United States Tax Court

United States Tax Court

T.C. Memo. 2023-89

RICHARD JOHN CARDULLA,

Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

—————

Docket No. 17579-18.

Filed July 19, 2023.

—————

P engaged in numerous real estate-related activities

with respect to which R disallowed his claimed losses and

increased his gross income. Among P’s activities was the

use of a single-member LLC, a disregarded entity, to

purchase real estate. In exchange for the real estate, the

sellers received from the LLC its secured Note for

$1,200,000 with 10% simple interest accruing yearly; with

payments of neither principal nor interest due until

expiration of the 12-year term of the note. Using the

accrual method of accounting, the LLC accrued and

deducted interest of $120,000 on account of the Note (no

payment of principal had been made).

Held: Disallowance of numerous real estate-related

deductions sustained for lack of substantiation.

Held, further, Note was bona fide indebtedness.

Held, further, Note was a debt instrument having

original issue discount.

Held, further, without a change in method of

accounting, LLC could not for examination years accrue

interest payments under OID rules.

Served 07/19/23

2

[*2]

Held, further, LLC’s property was held for long-term

appreciation and not in trade or business; interest on Note

was investment interest subject to I.R.C. § 163(d)

limitation on investment interest.

Held, further, increases in capital gain income

sustained.

Held, further, adjustment to Social Security benefit

sustained.

Held, further, accuracy-related penalty sustained.

—————

Richard John Cardulla, pro se.

Jeffrey L. Heinkel, Heather K. McCluskey, and Julia Kapchinskiy, for

respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: By Notice of Deficiency dated July 26, 2018

(Deficiency Notice), respondent determined deficiencies in, and

accuracy-related penalties with respect to, petitioner’s 2014 and 2015

income tax liabilities as follows: 1

Year

Deficiency

Accuracy-Related Penalty

§ 6662(a)

2014

$23,653

$4,731

2015

44,041

8,808

Petitioner made federal income tax returns for his taxable

(calendar) years 2014 and 2015 on Forms 1040, U.S. Individual Income

Tax Return. He included with each return two Schedules C, Profit or

Loss From Business, and one Schedule E, Supplemental Income and

1 Unless otherwise indicated, statutory references are to the Internal Revenue

Code, Title 26 U.S.C. (Code), in effect at all relevant times, regulation references are

to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times,

and Rule references are to the Tax Court Rules of Practice and Procedure. All dollar

amounts have been rounded to the nearest dollar.

3

[*3] Loss. The first Schedule C included with each return (Schedule

C–1) is with respect to a real estate business named “X-Way Delta, LLC”

(X-Way Delta). The second Schedule C included with each return

(Schedule C–2) is with respect to an unnamed real estate business.

The questions for decision are as follows.

1. Whether petitioner’s Schedules E income from partnerships

and S corporations should be increased by $4,241 and $109,755 for 2014

and 2015, respectively?

2. Whether he is entitled to deduct additional Schedule E rental

real estate expenses of $5,369 and $8,801 for those years, respectively?

3. Whether he is entitled to deduct Schedule C–2 total expenses

of $29,258 and $51,000 for those years, respectively?

4. Whether he is entitled to deduct Schedule C–1 total expenses

of $130,869 and $131,593 for those years, respectively?

5. Whether he has unreported capital gain income from Island

Mountain, LP (Island Mountain), of $23,655 and $19,170 for those years,

respectively?

6. Whether, for 2014, he must include in gross income Social

Security benefits of $8,451?

7. Whether, for 2015, he is liable for a section 6662(a) accuracyrelated penalty of $8,808? 2

All other adjustments made by respondent in determining the

deficiencies in tax for the years at issue are computational, resulting

from the above referenced adjustments. Those computations and

adjustments will not be discussed further.

2 Respondent has conceded the accuracy-related penalty that he determined

for 2014.

4

[*4] Petitioner bears the burden of proof. See Rule 142(a)(1). 3 With

respect to the accuracy-related penalty, respondent bears a burden of

production. See § 7491(c).

FINDINGS OF FACT

Preliminary Statement

Before making our findings of fact, we pause to address

petitioner’s failure to comply with Rule 151, which addresses briefs. At

the conclusion of the trial in this case, we ordered the parties to file

briefs, setting a schedule for seriatim briefs, petitioner to open,

respondent to answer, and petitioner to reply. We directed petitioner’s

attention to Rule 151. Rule 151(e)(3) requires that an opening brief

contain proposed findings of fact in the form of numbered concise

statements of essential fact and not a discussion or argument relating

to the evidence or the law. Petitioner’s Opening Brief violates the Rule

in that petitioner makes 12 proposed findings, virtually none of which

are concise statements of essential fact and most of which respondent

correctly identifies as comprising legal argument and not statements of

fact.

For example, petitioner proposes that we find:

3. The facts support X-Way Delta’s property was not a

capital asset under IRC section 1221(a)(1) in that a capital

asset does not include “property held by the taxpayer

primarily for sale to customers in the ordinary course of his

trade or business.” . . .

....

3 Section 7491(a)(1) provides that, if a taxpayer offers credible evidence with

respect to any issue relevant to determining his tax liability, the burden of proof with

respect to the issue is on the Commissioner. See also Rule 142(a)(2). Section 7491(a)(1)

applies only if the taxpayer complies with the relevant substantiation requirements in

the Code, maintains all required records, and cooperates with the Commissioner with

respect to witnesses, information, documents, meetings, and interviews.

See

§ 7491(a)(2)(A) and (B). The taxpayer bears the burden of proving compliance with the

conditions of section 7491(a)(2)(A) and (B). See, e.g., Mileham v. Commissioner, T.C.

Memo. 2017-168, at *30. Petitioner neither proposes facts to support his compliance

with the conditions of section 7491(a)(2)(A) and (B) nor persuasively argues that

respondent bears the burden of proof on any issues because of section 7491(a)(1). We

therefore conclude that section 7491(a)(1) does not apply in this case.

5

[*5]

6. The facts support that the deductions taken by

Petitioner were necessary expenses in carrying on his

business and were actually paid or accrued in the years in

question. . . .

Petitioner’s Reply Brief also violates Rule 151(e)(3), which

requires that, in a reply brief, a party “set forth any objections, together

with the reasons therefor, to any proposed findings of any other party.”

Respondent in his Answering Brief proposed 222 findings of fact.

In reply, petitioner makes no systematic response. His Reply Brief is a

37-page narrative, initially attacking respondent’s attorneys and then

comprising what amounts to additional testimony without significant

citation of the record interspersed with apparent objections to eight or

so of respondent’s proposed findings.

Petitioner has not provided us with usable proposed findings of

fact. Moreover, because he failed to object to substantially all of

respondent’s proposed findings, we must conclude that he accepts

respondent’s unobjected-to proposed findings of fact as correct. See, e.g.,

Jonson v. Commissioner, 118 T.C. 106, 108 n.4 (2002), aff’d, 353 F.3d

1181 (10th Cir. 2003).

