.
Some of the dates appear twice and others
I.
do not .
The Commissioner' s counsel wondered why Mr . Daoud had
two logs for the same year, and during the cross-examination she
asked him:
Q
Are they all for 2000, or could you explain that
to us?
A
It looks like both of them are for 2000.
*
*
*
*
*
*
Q
And you don' t have one for 2001?
A
I may. I don' t really know.
*
During the 'next part of her cross-examination, the
Commissioner's counsel asked Mr. Daoud about his other travel
expenses.
She questioned him about the dates of specific trips
and the corresponding business purpose.
For each trip, Mr. Daoud
explained who interviewed him or described a Wienerschnitzel
function that he and his wife attended.
One of the receipts Mr.
Daoud was questioned about came from a hotel in Lake Tahoe.
The
receipt showed that two adults checked into a hotel on December
22, 2001, and checked out on the 26th.
Mr. Daoud explained that
this trip was for a Wienerschnitzel conference.
The
Commissioner's counsel found it odd and asked:
Q
Would you characterize this as a Christmas
conference?
A
It is not really up to us when they hold it.
It is when they hold it and we go to it .
Q
Do they typically hold Wienerschnitzel
conferences over the Christmas holidays?
- 13 -
A
Occasionally, yes, they do.
of the franchisees.
This is on the request
The Commissioner's counsel continued asking Mr. Daoud
questions about specific receipts but soon returned to the
mileage logs to ask about specific dates listed.
For example:
Q
And on 2/7, you went to Mission [Viejo]?
A
Yes.
Q
And who did you interview with there?
A
Another employer. I don't really remember the
name.
*
,
*
*
*
*
*
*
Q
On 2/16, you went to Santa Monica?
A
It looks like Santa Monica.
Q
Okay. And on 2/19 you went to Riverside?
A
Yes.
Q
And who did you interview with in Santa Monica?
.A
I don't really remember.
Q
Okay. But you had an interview?
A
Yes, all these are interview related.
Q
Okay. And who did you interview with in
Riverside?
A
Give me a second, please. I believe it was--I
believe they are a subsidiary, and I don't
remember exactly-their name.
Having gotten what she wanted from Mr. Daoud, the
Commissioner's counsel asked him to compare the dates on the
receipts with those on the mileage logs:
- 14 -
Q
All right . Mr . Daoud, we have now just gone over
some of your travel, and I am just curious . Isn' t
it true that you just testified that on February 7,
2000, you were on an interview in Mission [Viejo]?
Yet, you have also testified that * * * on 2/7
* * * you were in Portland? * * *.
A
It can be.
Something in the morning and something
in the afternoon.
Q
And so you went to both of them?
A
Possibly.
Q
Okay. Now what about how you just testified that
on 2/14 that you were in Long Beach, and on 2/16,
* * * were in Santa Monica, and on 2/19, you were
in Riverside for interviews. Yet at the same time,
you were in Korea between 2/13 and 2/19? How can
that be? That's quite a far distance.
*
A
*
*
*
*
*
*
*
*
The Korea trip * * * was 2001.
*
*
*
*
*
Q
This is your ticket to Korea, correct?
A
Yes.
Q
And if y~ou look at the date of issue, February 9,
2000 and not 2001,
A
correct?
It looks like it .
Through further cross-examination, the Commissioner's .;
ounsel showed that the mileage logs placed Mr. Daoud in Oxnard
pn the same day he was in Toronto,
in California when he was in
Illinois, at interviews in several California cities when he was
·l
apparently in London, and in San Jose and Santa Monica when he
was shown to be in Hawaii.
Mr. Daoud then conceded that it was
possible that the mileage logs reflected two separate years, one
- 15-for 2000 and one for 2001.
But even if we assume that the
mileage logs cover both years, it would, not explain.the
inconsistences between the logs and,Mr. Daoud'-s other -travel
receipts.
This extraordinarily effective cross-examination
substantially undermined Mr. Daoud's credibility and the value of
any of the evidence that he himself created.
Discussion
I.
The Commissioner'-s Motion To Amend the Pleadings
We must first decide swhether to grant the Commissioner's
motion to conform the pleadings to the evidence presented at
trial, to'let him.assert a fraud penalty for both 2000 and 2001.
See sec. 6214(a); Rule 41(b).
Rule 41(b) (1) treats an issue as
if raised in the pleadings if it was tried with the express or
implied consent of the parties.
Commissioner,
F.3d 778
103 T.C.
525,
(10th Cir. 1996).
See, ee.g., LeFever v.
$38-39 and n.16
(1994),
affd.
That's what happened here.
100
The
Daouds failed to object to the Commissioner's motion at trial.
The facts giving rise to the Commissioner's motion were raised
during trial, and without objection.
And both parties addressed
the substance of whether the civil-fraud penalty should be
applied to the entire 2000 and 2001 deficiency in their briefs.
There's also no surprise here--the evidence on which the
Commissioner bases his motion comes from Mr. Daoud's own
testimony and the facts stipulated by the parties.
We will
- 16 -
therefore grant the Commissioner' s motion and allow him to assert
the additional civil-fraud penalties.4
II.
Substantiation of the Disputed Schedule C Items
The parties dispute $192, 683 of Schedule C expenses for 2000
and $204, 276 for 2001.
