T .C . Summary Opinion 2006-127

T .C . Summary Opinion 2006-127

UNITED STATES TAX COUR T

MICHAEL D . AND CHRISTINE R . ALEXANDER, Petitioners v .

COMMISSIONER OF INTERNAL REVENUE, Responden t

Docket No . 12445-05S . Filed August 21, 2006 .

Michael D . and Christine R . Alexander, pro sese .

Aimee R . Lobo-Berg , for respondent .

PANUTHOS,

Chief Special Trial Judge : This case was heard

pursuant to the provisions of section 7463 of the Internal

Revenue Code in effect at the time the petition was filed . The

decision to be entered is not reviewable by any other court, and

this opinion should not be cited as authority . Unless otherwise

indicated, subsequent section references are to the Internal

Revenue Code in effect for the year in issue, and all Rule

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

SERVED AUG 2 1 2006

2 _

Respondent determined a deficiency of $7,368 in petitioners'

1998 Federal income tax . After a concession by petitioners,' the

issues for decision are : (1) Whether petitioners can deduct

interest paid on a home equity loan as an ordinary and necessary

business expense ; (2) whether petitioners can deduct payments to

their son as wage expense ; (3) whether petitioners can deduct

payments to their daughters as wage expense ; and (4) whether

respondent is estopped from disallowing petitioners' claimed wage

expense deductions .

Background

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

Petitioners Michael Alexander (Mr . Alexander) and Christine

Alexander (Mrs . Alexander) are married and resided in Bandon,

Oregon, at the time their petition was filed . Petitioners filed

a joint Federal income tax return for the taxable year 1998 .

1 .

The Tree Farm

In 1990, petitioners purchased a parcel of land in Port

Orford, Oregon, and began operating a tree farm . Over the next

several years, petitioners purchased various equipment for the

tree farm, including a tractor, two trailers, and a sprayer .

Petitioners paid more than $50,000 for the equipment, which the y

1 Petitioners concede $22,815 of expense deductions claimed

on Schedule E, Supplemental Income and Loss . The remaining

adjustment's in respondent's notice of deficiency are

computational ; therefore, we do not address them .

- 3 purchased using credit cards . Petitioners deducted the interest

payments on the credit card debt on Schedule F, Profit or Loss

From Farming, in prior taxable years .

In or before 1998, petitioners obtained a home equity loan

and used the proceeds to pay off the credit card debt incurred in

connection with the equipment . Petitioners paid $5,8712 of

interest on the home equity loan in 1998 and claimed that amount

as an interest expense deduction on their Schedule F .

Respondent determined that the interest expense was not paid

or incurred in connection with the tree farm and, therefore,

should not be deducted on Schedule F . Instead, respondent

determined that the interest expense should be deducted on

Schedule A, Itemized Deductions .

2.

The Seamstress Busines s

In 1998, Mrs . Alexander operated a seamstress business from

petitioners' home . During that year petitioners' son, Steven,

was a 21-year-old college student in California . When Steven

returned home for the summer, he assisted Mrs . Alexander with th e

seamstress business . Steven performed a variety of tasks such as

purchasing supplies, drafting sewing patterns, and cleaning Mrs .

2 All amounts are rounded to the nearest dollar .

- 4 Alexander's work space . Steven worked 378 hours and was paid

$4,000, for an hourly rate of $10 .58 . 3

Although Steven worked only during the summer, petitioners

paid him the $4,000 over the course of the year . For example,

from January through April 1998, petitioners made payments to

Steven totaling $481 . Petitioners treated these payments as wag e

advances . In November and December 1998, petitioners made

payments to Steven totaling $2,526 . Petitioners paid the

majority of the $4,000 directly to Steven, although a portion wa s

paid to third parties on his behalf .

Petitioners reported gross receipts of $1,301 for the

seamstress business on Schedule C, Profit or Loss From Business,

attached to their 1998 tax return . Petitioners claimed expense

deductions totaling $4,666, of which amount $4,000 represented

the payments to Steven . There is no indication that petitioners

paid employment taxes on Steven's earnings or that they issued

him a Form W-2, Wage and Tax Statement . There is no indication

petitioners filed a Form 940, Employer's Annual Federal

Unemployment (FUTA) Tax Return, or Forms 941, Employer's

Quarterly Federal Tax Return . Respondent disallowed the claimed

wage expense deduction in full .