Stipulation

The parties have stipulated certain facts and the authenticity of

certain documents. The facts stipulated are so found, and the

documents stipulated are accepted as authentic.

Petitioner

Petitioner is an attorney. His mailing address was in California

when he filed the Petition. He has been involved in real estate activities

for many years.

Real Properties

The following real properties figure in petitioner’s tax returns for

2014 and 2015.

L Street—L Street is real property in southeast Washington, D.C.

During the years at issue, the property was a vacant lot. Up until

sometime before 2014, petitioner was sole owner of the property. During

his sole ownership, he installed a fence around the property. The record

6

[*6] contains two invoices from Long Fence, both dated in February

2006, both for delivery to L Street, both billed to Cardulla Properties,

one for the short-term lease of “panels” and the second, for $9,566, for

delivery and installation of a chain link fence.

Plaza Boulevard—Plaza Boulevard is a real property in National

City, California. During the years at issue, it was a vacant lot.

Petitioner plans to build a “speculation house” on the lot. The property

was not rented during 2014 or 2015.

Turner Road—This property is in Bombay, California, next to

property owned by X-Way Delta. On the Turner Road property is a

house badly damaged by an earthquake. Petitioner has restored the

house and uses it as an office and a place to stay when he is visiting the

X-Way Delta property. Otherwise, the property is vacant.

L Street No. 2—A second property on L Street in southeast

Washington, D.C.

Commercial Street—A property in San Diego, California.

Salton Sea Property—The Salton Sea is a shallow, landlocked,

highly saline body of water in southern California. In 1985, petitioner

and three others—Scott Hettelsater, Tom Wagner, and Equitable

Finance (Equitable)—bought numerous parcels of real estate in

proximity thereto (Salton Sea property). Messrs. Hettelsater and

Wagner were longtime acquaintances of petitioner. Mr. Wagner was

president of Equitable. Initially, each person owned his (its) parcels

separately. Petitioner’s idea was to develop the Salton Sea property as

a mobile home park or hot water spa. He viewed development of the

property as his project, in which Messrs. Hettelsater and Wagner and

Equitable (Investors) invested.

After 20 years of unsuccessful

development efforts, the Investors lost heart and wanted to sell their

parcels. Petitioner thought he could save the project, and he offered to

buy out the Investors, although he told them that he could not then

afford to pay cash. Petitioner formed X-Way Delta to purchase parcels

from the Investors. Petitioner receives $5,000 a year from a fish farm

with an easement that allows the farm’s wastewater to pass through an

unidentified portion of the Salton Sea property on its way to the sea.

7

[*7] Entities

The following entities figure in petitioner’s tax returns for 2014

and 2015.

Island Mountain—Island Mountain is a limited partnership of

which petitioner was a member.

X-Way Delta—X-Way Delta, a single-member limited liability

company (LLC) of which petitioner is the member. Petitioner formed XWay Delta in 2005 as a vehicle by which to make good on his offer to buy

out the Investors. X-Way Delta acquired the Investors’ interests in 11

of the parcels constituting the Salton Sea property. It acquired those

interests (X-Way Delta property) by way of seven individual quitclaim

deeds and one grant deed (collectively, Deeds). For an unstated

“valuable consideration,” each Investor released his (its) interests in

certain of the 11 parcels in favor of X-Way Delta. All of the Deeds are

dated either December 28 or 29, 2005. None was recorded. Absent from

the record is any deed evidencing petitioner’s transfer of property to

X-Way Delta.

In consideration of the X-Way Delta property, X-Way Delta

executed a document styled “Note Secured By Deed of Trust” (Note and

Deed of Trust, respectively). The Note is dated December 29, 2005, and

states that, for value received, X-Way Delta promises to pay to Equitable

and Mr. Hettelsater $1,200,000 “with interest from January 1, 2006,

until paid at the rate of 10% per annum.” It further states that “the

whole sum of principal plus accrued interest” is due and payable on or

before January 1, 2018. It states that it is a purchase money mortgage.

It concludes that it is secured by a Deed of Trust, “affecting the following

parcel numbers [viz, five of the six parcels listed in the Deed of Trust].”

The Deed of Trust is dated January 4, 2006. The parties to it are

X-Way Delta, “Trustor”; Chicago Title Co., a California corporation,

“Trustee”; and Equitable and Mr. Hettelsater, “Beneficiaries.” The Deed

of Trust recites that X-Way Delta grants to Chicago Title Co. “in Trust

with Power of Sale that property . . . described as,” and here are listed 6

of the 11 parcels constituting the X-Way Delta property. The Deed of

Trust is recorded.

The record contains no contracts of sale for any parcels

constituting the X-Way Delta property. Nor were the parcels appraised

before the Deeds were executed or the Note executed. Petitioner

8

[*8] testified that he and the Investors were “thinking about 1,000 or

1,200 an acre, around that.”

X-Way Delta paid no interest during the 12-year term of the Note,

nor, when the Note matured in 2018, did it pay the accrued interest or

principal. Petitioner claims that, when the Note matured, the creditors

extended its term to 2024.

In 2007, petitioner thought he had a buyer for the X-Way Delta

property, but the potential sale fell through because of a downturn in

the economy.

Petitioner believes that, since 2007, environmental problems in

the Salton Sea area have increased. He analogizes the area to the Love

Canal. Because of environmental problems, he feels that the doors have

shut to development of the X-Way Delta property. He believes that,

without a $20,000 tax saving from the deduction of interest accruing on

the Note, maintaining the property would be “nonsurvivable.” He thinks

that the value of the property lies in holding onto it long enough, and

then someone will be able to make use of minerals under it and develop

it for hydrothermal energy.

X-Way Delta does not maintain books and records.

Petitioner’s Returns and Respondent’s Adjustments

Petitioner’s 2014 and 2015 returns are mostly handwritten, and

neither return reports any taxable income or tax due. In processing

those returns, respondent made numerous mathematical and

computational corrections. One notable feature of both returns is that,

on both, petitioner claims the same deduction for an X-Way Delta loss

twice, on separate schedules. For 2014, petitioner claimed an X-Way

Delta loss of $125,869 on both Schedule C–1 and on Schedule E, Part II.

For 2015, he did likewise with respect to an X-Way Delta loss of

$126,593. He testified that he did so because he did not know the

difference between an S corporation and a single-member LLC.

Schedule E—Island Mountain and X-Way Delta

Petitioner’s returns for 2014 and 2015 both include a Schedule E.

Part I of Schedule E is for reporting income or loss from rental real

estate and royalties, and Part II is for reporting income or loss from

partnerships and S corporations. Petitioner listed two pass-through

entities in Part II of each Schedule E, Island Mountain and X-Way

9

[*9] Delta, which petitioner mistakenly identified as an S corporation

but which, as found, is a single-member LLC. 4

Island Mountain issued petitioner for 2014 a corrected Schedule

K–1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc.,

reporting $4,241 of ordinary income and $23,655 of long-term capital

gain. It issued him for 2015 a Schedule K–1 reporting $2,332 of ordinary

income and $19,170 of long-term capital gain. Respondent determined

that petitioner had not reported the ordinary income amounts from

those schedules and increased his Schedule E, Part II income for each

year accordingly.

