UNITED STATES TAX COURT
Agency decision
Ask Donna
What actually matters in this document.
Text
T.C. Memo. 2013-125
UNITED STATES TAX COURT
EDMOND AUDREY HEINBOCKEL AND LYDIA ROSE HEINBOCKEL,
Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 12139-09, 9311-10.
Filed May 13, 2013.
David Harlow, for petitioners.
Kaelyn Romey, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HOLMES, Judge: Ed and Lydia Heinbockel are a happy couple possessed
by entrepreneurial spirit. In 2Ó05-07 Ed worked full time running a successful
training simulations company, while Lydia--a visibly fashionable and energetic
[ SERVED MAY 1 3 2013
-2[*2] woman--ran a personal-shopping business "24-7". The Heinbockels claim
that their income from these two sources was significantly offset by losses from
three other activities during those years. Although these cases force us to
rummage through some of the shopping business expenses to check for
substantiation, most of the disagreement--as measured by the money at stake-between the IRS and the Heinbockels is about whether their forays into plane
chartering, grape farming, and moneylending were motivated by profit.
FINDINGS OF FACT
I.
Entrepreneurial Ed's Eclectic Experiences
Before Grand Theft Auto, before World of Warcraft, before even Sonic the
Hedgehog, Leisure Suit Larry left the Land of the Lounge Lizards to become the
unlikely hero of an incredibly successful seven-game series (e.g., Leisure Suit
Larry Goes Looking For Love (in Several Wrong Places)) that created a cultlike
following.' Larry was born and grew to immaturity at a software company called
Sierra On-line, and Ed Heinbockel was Sierra's CFO. Although Ed modestly
called Larry a "warped idea", Sierra's enormous success in the early days of video
games clearly took some entrepreneurial skill. And this Ed showed at an early
1 Seven-game series for now. We take judicial notice that Leisure Suit
Larry: Reloaded is set to be released on the world in the very near future.
-3[*3] age. He graduated from Cal Poly-San Luis Obispo in 1980 with a degree in
mechanized agriculture, but went back to his alma mater in the mid-80s to improve
his business acumen--earning his MBA from Cal Poly-SLO. After a successful
five-year run at Sierra--and at about the same time that Larry's colleague,
Passionate Patti, was Doing a Little Undercover Work-Ed cashed out his Sierra
stock and formed Tsunami Media, Inc.
With Ed at the helm from Tsunami's inception to its eventual sale in 1999,
Tsunami produced several interactive video games. One of its most popular
creations, a submarine-warfare simulation named Silent Steel, sold over four
million units. One of those units landed in the hands of an FBI employee, who
was so impressed that he recommended that its technology be adopted to train
counterterrorism agents. The FBI called Ed sometime in 1997, and they agreed
that he would provide a hundred hours' worth of counterterrorism training. To
avoid the perception that the FBI was training counterterrorism agents by having
them play computer games, Ed sensibly agreed to create a new entity to foster this
relationship--turning the technology that had transformed computer games into
technology that transformed personnel training.
With the help of two angel investors--Eric Garen and Newt Becker--whom
Ed knew through an investment-banker friend, Michael Kane, Ed started Visual
-4[*4] Purple, LLC to build training simulations. Although VP's operating
agreement listed three managers, Ed ran the show--he was in charge of the day-today management, and held a majority ownership interest at all times between 2005
and 2007. Almost immediately after Ed formed VP, it inked a contract with the
FBI for over $5 million--and its relationship with the Bureau stayed strong until
September 11, 2001. After 9/11, however, VP found its status with the FBI in
limbo. Because of that uncertainty, VP realized that it needed to expand its client
base to other parts of the intelligence community.
It was fairly successful in doing so, and secured a seven-figure contract with
the Department of Homeland Security in 2004. But this deal, although lucrative,
was not without risk, because the deal meant VP had to move beyond interactive
movies to full 3-D simulations, and Ed and his team ran into a steep learning curve
that required them to spend lots of time and money. Although he wasn't putting in
hundred-hour weeks as he had during the company's formative years, he was still
working "long hours"--on average 40 to 50 hours per week. This costly shift to 3D simulations, and what Ed called the "lumpy" nature of government contracting,
led to wildly variable cashflows during the mid-2000s. More than a few times
during these years--including 2005-2007--Ed was forced to inject his own money
into VP "as needed to bridge payrolls on occasion, and make ends meet." VP
-5[*5] reported on its own returns that it fell into the red in 2006 and 2007, though
Ed himself was still drawing a good salary that ranged between $150,000 and
$200,000.
Sometime in late 2006 or early 2007, a third-party buyer sought to gobble
up VP along with five or six other companies. In evaluating this offer, Kane,
Garen, and Becker disagreed with Ed over whether his bridge funding should be
credited to him as contributed capital. After mediation, Ed decided to buy them
out in late 2007. This was a big risk, and Ed "basically sold everything,"
including his house. The anticipated third-party sale for VP fizzled, and after the
buyout Ed continued to run the company, which remains successful to this day.
II.
Long Beach Lydia Lured from LA
Lydia Heinbockel shared her husband's business sense. Growing up in
Long Beach, Lydia was an accomplished model from her late teens to her late
twenties. She started in business as an LA sales rep for Pierre Fabre, a French
pharmaceutical company with a cosmetics line. In 1997, during her stint at Pierre
Fabre, she met Ed. They married later that year, and Ed convinced her to move
away from Southern California. They bought a home in San Luis Obispo at the
end ofl998.