Petitioners introduced a document they prepared titled

"Steven's Hours", which indicates that Steven earned $4,158, or

$11 per hour . Petitioners did not explain the discrepancy

between the earnings shown on this document and the amount they

actually paid Steven .

3.

The Dog-Breeding Busines s

In 1998, Mrs . Alexander also operated a beagle-breeding

business from petitioners' home . Petitioners' three daughters

assisted Mrs . Alexander with this business throughout the year .

Petitioners' daughters are Margot, who was 17 years old in 1998 ;

JCA, who was 9 years old ; and JRA, who was 8 years old .' The

daughters performed tasks such as cleaning the dogs and the yard

in which they exercised, putting up fencing, taking out the

garbage, and caring for newborn puppies .

Petitioners credited each daughter with $4,250 of earnings,

for a combined total of $12,750 . In general, petitioners did not

pay their daughters in cash . Instead, petitioners kept a running

total of their daughters' earnings . When a daughter wished to

make certain purchases, petitioners bought the goods or services

for the daughter and deducted the purchase price from the

daughter's running total . If the balance of a daughter's running

total was insufficient to make a purchase, the daughter was

allowed to receive an advance or "go negative ." Petitioners did not require their daughters to pay for basic

goods such as food . Their daughters were required, however, to

pay for nonessentials such as their share of family ski trips or

family trips to Disneyland . The daughters also paid for items

such as books, room decorations, toys, movie rentals, and certai n

4 The Court uses only the minor children's initials .

- 6 items of clothing . Petitioners required their children to pay

for such items because they wanted to instill a strong work ethic

in them .

Petitioners reported gross receipts of $4,900 for the dogbreeding business on a separate Schedule C . Petitioners claimed

expense deductions for the business totaling $16,007, of which

amount $12,750 represented payments to their daughters . There is

no indication petitioners issued a Form W-2 to any of their

daughters . Respondent disallowed $12,295 of the claimed wage

expense deduction . It is not clear why respondent allowed the

remaining $455 .

Discussion

In general, the Commissioner's determinations set forth in

a

notice of deficiency are presumed correct, and the taxpayer bears

the burden of showing that the determinations are in error . Rule

142(a) ;

Welch v . Helverina ; 290 U .S . 111, 115 (1933) . Pursuant

to section 7491(a), the burden of proof as to factual matters

shifts to respondent under certain circumstances . We decide this

case without regard to the burden of proof . Accordingly, we need

not decide whether section 7491(a) applies in this case . 5

A taxpayer who is carrying on a trade or business generally

may deduct ordinary and necessary expenses paid or incurred i n

5 Petitioners filed a motion to shift the burden of proof to

respondent . Because the burden of proof does not affect the

outcome of this case, that motion was denied .

- 7 connection with the operation of the business . Sec . 162(a) ; see

also Commissioner v . Lincoln Sav . & Loan Association , 403 U .S .

345, 352 (1971) ;

FMR Corp . & Subs . v . Commissioner , 110 T .C . 402,

414 (1998) . Respondent does not dispute that the tree farm,

seamstress business, and dog-breeding business each qualifies as

a trade or business for Federal income tax purposes . Thus, we

address only whether the expenses are ordinary and necessary ; and

whether they were paid or incurred in connection with the

respective businesses .

1 .

Interest Expense on the Home Equity Loa n

As a preliminary matter, we note that petitioners claimed ar. .

interest expense deduction of $5,951, which respondent disallowed

in full . Petitioners introduced a Form 1098, Mortgage Interest

Statement, which shows $5,871 of mortgage interest paid .

Petitioners did not introduce any evidence with respect to the

remaining $80 of the claimed interest expense deduction . We

therefore consider that petitioners have conceded that amount of

the adjustment . See Nicklaus v . Commissioner , 117 T .C . 117, 120

n .4 (2001) ;

Korchak v . Commissioner , T .C . Memo . 2005-244 n .6 .

