T.C. Summary Opinion 2018-44

RS

T.C. Summary Opinion 2018-44

UNITED STATES TAX COURT

JAMES E. LAWSON AND CHRISTIANE D. LAWSON, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 24688-15S.

Filed September 17, 2018.

James E. Lawson and Christiane D. Lawson, pro sese.

Angela B. Reynolds, for respondent.

SUMMARY OPINION

CARLUZZO, Chief Special Trial Judge: This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in effect when the

petition was filed.¹ Pursuant to section 7463(b), the decision to be entered is not

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

(continued...)

SERVED Sep 17 2018

-2reviewable by any other court, and this opinion shall not be treated as precedent

for any other case.

In a notice of deficiency dated June 25, 2015 (notice), respondent

determined deficiencies in, and penalties with respect to, petitioners' Federal

income tax for 2012 and 2013 as follows:

Year

Deficiency

Penalty

sec. 6662(a)

2012

2013

$6,446

6,716

$1,289.20

1,343.20

After concessions,2 the issues for decision for each year are whether

petitioners are: (1) entitled to deductions claimed on a Schedule E for taxes,

mortgage interest, and insurance, (2) entitled to deduct an S corporation loss

¹(...continued)

Code of 1986 (Code), as amended, in effect for the years in issue. Rule references

are to the Tax Court Rules of Practice and Procedure.

2Petitioners concede the adjustments in the notice for: (1) deductions

claimed on Schedules E, Supplemental Income and Loss, for depreciation expense

or depletion, repairs, and cleaning and maintenance for 2012 and 2013 and (2) the

charitable contribution deduction claimed on Schedule A, Itemized Deductions,

for 2012. Respondent concedes that to the extent this Court finds petitioners are

not entitled to a Schedule E deduction for 2013 for mortgage interest, petitioners

are entitled to a Schedule A deduction for mortgage interest of $2,061.34 in excess

of the amount already claimed on the Schedule A.

-3claimed on Schedule E, and (3) liable for a section 6662(a) accuracy-related

penalty.

Background

Some of the facts have been stipulated and are so found. At the time the

petition was filed, petitioners resided in Illinois.

Petitioners resided in Manhattan, Illinois (Manhattan property), during 2012

and until June 21, 2013, at which point they sold the Manhattan property for

$550,000 and moved to Manteno, Illinois (Manteno property). At the time of the

sale, the Manhattan property was encumbered by a mortgage of $206,444.68,

which was paid in full with the sale proceeds. Petitioners obtained a mortgage to

finance the purchase of the Manteno property.

According to a copy of a homeowner's insurance policy, petitioners insured

the "dwelling" on the Manhattan property for $789,000 during the coverage period

of November 1, 2012 through November 1, 2013. That policy required an annual

premium of $1,619. According to another homeowner's insurance policy,

petitioners insured the "dwelling" on the Manhattan property for $812,000 during

-4the coverage period of November 1, 2013 through November 1, 2014.3 That

policy required an annual premium of $1,673.

During 2013 petitioners paid $4,888.48 of mortgage interest with respect to

the mortgage on the Manhattan property and $1,722.18 of mortgage interest with

respect to the mortgage on the Manteno property.

The Manhattan and Manteno properties each consisted of a residential

dwelling as well as a pole-barn garage that was used in petitioners' steel

transportation business, Jelco Transportation, Inc. (Jelco). In 1973 Mr. Lawson

began a business that he operated as a sole proprietorship until petitioners

incorporated Jelco in 1995. From then on the business was conducted through

Jelco. At all times relevant Jelco was an S corporation owned in equal shares by

petitioners. Jelco's corporate offices were shown to be at the same address as

petitioners' residence during each year in issue.

Jelco used the pole-barn garages on the Manhattan and Manteno properties

to store equipment, including tractors, trailers, and trucks, used in its business.

There is no written lease that evidences the arrangement. The evidence is

3The parties stipulated that the Manhattan property was sold on June 21,

2013. Nonetheless, the record shows that petitioners insured the Manhattan

property through November 1, 2014, a date almost 1-1/2 years after the sale. This

apparent discrepancy has not been explained.

-5inconsistent and inconclusive regarding any rent that Jelco might have paid to

petitioners for the use of the garages.

During the years in issue Mrs. Lawson was employed by Jelco as its

secretary and treasurer. Apparently, Jelco agreed to pay Mrs. Lawson a weekly

salary of $1,000; however, no cash payments were actually made. In lieu of cash

salary payments to Mrs. Lawson, Jelco apparently paid some of petitioners'

personal expenses. The specifics of any such arrangements cannot be determined

from what has been submitted.