The Daouds deducted expenses in multiple
categories, but we divide them into two:
(1) expense categories
for which the Daouds have offered no evidence, and (2) expense
categories that the Daouds actually tried to substantiate .
We
quickly deal with those items that fall into the first category.
Because the Commissioner' s determination is presumed correct,
without further evidence the Daouds have not met their burden of
proof.
See Rule 142(a).
The Daouds therefore have failed to
substantiate the disputed portions of the following categories of
expenses:
car and truck, depreciation, pensions and profit
sharing plans, utilities, legal and professional fees, and
laundry.
We next consider whether the Daouds have substantiated any
of the remaining expenses .
A.
Cost of Goods Sold
The Commissioner says that the Daouds aren' t entitled to
$23,158 of their cost-of-goods-sold adjustment--the difference
between the total cost of goods sold reported on the Daouds' 2000
4 He of course bears the burden of proving that the penalty
is warranted by clear and convincing evidence. See sec. 7454(a);
Rule 14 2 (b) .
.
1
- 17 -
return and the corresponding amount listed on the Quicken
reports.
The Daouds don't attempt to reconcile this discrepancy.
Instead they argue that the amounts they claimed were reasonable,
and thus should be allowed in full.
But we don't believe that
the Commissioner acted unreasonably in denying less than four
percent of the Daouds' claimed cost of goods sold in 2000.
This
is especially true given the fact that the revenue agent relied
on the Daouds' own Quicken reports in reaching her conclusion.
The Daouds also tried to substantiate the disputed portion
of the cost of goods sold with an exhibit containing page after
page of photocopied receipts from grocery stores and wholesale
clubs.
These receipts are of little value.
Without an
explanation from the Daouds, it is impossible for us to
distinguish items used at their Wienerschnitzels from those used
by them personally.
Many of the items on the receipts are
household or personal care products, or food and drink (e.g.,
liquor) that we find were probably not served or used at their
restaurants.
We therefore sustain the Commissioner's cost-of-
goods-sold adjustment for 2000.5
5 The Daouds entered into evidence a number of checks
written to their payroll-service company. The Commissioner
allowed the funds paid on these checks as part of cost of goods
sold.
These checks do not, therefore, substantiate any of the
expenses still in dispute.
- 18 -
B.
Insurance
The parties dispute only the Cypress restaurant' s insurance
expenses for 2000 and 2001.
The Commissioner did allow $2, 314 of
the $4,633 amount claimed for 2000, and $1,875 of the $4,994
amount claimed for 2001.
But the Daouds argue that they are
entitled to the full amount and offer invoices from their
insurance agent, and a policy summary from their insurance
carrier.
According to these documents, the insurance premium for
the Cypress Wienerschnitzel in 2001 was about $2,000.
(The
Daouds introduced no evidence on their 2000 insurance expense.)
Although the $1, 875 the Commissioner allowed is less than the
premiums shown on the documents, the Daouds have not proven that
they paid those premiums.
We therefore find in favor of the
Commissioner.
C.
Mortgage and Other Interest
The parties dispute $13, 286 of the mortgage-interest expense
claimed for 2000 and $7, 685 for 2001.
The Commissioner
disallowed these expenses because the Daouds were renters, not
owners, of their Wienerschnitzels' real estate.
Mr. Daoud
conceded that the mortgage label wasn' t proper, but said that he
had just mistakenly reported as mortgage interest the interest
they paid to finance their purchase of restaurant equipment.
As
proof, he offered canceled checks totaling $15,807 written to a
credit union in 2001.
These checks and Mr. Daoud's testimony
don' t prove that the payments were being made on a business, and
- 19 -
not a personal, loan; therefore, we find that they failed to
substantiate the disputed interest expenses.
D.
Equipment Lease
The Commissioner disputes equipment-lease deductions
totaling $18,839 for 2000 and $23,869 for 2001.
The Daouds claim
that part of the 2000 equipment-lease expense was for an ice
machine at their Irvine restaurant that cost $165 per month.
To
substantiate this expense, they introduced a leasing contract for
years other than 2000 and canceled checks showing that they made
their payments.
sThese are the types of records we like to see,
but the Commissioner 'is also correct that on this point they were
superfluous--he had already allowed the ice-machine expense.'
The only evidence the Daouds provide to substantiate the
rest of their equipment-lease expenses is a stack of canceled
checks written to three different banks.
As with the mortgage-
interest expense, they did not provide any additional
documentation to show the purpose for those checks.
And our
examination of the 2000 Quicken reports showed checks written to
the same banks for the same amounts also showing up as "Mortgage
Interest Expense," "Other Interest Expense," and "Material &
Supplies."
Such double-duty doesn't work: the Daouds aren't
entitled to claim any of the disputed equipment-lease expenses.
6 The Daouds originally claimed $9,744 and the Commissioner
allowed $1,980 ($165 x 12 months), leaving the disputed balance
of $7,764.
- 20 E.
Lease Expense:
Other Business Property
The parties' only dispute in this category is over the
expense of leasing the building and land used by the Cypress
Wienerschnitzel in 2001.
I -
The Commissioner allowed $72,000 of the
$88,640 claimed.
The Daouds argue that they are entitled to a deduction for
the money they paid the franchisor under a common-area
maintenance contract, about $395 a month.