Respondent's determination is sustained to the extent of $80 .

With respect to the remaining $5,871 of interest expense,

the parties agree this amount is deductible . They disagree

whether it is an itemized deduction, or a trade or business

expense . The distinction is important because section 68(a)

reduces itemized deductions once a taxpayer's adjusted gross

income (AGI) exceeds the "'applicable amount" . See Chu v .

Commissioner , T .C . Memo . 2005-110- . Trade or business expenses

are not subject to this limitation . See Bishop v . Commissioner ,

T .C . Memo . 2001-82 n .5 . In addition, trade or business expenses

reduce the taxpayer's AGI, thereby reducing the itemized

deductions lost under section 68(a) .

Id .

For petitioners to prevail on this issue, the interest

expense must be "properly allocable to a trade or business" . See

sec . 163(h)(2)(A) . Section 1 .163-8T, Temporary Income Tax Regs .,

52 Fed . Reg . 24999 (July 2, 1987), provides the rules for th e

allocation of interest expense for purposes of section 163(h) .6

Robinson v . Commissioner , 119 T .C . 44, 70 (2002) . . Debt is

allocated to expenditures in accordance with'the use of the debt

proceeds . Sec . 1 .163-8T(c)(1), Temporary Income Tax Regs ., 52

Fed . Reg . 25000 . In general, interest expense accruing on a debt

during any period is allocated to expenditures in the same manner

as the debt is allocated .

Id .

Subject to exceptions not

relevant here, the allocation is not affected by the use of an

interest in any property to secure the repayment of such debt or

interest .

Id .

A trade or business expenditure is an expenditur e

6 Temporary regulations are entitled to the same weight as

final regulations . See Peterson Marital Trust v . Commissioner ,

102 T .C . 790, 797 (1994), affd . 78 F .3d 795 (2d Cir . 1996) ; Truck

& Equip . Corp . v . Commissioner , 98 T .C . 141, 149 (1992) .

- 9 in connection with the conduct of any trade or business other

than the trade or business of performing services as an employee .

Sec . 1 .163-8T(b)(7), Temporary Income Tax Regs ., 52 Fed . Reg .

25000 .

Petitioners incurred credit card debt to purchase equipment

for the tree farm . The credit card debt therefore was allocable

to a trade or business expenditure . See sec . 1 .163-8T(b)(7) and

(c)(1), Temporary Income Tax Regs .,

supra . The temporary

regulations provide that to the extent proceeds of any debt (the

"replacement debt") are used to repay any portion of a previously

existing debt, the replacement debt,' is allocated to th e

expenditures to which the repaid debt was allocated . Sec . 1 .1638T(e)(1), Temporary Income Tax Regs ., 52 Fed . Reg . 25004 . Mr .

Alexander credibly testified, and we so find, that petitioners

used the proceeds from the home equity loan to repay the credit

card debt . The home equity loan therefore is "replacement debt"

and the interest accruing thereon is properly allocable to a

trade or business expenditure . See sec . 1 .163-8T(c)(1),

Temporary Income Tax Regs .,

supra . We hold for petitioners on

this issue to the extent of $5,871 .

2 .

Payments to Petitioners' So n

Compensation is deductible as a trade or business expense

only if it is (1) reasonable in amount, (2) based on services

actually rendered, and (3) paid or incurred . See O'Connor v .

- 10 Commissioner , T .C . Memo . 1986-444 ; sec . 1 .162-7(a), Income Tax

Regs . Compensation meeting those requirements is deductible even

Eller v .

if the employer is a parent and the employee a child .

Commissioner , 77 T .C . 934, 962 (1981) ;

Hamdi v . Commissioner ,

T .C . Memo . 1993-38, affd . without published opinion 23 F .3d 407

(6th Cir . 1994) . When a familial relationship is involved,

however, the Court closely scrutinizes the transaction .

v . Commissioner , 48 T .C . 439, 450 (1967) ;

Denman

Hamdi v . Commissioner ,

supra . Section 262(a) generally disallows deductions for

personal, living, or family expenses . A normal supposition when

payments are made to dependent children or when items are

purchased for them is that the money or items are in the nature

of support and thus nondeductible under section 262 .