As stated, petitioner reported a loss from X-Way Delta of $126,593

on his 2015 Schedule E, Part II. He also reported there his Island

Mountain long-term capital gain of $19,170. Netting the two amounts

($19,170 − 126,593 = $−107,423), he reported a Part II loss of $107,423

(Part II loss). On Part I of his 2015 Schedule E, he reported a net gain

of $63,226. Subtracting his Part I gain of $63,226 from his Part II loss

of $107,423 results in a difference of $44,197 or, in other words, a 2015

Schedule E loss of $44,197. Petitioner should have carried that loss to

the front page of his 2015 Form 1040 and entered it on line 17 (where

Schedule E gain or loss is included in the computation of total income).

But he did not, leaving line 17 blank. In processing petitioner’s 2015

return, respondent corrected for petitioner’s omission of a line 17

amount. He entered into his computers −$44,197 as the amount that

should have been reported as a 2015 Schedule E loss on line 17.

Subsequently, in determining a deficiency in petitioner’s tax for

2015, respondent adjusted petitioner’s income by disallowing the 2015

Schedule E, Part II loss of $107,423, presumably on the grounds that,

X-Way Delta being a disregarded entity, Schedule E, Part II, reporting

was inappropriate for any X-Way Delta loss and Island Mountain’s

capital gain should have been reported on Schedule D, Capital Gains

and Losses. 5 Respondent’s disallowance of the Part II loss exactly offset

Thus, we assume that, pursuant to Treasury Regulation § 301.7701-3(b),

X-Way Delta is disregarded as an entity separate from its owner. For tax purposes,

X-Way Delta’s business is treated as a proprietorship of which petitioner is considered

the proprietor. E.g., Brown v. Commissioner, T.C. Memo. 2014-167, at *3.

4

5 That explanation would appear to justify only reclassifying the $107,423 loss

as a 2015 Schedule C loss of $126,593 and a 2015 Schedule D gain of $19,170, rather

than disallowing the loss altogether. Such reclassification was unnecessary for the

$126,593 loss from X-Way Delta because petitioner had already reported that loss for

10

[*10] the inclusion of that loss in the Schedule E amount that

respondent treated petitioner as erroneously having omitted from

line 17. Accompanying the Deficiency Notice is Form 5278, Statement–

Income Tax Changes. The amount of the 2015 Schedule E adjustment

for partnership and S corporation gains and losses is positive $109,755,

which is the sum of the disallowed Part II loss of $107,423 and the

omitted $2,332 of Island Mountain ordinary income from the corrected

Schedule K–1. 6

Schedule E—Rental Real Estate

On his 2014 and 2015 Schedules E, Part I, petitioner listed five

rental properties: L Street, Plaza Boulevard, Turner Road, L Street

No. 2, and Commercial Street.

For neither year did he report any rents (or other income) from

the first three properties. He reported total expenses for the five

properties of $84,865 and $77,113 for those years, respectively. Of those

sums, $20,405 and $15,290 were the expenses allocable to the first three

properties. The following Tables 1 and 2 detail what petitioner reported

for 2014 and 2015 for those three properties.

second time on his 2015 Schedule C–1. As to the misreported $19,170 Island Mountain

long-term capital gain, respondent removed it from Schedule E and made a positive

adjustment to petitioner’s 2015 Schedule D income in a like amount.

6 For 2014, petitioner also reported on Schedule E, Part II, an Island Mountain

long-term capital gain ($23,655) and an X-Way Delta loss ($125,869) for the net Part

II loss of $102,214. Petitioner had a Part I gain of $36,468, which, when added to the

Part II loss of $102,214, produced a Schedule E loss of $65,746, which petitioner did

enter on line 17 of his 2014 Form 1040. In processing petitioner’s 2014 return,

respondent disregarded the Part II loss as a component of petitioner’s line 17

Schedule E amount, entering into his computer only the Part I gain of $36,468. He

then had no need to disallow the Part II loss because he had disregarded it, and his

Schedule E adjustment for 2014 includes only the unreported Island Mountain

ordinary income amount of $4,241. As with 2015, petitioner had reported the $125,869

X-Way Delta loss for a second time on his 2014 Schedule C–1. Respondent increased

petitioner’s Schedule D income by $23,655 on account of the Island Mountain longterm capital gain.

11

[*11]

Table 1

2014

L Street

Plaza Boulevard

Turner Road

—

—

—

Income:

Rents

received

Expenses:

Legal and

professional

fees

$350

Repairs

$500

6,000

Taxes

222

859

Utilities

224

Depreciation

$2,443

1,014

8,793

Total

expenses

$2,443

$1,736

$16,226

Loss:

($2,443)

($1,736)

($16,226)

Table 2

2015

L Street

Plaza Boulevard

Turner Road

—

—

—

Income:

Rents

received

Expenses:

Repairs

$1,000

$600

Taxes

231

861

Utilities

348

Depreciation

$2,443

1,014

8,793

Total

expenses

$2,443

$2,245

$10,602

Loss:

($2,443)

($2,245)

($10,602)

Respondent disallowed any deduction for those expenses for lack

of substantiation and on the grounds that the properties were not rental

properties.

12

[*12] As explained below, respondent also disallowed a deduction for

the expenses petitioner reported on the Schedules C–2 but allowed some

of those expenses as additional expenses on the Schedules E, Part I. The

following Table 3 shows the resulting allowance of Schedule E, Part I,

expenses.

Table 3

Year

2014

2015

Rental expenses

claimed on Schedule

E, Part I

$84,865

$77,113

2.

Disallowed Schedule

E, Part I, expenses

(20,405)

(15,290)

3.

Additional Schedule

E, Part I, expenses

from Schedule C–2

25,774

24,091

4.

Schedule E, Part I,

expenses allowed

$90,234

$85,914

5.

Schedule E, Part I

adjustment to

taxable income

(line1–line 4)

($5,369)

($8,801)

1.

Schedule C–2: Real Estate Business

Petitioner’s Schedules C–2 state that they relate to a real estate

business of his. On the 2014 Schedule C–2, petitioner did not specify an

accounting method. On the 2015 Schedule C–2, he checked the box

“Accrual.” The following Table 4 shows petitioner’s Schedules C–2

reporting of income, expenses, and net profits.

13

[*13]

Table 4

2014

2015

Income

$36,000

$51,000

Tentative

expenses

(29,258)

(25,285)

Tentative

profit

6,742

25,715

-0-

(25,715)

$6,742

$0

Home

office

expense

Net

profit

For 2015, petitioner intended to claim no home office expense

deduction. In error, however, he entered, $25,715, his 2015 tentative

profit, on the line for reporting a home office expense and left blank the

line to report his 2015 net profit. In processing his 2015 return

respondent netted his reported home office expense against his tentative

profit and treated the difference—zero—as his 2015 Schedule C–2

income.