-6[*6] Lydia was well aware that her new home was far away from the big cities
that she enjoyed. But she sensed an opportunity in the dearth of quality clothing
that she saw there. She created Lydia's World (also known as Lydia's Personal
Shopping Services), offering designer lines with a personal touch to "very upscale
women."2 She would buy (or obtain on consignment) clothes from about a dozen
internationally known designers, and bring those collections to trunk shows that
she advertised in email invites. She had no storefront, but started with three trunk
shows a year that lasted a week or two each (spring, fall, and holiday), and soon
the business expanded into an "all-year-round, all-the-time business" where she
would hold trunk shows at various times throughout the year in many of her
clients' homes. During any given in-home show, Lydia would spend a few hours
with "two or three girlfriends" personally outfitting them, while treatirig them to
champagne and appetizers. So personalized was Lydia's service that she ensured
her clients wouldn't unwittingly commit an embarrassing fashionfaux pas: Lydia
said that she had women come in at separate times knowing they would be
attending the same party, and she "really secretly" made sure that they bought
different dresses. This personal touch persuaded her clients to spend an average of
2 The Heinbockels listed Ed as the proprietor of Lydia's World on each of
the Schedules C at issue, but, as discussed infra, we reject that characterization.
-7[*7] $1,500 per outing. Despite the fickleness of the fashion industry, Lydia's
ability to market her brands to a loyal customer base brought in gross sales of
between $65,000 and $135,000 during 2005 through 2007. Lydia's World
reported net profits of more than $7,000 for 2005 and nearly $23,000 for 2006. In
2007, however, it reported a net loss of over $20,000--though this included a
deduction of over $30,000 for wages (which really were just cash withdrawals
made by Lydia).
III.
The Loss-Generating Activities
The Commissioner was more concerned with the Heinbockels' losses.
There were three big ones: one reported on a Schedule C, Profit or Loss From
Business; another on a Schedule E, Supplemental Income and Loss, Part I, Income
or Loss From Rental Real Estate and Royalties; and the third on a Schedule F,
Profit or Loss From Farming. We look at each.
A.
Collective Flight
The Schedule C activity was Ed's. He called it Collective Flight, and he
argues that it was a one-airplane transport company. Collective Flight was not
Ed's first foray as a pilot. He began flying when he was only 15, went solo at 16,
and won his private license by 17. He credibly def'med flying as his "passion",
and he later became a commercial- and instrument-rated pilot. When VP won its
-8[*8] contract with Homeland Security in 2004, Ed saw an opportunity to combine
his love for flying with VP's business. He decided that he "really needed an
airplane" and that VP, as his "anchor client," "was going to be the prime mover on
this." He bought a Mooney Encore, a four-passenger single-engine aircraft.
Although Ed testified that he bought it for business purposes, the documents he
signed to buy the airplane suggest otherwise: The loan agreement had a space to
complete the following clause: "This Property will be used for
purposes." The word "PERSONAL" was typed in that space.3
Collective Flight never really got off the ground. As Ed put it, his "best-laid
plans didn't work out so well." Although Ed occasionally flew the plane to
transport himself for VP-related trips, he typically used commercial airlines.
When Ed did use his own plane, he often decided against having VP reimburse
Collective Flight because of VP's cashflow problems.. And Ed never did find any
3 David Harlow, who is currently vice president and general counsel for VP,
was trial counsel for the Heinbockels. When Harlow asked Ed questions about
this loan agreement, he referred to a copy of it where the word "PERSONAL" had
been mysteriously made illegible-or what Ed later called "digital trash." No
other word on that copy was unreadable. Counsel for the Commissioner pointed
out that the word "PERSONAL" was perfectly legible on the copy the IRS had
obtained that was also in the record. We did not admit the copy that Mr. Harlow
was using because it was clearly inauthentic. See Fed. R. Evid. 1003. We think it
more likely than not that the insertion of the "digital trash" was intentional, and
this finding does affect our view of the Heinbockels' overall credibility.
-9[*9] other revenue sources to lift Collective Flight closer to profitability. He was
unable to convince any of his other contacts to become clients because, according
to Ed, they were looking to fly in a nicer twin, cabin-class airplane.
Collective Flight's income did not soar. Although it managed to gross
about $30,000 in 2006, it reported less than $4,000 for 2005 and $6,000 for 2007.
And its reported expenses dwarfed that gross revenue. Those expenses ranged
from nearly $100,000 in 2005, to about $75,000 in 2006 and 2007. The aggregate
net loss for these years was nearly $210,000.
B.
"Residential Rental" (Lending Activity)
The Heinbockels also reported a net loss on a Schedule E for 2005 in
connection with a "residential rental" in Compton known as the Willow property.
They did not, however, actually own that property during any of the years at issue-this claimed loss arose instead from a loan that Lydia had made. Lydia testified
that she would occasionally lend money to her brother, David Finzi, to rehabilitate
various rental properties, and Finzi would give her "a good, attractive interest rate
in return." This particular deal went sour, the property became abandoned, and a
bank--First Wilshire Financial--sued. According to Lydia, since her maiden name
was also Finzi, she "got drug into this lawsuit." She lawyered up, and at least one
attorney, Michael Baum, engaged in a mediation in 2005 that eventually led to an
-10[*10] award of $230,000 in Lydia's favor. The Heinbockels reported all this very
oddly: They claimed an $85,000 capital loss on Schedule D from this "Wilshire
Financial" settlement, but deducted about $35,000 in legal fees on their Schedule
E. That amount represented what the Heinbockels called the difference--due to
"excessive legal fees"--between what they felt Lydia was owed from the
settlement and what she received. They did offset the $35,000 by $9,300 in
income reported as "rents received"on the Schedule E.
C.