But the invoices
offered are for the Irvine, not the Cypress, store and from 2000,
not 2001.
The Daouds did not provide us with Cypress's lease or
any other evidence showing Cypress's obligation to pay this
amount.
We nevertheless found, buried deep within one of the
Commissioner's exhibits, copies of eight checks drawn on
Cypress's bank account and deposited by the building's lessor.
Five checks are for $6,-129.69 and three are for $6,341.73. ~ We
find these checks substantiate eight rent payments made for eight
different months in 2001..
Although the Daouds cannot fully substantiate their rental
expense for the entire year, under Cohan we can approximate the
!
allowable amount if we haver a reasonable basis to do so.
Cohan
! i,
v. Commissioner,
Commissioner,
39 F.2d 540,
85 T.C.
731,
543-44
742-43
(2d Cir.
(1985).
1930); Vanicek v.
Therefore, we will
allow the Daouds to claim $6,129.69--the lesser of the two
amounts listed on the checks--for each of the four months not
- 21 proven directly.
This issa.small victory for thesDaouds:
We
-
find substantiation of $74,192.40 of their lease-expenses for
2001,. which comes out to be $2,192.49 more than the Commissioner
allowed.
F.
Repairs
The Daouds offered copies of checks to prove the ,disputed.
repair expenses of $6,930 for 2000 and $19 541 for 2001.
Three
of the checks were written from the Irvine Wienerschnitzel's bank
account in 2000, and their total is less than the amount already
allowed by. the Commissioner for this category.
The fourth check
was written from the Daouds' personal account in 2001, and the
only evidence offered to explain its purpose is Mr. Daoud's
testimony that it was for repairs.
We are not persuaded, and
find that the Daouds have not substantiated the disputed repair
expenses.
G.
Supplies
Included with the receipts previously discussed are ones
from Home Depot and ,Restaurant Depot, which the Daouds.argue
substantiate their deductions for supplies.-
During his
testimony, Mr. Daoud claimed that these receipts were for
restaurant supplies.
We do find Mr. Daoud's claims more likely
than not true for the items that he bought at Restaurant, Depot,
but the.things he bought at Home Depot could just as likely have
been used by the Daouds at home.
.The Daouds' inability to prove
that these items were bought for a business purpose is not the
- 22 -
only problem here--the total amount the Commissioner.allowed the
Daouds for supplies is greater than the total amount they claimed
Con their returns.7
And while $3,099 is still in dispute for 2001
($1, 474 for Cypress and $1, 625 for Irvine) , the Daouds have not
provided any specific proof that these receipts correspond to
that amount.
H.
We again find for the Commissioner.
Taxes & Licenses
The Commissioner and the Daouds continue to argue over
property taxes and licensing fees .
For the Cypress store, the
Commissioner allowed only $5, 088 for 2000 and $25 for 2001; for
the Irvine store, he allowed $2, 497 for 2000 -and nothing for
2001.
Even though the Daouds did not own the property their
Wienerschnitzels sat on, they claim that both franchise
agreements required them to pay property taxes .
If true, this
would be a proper business deduction, though properly reportable
as part of- their rental/lease expense .
1.162-11(a),
Income Tax Regs.
See sec . 162 (a) ; sec .
But here again they produce no
records for the Cypress store, and so we find for the
Commissioner on this issue.
7 On Cypress's Schedule C for 2000, the Commissioner allowed
a $15,736 deduction for "Supplies" even though the Daouds claimed
only $7,692.
Nothing was claimed or allowed for Irvine in 2000.
And for 2001, the Commissioner allowed $833 of Cypress's $2,307
supply expense, and zero of Irvine's $1,625 supply expense.
Thus, the total deduction allowed by the Commissioner for
supplies, $16,569, is $4,945 more than the total deductions taken
by the Daouds on their returns .
- 23 The Daouds did produce invoices for real-property taxes on
the Irvine store for two fiscal years: 1999-2000 and 2000-2001.
The tax liabilities shown were for $4,816 and $4,894.82,
respectively.
They also provided records showing that their
landlord billed them for the Irvine property's taxes (plus a copy
of a $424 bill from the City of Orange for health-service fees).
Invoices by themselves don't prove payment.
But the Closing
Statement generated by Heritage Escrow Company, documenting the
sale of their Irvine business in November 2001, confirms that
they were current on their real-property taxes and health-service
fees through the closing date.
Though the documentation is
sparse, we do find it more 'likely t.han not that the Daouds paid
real property taxes totaling $4,856 in 2000 and $4,283 in 2001.8
We also find it more likely than not that the Daouds paid $424 in
health-service fees in 2000 and $347 in 2001.
After subtracting
what the Commissioner previously, allowed, the Daouds are entitled
to claim an additional $2,783 for 2000 and $4,630 for 2001.
I.
Travel, Meals, and Entertainment
The Daouds argue that they are entitled to deduct $10,534 in
expenses for travel to Lake Tahoe in 2000; and $7,782 for travel
to Hawaii for a Wienerschnitzel conference in 2001.
They showed
receipts from these trips. and Mr. Daoud testified about the
trips' business purpose.
While we believe that the
* Because the Daouds sold their business in November 2001,
the expenses for "Taxes & Licenses" are less in 2001.
... I,.