Jelco maintained a corporate bank account at First Bank of Manhattan

during the years in issue. Some, if not many, of petitioners' personal expenses

were paid with checks drawn on the business account. For example, during 2012

petitioners' mortgage payments on the Manhattan property were made from that

account. Those payments include $11,693.11 of mortgage interest.

Petitioners' timely filed joint 2012 and 2013 Federal income tax returns

were prepared by a paid income tax return preparer. On each return petitioners

reported on Schedule E income and expenses attributable to Jelco's use of the

pole-barn garages. Petitioners reported $28,000 of income on each Schedule E

and expenses as follows:

-6Expense

2012

2013

Cleaning and maintenance

Insurance

Mortgage interest paid to banks, etc.

Repairs

$605

3,030

5,846

888

$680

2,020

4,336

1,864

Taxes

7,058

10,395

Depreciation or depletion

1,018

976

Petitioners' returns each also include Schedules A. As relevant here, the

following deductions are claimed:

Deduction

Real estate taxes

Home mortgage interest

Points not reported to you on Form 1098

2012

2013

$7,058

5,846

-0-

$10,395

4,336

463

Jelco filed a Form 1120S, U.S. Income Tax Return for an S Corporation, for

each year also prepared by petitioners' return preparer. The 2012 and 2013 Forms

1120S show losses of $26,606 and $73,935, respectively. Petitioners' pro rata

shares of Jelco's net operating losses for 2012 and 2013 are taken into account in

the computation of the adjusted gross income shown on petitioners' returns.

In the notice respondent: (1) disallowed the deductions claimed on the

Schedules E for 2012 and 2013, (2) disallowed the S corporation losses claimed

on the Schedules E for 2012 and 2013, (3) disallowed $5,835 of a $6,687

charitable contribution deduction claimed on Schedule A for 2012, and

-7(4) imposed a section 6662(a) accuracy-related penalty for each year on several

grounds, including "negligence or disregard of rules or regulations" and

"substantial understatement of income tax". According to the notice, the

deductions claimed on the Schedules E were disallowed because petitioners "did

not establish that the business expense shown on * * * [their] tax return was paid

or incurred during the taxable year and that the expense was ordinary and

necessary to * * * [their] business." Some of the adjustments made in the notice

have been agreed to between the parties or conceded by one or the other of them,

and other adjustments are computational. Those adjustments will not be

discussed.

Discussion

I. Schedule E Deductions

As we have observed in countless opinions, deductions are a matter of

legislative grace, and the taxpayer bears the burden of proof to establish

entitlement to any claimed deduction.4 Rule 142(a); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292

U.S. 435, 440 (1934). A taxpayer claiming a deduction on a Federal income tax

4Petitioners do not claim and the record does not demonstrate that the

provisions of sec. 7491(a) are applicable, and we proceed as though they are not.

-8return must demonstrate that the deduction is allowable pursuant to some statutory

provision and must further substantiate that the expense to which the deduction

relates has been paid or incurred. Sec. 6001; Hradesky v. Commissioner, 65 T.C.

87, 90 (1975), aff'd per curiam, 540 F.2d 821 (5th Cir. 1976); Meneguzzo v.

Commissioner, 43 T.C. 824, 831-832 (1965); sec. 1.6001-1(a), Income Tax Regs.

Taxpayers may deduct ordinary and necessary expenses paid in connection

with operating a trade or business. Sec. 162(a); Boyd v. Commissioner, 122 T.C.

305, 313 (2004). To be ordinary the expense must be of a common or frequent

occurrence in the type of business involved. Deputy v. du Pont, 308 U.S. 488, 495

(1940). To be necessary an expense must be appropriate and helpful to the

taxpayer's business. Welch v. Helvering, 290 U.S. 111, 113 (1933). The

expenditure must be "directly connected with or pertaining to the taxpayer's trade

or business". Sec. 1.162-1(a), Income Tax Regs. On the other hand, section

262(a) generally disallows a deduction for personal, living, or family expenses.

With these fundamental principles of Federal income taxation in mind, we

consider petitioners' claims to the various deductions in dispute for the years in

issue.

-9A. Taxes

Petitioners claimed deductions of $7,058 and $10,395 for taxes on their

Schedules E attached to their 2012 and 2013 returns, respectively. According to

respondent, petitioners have not (1) established that the expenses were paid or (2)

shown that these expenses were "ordinary and necessary" to petitioners' Schedule

E business.

Petitioners did not provide any evidence of the payment of real property

taxes in 2012. Petitioners provided a photocopy of a $6,946.20 check from Jelco

to Will County, Illinois, for real property taxes paid in 2013. The check is

corroborated by a debit from Jelco's checking account at First Bank of Manhattan

on June 4, 2013. Having elected to conduct the business in corporate form,

petitioners are bound by the Federal income tax consequences of that election.

