T. C. Memo. 2005-287
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ORDED
. ERVI CE
CA
PAT.
T. C. Memo. 2005-287
UNITED STATES TAX COURT
JOSEPH A. AND SARI F. DEIHL, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
. Docket Nos.
16293-02,
Filed December 15, 2005.
1024-03.
. During 1996, 1997, and 1998, Ps operated a
multilevel marketing enterprise through two related S
corporations, M and K.
Held:
Ps are entitled to deductions claimed
through and in connection with expenditures of M and K
as redetermined herein for 1996, 1997, and. 1998.
Held, further, Ps are not entitled to include in
cost of goods sold for M an amount claimed for
purchases in 1998.
Held, further, Ps are not entitled to a reduction
in adjusted gross income of $550, 000 for 1996.
Held, further, Ps are liable for accuracy-related
penalties pursuant to sec. 6662, I.R.C., for 1996,
1997, and 1998.
i
saavao E J 12000
- 2 Donald W. MacPherson and Bradley Scott MacPherson, for
petitioners.
Jonae A. Harrison and J. Robert Cuatto, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
WHERRY, Judge:
In these consolidated cases, respondent
determined the following deficiencies and penalties with respect
to petitioners'
Federal income taxes:
Year
Deficiency
1996
1997
1998
$1,364,714
2,348,943
1,108,775
Sec.
Penalty
6662, I.R.C.
$272,942.80
608,473.00
221,755.00
After concessions by the parties, the principal issues for
decision are:
(1) Whether petitioners are entitled to deductions claimed
through and in connection with expenditures of two related S
corporations, Mayor Pharmaceutical Laboratories, Inc.
and KareMor International, Inc.
1996,
1997,
(Mayor),
(KareMor), for the taxable years
and 1998;
(2) whether petitioners are entitled to include in the cost
of goods sold for Mayor an amount claimed for purchases in 1998;
(3) whether petitioners are entitled to a reduction in
adjusted gross income of $550,000 for the taxable year 1996; and
- 3 (4) whether petitioners are liable for the section 6662
accuracy-related penalty for 1996, 1997, and 1998.¹
Certain additional adjustments, e.g., to itemized deductions, are
computational in nature and will be resolved by our holdings on
the foregoing issues.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulations of the parties, with accompanying exhibits, are
incorporated herein by this reference.
To facilitate disposition
of the above issues, we shall first set forth general findings of
fact and then, where appropriate, make additional findings in
conjunction with our analysis of and opinion on discrete issues.
Petitioners Joseph A. and Sari F. Deihl (individually
referred to as Mr. Deihl and Mrs. Deihl, respectively) are
husband and wife.
During the years in issue and at the time the
petitions were filed in these cases, petitioners resided at 4627
East Foothill Drive, Paradise Valley, Arizona 85253.
have two children, Joseph Deihl II
(Bill).
Petitioners
(Joe II) and William Deihl
During the years in issue, Joe II was married to Kim,
and Bill was married to Denyse.
Petitioners also have several
grandchildren.
¹ Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years in issue, and Rule
references are to the Tax Court Rules of Practice and Procedure.
- 4 Mr. Deihl completed his formal education upon graduation
from the eighth grade and has since been engaged in a series of
entrepreneurial business ventures.
Mrs. Deihl, who has an
eleventh grade education, was an integral participant with her
husband in these ventures.
In the.early 1980s, petitioners began
to investigate the possibility of developing and marketing a
vitamin complex administered in spray form.
Petitioners in the
mid-1980s acquired a patent for the formula for such a spray
multivitamin and incorporated Mayor to manufacture the product.2
Petitioners jointly own 100 percent of the stock in, are officers
of, and control Mayor.
Petitioners experimented with several different
methodologies for marketing their product, which came to be known
as VitaMist.
An initial attempt at placement in convenience
stores was unsuccessful.
Petitioners later sold the product
through a third-party network marketing company,
but that company subsequently went bankrupt.
"Eureka Foods",
Then, for a period
of several years, petitioners marketed the product through Home
Shopping Network.
Eventually, in 1992, petitioners incorporated
KareMor to market the VitaMist products.3
As with Mayor,
petitioners jointly own 100 percent of the stock in, are officers
of, and control KareMor.
2 Mayor elected S corporation status in 1991.
3 KareMor elected S corporation status in 1993.
- 5 -
KareMor was structured as a multilevel network marketing
company with hierarchical levels of distributors.
In ascending
order from entry to the highest echelon, the levels included.:
Consultant, Silver, Gold, Opal, Sapphire, Ruby, Emerald, Diamond,
and Crown.
Distributors were independent representatives who
purchased from KareMor and then resold the VitaMist products.
Distributors also had the opportunity to recruit additional
distributors, resulting in a pyramid structure of what were
referred to as "downline" distributors.
Advancement in the
KareMor organization depended upon the volume of product
purchases generated by the distributor and his or her downline
associates, as well as upon the width and depth of this downline
network.
The compensation earned by a distributor from participation
in the KareMor network similarly depended upon the volume of
product purchases generated by both the distributor and his or
her downline network.
For instance, higher volume distributors
received larger discounts on VitaMist product purchases,
providing potentially greater. profit margins on resales down
through their chains of downline associates and/or to ultimate
consumers.
The compensation credited to a distributor could thus
generally be characterized as equivalent to a system of
commissions, bonuses, or "overrides".
- 6 In keeping with KareMor's nature as a multilevel marketing
organization, a primary focus of the entity's operations was on
motivating its distributors.
To that end, KareMor sponsored
large-scale conventions and also conducted smaller training and
meeting events at locations throughout the country.
Extensive
use was likewise made of prizes and awards as motivational
incentives, many of which were given away at the conventions.
For instance, during the years in issue, a convention was held
each calendar quarter and typically lasted 3 days.
The schedule
would include substantive sessions devoted to training and
informati.onal or motivational speakers, as well as entertainment
portions featuring musical performers, dancers, celebrities,
prizes, etc.
Featured prizes might be cash, Rolex watches,
cruises, and so on.
Petitioners and members of their extended family played a
prominent role in interacting personally with distributors at
KareMor events.
In these interactions, petitioners believed that
it was critical for every aspect of their lives, from their
attire and personal grooming to their residence, to portray an
appearance of extreme affluence and success.
Petitioners felt
that distributors who were impressed to the point of being
overwhelmed with what could be achieved through multilevel
marketing would be encouraged to build their own downline
networks in hopes of reaping similar benefits.
- 7 -
In execution of this strategy, petitioners hosted at their
residence a number of events to which distributors were invited.
Petitioners frequently used their home for training sessions,
meetings, and entertainment functions, including an annual
Halloween party attended by as many as several hundred people and
an annual "come home" event used to showcase both the corporate
properties in Phoenix and petitioners' residence.
To accommodate
such usage and their image-related goals,. petitioners during the
period from late 1996 to early 1997 engaged in an extensive
renovation of their personal residence.
"showplace" or "trophy" home.
They sought to create a
Components of the remodel included
an enhanced driveway and fountain area, a columned porte cochere,
a large vestibule, redesigned bedroom and den/office area, raised
hallway ceilings, limestone flooring, new windows and French
doors, a lighting system, gold-leaf trim, furniture, and interior
design elements.
The residential property also included a
swimming pool, tennis court, fountain, and extensive landscaping.
Both Mayor and KareMor maintain their principal corporate
office in a complex located on 24th Street in Phoenix, Arizona.4
The complex occupies the east and west sides of the street and
includes multiple buildings and surrounding landscaping.
east side are three buildings:
On the
A two-story office building, a
4 The record fails to clarify the precise ownership, as
between petitioners and/or one of their various entities, of this
property.
- 8 -
manufacturing laboratory, and a storage warehouse.
Five
buildings are located on the west side and consist of both office
and warehouse or industrial space, some of which is leased to
third-party tenants.
In operating their businesses, petitioners employed the
services of several professional advisers.
Robert J. Hartmann,
an attorney, certified in Arizona as a tax law specialist in past
years and also holding a degree in accounting, met Mr. Deihl in
1983 and became involved in legal work for Mr. Deihl and his
companies.
Mr. Hartmann initially assisted with contract
disputes and organizational issues, and by 1998 approximately 70
percent of his practice was devoted to providing services for
petitioners and their entities.
At that time and at Mr. Deihl's
request, Mr. Hartmann relocated to an office on 24th Street to be
closer to the corporate headquarters.
With respect to the accounting function, prior to about the
1991 to 1992 period, petitioners had employed the services of an
outside accounting firm, referred to as "Duskin & Duskin",
apparently working principally with Bernie Duskin, alleged to be
a certified public accountant (C.P.A.).
Mr. Duskin introduced
Mr. Deihl to Martin D. Goltz, recently arrived in Arizona from
Illinois.
Mr. Goltz had received from DePaul University in
Chicago,
Illinois, a degree in accounting in 1964 and then a
juris doctorate in 1967.
Mr. Goltz was licensed by the State of
- 9 Illinois as a C.P.A. in about 1966 and maintained that license
for approximately 20 years.
He thereafter ceased to renew the
license because he had not fulfilled continuing education
requirements.
Mr. Goltz similarly obtained a license to practice
law from the State of Illinois in 1967 or 1968, and he maintained
the license until he was disbarred in 1985 or 1986.
After being introduced to Mr. Deihl, Mr. Goltz was engaged
042
by Mayor as an independent contractor to perform part-time
accounting and consulting work.
During 1994 or 1995, Mr. Goltz
was hired as a full-time employee and provided with an office at
the corporate headquarters where he displayed the various
professional degrees and certificates pertaining to his career as
a C.P.A. and attorney in Illinois.
By 1996, the first of the
years in issue, Mr. Goltz served as the accountant and CFO for
both Mayor and KareMor.
Mr. Goltz prepared the original income
tax returns for petitioners, Mayor, and KareMor for 1996 and
1997.
As the businesses grew throughout the years in issue,
Mr. Goltz became overwhelmed with the volume of work.
An
individual hired to assist him proved to be a poor fit for the
companies and failed to relieve the burden.
The business and tax
records were not computerized and were manually prepared.
Mr. Goltz estimated substantially all of the expense items,
including the inventory for both companies.
As he testified:
- 10 -
"And it certainly wasn't intentional but it was literally
throwing numbers together to try to get the returns, you know,
filed on time."
At some point during 1998, and apparently in conjunction
with an investigation into whether to take one of his entities
public, Mr. Deihl engaged the C.P.A. firm Donald R. Leo and
Company, Ltd., to review financial materials and tax returns.
As
problems came to light, Mr. Goltz was demoted from his position
as CFO; an individual named Pam Roeper was hired to succeed him
in that role; and Mr. Leo was engaged to reconstruct financial
records, to create general ledgers, and to prepare tax returns
based thereon.
Mr. Goltz stayed with the companies until late
2000 attempting to provide whatever assistance he could to Mr.
Leo.
Between June of 1998 and April óf 2000, Mr. Leo prepared
and filed on behalf of petitioners, Mayor, and KareMor amended
returns for 1996 and 1997, and original and (for petitioners
only) amended returns for 1998.
OPINION
I.
Preliminary Matters
A.
Record Generally
As indicated by the recitation of issues at the outset of
this opinion, these cases principally concern petitioners'
entitlement, through their S corporations, to deductions or
offsets for a wide range.of expenditures.
The notices of
r
- 11 -
deficiency involved nearly a hundred adjustments, and the parties
are to be commended for substantially narrowing the categories
that remain at issue.
Nevertheless, a few preliminary comments
about the status of the record are in order.
Despite the above-mentioned narrowing of the issues,. the
categories that remain in dispute incorporate many dozens of
discrete outlays.
thousand pages.
The stipulated exhibits alone run well over a
Yet as to a substantial portion of the
individual items claimed, petitioners failed to address the
specific expenditures at trial or on brief .
Petitioners'
testimony instead tended to be broad brushed and conclusory in
approach.
There is no shortage of blanket testimony resorting to
use of the word "all" in various contexts that the Court is
simply unwilling to countenance at face value.