- 24 -
Wienerschnitzel organization has conferences, we do not believe
Mr. Daoud's testimony that these trips were for those
conferences.
We need corroboration, especially given Mr. Daoud's
claim that he.and Mrs. Daoud were in Lake Tahoe on Christmas Day
for a conference.
Even if we credited his testimony on this
point, section 274(d) requires enhanced substantiation for travel
expenses which neither Daoud supplied.
We therefore find that
they are not entitled to deduct these travel expenses.
The Daouds also claim that the numerous restaurant receipts
introduced into evidence were for meals with suppliers and other
people related to the Wienerschnitzel business.
Mr. Daoud cannot
remember the specifics of the meals, but he assured us in his
testimony that they were for business.
This testimony also lacks
the specificity that section 274(d) requires.
We find that the
Daouds can't deduct these meals.
J.
Other Expenses .
1.
Contracted Services
To substantiate the deductions for contracted services, the
Daouds offer copies of checks written to various individuals.
The Daouds, however, failed to explain what the individuals did
for, them.
The only explanation they gave is that one of the
individuals was a labor contractor who helped out at their Irvine
store.
With only the checks and Mr. Daoud's testimony, we are
not convinced that the money was spent for a business purpose.
|-
- 25 Therefore, we will allow neither the disputed $931 for 2000 nor
the disputed $1,932 for 2001.
2.
Pest Contról
The Commissioner allowed the Daouds almost $1,000 for pest-
control expenses in 2001, but the parties still fight over $918
in 2000 and an extra $96 in 2001. • To support their claim, the
Daouds offer invoices from Lloyd Pest Control for $692 billed and
dated 2001.
But they don't argue that these invoices
substantiate expenses disallowed by the Commissioner, nor do they
offer any evidence to substantiate any 2000 expense for this
category.
We find for the Commissioner on this issue as well.
3.
Trash Collection
The Commissioner allowed the Daouds most of their claimed
expenses for trash collection, including an amount greater than
what they claimed on their 2001 returns for their Cypress store.
But the Daouds say they should still be able to deduct an extra
$381 in 2000 ($149 for the Cypress store and $232 for Irvine
store) and $104 in 2001 (for the Irvine store).
The Daouds
produced a few invoices billed to the Cypress location, but the
Commissioner already allowed an amount greater than the total of
the invoices.
The Daouds' failure to show how the invoices prove
any disputed amount forces us to toss this argument.
We find ·
that the Daouds failed to substantiate the disputed trash-
collection expense.
- 26 -
4.
Uniforms
The disputed uniform expenses are $2,401 for 2000 and $2,407
for 2001.
To substantiate these expenses, the Daouds offer only
invoices sent to their Cypress Wienerschnitzel in 2001.
The
invoices total $1,310, which is the exact amount the Commissioner
allowed.their Cypress store for that year.
Because no other
evidence was provided, we find that the Daouds have not
substantiated the disputed portions of the uniform expense.
III. Depreciation Recapture
The parties agree that the Daouds realized at least $12,325
of capital gain on the sale of their Irvine Wienerschnitzel in
2001, so we need to decide only if the Daouds are liable for the
$38,848 of section 1250 gain."
As we've already briefly noted, in calculating the Daouds'
section 1250 income the Commissioner started out with the
purchase price of the Irvine Wienerschnitzel in 1994
9 The only argument the Daouds make to dispute their
liability for section 1250 gain is that the parties agreed in the
stipulation: that $12,325 was the amount of gain that should have
been recognized in 2001; therefore, the Commissioner is estopped
from asserting any additional gain under section 1250. But the
stipulation states only that the Daouds "received capital gain in
2001 from the sale of their Irvine Wienerschnitzel in the amount
of $12,325 * * *." It does not stipulate to the overall gain
realized on the sale. Given that this Court applies general
contract principles when interpreting tax-settlement agreements,
the Daouds' position is without merit.
See, e.g., Dutton v.
Commissioner, 122 T.C. 133, 138 (2004).
Parties "are bound to
the terms agreed upon and not to the premises underlying their
agreement[.]"
Pack v. United States, 992 F.2d 955, 959-60 (9th
Cir. 1993) (citing Zaentz v. Commissioner, 90 T.C. 753, 761
(1988)).
- 27 -
(approximately $200,000) and divided it over 39 years--the
recovery period for nonresidential real property.
168(c).
See sec.
He then calculated that the annual allowable
depreciation under a straight-line method was $5,128 which, when
multiplied by the years that the Daouds owned the Irvine
franchise, equaled $38,848.
The math works, but the reasoning is wobbly.
Section 1250
applies to real property depreciable under section 167
(i.e.,
used in a trade or business) other than section 1245 property.
See secs.
167(a),
1250(c); sec.
1.1250-1(e) (3),
Income Tax Regs.
When section 1250 property is disposed of (e.g., sold or
exchanged), a taxpayer generally has to recognize as ordinary
income the lesser of (1) the "additional depreciation," or (2)
the taxpayer's gain on the disposition of the property.
1250(a) (1); sec. 1.1250-1(a), Income Tax Regs.
See sec.
Additional
depreciation--for property acquired after 1.975 and held for more
than one year--is usually the amount of depreciation (or
amortization) claimed by the taxpayer in excess of the amount
allowed under a straight-line method.1°
1.1250-2(a),
Sec. 1250(b) (1); sec.