Grape Farming
The Mooney aircraft was not the Heinbockels' only big-ticket purchase in
2004; they also bought a piece of raw land in wine country just north of San Luis
Obispo. The Heinbockels both said they bought the land not just to build a home
but with the hope of turning part of it into a Zinfandel grape farm. Ed said that
establishing a vineyard could allow them to "have fun as .a family in the near term
and be making money at it." Ed was specifically attracted to the property because
it would allow him to return to his farming roots without the time and resource
burden of cash crops, and Lydia was.excited by a vineyard's potential to attract
more clients for Lydia's World. They hired an architect in late 2004 to draft plans
for the property, and purchased a tractor--to grade the land--for almost $70,000 on
the last day of December 2004.
-11[*11] But grading the land quickly reaped a harvest of local opposition to their
plans. Although Ed said that he believed he was allowed to do minor grading
without violating any county rules or regulations, or any of his homeowners
association's rules, his neighbors disagreed. The homeowners association filed a
complaint with San Luis Obispo County, and in April 2005 the County
Department of Planning and Building sent the Heinbockels a notice of violation of
three different county code provisions. It ordered them to immediately cease all
work on the project until they obtained all the required permits. This stopped the
grading and started a "long, protracted battle" between the Heinbockels, their
neighbors, and the county. The neighbors also put pressure on the Heinbockels for
violating other rules--grading without approval, keeping a fuel tank on the
property, and leaving an inoperable vehicle on it as well. Ed and Lydia did
eventually win their skirmish with the county--it gave them a permit to move
material and establish a vineyard. The neighbors--or, as Ed called them, the
"absentee homeowners"--succeeded, however, in trampling down the
Heinbockels' plans for a vineyard with a wrath of lawyers. The couple never
planted a single grapevine on the property, and eventually sold it in September
2007. With no grape-farming income, the Heinbockels reported net losses of
about $49,000 for 2005; $13,000 for 2006; and $8,000 for 2007.
-12[*12] Three losing activities that offset a great deal of ordinary income does
sometimes catch the IRS's attention, and the Commissioner issued two notices of
deficiency to the Heinbockels. The Heinbockels timely filed petitions, and we
consolidated the cases and tried them in San Francisco. The Heinbockels were
California residents when they filed their petitions.
OPINION
The Heinbockels challenge the Commissioner's determinations to disallow
their losses, and also continue to press their claim that the Commissioner should
have let them deduct more of Lydia's World's expenses. There are other
adjustments, but they're all computational.4
I.
Preliminaries
A.
Burden of Proof
Taxpayers generally bear the burden of proving that they are entitled to any
deductions that they claim. Rule 142(a)(1); INDOPCO, Inc. v. Commissioner, 503
4 With one exception--the Heinbockels also put at issue the Commissioner's
interest calculations. Apart from a few exceptions that don't apply here, however,
we lack jurisdiction over interest that accrues on a tax deficiency that has yet to be
assessed. See, e.g., Hardin v. Commissioner, T.C. Memo. 2012-162, 2012 WL
2094304, at *5.
-13[*13] U.S. 79, 84 (1992); Welch v. Helvering, 290 U.S. 111, 115 (1933).5 This
includes the burden of substantiation. Hradesky v. Commissioner, 65 T.C. 87, 90
(1975), aff'd per curiam, 540 F.2d 821 (5th Cir. 1976).
Under section 7491(a)(1), if taxpayers produce credible evidence about any
factual issue, the burden of proof shifts from them to the Commissioner on that
issue. "Credible evidence is 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." Higbee v. Commissioner, 116 T.C. 438, 442
(2001). To shift the burden, taxpayers must comply with substantiation
requirements, maintain all the records that section 6001 requires, and cooperate
with the Commissioner's reasonable requests. Sec. 7491(a)(2). The Heinbockels
argued at trial that the burden should shift because they had produced sufficient
evidence to prove that they incurred the expenses claimed as deductions but
disallowed by the Commissioner. We disagree.
The Heinbockels and their trial counsel weren't necessarily the most
cooperative at audit. We find credible the revenue agent's testimony that he
wasn't able to review many documents needed to evaluate the Heinbockels'
5All Rule references are to the Tax Court Rules of Practice and Procedure.
All section references are to the Internal Revenue Code in effect for the years at
issue.
-14[*14] position because they refused to provide them. The records they did provide
at audit weren't sufficient to establish various items of income and deductions, and
were often more confusing than helpful. We therefore find that the Heinbockels
retain the burden of proving they are entitled to the deductions claimed. See Rule
142(a).
But there are some exceptions. The Commissioner bears the burden of
proof on any new matters, increases in deficiencies, or affirmative defenses
pleaded in his answer. Rule 142(a)(1); Welch, 290 U.S. at 115; see also Shea v.
Commissioner, 112 T.C. 183, 190-91 (1999); Parker v. Commissioner, T.C.
Memo. 2012-66, 2012 WL 796414, at *3. There are a few instances here where
the Heinbockels contend that the Commissioner has raised a new matter, and we
will take on those contentions as they arise.
B.
Requisite Profit Motive
Sections 162(a) and 212(1) allow a deduction for all ordinary and necessary
expenses paid or incurred during the tax year in carrying on a trade or business or
for the production of income. Before determining whether deductions are
allowable under those sections, however, a taxpayer must show that he is engaged
in the activity with the actual and honest objective of making a profit. Dreicer v.
-15-
[*15] Commissioner, 78 T.C. 642, 645 (1982), aff'd without published opinion,
702 F.2d 1205 (D.C. Cir. 1983).
Section 183(a) generally disallows any deduction attributable to an activity
"not engaged in for profit."6 Section 183(c) defines an "activity not engaged in for
profit" as "any activity other than one with respect to which deductions are
allowable for the taxable year under section 162 or under paragraph (1) or (2) of
section 212." The existence of a profit motive is a question of fact that we decide
on the basis of all facts and circumstances. See Elliott v. Commissioner, 84 T.C.