Hence, from a
substantiation standpoint, the Court is apparently expected in
many instances to rely on nothing more than perhaps credit card
statements and the characterizations reflected in the general
ledgers offered by petitioners.
In this connection, and as will become clearer in the
discussion to follow, the Court observes that petitioners'
general ledger categories for expenditures seem to be vaguely
defined, overlapping, random, and self-serving.
For example, the
rhyme or reason for labeling what would appear to be similar
outlays as incurred for training, meetings, and/or conventions,
- 12 -
versus for promotion, versus for meals and entertainment, versus
for marketing, is left largely unilluminated.
Additionally,
testimony regarding their preparation shows that the general
ledgers are largely noncontemporaneous attempts at reconstruction
of financial records without complete support in underlying
primary documentation.
Mr. Hartmann stated at trial:
"And when
Donald Leo was hired he looked at some of the tax returns that
had been filed and apparently there was no supporting books and
records that go with them.
Mr. Leo was hired to create this
general ledger for the years '95 '96,
1998."
'97.
I believe he also did
Mr. Goltz's testimony in explaining his role after the
hiring of Mr. Leo offers further details, as follows:
A
Actually what I was doing was most of my time
was spent working with the CPA, that's Mr. Leo and his
staff, bringing the records up to snuff.
Everything
was done manually before, okay. There was no computer
system in play and it was just an absolute disaster.
And I would get, I would haul boxes and boxes of
records and help with the inputting.
I wasn't doing it
but supplying information so that the records in
essence could be reconstructed because they were a
disaster.
Q
Did you classify the data that was inputted
or did the person just utilize the face of the check?
A
The accounting people were classifying it.
And if they had questions I'd do my best to answer them
or get the answer.
Or if they needed invoices and they
didn't have them I would do my best to, you know, get
them for them.
Q
* * * What was the ultimate work product as a
result of CPA Don Leo's efforts with your assistance?
- 13 -
A
There were statements issued for I'm not sure
of the time frame. My guess is '95, 6, 7. Maybe I'm
wrong but I think maybe '98. And after that I left and
I don't really know what took place. But financial
statements were being issued--were issued.
*
*
*
*
*
*
*
Q
Okay. Was a general ledger prepared as a
result of this effort?
A
Yes.
Such testimony hardly instills a resounding confidence in the
reliability of these documents.
Furthermore, even as to those items for which the record
contains some form of invoice or receipt, those documents in and
of themselves and absent any additional explanation from
petitioners are often insufficient to establish all requisites
for the treatment claimed.
Likewise, for the particular
expenditures that petitioners do touch on in the testimony
offered, their brief statements typically fall far short of
addressing all pertinent requirements for allowance.
Hence, while the Court has dealt with the record presented,
we are left with the overall impression that.,petitioners have
chosen to bank on a rather haphazard, big-picture, almost all-ornothing approach in lieu of the item-by-item documentation or
detail we would have expected for issues of this nature.
B.
Burden of Proof
Against the foregoing backdrop, the Court addresses the
parties' contentions regarding burden of proof.
As a general
- 14 rule, determinations by the Commissioner are presumed correct,
and the taxpayer bears the burden of proving otherwise.
142(a).
Rule
Section 7491 may operate, however, in specified
circumstances to place the burden on the Commissioner.
Section
7491 is applicable to court proceedings that arise in connection
with examinations commencing after July 22, 1998, and reads in
pertinent part:
SEC.
7491.
BURDEN OF PROOF.
(a) Burden Shifts Where Taxpayer Produces Credible
Evidence.-(1) General rule.--If, in any court
proceeding, a taxpayer introduces credible
evidence with respect to any factual issue
relevant to ascertaining the liability of the
taxpayer for any tax imposed by subtitle A or B,
the Secretary shall have the burden of proof with
respect to such issue.
(2) Limitations.--Paragraph (1) shall apply
with respect to an issue only if--
(A) the taxpayer has complied with the
requirements under this title to substantiate
any item;
(B) the taxpayer has maintained all
records required under this title and has
cooperated with reasonable requests by the
Secretary for witnesses, information,
documents, meetings, and interviews; * * *
*
*
*
*
*
*
*
(c) Penalties.--Notwithstanding any other
provision of this title, the Secretary shall have the
burden of production in any court proceeding with
respect to the liability of any individual for any
penalty, addition to tax, or additional amount imposed
by this title.
- 15 -
See also Internal Revenue Service Restructuring and Reform Act of
1998,
Pub. L.
105-206,
effective date.
sec. 3001(c),
112 Stat.
727,
regarding
Section 7491 is applicable here in that
examination of petitioner's 1996, 1997, and 1998 tax years began
after July 22,
1998.
With respect to the deficiency determinations in dispute,
the operative rules are contained in section 7491(a).
Petitioners make the assertion, apparently for the first time on
opening brief, that the burden of proof as to factual issues
shifts to respondent because "Petitioners have produced credible
testimony and documents, most especially regarding their reliance
on CPA's [sic] and an attorney."
The Court, however, concludes a
shift is not appropriate on this record for the reasons set forth
below.
First, as can be gleaned from the preceding discussion, the
Court finds that petitioners have failed to introduce credible
evidence with respect to the majority of the individual
expenditures in contention.
section 7491(a)
Credible evidence for purposes of
is defined as "the quality of evidence which,
after critical analysis, the court would find sufficient upon
which to base a decision on the issue if no contrary evidence
were submitted (without regard to the judicial presumption of IRS
correctness)."
H.
C.B. 747, 994-995.
Conf. Rept.
105-599,
at 240-241
(1998),
1998-3
Such quality is lacking in much of what has
- 16 -
been offered here.
Nonetheless, the Court need not probe this
matter in detail as to individual items because of the remaining
considerations discussed next.
Second, even where credible evidence is introduced, the
taxpayer must establish, as a prerequisite to any shift under
section 7491(a)(1), that he or she has complied under section
7491(a)(2) with all substantiation requirements, has maintained
all required records,- and has cooperated with reasonable requests
for witnesses, information, documents, meetings, and interviews.
H. Conf. Rept.
105-599,
supra at 239-240,
1998-3 C.B. at 993-994.
Petitioners in their burden of proof argument make no attempt to
address specifically whether they have satisfied these
conditions, and the record indicates that they have not.
Since this is primarily a substantiation matter, the ideas
of credible evidence and substantiation are to a significant
extent intertwined, and our comments above apply equally in this
context.
In addition, given the circumstances surrounding the
noncontemporaneous reconstruction of records underlying the
amounts claimed by petitioners in these cases and the lack of
supporting invoices or receipts for a significant number of the
outlays, maintenance of all required records would also appear to
be lacking.
Full cooperation is likewise called into question
where the record contains copies of information document requests
from respondent highlighting items requested during the
- 17 -
examination process and never supplied.
Thus, petitioners have
not shown compliance with section 7491(a)(2).
Third, this Court has noted in earlier cases the potential
impropriety of shifting the burden under section. 7491(a) where
the taxpayers did not raise the issue prior to the briefing
process.
E.g., Menard, Inc. v. Commissioner, T.C. Memo. 2004-
207; Estate of Aronson v. Commissioner, T.C. Memo. 2003-189.
042
The rationale for this concern rests upon the possible prejudice
to the Commissioner's ability to introduce evidence specifically
directed toward cooperation during the audit period.
Menard,
Inc. v. Commissioner, supra; Estate of Aronson v. Commissioner,
supra.
With respect to the accuracy-related penalty, the
Commissioner satisfies the section 7491(c) burden of production
by "[coming]
forward with sufficient evidence indicating that it
is appropriate to impose the relevant penalty" but "need not
introduce evidence regarding reasonable cause, substantial
authority, or similar provisions."
T.C. 438, 446
(2001).
Rather,
Higbee v. Commissioner, 116
"it is the taxpayer's
responsibility to raise those issues."
Id.
Because, as will be
more fully detailed infra, respondent has introduced sufficient
evidence to render the section 6662(a) penalty at least facially
applicable, the burden rests on petitioners to show.why it should
not be applied.
- 18 C.
Evidentiary Issue
At trial, petitioners sought to introduce into evidence a
20-minute videotape.
Mr. Deihl explained that videos were taken
of conventions, training sessions, and other KareMor events.
Clips from the collection of tapes so generated were then used to
create the 20-minute summary video offered at trial.
Respondent
objected to admission of the video based on rules 401, 901(a),
1001, 1002, and 1006 of the Federal Rules of Evidence, which
rules address relevance, authentication, the requirement of
original recordings, and use of summaries.
The Court reserved
ruling on the tape's admissibility and took the matter under
advisement.
Having had an opportunity to review the totality of the
record in light of the specific issues presented by these cases,
the Court believes respondent's concerns as to relevancy are well
taken.
Rule 401 of the Federal Rules of Evidence defines
"relevant evidence" as "evidence having any tendency to make the
existence of any fact that is of consequence to the determination
of the action more probable or less probable than it would be
without the evidence."
Mr. Deihl stated that the video tape
depicted "Actions at the conventions, the entertainers, the
arrivals, the pomp and circumstances, the pageantry, the gowns
worn".
Counsel for petitioners expressed the pr.offer as follows:
it is offered as for illustrative purposes as to what
happened with respect to the training sessions, what's
- 19 going on at the house, the hoopla, the hype, the
042
conventions, the costumes, the whole flavor of what
this gentlemen has created with KareMor. And that can
be illustrated by photos which we'll move to next, but
the photos don't show the excitement in the air like a
video does.
Initially, Mr. Deihl testified that only recordings from
1996, 1997, and 1998 were used in creating the videotape.
However, after similar assertions with respect to the years
depicted in various photographs were shown on voir dire to be
unreliable, counsel reproffered the videotape on the more general
basis of showing how KareMor operated over "the time frame of '93
through early '99."
On this basis, the Court is not convinced that the videotape
would make any fact of consequence to the resolution of these
cases more probable.
The record is already replete with
generalized evidence attesting to how petitioners ran a
successful multilevel marketing .enterprise, complete with hype,
pageantry, and prizes, as well as a glamorous residence and
wardrobe to fit the part.
The Court, as demonstrated in our
findings of fac.t, does not doubt that petitioners' business model
successfully used these strategies to instill enthusiasm in the
distributors.
Nonetheless, facts of consequence to the outcome of this
proceeding are those which would establish that petitioners have
met the substantiation and other requisites for the deduction of
each of the particular expenditures made in 1996, 1997, and 1998.
- 20 -
The videotape, by its nature, would not even connect any
individual outlay reflected in petitioners' ledgers, credit card
statements,. etc., to any specific business function during the
years in issue, since the tape purports to cover only a general
modus operandi from 1993 through 1999.
Court a rational foundation,
Nor would it afford the
for example, to estimate the
percentage of business versus personal use for a given type of
expense, since the tape purports to show only business events.
The Court cannot conclude that the video conforms to the
definition of relevant evidence in rule 401 of the Federal Rules
of Evidence.
Furthermore, even assuming that the videotape could clear
the relevancy hurdle, the evidence would properly be excluded
under rule 403 of the Federal Rules of Evidence, which reads:
"Although relevant, evidence may be excluded if its probative
value is substantially outweighed by the danger of unfair
prejudice, confusion of the issues, or misleading the jury, or by
considerations of undue delay, waste of time, or needless
presentation of cumulative evidence."
As indicated in the
preceding discussion, the tape would be needlessly cumulative on
this record.
Respondent did not object to admission of the photographs
offered by petitioners as generally showing petitioners'
promotional activities, including conventions, training, and
- 21 -
parties, from 1993 to 1999.
Thus, the Court has a visual
representation of petitioners' operations.
There is likewise no
shortage of generalized verbal descriptions regarding how
petitioners ran their operations, motivated distributors, gave
away prizes, created a lifestyle to envy, and so on.
The
generalized summary videotape would therefore add nothing
material to the evidence before the Court.
The Court shall
exclude the videotape on grounds of relevancy or cumulation and
need not reach the additional bases for exclusion argued by
respondent.
II.