Income Tax Regs.; see, e.g., Universal- Mktg., Inc.
1° The straight-line method requires taxpayers to take
depreciation deductions evenly over an asset's useful life or
recovery period--roughly, the asset's cost divided by the number
of years required by the Code. See sec. 1.167(b)-1, Income Tax
Regs.
- 28 v. Commissioner, T.C. Memo. 2007-305; Murry v. Commissioner, T.C.
Memo.
1993-471.
"[S]ection 1250 property" is usually a building, including
its structural components, owned by the taxpayer and used in his
trade or business.
See secs. 1245(a) (3), 1250(c); Hosp. Corp. of
Am. v. Commissioner,
109 T.C.
21,
56
(1997).
A leasehold
interest in land or a building, which is what the Daouds held in
|-
their Irvine Wienerschnitzel, may also qualify as section-1250
property.
Sec.
1250(c); sec.
see also Kingsbury v.
1.1250-1(e) (3),
Commissioner,
65 T.C.
Income Tax Regs.;
1068,
1090
(1976).
But tangible and intangible personal property used in the'
taxpayer's trade or business does not--it's governed by section
1245."
See sec.
1245(a) (3); Hosp. Corp.,
109 T.C. at 56-92
(discussing the differences between section 1250 and section 1245
property).
Under section 1245, all deductions for depreciation are
recouped as ordinary income to the extent a taxpayer realizes a
corresponding gain on the disposition of his section 1245
property."
v.
See e.g.,
Commissioner,
sec.
1245(a); Buffalo Tool & Die Mfg.
74 T.C. 441,
445
(1980).
Co.
Like section 1250,
section 1245 only applies when a gain is realized.
The key
" Section 1245 also includes some real property used in
mining, manufacturing, and certain service industries.
See sec.
1245(a) (3) (lB)-(C).
" See section 1245(b) for the exceptions and limitations.
29 -
distinction between the two sections is that section 1245
recaptures all depreciation deductions affecting the adjusted
basis of the property, and section 1250 only recovers "additional
depreciation."
Because the Code treats section 1250 and section 1245
property differently, the regulations require gain to be computed
separately for each type of property.
1.1250-1(a) (6),
See secs. 1.1245-T(a) (5),
Income Tax Regs.; Kingsbury, 65 T.C-.
at 1090.
Section 1.1245-1(a) (5), Income Tax Regs., states:
In case of a sale, exchange, or involuntary conversion
of section 1245 and nonsection 1245 property in one
transaction, the total amount realized upon the
disposition shall be allocated between the section 1245
property and the nonsection 1245 property in proportion
to their respective fair market values. * ***
The recapture rules for section 1245 are also usually applied on
I
an asset-by-asset basis.
See sec. 1.1245-1(a) (4), Income Tax
Regs.; Buffalo Tool & Die,
74 T.C. at 445-52; cf.
sec.
1.1250-5
(d) (2) (iii), Income Tax Regs.
In this case, the Commissioner incorrectly assumed that the
Irvine Wienerschnitzel was composed of only section 1250
property.
This is evident from the fact that his agent took the
aggregate value of the business property in 1994
(i.e., the
purchase price), and divided it by a recovery period used only
for section 1250 property.
But the restaurant was already there
in 1994, leading us to find that the Daouds had bought both
section 1250 and section 1245 property.
Certainly by 2001, much
- 30 -
of the Irvine franchise's property fell under section 1245
(e.g.,
franchise rights, machines, equipment, and purchased goodwill) .
The Commissioner also confused the application of section
1250 with section 1245.
The Commissioner added to the Daouds'
ordinary income the sum of all the depreciation that was
calculated under a straight-line method, for the period in which
they owned the business.
This is not right:
Section 1250 gain
is realized only if the Daouds took more than a straight-line-
depreciation deduction.
See sec. 1250; sec. 1.1250-1, Income Tax
Regs.
There is no evidence in the record that suggests the Daouds
used anything other than a straight-line method when depreciating
and amortizing their business's 1250 property.
The Daouds paid
rent in equal, monthly installments for the use of the land and
building, and it appears that they claimed depreciation
deductions on their Schedule Cs only for section 1245 property.*
We therefore find that the Daouds are not required to recognize
any recapture income under section 1250 .
The question of recapture under section 1245 is a bit more
complicated.
We have consistently held that we will not consider
"issues" which have not been pleaded, see , e . g . , Markwardt v .
Commissioner,
64 T.C.
989,
997
(1975) ; Troutman v.
Commissioner,
" The Daouds never depreciated their 2001 improvements,
which may or may not qualify as 1250 property.
See sec. 1250(c);
sec.. 1.48-1(e), Income Tax Regs.; Walgreen Co. v. Commissioner,
68 F.3d 1006,
1007
(7th Cir.
1995),
revg.
103 T.C.
582
(1994).
- 31 T.C. Memo. 2004-32, affd.
137 Fed. Appx.
70
(9th Cir. 2005), but
we can sustain the Commissioner's determination fot "reasons"
other than those gived in the notice of deficiency,.e.g., Estate
of Finder v. Commissioner, 37 T.C. 411, 423 (1961).
What
distinguishes "issues" from "reasons" is that a new issue would
alter the evidence presented, but a new reason is just a new
argument about the existing evidence.