227, 236 (1985), aff'd without published opinion, 782 F.2d 1027 (3d Cir. 1986);
sec. 1.183-2(b), Income Tax Regs. A taxpayer's statement of his intent is relevant,
but we give greater weight to objective facts. See Elliott, 84 T.C. at 236; sec.
1.183-2(b), Income Tax Regs.
Section 1.183-2(b), Income Tax Regs., lists the factors that we consider:
042 the manner in which the taxpayer carries on the activity;
042 his expertise or that of his advisers;
042 the time and effort he expends on the activity;
6 Section 183(b)(2) provides an exception to this general rule. If a taxpayer
engaged in an activity not for profit, deductions relating to that activity are
allowable up to the amount of gross income from that activity minus the
deductions that would be allowable whether or not the activity was for profit. See
Allen v. Commissioner, 72 T.C. 28,.32-33 (1979).
-16[*16]
042 the expectation that assets used in the activity may appreciate in
value;
042 his success in carrying on similar activities;
042 his history of income or losses with respect to the activity;
042 the amount of occasional profits, if any, from the activity;
042 his financial status; and
042 any elements of personal pleasure or recreation.
This list is nonexclusive, and the number of factors for or against the
taxpayer is not necessarily determinative. Sec. 1.183-2(b), Income Tax Regs. We
are to take all the facts and circumstances into account, and may give more weight
to some than to others. See Dunn v. Commissioner, 70 T.C. 715, 720 (1978),
aff'd, 615 F.2d 578 (2d Cir. 1980); sec. 1.183-2(b), Income Tax Regs.
C.
Substantiation
If taxpayers pass the trade-or-business test, they still must prove they are
entitled to the deductions that they claim. The most important rule is that
taxpayers have to keep records. As we mentioned above, section 6001 and its
accompanying regulations tell taxpayers to hold onto records that would enable
the IRS to verify their income and expenses. See sec. 1.6001-1(a), Income Tax
Regs.
-17[*17] Whether an expenditure is ordinary and necessary is generally a question of
fact. Commissioner v. Heininger, 320 U.S. 467, 475 (1943). A taxpayer must
show a bonaffde business purpose for the expenditure; there must also be a
proximate relationship between the expenditure and his business. Challenge Mfg.
Co. v. Commissioner, 37 T.C. 650 (1962); Henry v. Commissioner, 36 T.C. 879,
883-84 (1961). For an expense be "ordinary" means that "the transaction which
gives rise to it must be of common or frequent occurrence in the type of business
involved." Deputy v. du Pont, 308 U.S. 488, 495 (1940). For an expense to be
"necessary" means.that it is "appropriate and helpful" to the taxpayer's business.
Welch, 290 U.S. at 113. In contrast, except where the Code specifically says
otherwise, taxpayers can't deduct personal, living, or family expenses. Sec.
262(a).
When taxpayers prove that they have incurred deductible expenses but the
exact amounts are uncertain, we can estimate. See Cohan v. Commissioner, 39
F.2d 540, 542-44 (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742-43
(1985). There must, however, be sufficient evidence in the record to make the
estimate reasonable. Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957).
And when we do estimate, we bear heavily against taxpayers whose inexactitude is
of their own making. See Cohan, 39 F.2d at 544. And, as we discuss later, there
-18[*18] are some expenses that the Code doesn't let us estimate at all. See sec.
274(d); Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff'd, 412 F.2d 201
(2d Cir. 1969).
We now turn to apply these rules to each of the Heinbockels' activities.
II.
Schedule C: Collective Flight
A.
Trade or Business
For 2005 and 2006, the Commissioner disallowed the entire loss reported on
Collective Flight's Schedule C because the activity was not entered into for profit.
For 2007, however, the IRS's notice disallowed substantially all of Collective
Flight's expenses (over 99% of them) because they were not ordinary and
necessary business expenses--but not because the activity wasn't entered into for
profit. Therefore, the disallowed items on the respective notices were as follows:
Disallowed item
2005
2006
2007
Net loss
$96,028
$44,258
---
Other expenses
---
---
$31,206
Taxes & licenses
---
---
2,475
Interest--mortgage
---
---
16,983
Insurance other
than health
---
---
3,064
Depreciation &
sec.179 expense
---
---
18,650
-19-
[*19] Car & truck
Total
--96,028
--44,258
3,853
76,231
In the Commissioner's pretrial memo, he asserted the same theories as he did in
his respective notices. By the time of trial (as well as in his posttrial briefing),
however, the Commissioner contended that we should disallow Collective Flight's
2007 expenses because, among other reasons, the activity was not engaged in for
profit during that year as well. The Heinbockels argue that this means that the
burden of proof should shift to the Commissioner for that year.
We agree. After a case has begun, Rule 142(a) places the burden on the
Commissioner "in respect of any new matter, increases in deficiency, and
affirmative defenses, pleaded in the answer." However, we distinguish between
new matters and new theories. See Hurst v. Commissioner, 124 T.C. 16, 30
(2005). "[W]e have held that for respondent to change the section of the Code on
which he relies does not cause the assertion of the new theory to be a new matter if
the section relied on is consistent with the determination made in the deficiency
notice relying on another section of the Code." Id. (citation and internal quotation
marks omitted). A "new matter" is one that reasonably would alter the evidence
presented. A "new theory," in contrast, is just a new argument about the existing
evidence. Id. Although the notice of deficiency challenged virtually all of
-20[*20] Collective Flight's 2007 expenses, proof that a business is engaged in for
profit is reasonably likely to require the presentation of evidence different from
that required to prove that expenses should be allowable because they're ordinary
and necessary. We give the benefit of the doubt to the Heinbockels here, and
construe the Commissioner's new argument for 2007 as a new matter (not just a
new theory), and therefore shift the burden to him for that year. The revised
disallowed items are as follows:
Disallowed item
2005
2006
2007
Net loss
$95,9321
$46,0482
$71,1093
1 On their 2005 return, the Heinbockels claimed Collective Flight incurred a
net loss of $96,028. On brief, they claimed $96 less, which decreased the disputed
net loss to $95,932.