Respondent disallowed all of petitioner’s Schedule C–2 expenses

for both 2014 and 2015 on the grounds that petitioner had not shown

that he had incurred the expenses or, if he had, that they were paid

during the taxable year for ordinary and necessary business purposes.

To effect that disallowance, respondent increased petitioner’s reported

Schedule C–2 income by $29,258 and $51,000 for 2014 and 2015,

respectively. 7

Additionally, believing that, for each year, petitioner had

misreported the expenses from rental real estate on Schedule C–2,

respondent, for each year, moved a portion of those expenditures to the

year’s Schedule E, Part I. Respondent began with the total expenses

petitioner had reported on each Schedule C–2, $29,258 and $51,000, for

2014 and 2015, respectively. He reduced each total by the amount of

depreciation claimed—$3,484 and $1,194, respectively—and, for 2015,

the home office expense of $25,715. The resulting differences are the

7 Petitioner conceded at trial that he had no home office expense for 2015.

14

[*14] amounts shown on the following Table 5, which he allowed as

Schedule E, Part I, expenses. See supra Table 3.

Table 5

2014

2015

Total

expenses

$29,258

$51,000

Depreciation

(3,484)

(1,194)

Home office

expense

-0-

(25,715)

Difference

$25,774

$24,091

The depreciation expenses reported on the 2014 and 2015

Schedules C–2 relate to a computer, a small trailer, a backhoe, and a

scooter, as evidenced by depreciation schedules petitioner provided.

Respondent made no adjustments to the Schedule C–2 income

amounts petitioner reported, which, at trial and on brief, petitioner

admits were gross income from Island Mountain and from his other real

estate activities.

Schedules C–1: X-Ray Delta

For each of 2014 and 2015, petitioner’s Schedule C–1 identifies

X-Way Delta as the relevant business and reports that X-Way Delta uses

the accrual method of accounting. The schedules report income,

expenses and profit or loss as follows.

15

[*15]

Table 6

2014

2015

$5,000

$5,000

120,000

120,000

5,000

5,000

120

100

Taxes and licenses

3,422

3,997

Travel

1,326

1,440

Utilities

496

501

Other

505

535

Total expenses

$130,869

$131,593 8

Income (loss):

($125,869)

($126,593)

Income:

Gross receipts

Expenses:

Mortgage interest

Legal and professional

services

Office expense

Petitioner identified the $5,000 of gross receipts for each year as

payment from the fish farm for its easement.

Claiming that petitioner had not shown that either year’s

Schedule C–1 expenses were incurred or, if incurred, were paid during

the taxable year for ordinary and necessary business purposes,

respondent disallowed deductions for all the reported expenses,

increasing petitioner’s taxable income by $130,869 and $131,593 for

2014 and 2015, respectively.

Capital Gains

Respondent made positive adjustments of $23,655 and $19,170 to

petitioner’s gross income for 2014 and 2015, respectively, to account for

the long-term capital gains reported to petitioner on the Island

Mountain Schedules K–1.

8 The sum of total expense is $131,573, and income should be $126,573. The

parties can correct for those errors during the Rule 155 computations.

16

[*16] 2014 Social Security Benefit

Petitioner reported on his 2014 return a taxable Social Security

benefit of $9,942.

In processing petitioner’s return, respondent

disregarded that entry because he believed that petitioner had

computed his taxable Social Security benefit erroneously. Respondent

treated petitioner as having reported zero benefit. In his adjustments

to petitioner’s 2014 income, respondent made a positive adjustment of

$8,451 for Social Security benefits received.

Penalty Approval

Revenue Agent (RA) Keith Kawamoto conducted respondent’s

examination of petitioner’s 2014 and 2015 returns. He prepared a

penalty approval form that included a section 6662 accuracy-related

penalty for 2014 attributable to both petitioner’s negligence and his

substantial understatement of income tax. RA Kawamoto’s acting direct

supervisor, Ella Chernyak, signed the penalty approval form on

June 26, 2017, which was before respondent issued the Deficiency

Notice.

OPINION

I.

Schedule E—Island Mountain and X-Way Delta

A.

Island Mountain

Respondent would increase petitioner’s gross income by $4,241

and $2,332 for 2014 and 2015, respectively, on account of those amounts’

being reported to petitioner as his distributive shares of Island

Mountain’s ordinary income for those years.

At trial, in response to the Court’s question whether petitioner

saw any error in the positive adjustment of $4,241 for 2014, he answered

“no.” Nevertheless, petitioner argues on brief that the adjustment is

improper because he did report that income on his 2014 return.

Petitioner reported a profit of $6,742 on his 2014 Schedule C–2. He

claims that the $10,983 that he entered on the first page of his 2014

Form 1040, line 12, “Business income or (loss),” was the sum of his

distributive share from Island Mountain, $4,241, and his Schedule C–2

profit, $6,742.

Petitioner did not net his 2014 Schedule C–1 and C–2 profits and

losses before entering an amount on Form 1040, line 12. When $6,742

17

[*17] is subtracted from the amount he did enter on line 12, $10,983, the

difference is $4,241. The coincidence between that difference and

respondent’s same adjustment for unreported income from Island

Mountain leads us to accept petitioner’s explanation that he reported

that income along with his Schedule C–2 profit on line 12, and we so

find. We do not sustain respondent’s adjustment in that amount.

For 2015, petitioner claims that the $51,000 of gross income that

he reported on the 2015 Schedule C–2 included not only his $35,000

annual fee as general partner of Island Mountain but also his $2,332

distributive share of its ordinary income. For 2015, it would be quite

the coincidence if the $35,000 annual fee, the $2,332 Island Mountain

ordinary income, and whatever other amounts are included in the gross

income reported on the Schedule C–2 end up being a round $51,000.

Petitioner has not convinced us, and we will not disturb respondent’s

positive adjustment of $2,332.

B.

X-Way Delta

Because X-Way Delta is not an S corporation (or a partnership),

we see no error in respondent’s 2015 Schedule E adjustment disallowing

the Part II loss of $107,423.

C.

Total Schedule E Adjustments

Respondent erred in increasing petitioner’s Schedule E, Part II

income by $4,241 for 2014, but he did not err in increasing his

Schedule E, Part II income by $109,755 ($2,332 + 107,423 = $109,755)

for 2015.

II.

Schedule E—Rental Real Estate: L Street, Plaza Boulevard,

Turner Road

A.

Introduction

Respondent disallowed any deduction for Table 1 and 2 expenses

for lack of substantiation and because the properties were not rental

properties.

Section 162(a) “allow[s] as a deduction all the ordinary and

necessary expenses paid or incurred during the taxable year in carrying

on any trade or business.” Section 212(1) and (2) similarly allows an

individual a deduction for all the ordinary and necessary expenses paid

or incurred during the taxable year for the production or collection of

18

[*18] income or the management, conservation, and maintenance of

property held for the production of income. Section 167(a) “allow[s] as a

depreciation deduction a reasonable allowance for the exhaustion, wear

and tear . . . (1) of property used in the trade or business, or (2) of

property held for the production of income.”