S Corporation Expenditure Deductions
The expenditures of Mayor and KareMor at issue in this
proceeding were categorized, first in general ledgers and then
correspondingly in relevant tax returns, notices of deficiency,
stipulations, and briefs, as pertaining to (1) capitalized
business improvements;
(2) landscaping;
(3) security;
(4)
training, meetings, and/or conventions;
(5) promotion;
(6)
suspense;
(7) marketing; or (8) meals and entertainment.
As
alluded to previously and as will be further elucidated infra in
text, some of these classifications are ambiguous at best and do
not lend themselves to analysis of pertinent issues.
Accordingly, for purposes of discussion herein, the Court will
employ the following groupings:
improvements;
(2)
landscaping;
(1) Amortization of residence
(3)
security;
(4) clubs;
(5)
- 22 -
entertainment;
(6) gifts, awards, or cash;
equipment and furnishings;
(7) clothing;
(8)
(9) contributions; and (10) promotion
or marketing.
A.
General Rules
Deductions are a matter of "legislative grace", and "a
taxpayer seeking a deduction must be able to point to an
applicable statute and show that he comes within its terms."
Colonial Ice Co. v. Helvering, 292 U.S. 435,
Rule 142(a).
440
New
(1934); see also
As a general rule, section 162(a) authorizes a
deduction for "all the ordinary and necessary expenses paid or
incurred during the taxable year in carrying on any trade or
business".
An expense is ordinary for purposes of this section
if it is normal or customary within a particular trade, business,
or industry.
Deputy v. du Pont,
308 U.S. 488,
495
(1940).
An
expense is necessary if it is appropriate and helpful for the
development of the business.
467, 471 (1943).
Commissioner v. Heininger, 320 U.S.
Section 262, in contrast, precludes deduction
of "personal, living, or family expenses."
The breadth of section 162(a) is tempered by the requirement
that any amount claimed as a business expense must be
substantiated, and taxpayers are required to maintain records
sufficient therefor.
Sec. 6001; Hradesky v. Commissioner, 65
T.C.
affd.
87,
89-90
1.6001-1(a),
(1975),
Income Tax Regs.
540 F.2d 821
(5th Cir.
1976); .sec.
When a taxpayer adequately
- 23 -
establishes that he or she paid or incurred a deductible expense
but does not establish the precise amount, we may in some
circumstances estimate the allowable deduction, bearing heavily
against the taxpayer whose inexactitude is of his or her own
making.
Cohan v. Commissioner, 39 F.2d 540,
543-544
(2d Cir.
1930).
There must, however, be sufficient evidence in the record
to provide a basis upon which an estimate may be made and to
permit us to conclude that a deductible expense, rather than a
nondeductible personal expense, was incurred in at least the
amount allowed.
(5th Cir.
Williams v. United States, 245 F.2d 559, 560
1957); Vanicek v. Commissioner,
85 T.C.
731,
742-743
(1985).
Furthermore, business expenses described in section 274 are
subject to rules of substantiation that supersede the doctrine of
Cohan v. Commissioner, supra.
823,
Sanford v. Commissioner, 50 T.C.
827-828
(1968), affd. 412 F.2d 201
(2.d Cir.
1.274-ST(a),
Temporary Income Tax Regs.,
50 Fed.. Reg. 46014
6,
1985).
1969);. sec.
(Nov.
Section 274(d) provides that no deduction shall be
allowed for, among other things, traveling expenses,
entertainment expenses, gifts, and expenses with respect to
listed property (as defined in section 280F(d)(4) and including
passenger automobiles, computer equipment, and cellular
telephones)
"unless the taxpayer substantiates by adequate
records or by sufficient evidence corroborating the taxpayer's
- 24 own statement":
(1) The amount of the expenditure or use;
(2)
the time and place of the expenditure or use, or date and
description of the gift;
(3) the business purpose of the
expenditure or use; and (4) in .the case of entertainment or
gifts, the business relationship to the taxpayer of the
recipients or persons entertained.
Sec. 274(d).
In addition to the general business expense deduction rule
of section 162, section 167 authorizes "as a depreciation
deduction a reasonable allowance for the exhaustion, wear and
tear (including a reasonable allowance for obsolescence)--(1) of
property used in the trade or business, or (2) of property held
for the production of income."
Sec. 167(a).
When applying sections 162 and 167 in the context of
particular items of property, the following general framework has
emerged through caselaw.
Under either section, the initial
question is whether ownership and maintenance of the property is
related primarily to business or to personal purposes.
Artists, Ltd. v. Commissioner, 55 T.C.
94,
104
(1970)
Intl.
(and cases
cited thereat); see also, e.g., Richardson v. Commissioner, T.C.
Memo.
1996-368; Griffith v. Commissioner, T.C. Memo.
1988-445.
The answer to this question determines which of three approaches
is appropriate:
(1)
If acquisition and maintenance of the
property is primarily associated with profit-motivated purposes
and any personal use is distinctly secondary and incidental,
- 25 -
expenses and depreciation are deductible;
(2) if acquisition and
maintenance is motivated primarily by personal considerations,
deductions are disallowed; and (3) if substantial business and
personal motives exist, allocation becomes necessary.
Trading Co. v. Commissioner,
275 F.2d 578,
584-587
Intl..
(7th Cir.
1960), affg. T.C. Memo. 1958-104; Intl. Artists, Ltd. v.
Commissioner, supra at 104-105; Richardson v. Commissioner,
supra; Griffith v. Commissioner, supra; Kenerly v. Commissioner,
T.C. Memo. .1984-117.
Where the property in question is residential in character,.
a further limitation with potential bearing on business-related
deductions claimed under section 162 or 167 is.contained in
section 280A.
Effective for tax years beginning after 1975, that
statute reads in part:
SEC. 280A.
DISALLOWANCE OF CERTAIN EXPENSES IN
CONNECTION WITH BUSINESS USE OF HOME,
RENTAL OF VACATIONS HOMES, ETC.
(a) General Rule.--Except as otherwise provided in
this section, in the case of a taxpayer who is an
individual or an S corporation, no deduction otherwise
allowable under this chapter shall be allowed with
respect to the use of a dwelling unit which is used by
the taxpayer during the taxable year as a residence.
*
*
*
*
*
*
*
(c) Exceptions for Certain Business or Rental Use;
Lïmitations on Deductions for Such Use.-(1) Certain business use.--Subsection (a)
shall.not apply to any item to the extent such
item is allocable to a portion of the dwelling
- 26 unit which is exclusively used on a regular
basis--
(A) as the principal place of business for
any trade or business of the taxpayer,
(B) as a place of business which is used
by patients, clients, or customers in meeting
or dealing with the taxpayer in the normal
course of his trade or business, or
(C) in the case of a separate structure
which is not attached to the dwelling unit,
in connection with the taxpayer's trade or
business.
In the case of an employee, the preceding sentence
shall apply only if the exclusive use referred to
in the preceding sentence is for the convenience
of his employer.
(2) Certain storage use.-- * * *
(3) Rental use.-- * * *
B.
Amortization of Residence Improvements
The parties stipulated as follows:
"KareMor expended monies
for lavish improvements to PETITIONERS' personal residence.
Based upon those expenditures KareMor claimed amortized expenses.
RESPONDENT does not dispute the amounts claimed but disputes the
deductibility."
1996,
Petitioners seek deductions of $313,576 for
$549,028 for 1997, and $566,559 for 1998.
Both petitioners and respondent devote extensive discussion
on brief to whether the expenditures by KareMor for improvements
satisfy the threshold business purpose criterion pertinent to
deductibility under either section 162 or 167.
Respondent argues
that the amounts were not expended for ordinary and necessary
- 27 business purposes, while petitioners contend that creation of a
"trophy house" generates an ordinary and necessary business
expense akin to an outlay for marketing, promotion, or
advertising.
Respondent then goes on to argue that,
additionally, the standards for deductibility under section 280A
must be met but are not on these facts.
Petitioners, in
contrast, maintain that section 280A does not apply.
position is:
Their
"Respondent's reliance on §280A is misplaced for
the simple reason that that section deals with 'use of a
dwelling,' meaning use of a dwelling as a facility, not use of a
dwelling as a trophy house aka billboard in lieu of money spent
for highway billboard or other media purchases, such as radio,
t.v. and newsprint."
Because the Court concludes that section 280A is applicable
to petitioners' situation and that petitioners fail to meet the
requirements imposed therein, we find it unnecessary to probe
further the intricacies of sections 162 and 167.
Even assuming
arguendo that the improvements could be considered sufficiently
business-related in a multilevel marketing enterprise such as
petitioners'
to support deductibility under section 162 or 167,
section 280A precludes allowance.
The test of section 280A(a) states the following general
rule:
"Except as otherwise provided in this section, in the case
of a taxpayer who is an individual or an S corporation, no
- 28 deduction otherwise allowable under this chapter shall be allowed
with respect to the use of a dwelling unit which is used by the
taxpayer during the taxable year as a residence."
The plain
language thus mandates that if a dwelling unit is used as a
residence, no deduction is permitted.
For purposes of this rule,
"dwelling unit" is defined in
section 280A(f)(1)(A) to include "a house * * * and all
structures or other property appurtenant to such dwelling unit."
The only exception is for such a unit "used exclusively as a
hotel, motel, inn, or similar establishment."
280A(f)(1)(B).
Sec.
"Use as residence" is likewise a defined term; to
wit, a dwelling unit is used as a residence if it is used "for
personal purposes" during the. taxable year for a number of days
in excess of the greater of 14 days or 10 percent of the days it
is rented at fair value.
turn,
Sec. 280A(d)(1).
Personal use, in
is deemed to have been made of a dwelling unit for a day if
it is used for any part of the day for personal purposes by the
taxpayer or a family member.
Sec. 280A(d)(2).
In the case of an
S corporation, the foregoing rules are applied "by substituting
'any shareholder of the S corporation' for 'the taxpayer'".
Sec.
280A(f)(2).
Given these definitions, petitioners' semantic argument on
this issue devolves into mere sophistry.
There is no doubt that
the property at 4627 East Foothill Drive is a "house".
The
I
/
- 29 -
property was remodeled to become more grandiose, but it still
included a living room, dining room, family room, bedrooms,
bathrooms, etc.
Petitioners slept there, ate there, and had free
access to all areas of the home, gardens, and amenities such as
the pool.
Their grandchildren visited and could go anywhere they
pleased.
Petitioners entertained guests other than distributors
at the property.
Accordingly, 4627 East Foothill Drive was a
dwelling unit used by petitioners as a residence within the
meaning of section 280A.
Because section 280A applies, no deduction is allowed under
"this chapter" unless one of the enumerated exceptions is
satisfied.
"This chapter" refers to chapter 1, Normal Taxes and
Surtaxes, of the Internal Revenue Code and includes both sections
162 and 167, which are contained in part VI of subchapter B of
chapter 1.
Petitioners' apparent suggestion that they can avoid
the strictures of section 280A by meeting the requisites of
section 162 or 167 and their reliance on cases involving tax
years prior to the enactment of section 280A are unfounded.
As this Court has explained:
Section 280A was added to the Internal Revenue
.
Code by the Tax Reform Act of 1976 to provide
"definitive rules relating.to ded.uctions for expenses
attributable to the business use of homes." S. Rept.
94-1236
(1976),
1976-3 C.B.
(Vol.
3)
807,
839.
Prior
to the enactment of section 280A, this Court had
allowed a deduction for an office in an employee's
residence on the grounds that the maintenance of such
office was "appropriate and helpful" under the
circumstances.
Congress felt that clear-cut rules
- 30 -
governing deductibility were needed because of the
administrative burdens which resulted from requiring
taxpayers to substantiate the business element of what
is normally a personal item (i.e., maintenance of a
residence). Additionally, there was the concern that,
under the standards adopted by some courts
(particularly this Court), those which were otherwise
personal expenses were being allowed as deductions.
[Baie v. Commissioner,
refs. omitted.]
74 T.C.
105,
108-109
(1980); fn.
Cases pertaining to taxable years subsequent to the 1976
effective date of section 280A have enforced the statute in the
context of both claimed expenses and depreciation.
For instance,
in Griffith v. Commissioner, T.C. Memo. 1988-445, the taxpayer
claimed business expenses and depreciation with respect to his
residence for tax years both before and after s.ection 280A's
enactment.