2 On their 2006 return, the Heinbockels claimed Collective Flight incurred a
net loss of $44,258. On brief, they claimed an additional $1,790 of expenses to
increase the disputed net loss to $46,048.
3 On their 2007 return, the Heinbockels claimed Collective Flight incurred a
net loss of $70,957, with $5,757 of gross receipts and $76,714 in total expenses.
On brief, they claimed an additional $152 of expenses to increase the net loss to
$71,109. The Commissioner--by asserting first that Collective Flight wasn't an
activity engaged in for profit (as opposed to relying solely on the argument that
certain expenses weren't ordinary and necessary)--is now seeking to negate
Collective Flight's entire net loss.
-21[*21] We look to the usual section 183 factors.
1.
Manner in which the activity is conducted
We begin by considering whether Ed carried on Collective Flight in a
businesslike manner. See sec. 1.183-2(b)(1), Income Tax Regs. A taxpayer
operates in a businesslike manner when, among other things, he has a business
plan, advertises his goods or services, keeps complete records, and responds to
losses by changing what he does. See Engdahl v. Commissioner, 72 T.C. 659,
666-67 (1979); Rinehart v. Commissioner, T.C. Memo. 2002-9, 2002 WL 23954,
at *7.
We have to find that from day one Ed did not conduct Collective Flight in a
businesslike manner. When he bought the plane, the loan documents specifically
stated that he was going to use it for personal purposes. We find the revenue agent
credible when he testified that "the only reason" Ed set up Collective Flight was
that, through VP, he'd "be assured of renting time on this airplane that would pay
the expenses back." After Ed decided that he really needed an airplane for VP, he
testified he "built spreadsheets" and "talked to people" and came to the conclusion
that, in addition to VP's flying needs, "there was this nice sweet spot" for people
around San Luis Obispo that needed to get to northern and southern California.
The record, however, includes only a one-page "pro-forma" spreadsheet that Ed
-22[*22] admitted was done in a ''stream of conscious[ness]," and did not refer to any
specific clients other than VP and Lydia's World.
Ed also failed to keep complete records. There were no written contracts
between Collective Flight and VP--his only alleged customer. (Ed did say that he
flew for Lydia's World, but he did not bill it.) Although Ed said he provided a few
invoices to VP by email, he also testified that he decided against giving most of
them to anyone in VP's finance and accounting departments. We have found no
invoices in the record for 2006 or 2007; he instead would seek reimbursement
from VP for his Collective Flight costs by listing them on his VP expense reports.
Even in 2005--when he did send invoices to VP from Collective Flight--he chose
not to enter most of the flight charges onto VP's books because "it was kind of
silly" to do so as VP "couldn't pay them" because of its cashflow difficulties.
That may not have been the only reason. This billing (and overall relationship)
was so informal that Ed admitted that VP's other investors probably didn't know
about Collective Flight's arrangement with VP. (Those investors later complained
about Ed's self-dealing and unauthorized use of funds.) Since Ed controlled what
bills VP paid, and Ed was concerned about VP's cashflow, it's not surprising VP's
reimbursements to Collective Flight were few and far between. Although even
informal recordkeeping is sometimes enough to help show a profit motive, see
-23[*23] Keenan v. Commissioner, T.C. Memo. .1989-300, 1989 WL 65299,
Collective Flight's records were too spotty for us to find that it was carried on in a
businesslike manner.
Ed also failed to institute changes in an effort to earn a profit. He testified
that when he bought the plane, he thought VP's income stream would allow
Collective Flight to charge VP an hourly rate. However, even when Ed did
occasionally authorize VP to reimburse Collective Flight, VP did so according to
the much-less-profitable IRS standard reimbursement rate of $1.07 per mile.7 By
2006, after Ed realized the standard rate was all that VP was going to be able to
pay Collective Flight, he didn't do anything to change Collective Flight's business
model. Rather, without revenue from VP, he didn't "think [he] could fly enough
miles to make it pencil out." He said that in retrospect he "should have just sold it
at a loss in 2006," but instead he just continued to write off Collective Flight's
expenses on Schedule C on both his 2006 and 2007 returns. We also note that he
7 When asked why VP required a mileage reimbursement rather than an
hourly rate, Ed responded: "[A] broader business decision that I needed to make
on behalf of VP, and overcome my desire to be billing at an hourly rate where I
could have the airplane pencil-out for me and make some money. So I didn't have
the luxury because the cash flow and where the company stood in terms of
revenues and profitability or lack of profitability to do anything other than that."
We think that this is a very important bit of evidence of how Ed felt about his main
business interest in VP, parsed carefully, vis-a-vis his activities at Collective
Flight.
-24[*24] used the plane for personal purposes, but never made any attempt to allocate
the expenses between his personal and business use of the plane. Ed finally sold
the plane in 2009.
Citing Rabinowitz v. Commissioner, T.C. Memo. 2005-18, 2005 WL
1763776, the Heinbockels argue that it was significant that Ed obtained a rule 135
commercial pilot rating somewhere between 2004 and 2005. We did say in
Rabinowitz that the "FAA requirements to maintain a rule 135 certificate are more
onerous than the FAA requirements for aircraft that are not chartered to the
general public," and credited the fact that the taxpayer obtained this certificate
when we discussed whether he carried on the activity in a businesslike manner.