A taxpayer must keep books or records that substantiate the

expenses underlying each deduction claimed on his or her return.

§ 6001; Roberts v. Commissioner, 62 T.C. 834, 836 (1974). Claiming a

deduction on an income tax return is not sufficient to substantiate the

underlying expense. Wilkinson v. Commissioner, 71 T.C. 633, 639

(1979). Rather, an income tax return “is merely a statement of the

[taxpayer’s] claim . . . ; it is not presumed to be correct.” Roberts, 62 T.C.

at 837. With respect to a deduction for depreciation, “the taxpayer must

show that the property was used in a trade or business (or other profitoriented activity). In addition, the taxpayer must establish the

property’s depreciable basis, by showing the cost of the property, its

useful life, and the previously allowable depreciation.” Cluck v.

Commissioner, 105 T.C. 324, 337 (1995). A depreciation schedule alone

is insufficient to substantiate the deduction.

See Holden v.

Commissioner, T.C. Memo. 2015-131, at *65–66.

Under Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir.

1930), if a taxpayer claims a deduction but cannot fully substantiate the

underlying expense, the Court in certain circumstances may

approximate the allowable amount, “bearing heavily if it [so] chooses

upon the taxpayer whose inexactitude is of his own making.” The Court

must have some factual basis for its estimate, however, else the

allowance would amount to “unguided largesse.” Williams v. United

States, 245 F.2d 559, 560 (5th Cir. 1957); accord Eze v. Commissioner,

T.C. Memo. 2022-83, at *5–6.

B.

Discussion

We start and end with the question of whether petitioner has

substantiated the Table 1 and 2 expenditures for which he has claimed

deductions. He has not. Putting aside depreciation for the moment, the

remaining expenditures in the table are legal and professional fees,

repairs, taxes, and utilities. Petitioner has failed to direct us to material

in the record substantiating those expenditures—i.e., to whom paid, for

what purpose, when paid, what evidence of payment, and the like. Nor

has petitioner provided a factual basis from which, pursuant to Cohan,

we could approximate the amount of any of those expenditures.

19

[*19] Petitioner has failed to carry his burden of proof. For failure of

substantiation, we sustain respondent’s disallowance of any deduction

for the four described Table 1 and 2 expenditures.

For similar reasons, we disallow any deduction for the

depreciation deductions on Tables 1 and 2. For each of 2014 and 2015,

petitioner claimed for L Street a depreciation deduction of $2,443. We

are satisfied that in 2006, petitioner paid $9,566 to install a fence around

the property. Petitioner has pointed us to no evidence of any other

expenditure for a depreciable improvement to the property. And with

respect to the 2006 expenditure, petitioner has failed to show that any

depreciable basis remained to be claimed for either 2014 or 2015.

With respect to Plaza Boulevard and Turner Road, petitioner

attached to his 2014 and 2015 returns schedules that purport to show

the computation of the depreciation claimed for each of those properties.

And while the computations for Plaza Boulevard match the amounts on

Tables 1 and 2, petitioner has failed to explain what property was

depreciable with respect to Plaza Boulevard, which we have found to

have been a vacant lot during the years at issue. With respect to Turner

Road, the schedules show for each year total depreciation of $2,038, yet,

on his returns, as shown on Tables 1 and 2, petitioner reported $8,793

of depreciation. And while there may be property subject to depreciation

on the Turner Road property, petitioner has failed to propose facts from

which we could find its cost, useful life, and the remaining recoverable

basis during the years at issue. He has failed to prove his entitlement

to any depreciation deduction for either Plaza Boulevard or Turner Road

for either of the years at issue, and we sustain respondent’s disallowance

of any deduction.

III.

Schedule C–2 Expenses

As shown on Table 4, petitioner reported tentative Schedule C–2

expenses of $29,258 and $25,285 for 2014 and 2015, respectively.

Respondent disallowed any Schedule C–2 deduction for those expenses

but allowed portions, $25,774 and $24,091, for those years, respectively,

as Schedule E, Part I expenses. See supra Tables 3 and 5. Respondent

disallowed the differences, $3,484 and $1,194, as unsubstantiated

depreciation expenses. Petitioner has no objection to respondent’s first

action but contests respondent’s disallowance of the depreciation

deductions. Petitioner has presented depreciation schedules for each

year that list a computer, a small trailer, a backhoe, and a scooter, and,

for each item, purport to show the date purchased, the cost, prior

20

[*20] depreciation, method of depreciation, useful life, and the year’s

claimed depreciation. He has not, however, pointed us to evidence in

the record corroborating the unsubstantiated figures asserted on those

schedules. We will not disturb respondent’s disallowance of the

Schedule C–2 depreciation deductions.

See, e.g., Anyanwu v.

Commissioner, T.C. Memo. 2014-123, at *28–29 (sustaining the

Commissioner’s disallowance of a taxpayer’s depreciation deduction

where the taxpayer did not provide any testimony or other evidence at

trial to explain the numbers appearing on the depreciation schedule

filed with her return).

Respondent did not err in increasing petitioner’s reported 2014

Schedule C–2 income by $29,258 and, considering petitioner’s error in

claiming a $25,715 deduction for the business use of his home,

respondent did not err in increasing his 2015 reported Schedule C–2

income by $51,000.

IV.

Schedule C–1 Expenses

A.

Introduction

Respondent disallowed petitioner’s Schedule C–1 expense

deductions of $130,869 and $131,593 for 2014 and 2015, respectively, on

the grounds that petitioner had not shown that expenses were incurred

or, if incurred, were paid during the taxable year for ordinary and

necessary business purposes.

B.

Interest Expense

1.

Introduction

The largest of the disallowed expense deductions is an interest

expense of $120,000 for each year. The Note obligated X-Way Delta to

pay Equitable and Mr. Hettelsater principal of $1,200,000 plus accrued

interest (10% per annum) on or before January 1, 2018.

Section 163(a) “allow[s] as a deduction all interest paid or accrued

within the taxable year on indebtedness.” There is an exception to this

general rule. Section 163(h)(1) provides that in the case of a taxpayer

other than a corporation, no deduction shall be allowed for personal

interest which is paid or accrued during the tax year. Personal interest

does not include interest allocable to a trade or business, investment

interest, or interest taken into account in computing gain or loss from a

passive activity (passive activity interest). § 163(h)(2). The amount

21

[*21] allowed as a deduction for investment interest for any tax year

shall not exceed the net investment income of the taxpayer for the

taxable year. § 163(d)(1). Passive activity interest is taken into account

in determining passive activity losses, the deduction of which is limited

to passive activity income. See § 469(a)(1), (d)(1).

Section 163(e) addresses debt instruments issued with original

issue discount (OID) and provides that the issuer of a debt instrument

with OID is allowed a deduction for the taxable year equal to the

aggregate daily portions of the OID.