Holtz v .

Commissioner , T .C . Memo . 1982-436 .

In deciding whether payments to a child are deductible, we

examine all the facts and circumstances .

Eller v . Commissioner ,

supra . Facts that militate against the deductibility of such

payments include : (1) Failing to pay employment taxes' and fil e

' The employment tax sections of the Internal Revenue Code

are in subtitle C . Secs . 3111 and 3301 impose taxes on employers

under the Federal Insurance Contributions Act (FICA) and the

Federal Unemployment Tax Act (FUTA), respectively, based on wages

paid to employees . See Images in Motion, Inc . v . Commissioner ,

T .C . Memo . 2006-19 . Sec . 3101 imposes a tax on employees based

on their wages paid, which the employer is required to collect

under sec . 3102 .

Id

For purposes of FICA, employment does not

include service performed by a child under the age of 18 in the

employ of his father or mother . Sec . 3121(b)(3)(A) . Fo r

(continued . . .)

- 11 information returns8 with respect to the child ; (2) paying the

child a flat amount determined at the beginning of the year that

is not based on the services actually performed ; (3) a lack of

correlation between the dates and amounts of payments and the

hours allegedly worked by the child ; (4) failing to maintain

adequate records of the child's hours worked and amounts earned ;

and (5) compensating the child for services which are in the

nature of routine family chores . See

supra ;

O'Connor v . Commissioner ,

T .C . Memo . 1984-485 ;

Denman v . Commissioner ,

supra ;

Hable v . Commissioner ,

Furmanski v . Commissioner , T .C . Memo .

1974-47 .

There is no indication that petitioners paid employment

taxes on the $4,000 they paid Steven . Nor is there any

indication petitioners filed a Form 940, 941, or W-2 . These

facts tend to negate petitioners' contentions that the payment s

7( . . .continued)

.

purposes of FUTA, employment does not include service performed

by a child under the age of 21 in the employ of his father or

mother . Sec . 3306(c)(5) . Because Steven was 21 years old when

he performed services for the seamstress business, secs .

3121(b)(3)(A) and 3306(c)(5) are inapplicable .

8 The return of the Federal unemployment tax is required to

be filed on Form 940 . Sec . 601 .401(a)(3), Statement of

Procedural Rules . All other returns of Federal employment taxes

generally are required to be filed on Form 941 .

Id .

In

addition, wages paid to an employee are required to be reported

on Form W-2 . Sec . 1 .6041-2(a)(1), Income Tax Regs .

- 12 to Steven were intended as and constituted payments for bona fide

business employment . See Furmanski v . Commissioner ,

supra .

Mrs . Alexander testified that she calculated she could pay

Steven approximately $4,000 for the summer . Steven therefore was

paid a flat amount determined at the beginning of the year rather

than an amount based on the services he actually performed . This

fact militates against the deductibility of the payments . See

Furmanski v . Commissioner ,

supra .

Petitioners paid Steven the majority of the $4,000 either

before he started working in the summer or well after the summer

had ended . Thus, there was a lack of correlation between the

dates of the payments and the hours Steven worked . This fact

also weighs against the deductibility of the payments . See

O'Connor v . Commissioner ,

supra .

Petitioners recorded Steven's hours and wages on a list they

kept on their refrigerator . Although the list was not introduced

into evidence, the information contained thereon appears to be

summarized in the document titled "Steven's Hours" . See supra

note 3 . Petitioners also introduced a document titled "Steve's'

Summer Work Schedule" (the schedule) . The schedule lists a

number of tasks and hours worked, such as : (1) "Go get thread

and machine needles at fabric store . Pick up bags for vacuum

cleaner . Learn how to draw up pattern from measurements . 7

hours" ; (2) "Clean sewing room, box up materials and move

- 13 downstairs . Prepare to paint . 9 hours" ; (3) "Go rent rug

shampooer . Shampoo carpet sewing room . 9 hours" ; (4) "Clean up

and vacuum . 4 hours" ; and (5) "Go to San Francisco with mom to

help get wedding fabric . 8 hours ." Each document indicates that

Steven worked 378 hours .