Id., 2005 WL 1763776, at *4, *10. In contrast to Ed's activities here, however, the
taxpayer in Rabinowitz kept adequate books and records, charged arms-length
rates to charter customers, advertised extensively, and implemented changes to try
to make the activity more profitable. Id. at *11.
This factor weighs against Ed.
2.
Expertise of the taxpayer or advisers
The second factor asks whether Ed developed his own expertise or sought
guidance from industry experts. See sec. 1.183-2(b)(2), Income Tax Regs.
Although a taxpayer needn't make a formal market study in preparation for a trade
-25[*25] or business, he's expected to undertake a basic investigation of the factors
that would affect his profit. Westbrook v. Commissioner, T.C. Memo. 1993-634,
1993 WL 540784, at *7, aff'd, 68 F.3d 868 (5th Cir. 1995).
Ed testified that he did seek out advice in selecting the appropriate aircraft,
stating that he "[t]alked to a lot of different pilots, brokers of aircraft, guys who
had experience with different models." When asked the names of any of these
people, he said "one guy I considered * * * I can't remember his name, he has a
company called Rocky Mountain Mooney." Casual conversations with unknown
plane salesmen don't help much. Nor do his claims of other forms of training such
as having a valid medical certificate, obtaining renewal of his pilot's license, or
passing required drug tests--none of these are specific to flying for profit. There
was also no evidence that Ed had any discussions with lawyers, accountants, or
any other aircraft experts or advisers about the potential profitability of the
aircraft. Ed relied on his intuition, believing that VP--a company he controlled--
could help him "make a little money with this * * * and have some fun at the same
time." This, too, weighs against finding a profit motive.
3.
Taxpayer's time and effort
The third factor focuses on the time and effort the taxpayer spends on the
activity. See sec. 1.183-2(b)(3), Income Tax Regs. Devotion of a significant
-26[*26] amount of personal time to an activity may show a taxpayer has a profit
motive, particularly if he gets no substantial amount of personal pleasure or
recreation from it. See id.
We begin by observing that Ed didn't have a whole lot of personal time to
dabble in this activity. He was working full time at VP. His flight logs show only
160, 90, and 50 flight hours for 2005, 2006, and 2007, respectively. Despite those
numbers, Ed said he spent about ten hours per week with Collective Flight, two to
three of which were devoted to flying and the remainder devoted to administrative
or prep time. He admitted, however, that he kept no record of those administrative
hours to indicate whether he incurred them for VP or for Collective Flight. This
factor doesn't weigh in favor of a profit motive, either.
4.
Expectation that assets may appreciate in value
An expectation that the assets used in an activity will appreciate in value
might also indicate a profit objective. See sec. 1.183-2(b)(4), Income Tax Regs.
It's not hard to conclude that wear and tear on an aircraft would cause it to
depreciate. Although Ed suggested that the aircraft could've appreciated in value
if he would've been "able to support it," we don't find that testimony credible.
And he admitted that the plane lost value over the years and was ultimately sold at
a loss. This factor also weighs against the Heinbockels.
-27[*27]
5.
Success in carrying on other similar activities
A taxpayer's previous success in similar activities may show that the
taxpayer has a profit objective even though the activity is presently unprofitable.
See sec. 1.183-2(b)(5), Income Tax Regs. There's no evidence here, however, that
Ed was previously successful in the aircraft industry. To the contrary, the
Heinbockels claimed a substantial loss on their 2004 return.
6.
History of income and losses
A series of losses during the initial or startup stage of an activity may not
necessarily show that an activity is not engaged in for profit. See sec. 1.1832(b)(6), Income Tax Regs. Collective Flight, however, kept on losing money
beyond its startup period. After it sustained an initial loss in excess of $180,000 in
2004, Collective Flight's gross income and expenses (as adjusted by the
Heinbockels at trial and on brief) were as follows:
Year
Income
Expenses
Net loss
2005
$3,720
$99,652
$95,932
2006
2007
30,105
5,757
76,153
76,866
46,048
71,109
Collective Flight thus didn't come close to generating a profit during any
year at issue. And there's no evidence that those losses were due to customary
-28[*28] business risks. See id. In 2006 after VP limited reimbursement to $1.07 per
mile, Ed admitted that he knew he had a dying business model. This is another
factor that weighs against the Heinbockels.
7.
Amount of occasional profits
The seventh factor explores the amount of profits generated in relation to
the amount of losses incurred. See sec. 1.183-2(b)(7), Income Tax Regs. Not
much exploring to do here. There's no evidence that Collective Flight ever
generated a profit before Ed sold the aircraft at a loss in 2009.
8.
Financial status of the taxpayer
The presence of other substantial income may indicate a lack of profit
motive, especially if there are personal or recreational elements involved in the
activity. See sec. 1.183-2(b)(8), Income Tax Regs.
Ed's annual wages from VP during that three-year span averaged over
$180,000. Ed and Lydia's interest income for that same period (most of which
came from VP) averaged over $30,000 per year. Collective Flight's substantial
net losses, if found to be deductible, would be available to offset a large portion of
the Heinbockels' income, generating significant tax savings. And, as we discuss
below, this activity has strong personal or recreational elements.
The Heinbockels still.don't have a factor weighing in their favor.
-29[*29]
9.
Elements of personal pleasure
The final factor we examine is whether the activity had elements of personal
pleasure or recreation. See sec. 1.183-2(b)(9), Income Tax Regs. There is no
doubt that there are plenty of them here. Ed testified, " I love to fly. I'll be real
up-front about that. Flying's always been a passion of mine." We find his
testimony credible. Ed had bought several other planes in the past and even
owned a helicopter. The presence of Ed's personal passion to pilot planes-especially in light of the other factors--weighs heavily against him. See id.