Respondent argues that petitioner may not deduct the interest

accrued on the Note because the interest did not accrue on a bona fide

loan and, if it did, the X-Way Delta property was held for investment

and, thus, petitioner’s deductions were limited. Petitioner answers in

rebuttal that the Note evidenced a bona fide loan, that the interest was

incurred in his trade or business, and that interest accrued on real

estate you own is deductible: “If you use the accrual method of

accounting, you can deduct interest over the period it accrues, regardless

of when you pay it.”

2.

Bona Fide Loan

“A bona fide debt is a debt which arises from a debtor-creditor

relationship based upon a valid and enforceable obligation to pay a fixed

or determinable sum of money.” Treas. Reg. § 1.166-1(c). “Whether an

advance gives rise to a bona fide debt for Federal tax purposes is

determined from all the facts and circumstances.” 2590 Assocs., LLC v.

Commissioner, T.C. Memo. 2019-3, at *21. Where the facts indicate that

no bona fide debt was created, an advance may indicate some other

relationship between the alleged debtor and creditor. For example, an

advance to a corporation may properly be classified as a contribution to

capital, see, e.g., Davis v. Commissioner, 69 T.C. 814, 835 (1978), or an

advance to a family member may actually be a gift, see, e.g., Bragg v.

Commissioner, T.C. Memo. 1993-479, 1993 WL 413014, at *14.

The objective factors here indicate that the Note constituted bona

fide debt. By its own terms, it is a promise to pay money. It provides

that, “for value received,” the maker, X-Way Delta promises to pay two

named persons a fixed sum, along with interest, on or before a date

certain. It is secured by the Deed of Trust. And although it was not paid

on the last date prescribed for payment, petitioner testified without

contradiction that the creditors had extended the due date. In any

22

[*22] event, validity of debt is determined upon issuance. If the Note

was valid debt when issued, the failure to pay principal upon maturity,

even without extension of the due date, would not have caused the debt

to be invalid.

We have said that the objective of the inquiry into the bona fides

of a debt is not to count factors but to evaluate them. 2590 Assocs., T.C.

Memo. 2019-3, at *23. “The factors,” we have said, “aid in our

determination of whether the parties intended to create indebtedness

with a reasonable expectation of repayment and whether that

expectation comported with economic reality.” Id. Equitable and

Mr. Hettelsater transferred interests in discernable parcels of real

estate to X-Way Delta in consideration of a promise to pay in the future

$1,200,000 (plus interest), the whole obligation secured by a deed of

trust. We have no idea whether this was a fair exchange or not.

Nevertheless, although petitioner and Messrs. Hettelsater and Wagner

(president of Equitable) were longtime acquaintances, there is no

indication of any family relationship, and respondent has constructed no

narrative of X-Way Delta and the Investors contributing the Note and

parcels of real estate, respectively, to a joint venture. We conclude, and

find, that the Note constituted bona fide debt.

3.

Accounting for Interest

a.

Introduction

Although X-Way Delta had no obligation to pay either interest or

principal on the Note before its maturity on January 1, 2018, petitioner

reported on the Schedules C–1 for each of 2014 and 2015 an interest

deduction of $120,000. Petitioner believed that he had elected an

accrual method of accounting for X-Way Delta and that the interest

expense for the Note accrued ratably. Apparently, petitioner was not

aware of the rules for deducting OID. Because of that failure, we must

also be concerned with the rules for changing a method of accounting.

b.

OID

A debt instrument has OID if the stated redemption price at

maturity exceeds the issue price. See § 1273(a)(1). In general, the term

“stated redemption price at maturity” means interest and other

amounts payable at maturity other than interest paid periodically at

least annually. See § 1273(a)(2). Unless there were a prepayment, the

23

[*23] stated redemption price at maturity of the Note would be

$2,640,000 ($1,200,000 + ((0.1 × $1,200,000) × 12) = $2,640,000). 9

Section 1274 addresses the issue price of certain debt instruments

issued for property. The section applies to debt instruments given in

consideration for the sale of property if (1) the stated redemption price

at maturity exceeds, where there is adequate stated interest, the stated

principal amount and (2) payments are due more than six months after

the sale or exchange of the property. See § 1274(c)(1). Section 1274

provides the issue price of the Note because it was given in consideration

for the sale of property and the two further conditions set forth in section

1274(c)(1) are met. To begin with, the Note has adequate stated

interest. This is so because the stated principal amount for it—

$1,200,000—is less than the imputed principal amount of it—

$1,574,700. 10 See § 1274(c)(2). Moreover, payments are due more than

six months after the sale or exchange of the property.

See

§ 1274(c)(1)(B). Because the Note has adequate stated interest, its issue

price is the stated principal amount, $1,200,000. See § 1274(a)(1).

Subtracting the issue price of the Note—$1,200,000—from the

stated redemption prices at maturity—$2,640,000—yields OID of

$1,440,000. See § 1273(a)(1).

Section 163(e)(1) allows as a deduction to the issuer for any

taxable year that portion of the OID with respect to a debt instrument

that is equal to the aggregate daily portions of the OID for days during

such year. 11 The daily portions of OID are determined under section

1272(a) (without regard to the rules for acquisition premium and de

minimis OID). See Treas. Reg. §§ 1.163-7, 1.1272-1. Applying a yield to

maturity of 6.79114% compounded annually, respondent has calculated

OID interest accruals for the Note of $137,850 and $147,211 for 2014

9 Petitioner claimed a deduction for X-Way Delta of $120,000 of accrued

interest for each year from 2006 through 2015. That fact supports a finding that the

Note called for simple interest at a rate of 10% a year.

10 The imputed principal amount of the Note is the sum of the present values

as of the issue date of all payments, including interest, due under it using a test rate

of interest as determined under Treasury Regulation § 1.1274-4. See Treas. Reg.

§ 1.1274-2(c)(2). Compounding annually and using a test rate of 4.40%, see Rev. Rul.

2005-66, Table 1 (Long Term), 2005-2 C.B. 686, 687, the imputed principal amount for

all payments due under the Note—$2,640,000—is $1,574,700.

11 There is no indication that the parties to the Note elected under section

1274A(c) to use the cash method.

24

[*24] and 2015, respectively. 12 Pursuant to section 163(e)(1), petitioner

would normally be able to deduct those amounts as interest accruals

unless limited by the rules addressing investment interest. However,

petitioner may not be entitled to deduct the OID accruals of $137,850

and $147,211 for 2014 and 2015 because they exceed the ratable

accruals of interest ($120,000 for each year) that X-Way Delta reported.

c.