For 1974 and 1975, the Court applied the standards
set forth in Intl. Artists, Ltd. v. Commissioner, 55 T.C. 94
(1970), and advocated by petitioners here, but then noted that
section 280A would preclude an allocation between business and
personal use for 1976 through 1978 without a showing of exclusive
business use of a portion of the home.
supra.
Griffith v. Commissioner,
Similarly, addressing tax years 1980 through 1982, the
Court in Hefti v. Commissioner, T.C. Memo. 1988-22, affd. without
published opinion 894 F.2d 1340 (8th Cir. 1989), discussed the
legislative history and observed that "Any personal use of a room
or segregated area will preclude its use in computing
depreciation or other allocable expenditures".
- 31 -
On a related point, petitioners' contention that the
deductions at issue should be allowed notwithstanding section
280A because the house functions as a "trophy house" or
"billboard" and could be characterized as marketing, promotion,
or advertising is essentially a claim that the applicability of
section 280A should turn on the type of business use to which the
otherwise residential property is put.
This position has been
rejected in words that ring true here:
Section 280A provides a broad general rule
requiring disallowance of deductions attributable to
the business use of a personal residence, irrespective
of the type or form of business use.
It is true that
the potential for abuse in this area was typified by
the situation where a taxpayer would make a dubious
claim for a home office deduction. * * * Unfortunately
for the petitioners here, the words of the law which
Congress passed are straightforward and much broader in
their applicability--sufficiently broad as to catch
petitioners in their net. We are not, therefore, at
liberty to "bend" the law, much as we may sympathize
with petitioner's position.
[Baie v. Commissioner,
supra at 110; emphasis added.]
As regards exceptions under section 280A(c), the record does
not show, and indeed petitioners have never claimed, that any are
met here.'
No portion of the residence was used exclusively for
business.
Hence, neither petitioners nor any of their related
entities are entitled to deductions for the capitalized residence
improvements.
5 Petitioners state on brief:
"Never have Petitioners
claimed that (a) their home was a place of business, or (b)
use by distributors was exclusive."
that
- 34 -
Mr. Deihl also testified to approximate acreage of 10 for
the corporate property, "about 1.8" for his home, and "about an
acre, acre plus" for Joe II's residence.
However, no documentary
evidence corroborates these numbers, and square footage in any
event would seem to be a poor basis for allocation when the scope
of landscaping is likely to differ markedly between a showplace
home and more prosaic commercial real estate.
Furthermore, to
the extent that any references to a particular property can be
gleaned from the invoices, these would appear to be weighted
toward the residential premises.
The law.therefore does not
countenance any further deduction for maintenance and
landscaping.
D.
Security
The disputed security services were provided by Michael Reed
and his subcontractors., by Capital Guard & Patrol, Inc., and by
Arizona Protection Agency.
Invoices in the record show that
security services were provided by these entities at both the
corporate property on 24th Street and at petitioners'_ personal
residence on Foothill Drive.
Protection was also provided to
members of the Deihl family when traveling.
Although invoices
were occasionally addressed to KareMor, the disputed security
services were paid and deducted by Mayor during 1997 and 1998 in
the claimed amounts of $192,918.70 and $72,124.64, respectively.
- 35 -
Costs of security at the corporate. property are deductible
as a business expense under. section 162.
On audit, after
extensive review of documentation, respondent allowed deductions
on this basis of $91,372 in 1997 and $24,267 in 1998 that the
record reasonably permitted to be identified and allocated to the
corporate property.
Respondent later stipulated the concession
of an additional $1,100 for 1997, the nature of which has not
been further explained.
Petitioners do not directly allude to
any particular charges disallowed that were in fact attributable
to the corporate premises and not so characterized by respondent.
However, as detailed below in connection with our investigation
of petitioners' complaint regarding security on a trip to Puerto
Rico, the Court has concluded that an additional deduction for
security on the corporate premises is appropriate.
Costs of securing residential property are generally
042
nondeductible under section 280A for the reasons previously
discussed in conjunction with petitioners' claims regarding
capitalized improvements and landscaping.
Mr. Deihl testified ·
that security services were utilized at petitioners' home only
during the latter part of 1996 and early 1997, but this testimony
is patently contrary to the documentary evidence.
Invoices
explicitly show charges for security at the house into at least
March of 1.998, and the record lacks substantiation or explanation
for a number of expenditures beyond that date.
Mr. Deihl's
..
- 36 -
assertion that security expenses were 96 to 97 percent business
in nature and only 3 to 4 percent personal is likewise in direct
conflict with the respective charges shown for the Foothill Drive
and 24th Street properties in the proffered invoices.
Thus, what
testimony was offered concerning the proportion of security costs
attributable to the residence has proven unreliable.
Nor have
petitioners suggested grounds on which any particular expenses
disallowed as potentially residential should not be subject to
the proscriptions of section 280A.
Regarding costs for security while traveling, Mr. Deihl
testified that guards secured merchandise at conventions but also
protected family members, particularly children, by acting as a
buffer between them and the distributors and by escorting them
amongst the various rooms, etc.
Petitioners'
sole and entire
argument on brief addressing security is as follows:
"we find
that Respondent disallowed almost $12,000 in security expense
with respect to security guards during a trip to Puerto Rico in
February of 1998 for Petitioners' training.
Petitioners
testified about the need for security during their business'
trips."
The referenced outlay is evidenced by an invoice from
.
Michael Reed dated February 18, 1998, showing three charges.
The
first is $8,646 for 752 hours, at the stated rate of $11.50 per
hour, on 2/8/98 through 2/21/98, at the location "POST 1".
Next
- 37 -
listed is. $3,000 for Tony, Jennifer, and Karlas "ON EP TRIP TO P.
RICO", on 2/11 through 2/14, at the rate of $250 per guard per
day.
Third is $2,829 for 246 hours, at the rate of $11.50 per
hour, on 2/8/98 through 2/21/98,
at the.location "POST 2".
Respondent allowed $2,829 of the $14,475 total amount as a
deduction and disallowed the remaining $11,646.
Other invoices from Michael Reed contained in the record
show locations "HOUSE" and "PLANT", indicating a practice of
billing based on these two categories.
In examination of the
above-described and less definitive invoice, it appears that
respondent, absent further explanation from petitioners, may
arbitrarily have allowed the lesser charge.
Nonetheless, on the
basis of an invoice for the previous 2-week period, which as
corrected shows an identical 246 hour and 752 hour split for
locations "HOUSE" and "PLANT", respectively, the Court is willing
to allow petitioners an additional $5,817 in security expenses
($8,646 - $2,829) as attributable to the corporate property.6
As to the costs incurred for security while traveling,
Mr. Deihl's testimony convinces us that while a portion may
represent legitimate business expenses, many are far more
6 The Court notes that with respect to the only other 2-week
periods in 1998 for which invoices are in the record, the
documents fail to support a similar allocation either because all
charges are characterized as attributable to "HOUSE" or because
the two locations are listed without specifying the hours or the
charges for a particular location.
- 38 -
personal in nature.
Again, however, the record provides no guide
for any reasonable estimation under Cohan v. Commissioner, 39
F.2d at 543-544.
petitioners'
Therefore, given the state of the record7 and
lack of any explanation or further argument, the
Court is not in a position to conclude that respondent's
allocations, with the limited exception discussed above, are
other then generally reasonable and supported by the available
documents.
E.
Clubs
One of the many subsets of expenditures deducted by
petitioners under the category referred to as training, meetings,
and/or conventions are outlays to Arizona Club, to Gardiner's
Resort on Camelback (also referred to as Gardiner's Tennis
Ranch), and to Gainey Ranch Golf Club.
Mr. Deihl testified that
the Arizona Club is a private social club, charging membership
fees, with restaurant, banquet, and catering facilities.
He
stated that petitioners used the Arizona Club for events such as
business luncheons and training meetings.
They also utilized the
catering services for outside parties at their home.
Additionally, Mr. Deihl testified that the family made personal
use of the club for events including holiday functions and
7 As an additional observation, we point out that at least
$1,800 deducted as a security expense is highly suspect in that
invoices show the amount was charged to provide band music and
three carolers at a Christmas party.
- 39 -
children's parties.
He estimated that 80 to 85 percent of the
use was for business purposes and that 15 to 20.percent was for
pleasure or personal purposes.
Gardiner's Resort, according to Mr. Deihl, is a private
tennis club where petitioners hosted certain smaller KareMor
meetings and events.
It was Mr. Deihl's testimony that all use
of Gardiner's Resort was business rather than personal in nature.
As regards Gainey Ranch Golf Club, petitioners offered no mention
of this facility either at trial or on brief.
The record contains a number of invoices from each of these
clubs, and the descriptions of the charges thereon typically fall
into one of three general categories.
The majority of the
descriptions include one or more words indicating food or drink
services (or tips in connection therewith), such as "Restaurant",
"Dinner", "Lunch", "Food", "Bev", "Wine", "Bar", "Banquet",
"Caterout",
"Tip", etc.
A smaller number of the descriptions
indicate equipment rentals, requested services, or labor in
connection with catered events.
The remaining descriptions
principally comprise membership dues, finance charges, late fees,
or contributions to an employee Christmas fund.
As previously indicated, section 274 imposes limitations on
expenses relating to entertainment and associated facilities
beyond the general business purpose criterion of section 162.
Section 274(a) reads as follows:
- 40 SEC. 274.
DISALLOWANCE OF CERTAIN ENTERTAINMENT,
EXPENSES.
ETC.,
(a) Entertainment, Amusement, or Recreation.--
(1) In general.--No deduction otherwise
allowable under this chapter shall be allowed for
any item-(A) Activity.--With respect to an
activity which is of a type generally
considered to constitute entertainment,
amusement, or recreation, unless the taxpayer
establishes that the item was directly
related to, or, in the case of an item
directly preceding or following a substantial
and bona fide business discussion (including
business meetings at a convention or
otherwise), that such item was associated
with, the active conduct of the taxpayer's
trade or business, or
(B) Facility.--With respect to a
facility used in connection with an activity
referred to in subparagraph (A).
In the case of an item described in subparagraph
(A), the deduction shall in no event exceed the
portion of such item which meets the requirements
of subparagraph (A) .
(2) Special rules.--For purposes of applying
paragraph (1)-(A) Dues or fees to any social,
athletic, or sporting club or organization
shall be treated as items with respect to
facilities.
(B) An activity described in section 212
shall be treated as a trade or business.
(C) In the case of a club, paragraph
(1) (B) shall apply unless the taxpayer
establishes that the facility was used
primarily for the furtherance of the
taxpayer's trade or business and that the
- 41 -
item was directly related to the active
conduct of such trade or business.
(3) Denial of deduction for club dues.-Notwithstanding the preceding provisions of this
subsection, no deduction shall be allowed under
this chapter for amounts paid or incurred for
membership in any club organized for business,
pleasure, recreation; or other social purpose.
Regulations further define entertainment as "any activity
which is of a type generally considered to constitute
042
entertainment, amusement, or recreation, such as entertaining at
night clubs, cocktail lounges, theaters, country clubs, golf and
athletic clubs, sporting events, and on hunting, fishing,
vacation and similar trips", sec. 1.274-2(b)(1)(i), Income Tax
Regs., and explain:
An objective test shall be used to determine whether an
activity is of a type generally considered to
constitute entertainment.
Thus, if an activity.is
generally considered to be entertainment, it will
constitute entertainment for purposes of this section
and section 274(a) regardless of whether the
expenditure can also be described otherwise, and even
though the expenditure relates to the taxpayer alone.
This objective test precludes arguments such as that
"entertainment" means only entertainment of others or
that an expenditure for entertainment should be
characterized as an expenditure for advertising or
public relations. * * * [Sec. 1.274-2(b)(1)(ii), Income
Tax Regs.]
Turning to the situation before us, the Court is satisfied
that the Arizona Club, Gardiner's Resort, and Gainey Ranch Golf
Club are clubs within the meaning of the above-quoted statute and
regulations.
Section 274(a)(3) operates as a complete and
outright ban on any deduction for club membership dues.