It is not clear when petitioners prepared these documents or

whether they accurately reflect Steven's hours, duties, and

earnings . Even if we accept the accuracy of the documents, many

of the tasks that Steven performed are in the nature of routine

family chores such as cleaning, vacuuming, taking out garbage,

and accompanying Mrs . Alexander on shopping trips . Such chores

are "part of parental training and discipline rather than the

services rendered by an employee for an employer ."

Commissioner ,

Denman v .

supra at 450 .

Finally, we note that even if Steven performed tasks that

were not routine family chores, the schedule does not separately

identify the number of hours he spent on such tasks . Where a

taxpayer establishes that he incurred a business expense but

cannot prove the amount of the expense, the Court may approximate

the amount allowable, bearing heavily against the taxpayer whose

inexactitude is of his own making .

Cohan v . Commissioner , 39

F .2d 540, 544 (2d Cir . 1930), affg . in part and remanding 11

B .T .A . 743 (1928) ;

Kina v . Commissioner , T .C . Memo . 2006-112 . To

apply the Cohan rule, however, the Court must have a reasonable

- 14 basis for estimating the amount of the expense .

Commissioner , 85 T .C . 731, 742-743 (1985) ;

Vanicek v .

Keenan v .

Commissioner , T .C . Memo . 2006-45 . Here, the record does not

provide a reasonable basis for estimating the portion of Steven's

compensation, if any, that is deductible . We therefore do not

apply the Cohan rule .

On the basis of all of the facts and circumstances, we

conclude that the payments to Steven represent personal, living,

or family expenses . See sec . 262(a) . The tasks that Steven

performed are mostly in the nature of routine family chores .

Petitioners predetermined the amount they would pay him and

failed to observe the formalities of the employee-employer

relationship, such as paying employment taxes, filing information

returns, and paying Steven promptly for the hours he worked .

Thus, petitioners cannot deduct the payments to Steven as wage

expense . Respondent's determination is sustained .

3 .

Payments to Petitioners' Daughter s

Petitioners' daughters were under 18 years old in 1998 .

Petitioners therefore were not required to pay employment taxes

on their earnings or file Forms 940 and 941 . See secs .

3121(b)(3)(A), 3306(c)(5) . Petitioners were required, however,

to issue their daughters Forms W-2 . See sec . 1 .6041-2(a)(1),

Income Tax Regs . Petitioners' failure to do so undercuts their

assertion that their daughters were bona fide employees of the

- 15 dog-breeding business . See Haeder v . Commissioner , T .C . Memo .

2001-7 (taxpayer's failure to issue wife a Form W-2 militated

against the deductibility of payments to her) ; see also Martens

v . Commissioner , T .C . Memo . 1990-42, affd . 934 F .2d 319 (4th Cir .

1991) .

On the issue of how the daughter's compensation was

determined, Mrs . Alexander's testimony was inconsistent . She

initially testified that petitioners predetermined they could pay

each daughter approximately $4,250 for the year . She later

testified, however, that petitioners paid each daughter $7 an

hour . It is difficult to believe that each daughter earned

exactly $4,250 for the year unless that amount was predetermined .

Furthermore, we note that $4,250 was the amount of the standard

deduction in 1998 . See sec . 63(c) ; Rev . Proc . 97-57, sec . 3 .04,

1997-2 C .B . 584, 586 . As a result, each daughter could earn up

to $4,250 without having to pay Federal income tax . We conclude

that petitioners paid their daughters a flat amount that was

determined at the beginning of the year, rather than an hourly

rate . This fact weighs against the deductibility of the

payments . See Furmanski v . Commissioner , T .C . Memo . 1974-47 .