Change in Method of Accounting

We begin by saying that petitioner has not convinced us that, the

OID rules aside, X-Way Delta could use an accrual method of

accounting. A taxpayer with two or more separate and distinct trades

or businesses may use a different method of accounting for each. See

§ 446(d); Treas. Reg. § 1.446-1(d)(1). Nevertheless, a trade or business

will not be considered separate and distinct unless the taxpayer

maintains a separable and complete set of books and records for such a

12 Yield to maturity is the discount rate that, when used in computing the

present value of the principal and interest payments, produces an amount equal to the

issue price of the debt instrument. Treas. Reg. § 1.1272-1(b)(1)(i). Applying that

discount rate (6.79114%) to the adjusted issue price (AIP) of the Note at the beginning

of each year, respondent determined OID interest accruals for each year as follows

(rounded):

Accrual year

AIP at beginning

of year

OID

2006

$1,200,000

$81,494

$1,281,494

2007

1,281,494

87,028

1,368,522

2008

1,368,522

92,938

1,461,460

2009

1,461,460

99,250

1,560,710

2010

1,560,710

105,990

1,666,700

2011

1,666,700

113,188

1,779,888

2012

1,779,888

120,875

1,900,762

2013

1,900,762

129,083

2,029,846

2014

2,029,846

137,850

2,167,695

2015

2,167,695

147,211

2,314,907

2016

2,314,907

157,209

2,472,115

2017

2,472,115

167,885

2,640,000

$1,440,001

AIP at end of year

25

[*25] trade or business. Treas. Reg. § 1.446-1(d)(2). X-Way Delta did

not maintain books and records, and petitioner uses the cash receipts

and disbursements method of accounting for his other business

activities. 13 It is, therefore, not clear that X-Way Delta is a business

separate and distinct from his other businesses, for which petitioner

uses the cash method of accounting. Nevertheless, it appears that

petitioner has used an accrual method with respect to X-Way Delta for

some time, and any change would require the consent of the

Commissioner. See § 446(e); Treas. Reg. § 1.446-1(e)(2)(i) (expressly

bringing a change from an improper or unpermitted method of

accounting within the ambit of section 446(e)). Thus, without the

Commissioner’s permission, petitioner would be precluded from

deducting interest accruals on the Note under the OID rules if those

deductions exceeded the ratable accruals petitioner had been deducting,

which they do. Larger accruals under the OID rules occur towards the

end of the term of the Note. Neither has petitioner asked respondent to

change X-Way Delta’s method of accounting nor has respondent made

any change. 14

4.

Character of the Interest

The interest accrued in 2014 and 2015 on the Note constitutes

either interest allocable to a trade or business, investment interest,

passive activity interest, or, if none of the former, personal interest.

A taxpayer may have separate and distinct activities within the

same broad category of business. Resser v. Commissioner, T.C. Memo.

1991-423. Generally, activities carried out by a taxpayer-owned entity,

even a single-member LLC that is a disregarded entity, are viewed as

activities separate from the taxpayer’s, and the entity is tested on a

stand-alone basis to see whether the activities rise to the level of a trade

or business. See, e.g., Conner v. Commissioner, T.C. Memo. 2018-6,

at *26–30 (considering the activities of each of taxpayer husband’s four

disregarded-entity LLCs on a stand-alone basis and finding that the

On the 2014 Schedule C–2, petitioner checked no box indicating any

accounting method; on the 2015 Schedule C–2 he checked the accrual box. Apparently,

the 2015 Schedule C–2 is in error because, at trial, petitioner testified that the accruals

from Schedules C–1, X-Way Delta, were the only accruals on his return.

13

14 Assuming that the Note is valid indebtedness, respondent computes a section

481(a)(2) adjustment for 2014 (the earliest open year) increasing X-Way Delta’s gross

income by $130,154, “representing the sum of the excess deductions claimed in prior

years under the simple interest method compared to the deductions that would have

been allowable under the OID rules for those years.”

26

[*26] activities of none rose to the level of carrying on a trade or

business), aff’d, 770 F. App’x 1016 (11th Cir. 2019).

Activities relating to undeveloped real property are subject to a

facts and circumstances test to determine whether the activities rise to

the level of a trade or business. See Polakis v. Commissioner, 91 T.C.

660, 669–70 (1988). It is not a trade or business where development

activities are in the exploratory or formative stages. Conner, T.C. Memo.

2018-6, at *25. Among the tests that the courts have come to rely on in

determining the nature of the taxpayer’s activities with respect to real

estate are the following:

the nature and purpose of the acquisition of the property

and the duration of the ownership; the continuity of sales

or sales-related activity over a period of time; the volume

and frequency of sales; the extent to which the taxpayer or

his agents have engaged in sales activities by developing or

improving the property, soliciting customers, and

advertising; and the substantiality of sales when compared

to other sources of taxpayer’s income.

Polakis, 91 T.C. at 670.

X-Way Delta acquired its property after 20 years of petitioner’s

failed attempts to develop it and after the Investors lost faith in its

potential. X-Way Delta has not sold or developed the property, and the

one potential sale of the property in 2007 fell through because of a

downturn in the economy. Petitioner believes that, since then,

environmental problems in the Salton Sea area have increased. He

analogizes the Salton Sea area to the Love Canal, and he believes that

the doors to development of the property have been shut. He thinks that

the value of the property is in holding onto it long enough, and then

someone will be able to make use of minerals under it or develop it for

hydrothermal energy. He has not shown that he advertised the property

or otherwise sought purchasers or development opportunities for it.

Petitioner has failed to convince us that, during 2014 and 2015,

X-Way Delta’s activities with respect to its property amounted to a trade

or business. X-Way Delta was holding its property for long-term

appreciation. And while petitioner reported $5,000 of receipts each year

on Schedule C–1 as payment for an easement granted to a fish farm, he

has not shown that the easement burdened property owned by X-Way

Delta (as opposed to petitioner’s portion of the Salton Sea property,

27

[*27] which he has not shown that he transferred to X-Way Delta). In

any event, $5,000 is less than one-half of one percent of the $1,200,000

that X-Way Delta claims to have paid the investors for what may have

been more than 1,000 acres. And, even if the easement did burden a

portion of X-Way Delta’s property (nothing in the record tells us how

much), petitioner has failed to convince us that the easement rental was

more than an incidental aspect of what was overwhelmingly an

investment purpose for holding the property. See, e.g., Anderson v.

Commissioner, T.C. Memo. 1982-576, 1982 Tax Ct. Memo LEXIS 169,

at *19; Treas. Reg. § 1.469-4(b)(1). Accordingly, petitioner cannot

deduct the interest X-Way Delta accrued on the Note for 2014 or 2015

as interest allocable to trade or business.

Perhaps because respondent sees the easement rental as

incidental to holding the property for investment (i.e., for appreciation),

he does not argue for application of the passive activity loss rules. See

Temp. Treas. Reg. 1.469-1T(e)(3)(vi)(B).

And perhaps because under that temporary regulation the

easement rental is incidental to holding the property for investment, he

is willing to concede that, if the property is not trade or business

property, it is property held for investment (and the interest is not

personal interest), despite the poor fit under sections 163(d)(5)(A)(i) and

469(e)(1). We accept that X-Way Delta’s 2014 and 2015 interest

payments were payments of investment interest. Petitioner’s deduction

of that interest for each year cannot exceed his net investment income.

See § 163(d)(1). We leave that computation to the parties under Rule

155.