Pursuant
- 42 -
to regulations, this rule applies to "membership in any club
organized for business, pleasure, recreation, or other social
purpose", which definition includes, but is not limited to,
"country clubs, golf and athletic clubs, airline clubs, hotel
clubs, and clubs operated to provide meals under circumstances
generally considered to be conducive to business discussion."
Sec.
1.274-2(a)(2)(iii)(a),
Income Tax Regs.
Membership dues and
related charges paid to the Arizona Club, Gardiner's Resort, and
Gainey Ranch are therefore nondeductible.
With respect to other amounts paid to clubs, legislative
history accompanying passage of section 274(a)(3) in 1993, after
stressing the blanket disallowance for club dues, states:
"Specific business expenses (e.g., meals) incurred at a club are
deductible only to the extent they otherwise satisfy the
standards for deductibility."
H. Conf. Rept. 103-213, at 583
(1993), 1993-3 C.B. 393, 461.
Here, the record fails to show
that the payments made to the Arizona Club, Gardiner's Resort,
and Gainey Ranch do so.
Petitioners claimed expenses under the
characterization of training, meetings, and/or conventions but
have offered insufficient evidence tyo connect any of the
expenditures to a particular business outing or function.
Generalized testimony and unsupported estimates regarding
business use constrain us to rely on the invoices themselves.
These invoices indicate meal and entertainment expenditures
- 43 -
subject to a number of restrictions under section 274, and
petitioners have not shown otherwise.
Even leaving aside
potentially applicable limitations under section 274(a) and (n),
it is enough to note that petitioners have in any event failed to
substantiate the expenditures pursuant to the exacting strictures
of section 274(d).
F.
Entertainment
With respect to various other specific expenditures claimed
either under training, meetings, and/or conventions or under
promotion, petitioners offered testimony suggesting a connection
to activities or functions of a nature generally thought to
pertain to entertainment.8
Although petitioners deducted these
amounts as expenses for training, meetings, and/or conventions or
for promotion, they once again failed to offer any evidence that
would link the costs to any particular business function or event
or would show that the standards of section 274 should not apply.
8 As noted in our preliminary remarks, with respect to a
substantial portion of the items deducted as expenses for
training, meetings, and/or conventions or for promotion,
petitioners failed to address the specific expenditures at trial
or on brief.
It is here in particular that the Court is
unwilling to rely on the self-serving characterizations used in
the general ledgers or mere credit card charge statements, which
standing alone do little to establish even a threshold business
purpose. We are equally unwilling to credit petitioners' blanket
assertion that all charges to their "company" card were properly
business related.
Such a position simply is not credible on the
record presented.
- 44 -
More than $11,000 was reported as paid to Aramark Sports &
Entertainment in June of 1998, but no invoices or bills are
contained in the record.
The sole testimony regarding these
amounts was the following statement by Mrs. Deihl:
"I believe
those are entertainers that we hired because we used to for the
conventions and different events that went on we would hire
dancers and magicians and all, sort of entertainers."
Similarly,
Mrs. Deihl testified as to payments to Arizona Arts Chorale in
March of 1997 deducted by KareMor:
"Arizona Arts Chorale I
believe is a local chorus or singing group", which was hired to
"Entertain distributors" for business events.
While the Court
has little doubt that petitioners did employ various entertainers
in conjunction with business functions, this generalized
testimony is insufficient to establish the deductibility of any
particular outlay for purposes of either section 162 or section
274.
A like problem exists with respect to payments to Affairs
Unlimited in the amount of $6,000 made in September of 1997 and
deducted by KareMor and in the amount of .$11,372.56 made in
November of 1997 and deducted by Mayor.
the record is:
The sole explanation in
"They're a staging company.
decor for parties."
They set up sets and
The Court was not provided with evidence or
facts about the nature of any specific "parties" that would
support deductibility of these items.
- 45 -
In at least two instances, petitioners apparently attempted
to deduct tickets purchased to entertainment events produced by
third parties.
An expenditure labeled "TICKET SALES" for ASU
Gammage in October of 1998 was deducted by KareMor under the
training, meetings, and/or conventions category, and Mrs. Deihl
testified:
"I do know, I do vaguely recall the fact that we took
quite a few distributors during one of the meetings or
e
conventions that was here to Gammage for a program.
remember what the program is."
I don't
Petitioners also claimed a
$21,220 deduction through KareMor for tickets to one or more
Arizona Diamondbacks baseball games.
They characterized this
expense as one for meals and entertainment but offered no
evidence or argument at trial or on brief.
Both of these items
would seem to be classic section 274 scenarios, but the
documentation is patently insufficient to validate any
deductions.
G.
Gifts, Awards, or Cash
In the course of the multilevel marketing enterprise,
petitioners through Mayor and KareMor gave away, principally to
distributors, substantial quantities of cash and merchandise.
These items were generally intended to serve a motivational
purpose, generating incentive and excitement.
In some instances,
random cash awards presumably served an additional purpose of
encouraging distributors to attend business program
- 46
presentations.
-
Concerning the deductibility of such items, the
parties focused their discussion and arguments at trial and on
brief on the following categories:
Neiman Marcus,
Cash, items purchased at
items purchased at Landmark Jewelers Ltd.
(other
than Rolex watches), Rolex watches, items purchased at Saba's
Western Wear,' and Boss Day Planners.
As relevant here, the proper standard for determining the
deductibility of the various items given away by petitioners'
corporations depends upon which of two broad characterizations is
applicable to each item.
Memo. 2000-330, affd.
See, e.g., Dobbe v. Commissioner, T.C.
61 Fed. Appx. 348
(9th Cir. 2003); Jordan
v. Commissioner, T.C. Memo.
1991-50; McCue v. Commissioner, T.C.
Memo.
Commissioner, T.C. Memo.
1983-580; St. John v.
1970-238.
Deductions for business gifts within the meaning of section
274 are flatly disallowed to the extent that the expense for
gifts to a particular individual exceeds $25 for the taxable
year.
Sec.
274(b)(1);
sec.
1.274-3(a),
I_ncome Tax Regs.
The
term "gift" for purposes of this section is defined as "any item
excludable from gross income of the recipient under section 102
which is not excludable from his gross income under any other
* Due to the abbreviations and other simplification used in
many of the documents in the record, the precise name of various
of the establishments at which claimed expenditures were incurred
is unclear.
The Court therefore has sought merely to enable a
reasonable identification of the vendors based on available
information in the record.
- 47 -
provision of" chapter 1 of the Internal Revenue Code.
274(b)(1); sec.
1.274-3(b)(1),
statutory sense, in turn,
285
(1960)
A gift in this
"proceeds from a 'detached and
disinterested generosity'".
278,
Income Tax Regs.
Sec.
Commissioner v. Duberstein, 363 U.S.
(quoting Commissioner v. LoBue,
(1956)); see also Dobbe v. Commissioner, supra.
351 U.S. 243,
246
Such business
gifts not in excess of $25 are deductible to the extent that the
strict substantiation rules of section 274(d) are satisfied.
In contrast, expenditures for transfers made in recognition
of past services or as an incentive for future performance have
been permitted as deductions under section 162 on grounds that
they involve compensation includable in the gross income of the
recipient.
See, e.g., Dobbe v. Commissioner, supra; McCue v.
Commissioner, supra; St. John v. Commissioner, supra.
Prizes and
awards to sales personnel have been placed in this category.
See, e.g., Dobbe v. Commissioner, supra; Jordan v. Commissioner,
supra; McCue v. Commissioner, supra.
Concerning the cash, Mr. Hartmann and Mr. Deihl testified
with regard to petitioners' practices in giving away cash at
distributor conventions.
They refer to a convention event known
as "Make Joe pay" time, when Mr. Deihl would hand out "cash
prizes" or "awards" ranging from approximately $500 up to $2,500.
Mr. Deihl also mentioned gimmicks such as taping $20 bills under
chair seats for random recipients.
- 48 Based on this testimony, the Court is satisfied that
petitioners did use cash as an incentive or award to motivate
distributors, and these sums would conceivably be deductible
under section 162 as payments for past or future services.
Respondent likewise apparently accepted this view and accordingly
allowed a deduction for cash that petitioners were able, through
documentary evidence, to show was employed in such a manner.¹°
Specifically, petitioners provided one convention agenda listing
giveaways of $2,100, and respondent permitted a deduction for
that amount.
For a greater deduction, petitioners rely on the
categorical statement that a.ll cash claimed by petitioners as a
training, meetings, and/or convention expense or as a promotion
expense was "Absolutely" not used for personal purposes.
However, without more corroboration, the Court cannot credit such
a blanket assertion and is left without a basis for estimate.
Furthermore, regarding diversions such as the random taping
of smaller bills under chairs, the underlying motive would appear
to be more disinterested than compensatory.
Petitioners would
have no idea what attendee would select a particular seat, and
that individual could be a child or an accompanying friend or
family member as to whom any compensatory rationale would be a
¹° Respondent also permitted Mayor deduction in 1997 of
claimed cash amounts that the record established were used to pay
in cash specific service providers employed for business
purposes.
Petitioners have not alleged comparable facts with
respect to any further cash amounts.
.
- 49 far greater stretch.
Hence, these amounts would appear to be
business gifts subject to the strictures of section 274 and not
substantiated as requirèd therein.
With respect to purchases made at Neiman Marcus, Mr. Deihl
testified:
"we purchased items.there and gifts for all the
advisory boards and for the Crowns at all the conventions and
things of that nature.
We also purchased the--some Christmas
gifts for the employees from Neiman Marcus every year."
He
offered additional details.in the following colloquy on direct
examination:
Q
For what purpose did you use Neiman Marcus,
what kinds of purchases?
A
Well, it would be three separate things.
would be gifts from their gift gallery to the
individuals.
One
Q
Stop there. Gift from their gift gallery to
be. used as gifts or to be used as rewards?
042
A
To be used as, the purchase could be either
one, for rewards or gifts.
I cannot determine what
that is from there. But they also supplied some of the
gowns for the ladies in question that would come from
Neiman Marcus also.
Q
To .your knowledge any personal expenditures?
I should say expenditures in Neiman Marcus for personal
use? Without looking at the documents, just a general
question, Mr. Deihl, just a general question.
A
Well, .most of the time when we did things at
Neiman Marcus on behalf of the company we used the
company's credit card, an American Express card.
In
private uses we'd use our Neiman Marcus charge card
which is a separate structure entirely.
- 50 -.
The testimony pertaining to Landmark Jewelers was similar in
that Mr. Deihl indicated that purchases were made at the jewelry
store for both promotional rewards and "actual gifts".
He
further stated that he did not "recall" making any personal
purchase at Landmark Jewelers ·during the years in issue, although
Mrs. Deihl admitted that personal items had been bought at
Landmark Jewelers in earlier years.
Likewise, Mr. Deihl
testified to having purchased at Saba's "little cowboy boot
trinkets" to give away to convention participants.
However, he
also conceded that he made personal clothing purchases at Saba's
as well.
Hence, as .to each of the foregoing establishments, the
record supports that purchases falling into more than one of the
various categories that affect deductibility, i.e., compensatory
awards, business gifts, and personal items, were made.. Some
charges are therefore potentially allowable under section 162
alone, others are limited by section 274, and still others are
nondeductible under section 262.
Yet the record is insufficient
for the Court to differentiate and separate the actual charges
claimed into the appropriate categories.
Petitioners generally
chose not to offer item-by-item explanations,¹¹ and with the
¹¹ In. one instance, Mr. Deihl was questioned at trial about
a particular invoice item from Landmark Jewelers, namely, a
$13,900 sapphire, diamond, and platinum ring.
His response was:
"Sapphire is one of the achievement levels that we have in the
(continued...)
- 51 -
multiple possibilities that exist, including a category mandating
strict substantiation under section 274, the Court is in no
position to guess.
As regards Rolex watches, Mr. Deihl testified concerning how
these items were given away as prizes at conventions to topperforming distributors.
The Court is satisfied that petitioners
did in fact give away Rolexes as compensatory awards potentially
deductible under section 162.
The documentary record includes
two charges specifically identified as for Rolex watches, made at
Landmark Jewelers in May and September of 1997.