S_e_e Higgins v. Smith, 308 U.S. 473 (1940). Jelco's corporate existence cannot be

disregarded for Federal income tax purposes, see Moline Props., Inc. v.

Commissioner, 319 U.S. 436 (1943), and thus petitioners are not entitled to deduct

amounts paid by Jelco for petitioners' expenses on their 2013 Schedule E.

Otherwise, petitioners have not substantiated the Schedule E deductions for

taxes for either year in excess of the amounts respondent has already allowed as

- 10 deductions on petitioners' Schedules A. Accordingly, petitioners are not entitled

to deductions for taxes on their 2012 and 2013 Schedules E.

B. Mortgage Interest

Petitioners claimed deductions of $5,846 and $4,336 for mortgage interest

on their Schedules E attached to their 2012 and 2013 returns, respectively.

According to respondent, petitioners have not (1) established that the expenses

were paid or (2) shown that these expenses were "ordinary and necessary" to

petitioners' Schedule E business.

Subject to certain limitations, section 163(h)(2)(D) allows a deduction for

qualified interest paid on acquisition indebtedness or home equity indebtedness

with respect to a qualified residence. A qualified residence for purposes of section

163 includes the taxpayer's primary residence and one other home which is used

by the taxpayer as a residence (within the meaning of section 280A(d)(1)).

With respect to 2012, bank statements for a checking account held by Jelco

at First Bank of Manhattan show that Jelco made payments of $11,693.11 of

mortgage interest towards petitioners' mortgage on the Manhattan property. As

noted above, petitioners are not entitled to deduct on their Schedule E amounts

paid by Jelco for their expenses, see Moline Props., Inc. v. Commissioner, 319

U.S. 436; Higgins v. Smith, 308 U.S. 473, and petitioners have not otherwise

- 11 substantiated that they paid mortgage interest in excess of the amount respondent

has already allowed as a deduction on the Schedule A.

In 2013 petitioners paid $4,888.48 of mortgage interest with respect to the

mortgage on the Manhattan property and $1,722.18 of mortgage interest with

respect to the mortgage on the Manteno property. Although petitioners

erroneously reported the mortgage interest deduction on Schedule E, we find that

they are entitled to an additional Schedule A mortgage interest deduction of

$2,274.66, which includes respondent's concession, for 2013.

C. Insurance

Petitioners claimed deductions of $3,030 and $2,020 for insurance on their

Schedules E attached to their 2012 and 2013 returns, respectively. According to

respondent, petitioners (1) have not established that the expenses were paid or (2)

shown that these expenses were "ordinary and necessary" to petitioners' Schedule

E business.

Although petitioners provided copies of their homeowner's insurance

policies insuring the "dwelling" on the Manhattan property during the years in

issue, petitioners did not provide any records to substantiate payment of the

insurance premiums due with respect to the insurance policies. Accordingly,

- 12 petitioners are not entitled to a deduction for insurance expenses for either year in

issue.

II. S Corporation Losses

Respondent disallowed petitioners' deductions of the losses passed through

to them from Jelco in 2012 and 2013 because petitioners failed to establish that

either had any basis in Jelco. A shareholder may not deduct a loss passed through

to him or her from an S corporation to the extent that the loss exceeds the sum of

the shareholder's adjusted basis in his or her stock in the S corporation, plus the

shareholder's adjusted basis of any debt that the S corporation owes to the

shareholder. See sec. 1366(d)(1).

A taxpayer must establish the basis of his stock for purposes of determining

the amount of gain or loss he must recognize. "Proof of basis is a specific fact

which the taxpayer has the burden of proving." O'Neill v. Commissioner, 271

F.2d 44, 50 (9th Cir. 1959), § T.C. Memo. 1957-193.

According to petitioners, they have made numerous loans to Jelco since its

incorporation, as reflected in the basis analysis introduced into evidence, that

increase their bases in their shares sufficient to entitle them to deduct the Jelco

losses on their 2012 and 2013 Schedules E. Those loans, however, are not

evidenced by promissory notes or other credible evidence, nor have petitioners

- 13 established that any funds were actually transferred from them to Jelco.

Furthermore, petitioners' return preparer, who was responsible for preparing

petitioners' returns and Jelco's returns for 2012 and 2013, testified that

petitioners' bases in their shares of Jelco were "zero" during each year in issue.

Because petitioners have failed to establish sufficient bases in their Jelco stock to

allow for the deduction of the losses attributable to that corporation, they are not

entitled to deductions for those losses for the years in issue.