Commissioner,
124 T.-C.
16,
30
See, e.g., Hurst v.
(2005).
The Commissioner never argued nor determined that a part of
the Daouds' defibiency stemmed from section 1245 recapture, and
this is not a case where the dommissioner used the right rules
but labeled it with the wrong section number.
Under section
1245, the Commissioner's determination would still be amiss.Mi
We therefore find that Daouds werelnot put on- notice of the
section 1245 argument, and did not know to present evidence or
arguments addressing it.
" The Daouds did in fact sell some section 1250 property as
part of the sale of their business--for example, their leasehold
interest in the land and building, and possibly some of the
leasehold improvements that they had made. 'This means that some
of their adjusted basis and sale proceeds would still need to be
allocated between section 1245 and section 1250 property. This
the revenue agent did not do.
Even then, the 39-year recovery
period would not apply.
Intangibles such as purchased goodwill
and the right to operate a franchise all have a 15-year depreciation recovery period.
Sec. 197. And the Daouds' equipment and
other section 1245 property that they sold would likely be recoverable over 5 and 15 years. See sec. 168. Thus, we can't consider the $38,848 amount merely wearing- the wrong label to be a
reasonable estimate of the section 1245 gain.
1
- 32 -
Neither party litigated the issue of section 1245 gain.
Neither party tried to value the business's section 1245
property, and neither offered any valuation of the Daouds'
section 1245 property.
We therefore find in the Daouds'
favor on
the issue of section 1250 income.
. IV.
Penalties
A.
Fraud Penalties
.Section 6663(a) imposes a penalty of "an amount equal to 75
percent of the portion of the underpayment which is attributable
to fraud."
A taxpayer commits fraud when he "evade[s]
taxes
known to be owing by conduct intended to conceal, mislead, or
otherwise prevent the collection of taxes."
Commissioner,
94 T.C.
654,
661
(1990).
Parks v.
The Commissioner has
conceded that Mrs. Daoud is not liable for the fraud penalty and
we must determine only Mr. Daoud's liability.
To impose a penalty for fraud we must find that the
Commissioner has proven by clear and convincing evidence that (1)
an underpayment of taxes occurred, and (2) that some portion of
the underpayment was due to fraud.
142(b).
See sec. 6663(a); Rule
It is the second element that is often difficult for the
Commissioner to prove because he likely does not have direct
proof of the taxpayer's intent.
This is why we allow the
Commissioner to prove fraud with "circumstantial evidence and
reasonable inferences drawn from the facts * * *."
Commissioner,
I
91 T.C.
273,
297
(1988).
Meier v.
We have identified
- 33 -
various indicia of fraudulent intent.
Id. at 297-98.
These
include:
•
understatement of income;
•
inadequate records;
•
failure to file tax returns;
e
implausible or inconsistent explanations of behavior;
•
concealment of assets;
•
failure to cooperate with tax authorities;
e
engaging in illegal activities;
•
attempting to conceal illegal activities;
•
dealing in cash; and
•
failing to make estimated tax payments.
Id.
(citing Bradford v. Commissioner, 796 F.2d 303, 307-08
Cir.
1986), affg. T.C. Memo.
1984-601).
also prove fraud for each year in issue.
Commissioner,
99 T.C.
202,
210
(9th
The Commissioner must
See Niedringhaus v.
(1992).
If the Commissioner meets his burden as to any portion of
the underpayment, then we have to treat the entire underpayment
as attributable to fraud except to the extent the taxpayer
establishes, by a preponderance of the -evidence, that a portion
of the underpayment is not due to fraud.
1.
Sec. 6663 (b).
Fraud for 2000
The Commissioner has met.his burden with respect to the
first element of fraud--he has shown that the Daouds underpaid
their 2000 taxes.
Mr. Daoud even concedes that he wasn't
- 34 -
entitled to the loss reported on the sale of kitchen-equipment.
The second element, requiring the Commissioner to show fraudulent
intent at the time the Daouds reported the loss, is a bit
!
trickier.
This case is a good example of why we allow the Commissioner
to prove fraudulent intent using circumstantial evidence and the
taxpayer's entire course of conduct.
Mr. Daoud claims that he
reported the loss by mistake, and he asks us to believe that he
first learned about it when the revenue agent brought it to his
attention.
We do not believe him--Mr. Daoud's credibility
suffered during trial.
His testimony was often suspect, and the
records he provided have proven not to be what he said they were
on many subjects.
The first indicium of fraud, understatement of income, can
be shown by an overstatement of deductions.
982,
1019
E.g., Hicks Co. v.
Commissioner,
56 T.C.
(1971), affd. 470 F.2d 87
(1st
Cir. 1972).
For 2000, Mr. Daoud reduced the Daouds' income by
the $110,015 kitchen equipment loss, more than $200,000 in
unsubstantiated Schedule C expenses, and more than $10,000 in
unsubstantiated Schedule A deductions.
These deduction
overstatements are significant.
Mr. Daoud was also unable to substantiate expenses and
deductions because the Daouds kept inadequate records--another
indicium of fraud.
He tried to disguise this shortcoming by
hrowing-piles of documents at the revenue agent and counsel for
- 35 the IRS.
These documents are spotty and disorganized.