However, only as
to the September purchase does the record offer any evidence that
could tend to corroborate that the particular watch was employed
as a prize at a convention in the manner suggested.
Based on the
agenda for the KareMor convention held in the Fall of 1997, the
Court would be willing to find that a $13,400 business expense
for a Rolex watch had been substantiated and would be allowable
were it not for the consideration discussed in the following
paragraph.
Otherwise no sufficient evidence was presented, and
the possibility of personal use was also addressed only by
uncorroborated testimony that no Rolex watches were bought for
family members.
l¹(...continued)
organization.
But as I sit here at this point in time I don't
remember how this was done or whether it was done for Women of
KareMor or something of that nature." Such testimony only
underscores the shortcomings of the record in these cases.
- 52 An additional problem was highlighted in the testimony,
which problem applies to the Rolex watches as well as to the
other alleged incentive awards.
To wit, the record leaves
substantial uncertainty surrounding the issuance of Forms 1099,
Miscellaneous Income, to the distributors.
Mr. Deihl on several
occasions made statements to the effect that:
"everybody in the
company received a 1099 that would have included any cash or
Rolexes or any other prizes that they won to my knowledge", along
with "all their commissions and everything else they've earned."
On this point, the Court observes that petitioners' entities
claimed substantial deductions under the category "commissions",
separate and apart from. the deductions in dispute in these
proceedings.
No attempt has been made to elucidate us as to how
the commission deductions were computed vis-a-vis the amounts
assertedly reported on Forms 1099 and the amounts claimed for the
various incentive awards under training, meetings, and/or
conventions, under promotion, or under suspense.
As a result,
the record is ambiguous as to how the amounts deducted as
commissions were determined and whether there exists any
potential for a double deduction if additional amounts were to be
allowed for incentive awards.
For all of the reasons discussed
above, the state of the record renders it inappropriate to permit
any further deduction for the motivational giveaways.
- 53 -
The final type of giveaway addressed by the parties was
separately discussed on brief and appears to have been given
principally for purposes other than motivation.
Boss Day Planners, Mr. Deihl testified:
Concerning the
"As a new distributor
came on board he received a day planner which also contained all
the policies and procedures of KareMor and the code of ethics
that they were to follow and what was dismissible and where we
e
could terminate even the independent distributor for immoral acts
or things of that nature."
The record contains copies of checks
payable to Boss Day Planners, all dated 1999, which total
$136,444.35.
Petitioners, through KareMor, claimed $113,544.35
of this expenditure as a deduction for marketing in 1998.
On brief, respondent concedes that a valid business purpose
supported the outlay to Boss Planners but maintains that the
charges were contested in 1998 and not paid until 1999.
Referencing the checks just described, respondent states:
"each
check is dated after April 14, 1999, the date of settlement of
the dispute between Petitioners and Boss Day Planners."
Petitioners' response to this argument, consisting in its
entirety of two sentences, is as follows:
"As to the Boss
Planners marketing expense, Respondent recognizes (opening brief,
p.66) that the payments were made but not until after April 14,
1999.
However,
1999 is a closed year and thus, the deduction
should be permitted for 1998."
- 54 -
Petitioners apparently do not contest the underlying facts
upon which respondent's argument relies but instead offer,
without further explanation or support, what would seem to be a
novel legal theory.
Section 461 provides general rules with
respect to the proper year for taking deductions, which in turn
rest in part on the taxpayer's method of accounting under section
446.
An accrual method taxpayer, such as KareMor and Mayor in
these cases, is typically entitled to a deduction "in the taxable
year in which all the events have occurred that establish the
fact of the liability, the amount of the liability can be
determined with reasonable accuracy, and economic performance has
occurred with respect to the liability."
1(c)(1)(ii) (A),
461(h)(1),
1.461-1(a)(2)(i),
Secs. 1.446-
Income Tax Regs.; see sec.
(4).
The first prong of the above test requires the existence of
the liability to be fixed and noncontingent.
Commissioner, 84 T.C. 969,
977 (1985).
Vastola v.
The second prong
addresses amount, and the interaction of these two requirements
is illustrated by regulation:
While no liability shall be taken into account before
economic performance and all of the events that fix the
liability have occurred, the fact that the exact amount
of the liability cannot be determined does not prevent
a taxpayer from taking into account that portion of the
amount of the liability which can be computed with
reasonable accuracy within the taxable year.
For
example, A renders services to B during the taxable
year for which A charges $10,000.
B admits a liability
to A for $6,000 but contests the remainder.
B may take
- 55 -
into account only $6,000 as an expense for the taxable
year in which the services were rendered.
[Sec. 1.4611(a)(2)(ii),
Income Tax Regs.]
Thirdly, economic performance generally occurs in connection with
the provision of services or property as the services or property
is provided.
Tax Regs.
Sec. 461(h)(2) (A); sec.
1.461-4(d)(2)(i),
Income
An exception to this rule, under which economic
performance is deemed to occur only when payment is made, applies
in specified circumstances where the liability to make payments
arises, inter alia, out of a breach of contract.
Sec. 1.461-
4(g)(2), Income Tax Regs.
Here, the record lacks any specific information with regard
to the nature of the underlying.dispute and settlement with Boss
Day Planners.
Consequently, the Court is unable to ascertain
whether any, much less all, of the three requirements for accrual
have been satisfied.
We are faced with a situation where
petitioners do not dispute that they contested at least a portion
of the charges attendant to the Boss Day Planners transaction in
1998, they have not established any particular amount as to which
they had agreed by the end of the taxable year, and they made no
payments during the taxable .year.
deduction in these circumstances.
The Court cannot countenance a
- 56 -
H.
Clothing
Among the expenditures claimed by petitioners under the
categories of training, meetings, and/or conventions or of
promotion were a number of charges incurred at establishments
such a Capriccio's Apparel, Battaglia Shop, Saba's Western Wear,
Bardelli Apparel, Cuzzens Forum, Danese Creations, Andrelani, and
Neiman Marcus.
The sole documentary evidence for the majority
of these expenditures consists of credit card statements showing,
if anything, a one- or two-word explanation such as
"APPAREL/ACCESSORIES".
Only for purchases at Neiman Marcus do we
have any appreciable number of invoices.
Petitioners did not testify specifically as to any of these
charges but did offer generalized statements about their
purchases at these establishments.
Mr. Deihl stated that
Capriccio's Apparel was a women's fashion store, where Mrs. Deihl
and other women of the family would purchase gowns to be worn on
a one-time basis.
He likewise explained that Battaglia Shop was
a highend men's and women's clothing store where purchases "for
business purposes" were made.
His testimony about Saba's,
previously alluded to, admitted that both business and personal
purchases were made at the western wear shop.
Petitioners' position on and rationale for the deductibility
of such items was expounded in the following testimony:
- 57 Q
And describe for the Court your method of
operation with respect to wardrobe or costume for those
in your company participating at the conventions?
A
Well, if you're going to give the appearance
of affluence you have to be capable of looking the
part. And obviously wearing a different suit between
the morning session and the evening session has bearing
on it. More so with the women.
As I said earlier, we worked the tables, both my
sons and their wives and my wife. We would visit all
5,000 people. We would talk to all five, shake hands
with them, turn around and they would have met all
three of the families during that last night at that
last time.
So it would be imperative that the gowns
worn by the girls especially could not be the same ones
that they had on at an earlier function because they
were always a constant reference at the tables by the
distributors saying "What a beautiful gown."
"Isn't
that gorgeous."
It was obviously over the top type dress.
I mean
you couldn't wear it to the grocery store or the gym or
anything but it was done on purpose so that all the
children and everybody else had matching outfits on and
it just generated the enthusiasm backwards from them
that they wanted to be and participate.
Q
* * * The wardrobe we're talking about that
was paid for by the companies?
A
Yes.
Q
And what was the policy as to whether the
women could wear the dress more than once?
A
No. The dress, once the dress had been seen
it could not be seen again.
Q
And then what happened to the dress?
A
They all went to charity or were just given
away to third parties.
Q
men?
And what rule,
if any, with respect to the
- 58 -
A
The men was a little bit easier because most
of the time they would just have to have tuxedos. Our
requirement on the men was that they just couldn't--you
can't just walk into and buy a tuxedo at Men's
Wearhouse and expect somebody to say, "Gee, that's a
great looking piece of garment." It's how it's
tailored and how it fits that has more intensity to it.
*
*
*
*
*
*
*
Q
What was the rule with respect to the men as
to whether they were to wear the clothing purchased by
the company for reasons other than company purposes?
A
There was a six month rule: they had to
rotate suits or tuxes, clothing, at least they couldn't
wear the same tie and pushout or anything else like
that.
And the suit had to be rotated out so that
nobody saw them and they could say, "Hey, you were
there in that suit yesterday or the day before."
* * *
Q
What was the rule, if any, with respect to
whether the men could wear the clothing other than for
a company function?
A
It was never stated as such but nobody did
it, only because you were always overdressed whenever
you went into something.
I mean when you--the exact
same tie and shirt and went with the exact same suit so
it was a perfect fit and appearance. Now, you may have
six different ties and shirts for that suit.. But, you
know, if you walked down the street in it you would
almost look like a model walking around.
The test for the deductibility of clothing costs as ordinary
and necessary business expenses under section 162 rests on three
criteria:
The clothing must be (1) required or essential in the
taxpayer's employment,
(2) not suitable for general or personal
wear, and (3) not so worn.
1290
(1980); Yeomans v.
(1958); Bernardo v.
Hynes v. Commissioner, 74 T.C. 1266,
Commissioner,
Commissioner,
30 T.C.
T.C. Memo.
757,
767-768
2004 199.
In
- 59 -
applying the second prong, some cases have reflected a subjective
gloss, while others have taken an objective approach.
For
instance, as this Court recently explained:
The subjective test applied by this Court in
Yeomans v.
Commissioner, 30 T.C.
757,
768
(1958)
["not
suited for her private and.personal wear"] has been
specifically rejected by the Court of Appeals for the
Fifth Circuit in favor of an objective test, which
denies a business expense deduction for the cost of
clothing that is "generally accepted for ordinary
street wear" (i.e., for ordinary street wear by people
generally rather than by the taxpayer specifically).
Pevsner v. Commissioner, 628 F.2d 467, 470 (5th Cir.
1980),
revg. T.C. Memo,
1979-311 * * *
[Bernardo v.
Commissioner, supra.]
We further noted that the objective test "casts a wider net."
Id.
Here, petitioners cite Yeomans v. Commissioner, supra, while
respondent points to Pevsner v. Commissioner, supra.
However,
the difference in approaches is immaterial in that petitioners
have not established that they met either test.
A substantial
042
majority of the outfits revealed in photographs introduced by
petitioners of various events and conventions, albeit often
formal, are tasteful and would not be out of place in a myriad of
business or social settings where participants are expected to
"dress up".
Although a few of the ensembles do trend toward the
"costume" appellation that petitioners urge, petitioners have
made no attempt to show any linkage between specific charges and
the corresponding articles of clothing.
Hence, petitioners
clearly fall short of deductibility under an objective approach.
- 60 -
Even under a subjective methodology, the evidence in the
record is simply insufficient to permit a deduction.
Assuming
arguendo that a once-wear policy would render clothing unsuitable
for personal wear in petitioners' particular situation, Mr.
Deihl's generalized testimony does little to show that each of
the claimed charges was in fact for the purchase of such a oncewear item.
As respondent notes, among the Neiman Marcus charges
is one showing two turtlenecks at $165 each.
We are unconvinced
that Mr. Deihl's testimony is not overly broad and exaggerated,
and we are left with no reasonable basis on which to make any
estimate as to legitimately once-wear garments.¹²
I.
Equipment and Furnishings
The credit card statements submitted in conjunction with
expenditures claimed under training, meetings, and/or conventions
and under promotion also reflect purchases at various
establishments labeled with descriptions indicating some form of
equipment,
furnishings, or similar items.
For instance,
petitioners seek to deduct charges to Circuit City and Best Buy
characterized as "ELECTRONICS/APPLIANCES".