III. Section 6662(a) Accuracy-Related Penalty

Lastly, we consider whether petitioners are liable for a section 6662(a)

accuracy-related penalty for either year in issue. As relevant here, section 6662(a)

imposes a penalty of20% of the portion of an underpayment of tax attributable to

the taxpayer's: (1) negligence or disregard of rules or regulations or (2)

substantial understatement of income tax. Sec. 6662(a) and (b)(1) and (2).

"Negligence" includes any failure to make a reasonable attempt to comply with the

provisions of the Code, including any failure to keep adequate books and records

or to substantiate items properly. See sec. 6662(c); sec. 1.6662-3(b)(1), Income

Tax Regs. A "substantial understatement of income tax" includes an

understatement of income tax that exceeds the greater of 10% of the tax required

to be shown on the return or $5,000. See sec. 6662(d)(1)(A); sec. 1.6662-4(b),

- 14 Income Tax Regs. Respondent bears the burden of production with respect to the

imposition of the section 6662(a) accuracy-related penalties. See sec. 7491(c);

Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001).

Section 6751(b)(1) provides that, subject to certain exceptions in section

6751(b)(2), no penalty shall be assessed unless the initial determination of the

assessment is personally approved in writing by the immediate supervisor of the

individual making the determination or such higher level official as the Secretary

may designate. Written approval of the initial penalty determination under section

6751(b)(1) must be obtained no later than the date the notice of deficiency is

issued or the date the Commissioner files an answer or amended answer asserting

the penalty. Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), aff'g in

part, rev'g in part T.C. Memo. 2015-42; see also Graev v. Commissioner, 149 T.C.

__ (Dec. 20, 2017), supplementing and overruling in part 147 T.C. 460 (2016).

Compliance with section 6751(b)(1) is part of the Commissioner's burden of

production in any deficiency case in which a penalty subject to section 6751(b)(1)

is asserted. Chai v. Commissioner, 851 F.3d at 221.

The section 6662(a) accuracy-related penalties determined in the notice

were properly approved as required by section 6751(b)(1). The record includes a

Civil Penalty Approval Form, approving imposition of accuracy-related penalties

- 15 against petitioners for 2012 and 2013 and executed by the IRS tax examiner's

immediate supervisor before the date the notice was issued. Respondent has

proven sufficient facts to satisfy the burden of production as to that requirement.

Petitioners failed to maintain adequate substantiating records for expenses

underlying the deductions claimed on their 2012 and 2013 returns. Moreover, the

understatement of income tax for each year exceeds the greater of 10% of the tax

required to be shown on the return or $5,000. Therefore, respondent has met his

burden of production with respect to the imposition of section 6662(a)

accuracy-related penalties.

The accuracy-related penalty does not apply to any part of an underpayment

of tax if it is shown that the taxpayer acted with reasonable cause and in good faith

with respect to that portion. Sec. 6664(c)(1). The determination of whether a

taxpayer acted in good faith is made on a case-by-case basis, taking into account

all the pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.

Petitioners bear the burden of proving that they had reasonable cause and acted in

good faith with respect to the underpayments. See Higbee v. Commissioner, 116

T.C. at 449.

Reliance on professional advice will absolve the taxpayer if "such reliance

was reasonable and the taxpayer acted in good faith." Sec. 1.6664-4(b)(1), Income

- 16 Tax Regs. Under certain circumstances, a taxpayer's reliance upon professional

advice may establish the taxpayer's "reasonable cause" and "good faith" with

respect to an underpayment of tax if the taxpayer establishes that: (1) the

professional was provided with complete and accurate information, (2) an

incorrect return was a result of the preparer's mistakes, and (3) the taxpayer

demonstrates good-faith reliance on a competent professional. See Estate of

Goldman v. Commissioner, 112 T.C. 317, 324 (1999), aff'd without published

opinion sub nom. Schutter v. Commissioner, 242 F.3d 390 (10th Cir. 2000); see

a_lso Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), a_ffd,

299 F.3d 221 (3d Cir. 2002).

Although their returns were prepared by a paid income tax return preparer,

the return preparer used income and expense amounts petitioners provided.

Apparently, no source documents underlying the deductions were provided to the

return preparer; according to the return preparer, petitioners had "horrible books

and records". Because petitioners did not furnish the return preparer with

complete and accurate information, they failed to establish that their reliance upon

the return preparer constitutes "reasonable cause" and "good faith" with respect to

the underpayments of tax. Moreover, petitioners failed to explain their conceded

Schedule E deductions for 2012 and 2013 and Schedule A charitable contribution

- 17 deduction for 2012. See supra note 2. Accordingly, respondent's imposition of

section 6662(a) accuracy-related penalties for 2012 and 2013 is sustained.

To reflect the foregoing,

Decision will be entered

under Rule 155.