They
include what appear to be falsified mileage logs and numerous
receipts for personal items.
And almost all of Mr. Daoud's
records proved inadequate to substantiate the deductions and
expenses he disputes.
Attempting to conceal fraudulent activity is another
indicium of fraud present in this case.
When asked to
substantiate the $110,015 loss, Mr. Daoud gave the revenue agent
the altered bid that he was trying to pass off as a contract for
the purchase of equipment.
He claims that he gave the document
to the revenue agent because he panicked after finding out about
his mistake.
This story does not help his cause.
Whatever his
reasoning, he was trying to conceal his true income from the
Commissioner and that shows fraud.
Further evidence of fraud, and perhaps the most damaging, is
Mr. Daoud's implausible explanation of how the $110,015 loss got.
onto his return.
He asks us to believe that while preparing his
2000 return he found a bid among his tax papers and he mistakenly
entered it into Turbo Tax in a way that reduced his income by
$110,015.
Then months later, upon realizing his mistake, he
found the bid again, altered it, and gave it to the revenue agent
to substantiate the loss because he panicked.
implausible story:
This is an
Mr. Daoud was actively negotiating for other
bids from SILVA when the alleged mistake took place, so he was
familiar with the document.
The Daouds didn't sell any equipment
- 36 in 2000.
And why wouldn't he recognize his mistake when he
completed the return and discovered that all they owed in taxes
was $2,621 in self-employment-tax?
The final indicium of fraud present in this case is the
Daouds' failure to make estimated tax payments.
In 2000, the
only tax payments they made were those that Ameritech withheld.
With so many of the indicia of fraud present, we find that the
Commissioner has met his burden and proved by clear and
convincing evidence that a portion of the Daouds' 2000
underpayment was due to fraud.
We will therefore treat the Daouds' entire 2000 underpayment
as fraudulent.
See sec. 6663 (b).
This shifts the burden to Mr.
I ,
Daoud to prove that some portion of that underpayment was not
attributable to his fraud.
He argues, and we agree, that the
deduction he reported for the jewelry he gave to his wife was not
a result of fraud.
He identified the jewelry on the 2000 return
as "gift to spouse."
This deduction shows disregard for the tax
rules, but not fraudulent conduct.
As for the rest of the
h
underpayment, Mr. Daoud hasn't tried to show that any other
portion of it was not attributable to fraud beyond arguing that
his records substantiate his deductions and expenses.
I
2.
Fraud for 2001
In.his.brief, the Commissioner attempts to conflate the
penalty issue for 2000 and 2001, arguing the evidence of fraud
without referring to the particular tax year he is addressing.
- 37 -
But we can't impute or presume fraud--it must be established by
independent evidence for each tax year.
99 T.C. at -210; Petzoldt v. Commissioner,
(1989).
See, e.g., Niedringhaus,
92- T.C.. 661,
699
Thus, we next look to see if there is clear and
convincing evidence of an underpayment attributable to fraud for
2001.
The Commissioner did establish the, first element:
clearly was an underpayment in 2001.
There
The parties have even
stipulated the fact that the Daouds should have reported the
capital gain realized on the sale of their Irvine franchise.
And
as previously determined, the Daouds did take Schedule C
deductions in 2001 to which they were not entitled.
As to the issue of fraudulent intent, we look at the various
badges of fraud.
The first one, an understatement of income, is
shown by Mr. Daoud's unsubstantiated job search and Schedule C
expenses, and his failure to report the gain realized when the
Daouds sold their Irvine business.
Mr. Daoud also failed to make
estimated tax payments in 2001, another indicium of fraud.
But
these transgressions could also reflect mere negligence or a
disregard of the Code and regulations.
The Commissioner argues that Mr. Daoud's education and
experience elevate these omissions to fraud.
The Commissioner;
however, does not allege, and the record does not suggest, that
Mr. Daoud had any expertise cn: specialized knowledge in tax law.
We are not persuaded by the Commissioner's argument that Mr.
- 38 -
Daoud's general intelligence and prior experience of being
audited are enough to prove an intent to evade taxes.
The Commissioner also alleges that Mr. Daoud tried to
conceal his income in 2001 by "[burying] the sale of the Irvine
franchise as a loss on Schedule D-1, following the list of stock
sales."
We are unpersuaded.
Mr. Daoud, although incorrectly,
did disclose the sale of the Irvine business on the returns.
Moreover, the way he reported the sale shows an attempt to
disclose information, not conceal it.
The Commissioner also points to Mr. Daoud's testimony
regarding the :mileage logs as proof of fraudulent intent.
Mr.
Daoud, however, did not use the mileage logs to substantiate any
of his 2001 deductions.
He testified that the mileage logs were
exclusively for 2000, and only after the Commissioner's effective
cross-examination did Mr. Daoud suggest that it was possible that
some of the notations on the mileage logs were for 2001.
This
does not show an intent to evade his 2001 taxes, and in fact his
not relying on it to shrink his 2001 tax bill shows the opposite.
And the,Commissioner does not allege any other.misleading
statements were made by Mr. Daoud about his 2001 return.
We can't help but find that Mr. Daoud kept inadequate
records and was not always cooperative with the IRS for both
years.
But poor bookkeeping and frostiness toward IRS agents do
not necessarily prove fraudulent intent.
1.