Petitioners'
¹² As a final observation, we note that an additional basis
for disallowance rests in the fact that Mr. Deihl indicated that
garments were given to charity, thereby raising the possibility
of a double deduction absent evidence that these amounts were not
already incorporated in the charitable contribution deductions
claimed by the various related entities.
- 61 -
testimony with respect to expenses of this genre consists in its
entirety of the following from Mrs. Deihl:
Q
Okay.
I also see some major expenses for
Circuit City during that time frame; do you know what
these were for?
A
The only thing I can think of is it would be
computers but I'm not really sure.
Q
Computers for personal use or for--
A
No. Computers--
Q
--business?
A
No, for business use.
It would either be
computers or equipment for the company or for the
buildings.
Given the admitted ambiguity in this testimony, i.e., Mrs. Deihl
conceded that she was "not really sure", petitioners have failed
to establish either what was purchased or the business use
therefor.
Moreover, computers or peripherals would be subject to
the strict substantiation rules of section 274(d) as listed
property, absent a showing that the exception set forth in
section 280F(d)(4)(B) should apply.
Petitioners also claim an outlay by KareMor on September 5,
1997,
to Synthony Music for "MUSICAL EQUIP/ACC/SVC", as to which
Mrs. Deihl testified:
"Probably in-house, I would. think that was
part of the in-house recording equipment that we have."
From
this obtuse statement, the Court can draw little and certainly
not adequate substantiation of a business expenses under section
162.
- 62 As representative of the vast collection of expenditures
left unexplained, the Court further notes a similar difficulty
with a number of credit card charges that refer to furniture,
furnishings, home furnishings, leather furnishings, and related
items, as well as to charges at Bed, Bath & Beyond.
outlays for luggage.
Or consider
Without evidence, business relationship is
mere speculation, an endeavor not within the purview of this
Court.
Nonetheless, as to a charge for exercise equipment,
Mr. Deihl testified with specificity that the purchase was for a
workout center for employees at the office complex and
distinguished the more expensive gymnasium structure purchased
for his home.
The Court concludes that the $665.74 April 2,
1997, KareMor charge is a deductible business expense.
J.
Travel
The disallowed deductions include several charges that the
credit card statements indicate were for airline tickets to
destinations such as Brazil, Ireland, and Iceland.
Mr. Deihl
testified generally that attorneys, including Mr. Hartmann, were
sent on "Business related" travel.
He stated that an individual
involved in marketing and promotion, Jim Palasota, was sent to
Iceland "To do a training meeting and for the business."
Mr. Deihl also affirmed that he went to Ireland "Because we were
looking to expand our facilities into Ireland and we were invited
- 63 -
there by the Irish government".
He likewise asserted globally
that he had never taken a vacation or an airline trip for
personal reasons during the years in issue.
No details of any of
the trips were offered.
Leaving aside other potentially applicable limitations, the
Court observes that any deduction for travel would at minimum
require compliance with the strict substantiation provisions of
section 274(d).
Yet Mr. Deihl's testimony in this regard, not to
mention the uninformative credit card documents, falls woefully
short.
We do not even know the dates of the travel.
No
deduction is permitted.
K.
Contributions
Petitioners' records or testimony link several expenditures
to the idea of a contribution and/or charitable entity.
For
example, concerning an $800 May 6, 1996, Mayor check to New
Arizona Family characterized in the general ledger as for "Golf
Registration", Mr. Deihl testified:
"The New Arizona Families,
it's a charity here in town that we helped co-sponsor and
participated in a golf outing with them."
Petitioners sought to
deduct the amount under training, meetings, and/or conventions.
A.$1,000 June 3, 1997, KareMor charge to Phoenix Zoo was labeled
on credit card statements as "ADMISSION/TICKETS", but Mrs. Deihl
testified:
Zoo."
"I would assume it was a donation to the Phoenix
The amount was claimed under promotion.
64 -
A KareMor December 31, 1998, ledger entry for $25,840 to the
Heart Association, likewise deducted under promotion, was allowed
to the extent of $23,440, and the balance of $2,400 was denied.
The record contains a receipt from the American Heart Association
issued in connection with the 1998 Heart Ball acknowledging cash
received of $25,000, less a value of $1,560 for 10 seats at the
Heart Ball (including dinner, entertainment, and favors), for a
charitable contribution of $23,440.
No further testimony was
offered.
Petitioners also originally sought deduction of a $5,000
Republican Party contribution for KareMor in 1998 under training,
meetings, and/or conventions.
A $5,000 amount under this heading
was conceded by petitioners in the stipulation of facts without
indication of the specific charge or charges involved.
Petitioners did not present any argument on brief relating to
this expenditure.
The only other expense of $5,000 disallowed
under this category for KareMor in 1998 was one of the payments
to Aramark Sports & Entertainment, and petitioners on brief
requested a finding of fact supporting deduction of outlays to
this entity.
Although petitioners have never articulated any particular
legal theory bearing on the deductibility of the above payments,
we make the following general observations.
Section 170(a)
provides for deduction of charitable contributions made to or for
- 65 -
the use of an organization described in section 170(c) and
verified as required by the statute and corresponding
regulations.
As one example of the requisite verification,
contributions of $250 or more are disallowed unless the taxpayer
substantiates the donation with a contemporaneous written
acknowledgment by the donee.
Sec. 170(f)(8).
Here, only with respect to the American Heart Association
expenditure did petitioners offer a statement in compliance with
section 170(f)(8), and respondent properly allowed a deduction to
the extent supported by that document.
No basis for any greater
deduction has been suggested.
Concerning the other deductions, the record not only reveals
problems under section 170(f)(8) but also raises additional
issues.
Nothing establishes that any were made to qualified
donees.
The $5,000 payment to the Republican Party was
apparently conceded, and political contributions are generally
disallowed in any event.
628-629 (1991).
Cloud v. Commissioner, 97 T.C. 613,
Finally, the Court is not satisfied that the
payments to New Arizona Family and the Phoenix Zoo in fact
represented contributions and not some form of entertainment
expenditure subject to section 274.
L.
Promotion or Marketing
There are two other expenditures, one of which actually
consists of two separate charges, that petitioners deducted under
-.66 -
the label of either promotion or marketing and as to which they
commented specifically at trial or on brief.
Petitioners claimed
as promotion expenses for KareMor in 1997 payments of $2,000 and
$200 made to Gold's Gym on June 11 and 17, respectively.
A
purchase order and an invoice show that the amounts were paid for
equipment rental, gym rental, and labor in connection with a
"Birthday lift" by Peter Lupus on June 17, 1997.
Peter Lupus was
"the strongman off Mission: Impossible" and "a spokesperson for
the company".
Petitioners also offered a photograph of the June
17 event, about which Mr. Deihl testified:
A
* * * [The photo] is taken in California at
Gold's Gym.
It is Peter Lupus in a KareMor sponsored
event.
He is 65 years of age there. He is lifting a
250,000 pounds in 30 minutes.
VitaMist has rented the
gym. Guinness Book of World Records is there. A
weights and measure officer from the state of
California is there .to determine the weights and the
lifting and the preciseness of everything. Buddy
Hackett was there. Landau I think his name is from
Mission: Impossible also was there. News events were
there and it was promoted and on the news later that.
evening.
Q
And I notice you have VitaMist on the
clothing of--gym clothing I suppose of Mr. Lupus?
A
Mr. Lupus all his clothing had VitaMist made
into it and attached to it, especially his workout
gear.
The picture shows Mr. Lupus decked in VitaMist garb, and the
Court is satisfied that this event represents a promotional
endeavor.
An additional deduction of $2,200 will be permitted.
- 67 -
In contrast, and demonstrating the sharp distinction in how
petitioners supported a few expenses and left the Court to make a
leap of faith about the remainder, petitioners deducted under
marketing for KareMor $72,500 paid to Lifestyle Advantage in May,
June, and July of 1998 for what is characterized in the KareMor
ledger as "Sales Aides".
Respondent noted on opening brief the
absence of any evidence or testimony regarding these outlays.
042
response, petitioners on reply brief offer the following:
in reference to Lifestyle Advantage * * *
In
"And
[the general ledger]
shows that this 1998 expenditure ($72,500) is for 'sales aids'
which should not be surprising, given that Petitioners grossed
$19 million in that year."
Such a statement is utterly useless
to the Court in addressing any elements whatsoever of
deductibility.
No further deduction is warranted for these
payments.
III.
Cost of Goöds Sold
On page 2 of its 1998 Form 1120S, U.S. Income Tax Reburn
for an S Corporation, Mayor included $747,535 of "Purchases" in
computing cost of goods sold.
Respondent disallowed $123,250 of
"Purchases" with the explanation:
"The year end accrued payable
to Arizona Natural Resources in the amount of $123,250 was never
paid, as there was a dispute over this debt.
is not deductible."
Thus the $123,250
During 1998, Arizona Natural Resources,
Inc., manufactured for Mayor a line of cosmetics marketed as the
- 68 -
Sari Collection,¹³ and various payments were made to the company
throughout the taxable year.
However, as shown in a handwritten
notation on an invoice from Arizona Natural Resources and in
Mayor's general ledger, petitioners paid only a portion of a
billed charged and accrued the remaining $123,250 as an
additional account payable as of December 31, .1998.
Petitioners mention the purchases adjustment in their
pretrial memorandum, stating:
"This is a timing issue.
The
dispute was denied and the $123,250 was paid to Arizona Natural
resources [sic], plus interest and attorney fees.
Petitioners
should not be required to go back and amend returns for a year in
which the amount was actually paid."
Petitioners do not discuss
the matter on opening brief, while respondent concedes that
petitioners did incur valid business expenses with respect to the
Sari cosmetic line but argues:
this amount
[the $123,250],
"Because there was a dispute over
it was never paid.
If it were to
have been paid, however, deduction would not be permissible until
the date of payment."
their argument,
sentences:
Petitioners respond on reply brief, with
in its entirety, consisting again of two
"The monies owed Arizona Natural Resources were paid,
but after 1998, and thus, for a period closed for the companies.
Thus, the amount should be deducted for 1998."
¹³ Petitioners from time to time diversified the products
offered through their multilevel marketing structure.
- 69 Hence, although the parties' statements pertaining to this
adjustment are less than a model of clarity, the circumstances
underlying, as well as the parties' arguments with respect to,
the payable to Arizona Natural Resources would appear not to be
materially distinguishable from those concerning the payments to
Boss Day Planners discussed above.
Petitioners contested a
portion of the charges asserted by Arizona Natural Resources and
paid only after resolution of the dispute.
In this connection,
the Court takes judicial notice of litigation filed in 1999 by
Arizona Natural Resources against Mayor, KareMor, and petitioners
individually, which culminated in a judgment in favor of Arizona
Natural Resources for $333,258.13, inclusive of interest,
attorney fees, and costs, on October 8, 2003.
Res.,
Inc. v. Mayor Pharm. Labs.,
Super. Ct.,
Oct.
8,
Ariz. Natural
Inc., No. CVl999-070010
(Ariz.
2003).
Cost of goods sold operates as a reduction in gross income,
rather than as a deduction from gross income.
Income Tax Regs.
See sec. 1.61-3(a),
Nonetheless, the test for determining whether an
accrual method taxpayer is entitled to include an amount in cost of
goods sold is the. same as that for determining the appropriateness
of a deduction.
Secs. id., 1.446-1(c)(1)(ii), Income Tax Regs.
In
other words, an amount may be included in cost of goods s.old "in
the
taxable
year
in
which
all
the
events
have
occurred
that
establish the fact of the liability, the amount of the liability
- 70 can
be
determined
with
reasonable
accuracy,
and
economic
performance has occurred with respect to the liability."
Sec.
1.446-1(c)(1)(ii), Income Tax Regs.
Here, as was the case with the outlay to Boss Day Planners,
the record suggests that some, if not all, of the requisites for
inclusion of the $123,250 in cost of goods sold have not been met.
Respondent is sustained on this issue.
IV.
Reduction in Adiusted Gross Income
The parties'
positions with regard to the propriety of a
reduction in petitioners' 1996 gross income center on the concept
of duplication.