10.
Totality of the factors
After considering all facts and circumstances, we find that Ed has not shown
that he engaged in the Collective Flight activity for profit. The Heinbockels are
therefore not entitled to the deductions that they claimed to the extent that the
deductions exceed the income Collective Flight reported.
B.
Form 4797 Loss
The Heinbockels also claimed a loss of almost $10,000 for 2006 on Form
4797, Sales of Business Property, from the sale of a 2002 GM pickup that they
allege was used exclusively for Collective Flight. Although there are several
-30[*30] problems with the deductibility of this claimed loss,8 the most lethal is this:
Since we found that Collective Flight was not a trade or business, it logically
follows that the Heinbockels can't deduct a loss on the sale of a vehicle that was
allegedly used exclusively for that activity. See sec. 165(c). Without navigating
any other way to deduct the loss, the Heinbockels aren't entitled to a deduction for
it.
III.
Schedule E: Lending Activity
The Heinbockels admit that their claimed lending-activity loss of $25,784
should not have been reported on their 2005 Schedule E, but now argue that it
should have been reported as a trade-or-business net loss of $11,884 on a Schedule
C. They calculate as follows:
Claimed on return P claimed in brief
Item
(Sch. E)
(Sch. C)
Rent received in lieu of interest
$9,300
$9,300
Atty fees paid to David Harlow
-
(15,710)
Atty fees paid to Anthony Taylor
Atty fees paid to Michael Baum
-----
(28,782)
(54,890)
Unreimbursed advances
---
(3,000)
8 The Heinbockels claim this vehicle was placed in service in 2002, but
there's no evidence that the aircraft activity began before 2004. Furthermore,
although the Form 4797 reports a sale price of $12,000, the record shows that the
Heinbockels received $15,000.
-31[*31] Settlement proceeds
---
230,000
Less: principal
---
(148,801)
(35,084)
(25,784)
--(11,883)
Legal fees
Net loss
In connection with these adjustments, the Heinbockels also concede that the
capital loss of $85,294 claimed on Schedule D entitled "First Wilshire" shotild
really be a capital loss of $25,000 for their investment in "DM Video Stock" that
is unrelated to the lending activities (and also concede that the $25,000 is subject
to section 1211's capital-loss limitation of $3,000 per year).
Whew, that's quite a shift. Before wading through whether they
substantiated the expenses in arriving at that new net loss, we first must determine
whether this lending activity was actually a trade or business that would allow
them to deduct those expenses. See secs. 162, 183; sec. 1.183-2, Income Tax
Regs. If it's not, then we must decide whether the expenses they claimed would
be deductible under any other Code section and, if so, whether they were properly
substantiated. We also must decide how the money they received should be
characterized.
The Commissioner rejects the Heinbockels' new argument that they .
operated a lending business, asserting that this is just another attempt to deduct
personal expenses. The Commissioner emphasizes that the Heinbockels
-32[*32] completely failed to show that they treated this activity like a business. We
agree. Outside of a one-page flowchart that shows various instances where Lydia
purported to lend money to her brother, the Heinbockels didn't bring forth any
evidence to show that they operated this activity as a trade or business.. They
provided no books or records, showed no separate accounts, and proved no active
solicitation of business.
We find instead an ordinary family deal: They loaned Lydia's brother
money when he said he needed some. This is not a business. See sec. 1.183-2(b),
Income Tax Regs.; see also McCrackin v. Commissioner, T.C. Memo. 1984-293,
1984 WL 15510 (considering "other indications of a genuine loan business" when
loan activity is conducted "with insufficient regularity"). Even if we accepted the
flowchart as credible proof, we don't find that making a couple loans to one's
brother over a few years' time is a trade or business. See Imel v. Commissioner,
61 T.C. 318, 323 (1973) (finding that the making of less than ten loans over the
course of a four-year period didn't elevate that activity to the status of a separate
business); Sales v. Commissioner, 37 T.C. 576, 580 (1961) ("We do not believe, in
view of the factual matrix of this case, that the making of an isolated loan of
$120,000 is so extensive an activity as to justify a finding by this Court that the
partnership was engaged in the business of lending money").
-33[*33] When First Wilshire sued over the abandoned Compton property, the
Heinbockels did ring up some lawyer's bills trying to recover the amount of
money they had loaned to Lydia's brother for that property. Section 212 might
make those expenses deductible if the Heinbockels paid them for "the production
or collection of income" or "the management, conservation, or maintenance of
property held for the production of income." Sec. 212(1) and (2); see also Colvin
v. Commissioner, T.C. Memo. 2004-67, 2004 WL 516195, at *4-*5, aff'd, 122
Fed. Appx. 788 (5th Cir. 2005). (These expenses wouldn't be Schedule C
expenses, though. The Heinbockels would have to report them on their Schedule
A as miscellaneous itemized deductions subject to a 2% floor. See secs. 63(a), (d),
67(a) and (b); see also, e.g., Estate of Stangeland v. Commissioner, T.C. Memo.
2010-185, 2010 WL 3239181, at *8.)
Even this gets procedurally complicated. The Commissioner argues that the
Heinbockels aren't entitled to deduct any expenses because they incurred the legal
fees to recover a personal interest. We have to reject this argument; the
Heinbockels weren't trying to recover a personal interest in property--they didn't
own any part of the property. Rather, the Heinbockels made a loan to Lydia's
brother that he used to buy an investment property, in exchange for which they
were to receive income in the form of interest (or rent received in lieu of interest).
-34[*34] So if the Heinbockels spent money to try to recover on that loan, some of
those expenses would be paid to collect income and therefore would be deductible
on Schedule A. According to our caselaw, although the portion of expenses
attributable to the recovery of loan principal isn't deductible, the portion
attributable to both the recovery of loan interest and rental income is. See Kelly v.