See Terrell Equip. Co.
v. Commissioner, T.C. Memo. 2002-58; Piekos v. Commissioner, T.C.
- 39 Memo. 1982-602.
The IRS does argue that Mr. Daoud had a pattern
of underreporting his income and overstating his deductions.
But
a "pattern" of two years is thin soup, and not enough to let us
find clear and convincing evidence of fraud for 2001.
See Loftin
& Woodard,
1978)
Inc. v. U.S.,
577 F.2d 1206,
1239
(5th Cir.
(finding that even a "consistent and substantial understatement
of income is * * * [insufficient], by itselfs, to support a
finding of fraud").
The Commissioner does not allege, and the evidence does not
suggest, that Mr.,Daoud fabricated, destroyed, or concealed
documents related to his 2001 return.
Given the weight of the
evidence, we conclude that the Commissioner has failed to carry
his burden of proving, by clear and convincing evidence, that any
part of the 2001 underpayment was a result of fraud.
B.
Section 6662 Accuracy-Related Penalty
On the portion of the Daouds' deficiency not subject to
section 6663, the Commissioner seeks a 20-percent
accuracy-related penalty under section 6662 because of:
negligence,
(1)
(2) disregard of the rules or regulations, or (3) a
substantial understatement of income tax.
The Commissioner also wants Mrs. Daoud to be liable for an
accuracy-related penalty on the portion of the underpayment
already subject to Mr. Daoud's civil-fraud penalty.
An accuracy-
related penalty, however, cannot be imposed on one spouse where
the other one is liable for fraud.
See, e.g., Zaban v.
- 40 -
Commissioner, T.C. Memo. 1997-479.
Unl-ike the fraud penalty,
which is imposed -on each spouse separately, the accuracy-related
penal.ty applies jointly and severally.
See Talmage v.
Commissioner, T.C. Memo. 2008-34, affd. without published opinion
106 AFTR 2d 2010-5706, 2010-2 USTC par. 50,550 (9th Cir. 2010);
Aflalo v. Commissioner, T.C. Memo. 1994-596.
Thus, to impose an
accuracy-related penalty on Mrs. Daoud when her husband is liable
for fraud is "impermissible staicking."
Memo. ' 1997-479.
See, e.g., Zaban, T.C.
Therefore, we need to decide only whether the
ewelry deduction and the Daouds' 2001 underpayment will be
penalized under section 6662.
Once the Commissioner provides some evidence of negligence,
disregard of the Code and regulations, or a substantial
understatement, the burden of proving that the Commissioner got
his penalty determination wrong shifts to the taxpayer.
142(a); Higbee v. Commissioner,
116 T.C.
438,
446-47
See Rule
(2001).
A
taxpayer can shoulder this burden by showing that, under all the
facts and circumstances, he acted with reasonable cause and in
good faith.
Sec . 6664 (c) (i) ; sec. 1. 6664-4 (b) (1) , Income Tax
Regs.
Negligence, as the regulations define it,.is the failure to
make a reasonable attempt to prepare one's tax returns, keep
adequate books and records, substantiate items properly, or
otherwise comply with the Code.
Regs.
Sec. 1.6662-3(b) (1), Income Tax
Disregard of the rules includes careless, reckless, or
- 41 -
intentional disregard of the Code provisions or regulations.
Section 1.6662-3(b) (2), Income Tax Regs.
And an understatement
is substantial if it is more than $5,000 or 10 percent of the tax
required to be shown on the return, whichever is greater.
Sec.
6662(d) (1) (A).
We find that Mr. Daoud clearly disregarded the rules when he
deducted the cost of jewelry given to his wife in 2000 as a
business expense.,
The Daouds don't argue otherwise.
The Daouds
also claimed excessive Schedule C expenses on their 2001 return
which they were unable to substantiate, disregarding the
requirements of sections 162 and 274.
The fact that the Quicken reports do not match the amounts
claimed on their returns buttresses our finding that these
taxpayers were negligent in keeping their records and preparing
their 2001 returns.
See Lysek v. Commissioner, 583 F.2d 1088,
1094
affg. T.C. Memo.
(9th Cir.
1978),
1975-293.
The Daouds also
ignored the depreciation deducted in prior years when calculating
the adjusted basis of their Irvine business.
Commissioner, T.C. Memo. 1994-540.
See Bissey v.
We therefore find them liable
for a negligence penalty on their 2001 underpayment.
We also believe that we can sustain the section 6662 penalty
on the distinct ground that the Daouds substantially understated
their 2001 income tax.
If, as appears likely, their
understatement of income tax as calculated under Rule 155 exceeds
the greater of $5,000 or 10 percent of the tax required to be
- 42 -
shown on their 2001 return, the Commissioner has succeeded in
defending the section 6662 penalty on this alternative ground.
The accuracy-related penalty does not apply if the taxpayer
had reasonable cause and acted in good faith, sec. 6664(c) (1),
but the Daouds failed to present any evidence or make any
arguments addressing this defense.
i
·
We therefore find that the
accuracy-related penalty applies to the jewelry deduction they
took in 2000 and to the full amount of their 2001 underpayment.
An order granting
I
respondent' s oral motion to
conform the pleadings to the
e
-l j'
proof will be issued, and
decision will be entered under
Rule 155 .
I
.
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