C.

Other Disallowed Schedule C–1 Expenses

Petitioner claimed expense deductions (other than for the accrual

of interest) of $10,869 and $11,593 for 2014 and 2015, respectively, for

legal and professional services, office expense, taxes and licenses, travel,

utilities, and other expenses (together, noninterest expenses).

Petitioner argues that he substantiated the noninterest expenses

during respondent’s examination of his 2014 and 2015 returns.

Tax Court proceedings are de novo reviews of the taxpayer’s

liability. Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324, 328

(1974). The notice of deficiency is the starting point for our review, and

“our determination as to a [taxpayer’s] tax liability must be based on the

merits of the case and not any previous record developed at the

28

[*28] administrative level.” Id. Respondent disallowed the noninterest

expenses, and petitioner has failed to substantiate those expenses. We

will sustain respondent’s disallowance.

V.

Capital Gains

Island Mountain reported to petitioner capital gain income of

$23,655 and $19,170 for 2014 and 2015, respectively. Petitioner

misreported those amounts on his 2014 and 2015 Schedules E.

Respondent, in effect, disregarded those erroneous Schedule E

inclusions and increased petitioner’s 2014 and 2015 Schedule D income

by like amounts. Petitioner failed to address the issue on brief, and we

see no error. We sustain the adjustments.

VI.

Social Security Benefit

Petitioner reported a 2014 Social Security benefit of $9,942.

Respondent disregarded that reported amount because he believed that

petitioner had erroneously computed the taxable portion of the benefit.

Instead, he increased petitioner’s income for Social Security benefits by

$8,451, which he describes as a computation adjustment. Petitioner has

shown no error in respondent’s adjustments.

We sustain the

adjustments.

VII.

Accuracy-Related Penalty

A.

Introduction

Section 6662(a) and (b)(1) provides for an accuracy-related

penalty of 20% of the portion of an underpayment of tax required to be

shown on a return attributable to negligence or disregard of rules and

regulations (without distinction, negligence). Section 6662(a) and (b)(2)

provides for the same penalty amount on the portion of an

underpayment of tax attributable to any substantial understatement of

income tax. In the case of an individual, there is a substantial

understatement of income tax for a year if the amount of the

understatement exceeds the greater of (1) 10% of the tax required to be

shown on the return for the tax year or (2) $5,000. § 6662(d)(1)(A). The

amount of an understatement is reduced if there is substantial authority

for the taxpayer’s treatment of an item on his return.

See

§ 6662(d)(2)(B)(i). Also, the amount of the understatement is reduced

for any item that is adequately disclosed in the taxpayer’s return, or in

an attached statement, if there is reasonable basis for the taxpayer’s

treatment of the item. See § 6662(d)(2)(B)(ii). Finally, section 6664(c)(1)

29

[*29] provides a reasonable cause exception to imposition of the section

6662(a) accuracy-related penalty on that portion of an underpayment for

which it is shown that there was reasonable cause and the taxpayer

acted in good faith.

Only one accuracy-related penalty may be applied with respect to

any given portion of an underpayment even if that portion is subject to

the penalty on more than one of the grounds set out in section 6662(b).

Treas. Reg. § 1.6662-2(c).

B.

Burden of Production

1.

Introduction

The Commissioner bears a burden of production with respect to

the accuracy-related penalty including making a prima facie case that

the section 6751(b)(1) requirement for written supervisory approval has

been met. E.g., DeCrescenzo v. Commissioner, T.C. Memo. 2023-7,

at *18. Section 6751(b)(1) provides: “No penalty under this title shall be

assessed unless the initial determination of such assessment is

personally approved (in writing) by the immediate supervisor of the

individual making such determination or such higher level official as the

Secretary may designate.”

2.

Penalty Approval

We have found that Ms. Chernyak, RA Kawamoto’s acting direct

supervisor, signed the penalty approval form before respondent issued

the Deficiency Notice. Petitioner does not question that finding, nor

does he argue that approval should have come sooner (or does the record

provided any basis for an argument to that effect). The record is

sufficient for us to conclude that respondent has made a prima facie case

with respect to the penalty approval required by section 6751(b)(1).

3.

Grounds for the Penalty

Respondent has also made a prima facie case for the accuracyrelated penalty on the grounds that, for 2015, petitioner underpaid his

income tax because of his substantially understating the tax he was

required to show on his return. The amount of tax petitioner was

required to show was approximately the amount of the deficiency in tax

shown in the first paragraph of this report. Petitioner reported a zerotax liability on the 2015 return. Thus, for 2015, his understatement of

income tax was both equal to (100% of) the tax required to be shown on

30

[*30] the return and more than $5,000. In other words, it was a

substantial understatement of income tax. See § 6662(d)(1)(A).

Respondent claims as an alternative basis for the accuracyrelated penalty that petitioner’s 2015 underpayment of tax was due to

negligence. We need not reach that question.

C.

Burden of Proof

Respondent having met his burden of production with respect to

the penalty, the burden of proof (viz, the risk of nonpersuasion) is with

petitioner, which includes the burden to prove any affirmative defense.

See, e.g., Fabian v. Commissioner, T.C. Memo. 2022-94, at *38.

Petitioner makes no claim to any affirmative defense.

As we understand petitioner’s arguments they are as follows:

Respondent’s Attorney claims IRS Sec 6662(a) applies

because no adequate records were kept by Petitioner[,] . . .

[and] since her superiors approved the penalties, then that

constitutes proof of their validity. . . .

. . . It appears that Respondent’s Attorney’s position . . . is

that if income is reported on the wrong schedule, it is in

fact classified as unreported and the penalty should apply.

. . . Respondent’s Attorney maintains that the mere fact of

using the wrong schedule is enough to trigger the

application of the penalty.

Petitioner’s first argument may misunderstand the section

6751(b)(1) approval process. Penalty approval here was obtained before

the Deficiency Notice was issued, not by respondent’s counsel but by RA

Kawamoto from her supervisor, Ms. Chernyak.

In any event,

supervisory approval is merely procedural and does not establish the

substantive validity of the penalty. As we have said: “We do not secondguess the extent of the RA’s or the supervisor’s deliberations about

whether penalties should be imposed. We confine our search to seeking

evidence of written supervisory approval.” Cattail Holdings, LLC v.

Commissioner, T.C. Memo. 2023-17, at *11. Petitioner may be

mischaracterizing respondent’s argument to be that we have to uphold

the penalty because supervisory approval is sufficient to establish a

penalty was warranted. That is not the case.

31

[*31] Petitioner’s remaining arguments misapprehend the accuracyrelated penalty, which, here, we impose on the portion of petitioner’s

2015 underpayment of tax attributable to his substantial

understatement of his income tax. Respondent did not penalize

petitioner for entering amounts on the wrong schedules; he penalized

him for substantially understating his income tax. See § 6662(d)(2).

We uphold the accuracy-related penalty for 2015.

VIII. Conclusion

To reflect the foregoing,

Decision will be entered under Rule 155.