Petitioners contend that unless their gross income
for 1996 is reduced by $550,000, they will be taxed twice on this
amount.
1997
They allege that such a reduction was made with respect to
and
that
Respondent
a
like
contends
treatment
that
an
should
be
adjustment
accorded
was
made
to
for
1996.
1997
to
eliminate duplicate reporting for that year which does not exist
for the 1996 year.
Again, the underlying documentary record on this issue leaves
much to be desired.
1040,
U.S.
Mr. Goltz prepared petitioners' original Forms
Individual
Income
Tax
Return,
for
1996
and
1997.
Subsequently, Mr. Leo prepared Forms 1040X, Amended U.S. Individual
Income Tax Return,
for each of those years.
On the 1996
Form
1040X, petitioners reported an increase in adjusted gross income of
$550,000, derived from an additional $550,000 of nonpassive income
- 71 -
from partnerships and S corporations.
petitioners
reported
$1, 700, 000,
also
an
increase
derived
from
On the 1997 Form 1040X,
in adjusted
an
gross
additional
income
of
$1, 700, 000
of
nonpassive income from partnerships and S corporations.
The adjustments and def iciencies asserted in the statutory
notices for 1996 and 1997 were thereafter computed based on the
amounts
reported
in
the .Forms
1040X.
Among
the
adjustments
reflected in the notice of deficiency for 1997 is a decrease in
income of $1, 700, 000 labeled "AGI CHANGE FORM 1040X" and explained:
"The
$1,700,000
shown
on your
1040X
return
for
the
estimated
increase in income from the related entities is adjusted as shown
above."
No similar adjustment was reflected in the notice of
deficiency for 1996.
Respondent on reply brief addresses the circumstances behind
the difference as follows:
Petitioners' 1997 Forms 1040 and 1040X were prepared by
two different Certified Public Accountants. * * * Insofar
as Petitioners' 1997 Form 1040X reported an amount
previously
reported
in
the
Form
1040,
namely
$1,700,000.00
(now
$1,750,000.00),
the .
examiner
appropriately adjusted Petitioners'
Form 1040X by
reducing Petitioners' income by the duplicative amount.
In taxable year 1996, on the other hand, there were
no such duplicative amounts between Petitioners' Forms
1040 and 1040X. Consequently, Respondent' s examiner made
no similar adjustment in Petitioners' 1996 income as in
their 1997 income. * * *
Thus, respondent offers an explanation as to why a reduction
for the increased adjusted gross income reported on a Form 1040X
- 72 -
would be necessary in calculating a deficiency that is based on the
tax reported in the Form 1040X.
Such could be the case where the
Form 1040X in fact duplicated amounts reported in the original Form
1040.
Petitioners,
in
contrast,
seem
reduction is more uniformly necessary.
to
argue
that
a
like
Such could be the case only
if the deficiency were to be computed based on the tax reported in
the original Form 1040, without giving credit for additional tax
paid with the Form 1040X.
In fact, some of the language used by
petitioners could signal a misunderstanding of the basis for the
1996
and
1997
deficiencies,
although a cursory review of
the
notices and relevant returns shows that the baseline numbers in the
notices were taken from the Forms 1040X, not the Forms 1040.
So long as the amended returns are used as the starting point,
there would generally be no need to eliminate the additional income
reported therein from the deficiency.calculation.
the manner
in which the
Here, although
$1, 700, 000 was duplicated between the
original and amended 1997 returns is not clear from the record,
respondent was entitled to determine and concede on audit that it
had been.
Petitioners have not so much as alluded to, much less
demonstrated,
any analogous duplication between the original and
amended 1996 returns.
Accordingly,
the Court has no grounds for
mandating a concession by respondent of income voluntarily reported
by petitioners on their own Form 1040X for 1996.
- 73 -
V.
Accuracy-Related Penalties
Subsection
(a)
of section 6662 . imposes an accuracy-related
penalty in the amount of 20 percent of any underpayment that is
attributable to causes s.p.ecified in subsection
(b)(1)
of
section
6662
then
provides
that
(b) .
among
Subsection
the
causes
justifying imposition of . the penalty is negligence or disregard of
rules or regulations .
"Negligence" is defined in section 6662(c) as "any failure to
make a reasonable attempt to comply with the provisions of this
title", and "disregard" as "any careless, reckless, or intentional
disregard."
Caselaw similarly states that "'Negligence is a lack
of due care or the failure to do what a reasonable and ordinarily
prudent person would do under the circumstances.'"
Commissioner,
89
T. C.
Commissioner,
380
F.2d 499,
042
issue 43 T.C. 168
1011
(5th Cir.
regulations,
849,
(1964)
1990),
887
506
(1987)
(quoting
(5th Cir.
1967),
and T.C. Memo.
affd.
"'Negligence'
501 U.S.
also
Freytag v.
Marcello
v.
affg.
on this
1964-299), affd.
904 F.2d
868
includes
(1991).
any
Pursuant
failure
by
to
the
taxpayer to keep adequate books and records or to substantiate
items properly. "
Sec . 1. 6662-3 (b) (1) , Income Tax Regs .
An exception to the section 6662(a) penalty is set forth.in
section 6664(c)(1) and reads:
"No penalty shall be imposed under
this part with respect to any portion of an underpayment if it is
- 74 shown that there was a reasonable cause for such portion and that
the taxpayer acted in good faith with respect to such portion."
Regulations interpreting section 6664(c) state:
The determination of whether a taxpayer acted with
reasonable cause and in good faith is made on a case-bycase basis, taking into account all pertinent facts and
circumstances. * * * Generally, the most important factor
is the extent of the taxpayer's effort to assess the
taxpayer's proper tax liability. * * * [Sec. 1.66644(b)(1), Income Tax Regs.]
Reliance upon the advice of a tax professional may, but does
not necessarily, demonstrate reasonable cause and good faith in the
context of the section 6662(a)
penalty.
Id.;
see also United
States v. Boyle, 469 U.S. 241, 251 (1985); Freytag v. Commissioner,
supra at 888.
Such reliance is not an absolute defense, but it is
a factor to be considered.
Freytag v. Commissioner, supra at 888.
In order for this factor to be given dispositive weight, the
taxpayer claiming reliance on a professional must show, at minimum:
" (1) The adviser was a competent professional who had sufficient
expertise to justify reliance,
and accurate
actually
(2) the taxpayer provided necessary
information to the
relied
in
good
faith
Neonatology Associates,
P.A.
v.
(2000),
221
(3d
affd.
299
F.3d
adviser,
and
on
adviser's
the
Commissioner,
Cir.
2002);
(3)
the
taxpayer
judgment."
115
T.C.
see
also,
43,
99
e.g.,
Charlotte's Office Boutique, Inc. v. Commissioner, 425 F.3d 1203,
1212 & n.8 (9th Cir. 2005)
above three-prong test),
(quoting verbatim and with approval the
affg.
121 T.C.
89
(2003); Westbrook v.
- 75 Commissioner,
68 F.3d 868,
881
(5th Cir.
1995),
affg.
T.C.
Memo.
1993-634; Cramer v. Commissioner, 101 T.C. 225, 251 (1993), affd.
64 F.3d 1406
T.C.
158,
(9th Cir.
1995) ;
(1978);
Pessin v.
173
Ma-Tran Corp.
v.
Commissioner,
Commissioner,
70
59
489
T.C..473,
(1972); Ellwest Stereo Theatres v. Commissioner, T.C. Memo. 1995610.
As previously indicated, section 7491(c) places the burden of
production on the Commissioner.
The notices of deficiency issued
to petitioners generally asserted applicability of the section
6662(a) penalty on account of negligence or disregard, substantial
understatement,
sec. 6662(b).
and/or substantial valuation misstatement.
See
Respondent in its pretrial memorandum and on brief
has addressed only negligence or disregard of rules or regulations
as the basis for the penalties, and we shall do likewise.
We conclude that respondent has met the section 7491(c) burden
of
production
evidence
with
adduced
in
respect
to
the
these
cases
negligence
reveals
a
penalties.
serious
adequate records and substantiation for reported items.
threshold showing,
dearth
The
of
With this
the burden shifts to petitioners to establish
that they acted with reasonable cause and in good faith as to the
claimed items.
Petitioners here assert a reliance defense as the basis upon
which they should be relieved of liability for the section 6662 (a)
penalties.
Mr. Deihl, Mrs. Deihl, and Mr. Goltz testified as to
- 76 -
petitioners'
total
reliance
professionals
hired
with
preparation <functions.
on
Mr.
respect
to
Respondent,
Goltz
the
and
the
accounting
other
and
tax
in seeking to counter this
defense, focuses in particular on an alleged lack of competence on
the part of Mr. Goltz.
Petitioners in retort devote substantial
discussion to why their reliance on a professional who essentially
"duped" them was nonetheless reasonable.
unconvinced
that
questions
of
Mr.
The Court, however,
Goltz's
competency
is
are
sufficiently central to this issue to warrant the emphasis placed
thereon by the parties.
The deficiencies at issue were determined from the positions
reported in the amended returns for 1996, 1997, and 1998 prepared
on behalf of petitioners by Mr. Leo.
Any reliance was therefore
necessarily placed in significant part on Mr.
addressed Mr.
Leo.
No one has
Leo's competency in this proceeding.
Matters of
competency, i.e., the first prong of the above-quoted test,
thus
become more tangential to our analysis.
The second prong,
petitioners'
on the other hand,
lies at the crux of
entitlement to the relief sought.
Petitioners must
establish that they provided necessary and accurate information
with respect to all items reported on their tax returns, such that
it can be said that the incorrect returns resulted from error on
the part of the adviser(s).
See, e.g., Westbrook v. Commissioner,
supra at 881; Ma-Tran Corp. v. Commissioner, supra at 173; Pessin
- 77 -
v. Commissioner, supra at 489.
Petitioners here have not done so.
They have shown neither that they initially gave all requisite
information to Mr. Goltz nor that Mr. Leo had available for.his use
sufficient accurate materials to prepare correct returns.
For instance,
did petitioners at one time provide to their
advisers receipts or involces that would substantiate the many
expenditures for which the record contains no documentary evidence?
With
respect
receipts
to
those
or invoices,
items
that
were
did petitioners
reflected
offer to
in available
their advisers
further explanation, particularly in connection with purchases at
retail establishments, as to the intended recipient and/or use of
the articles purchased?
When they were at conventions, potentially
away from their accounting staf f , did they maintain documentation
of
business
personal
expenses
purchases?
that
arose
Were
the
and
carefully
professionals,
segregate
like
the
any
Court,
042
limited in various circumstances to blanket statements that "all"
outlays at a certain location or using a particular credit card
related to the businesses?
What specific information was available
to the advisers with respect to the improvements to petitioners'
residence?
On this record, the Court simply cannot conclude that
petitioners have met the evidentiary burden of the second prong of
the test for reasonable reliance.
The
Court
likewise
has
reservations
.about
petitioners'
compliance with the third prong that flow to a certain degree from
- 78 -
the problems raised.by the first two criteria.
to
reconstruct
records
and
to
prepare
Mr. Leo was hired
corrected
returns,
so
petitioners at that time were well aware of serious deficiencies in
Mr. Goltz's performance in these respects.
To have taken a hands-
off approach at that juncture, relying on Mr. Goltz to provide any
necessary underlying information and explanations, would not seem
consistent with ordinary care and prudence.
It further would seem
to negate a claim that reliance on the resultant product could be
in good faith.
petitioners
descriptions
in
Mr.
Goltz would appear even less
this
that
scenario
had
at
to
one
recall,
time
for
likely than
example,
elucidated
the
verbal
generic
descriptions in receipts, invoices, or credit card statements.
Yet
the record contains no suggestion that petitioners assisted in the
reconstruction in any meaningful way.
On these facts, petitioners have failed to establish that they
met each and every requirement necessary for successful imposition
of a reliance defense.
Petitioners remain liable for the section
6662(a) accuracy-related penalties.
The
Court has
considered all other arguments made by the
parties and, to the extent not specifically addressed herein, has
concluded that they are without merit or are moot.
To reflect the
foregoing and concessions by the parties,
Decision will be entered
under Rule 155.
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