As mentioned supra , the daughters generally did not receive

cash from petitioners . In addition, the daughters received

advances when they needed to make purchases . We have held that

similar arrangements indicate a lack of correlation between the

- 16 dates and amounts of payments and the hours allegedly worked b y

the children . See O'Connor v . Commissioner , T .C . Memo . 1986-444 .

This arrangement therefore militates against the deductibility of

the payments .

As they did with their son, petitioners recorded their

daughters' hours and earnings on a list that they kept on the

refrigerator . The list was not made part of the record .

Petitioners did introduce a summary of each daughter's hours (the

summaries), as well as a week-by-week description of each

daughter's tasks titled "1998 Timesheet" (the time sheet) . The

time sheet includes the following entries for Margot, the oldest

daughter : (1) "Walk dogs, clean yard and haul garbage . 7 .5

hours total for the week" ; (2) "Walk dogs, bleach dog bowls,

treat dogs for fleas, clip nails, cut grass in beagle yard .

12 .75 hours total for the week" ; and (3) "Walk dogs, pick up

yard, hose kennels, pick up kennels, clean sliding doors . 5

hours total for the week" . The time sheet includes similar

entries for JCA and JRA .

It is not clear when the summaries and time sheet were

prepared, or whether the information reflected in those documents

is accurate . Furthermore, as with the tasks that Steven

performed, most of the daughters' tasks are in the nature of

routine family chores, such as cleaning, mowing the yard, and

taking out the garbage . To the extent the daughters performed

- 17 tasks other than routine family chores, the time sheet does not

provide a reasonable basis for applying the Cohan rule . See

Vanicek v . Commissioner , 85 T .C . at 742-743 .

On the basis of all of the facts and circumstances, we

conclude that the payments to the daughters represent personal,

living, or family expenses . See sec . 262(a) . Petitioners failed

to issue Forms W-2 and predetermined the amounts they would pay

their daughters . The daughters' tasks were mostly in the nature

of routine family chores, and there was a lack of correlation

between the payments they received and the hours they worked .

Accordingly, petitioners cannot deduct the payments to their

daughters as wage expense . Respondent's determination is

sustained .

4 .

Estoppe l

Petitioners contend that at some point before or during

1998, they spoke to an employee of the Internal Revenue Service

(IRS) concerning their plan to hire their children as employees .

Petitioners contend the IRS employee indicated that petitioners

could deduct the compensation paid to their children .

Petitioners thus appear to argue that respondent is estopped from

disallowing their claimed deductions .

Equitable estoppel is a judicial doctrine that precludes a

party from denying his own acts or representations which induced

another to act to his detriment .

Hofstetter v . Commissioner , 98

- 19 respondent is not estopped from disallowing the claimed wag e

- 18 T .C . 695, 700 (1992) . It is well settled, however, that the

Commissioner cannot be estopped from correcting a mistake of law,

even where a taxpayer may have relied to his detriment on that

mistake .

Norfolk S . Corp . v . Commissioner , 104 T .C . 13, 59-60

(1995), affd . 140 F .3d 240 (4th Cir . 1998) . An exception exists

only in the rare case where a taxpayer can prove he or she would

suffer an unconscionable injury because of that reliance .

Id .

at

60 .

The following conditions must be satisfied before equitable

estoppel will be applied against the Government : (1) A false

representation or wrongful, misleading silence by the party

against whom the opposing party seeks to invoke the doctrine ; (2)

an error in a statement of fact and not in an opinion or

statement of law ; (3) ignorance of the true facts ; (4) reasonable

reliance on the acts or . statements of the one against whom

estoppel is claimed ; and (5) adverse effects of the acts or

statement of the one against whom estoppel is claimed .

Id .

In

addition, the Court of Appeals for the Ninth Circuit requires the

party seeking to apply the doctrine against the Government to

prove affirmative misconduct .

Miller v . Commissioner , T .C . Memo .

2001-55 .

Petitioners have not demonstrated affirmative misconduct by

.respondent, nor have they established the other elements

- 19 respondent is not estopped from disallowing the claimed wage

expense deductions .

Reviewed and adopted as the report of the Small Tax Case

Division .

To reflect the foregoing,

Decision will be entered unde r

Rule 155 .