Commissioner, 23 T.C. 682, 688-89 (1955), aff'd, 228 F.2d 512 (7th Cir. 1956).
In Kelly, the lawsuit led to a settlement that resulted in the collection of
principal, interest, and rental income. Although the taxpayer didn't produce
evidence to allow us to make a precise allocation, we allocated the expenditures
among principal, interest, and rental income in approximately the proportions of
principal, interest, and rental income recovered. See id. at 684-85. Since the
Heinbockels also didn't provide evidence to make a precise allocation, we'll
follow a similar path here. For any expenditures that are properly substantiated,
we'll multiply that amount by the percentage equal to the ratio of loan "principal",
$148,801, to "settlement proceeds", $230,000--64.7%--to állocate to expenditures
attributable to the recovery of principal (nondeductible). And we will allocate the
remaining percentage--35.3%--to expenditures attributable to either recovery of
loan interest or rent received in lieu of interest (deductible).
-35[*35] The Commissioner argues, however, that the Heinbockels failed to
substantiate that they paid any legal fees. He seems to assume that the amount
deducted on the Schedule E was for fees to a lawyer who forgave the entire
amount. He points to a letter from the lawyer describing a writeoff of over
$43,000 in legal fees due from the Heinbockels.
The problem for the Commissioner is that the schedule that lawyer prepared
shows that the amount written off--actually only $33,000--was attributable to
amounts billed in 2006. It is 2005 that is the year at issue for this activity, and for
that year the schedule shows the Heinbockels paid a total of $39,890 to that
lawyer. We therefore allow the Heinbockels to deduct 35.3% of that amount for
2005, albeit as a Schedule A deduction subject to the 2% floor.9
What about the fees that the Heinbockels claimed they paid to the other two
attorneys? The Heinbockels provided copies of the canceled checks paid both to
Anthony Taylor's law firm ($28,782) and to David Harlow ($15,710). They
provided a spreadsheet prepared.by them that asserted these fees were paid in
connection with the First Wilshire settlement. They also provided bills and
records that showed that both Taylor and Harlow did represent them in reaching
9 The $39,890 is $15,000 less than the amount the Heinbockels claimed--the
difference being a retainer that was subsequently returned to them.
-36[*36] that settlement. The Commissioner failed to address these two amounts in
his brief, and we will allow them to deduct 35.3% of both of those amounts, again
as Schedule A deductions subject to the 2% floor.
The Heinbockels also claim a $3,000 deduction in 2005 for "unreimbursed
expenses." Their spreadsheet says this represents an "unreimbursed 2/5/02
advance" to a "Hatch family trust." The only support they cite for this advance is
the flowchart that they created. This is just a summary of their assertion, not
proof, and we can find no other evidence that would support the deductibility of
this advance.
We now turn to characterizing the items of income on this Schedule E. We
find that the first item--$9,300 of "rents received in lieu of interest"--represents
interest income that the Heinbockels were owed. This is gross income to the
Heinbockels. See sec. 61(a)(4).
We next tackle the somewhat odd characterizations of the "settlement
proceeds" less "principal" that were nowhere to be found on the Heinbockels'
2005 return. As we noted earlier, Lydia didn't rent or own the property at issue in
the settlement during any of the tax years at issue; she just loaned money to her
brother so that he could buy the property. We therefore characterize the
"principal"--$148,801--as the loan she made, and the "settlement proceeds"--
-37[*37] $230,000--as the money she received from the mediation. That leaves,
however, an $81,199 accession to wealth. Having rejected the Heinbockels'
assertion that this income was part of a trade or business, how should we
characterize this income? Since Lydia didn't own any part of this property, it
wouldn't be proper to characterize this "gain" as capital. Rather, Lydia was a
lender, and received an "attractive" interest rate from her brother. Without any
other information on why they received so much more money than the amount
they purportedly invested, we characterize the difference as "the settlement of a
claim for lost income." Marcus v. Commissioner, T.C. Memo. 1996-190, 1996
WL 189940, at *3. And that lost income is gross income to the Heinbockels. See
id.
Lastly, we turn to the Heinbockels' concession that the capital loss of
$85,294 claimed on Schedule D entitled "First Wilshire"should really be a capital
loss of $25,000 for an investment in "DM Video Stock" that is unrelated to the
lending activity. The Commissioner didn't challenge the original capital loss, and
hasn't addressed the new capital loss or its new characterization. So we accept the
Heinbockels' concession of all but the $25,000 capital loss, which is of course
subject to section 1211's limitation.
-38[*38] IV.
Schedule F: Grape Farming
The Heinbockels didn't report a single dollar of income on the grape
farming Schedules F for the years at issue. They did, however, claim a bountiful
harvest of deductible losses:
Year
Income
Expenses
Net loss
2005
-0-
$49,126
$49,126
2006
-0-
12,771
12,771
2007
-0-
8,486
8,486
By the time of trial, the Heinbockels claimed some additional expenses for
2005 and 2006, resulting in alleged net losses of $52,953 and $14,094,
respectively.
The Commissioner disputes these losses but, as he did with Collective
Flight, changed his mind about just why the farming losses were not deductible.
In the notice of deficiency for 2005 and 2006, he disallowed all reported losses
because amounts spent during a farm's preproduction period must be capitalized.
Since the Heinbockels never grew a single grape before they sold the property, the
Commissioner determined that those amounts should have been added to their
basis. The notice of deficiency for 2007, however, disallowed only the
depreciation expense of $4,908 (instead of the entire $8,486 loss) for lack of
-39[*39] substantiation and for failure to show that the expense was ordinary and
necessary to the business.
The Commissioner changed his argument in his pretrial memos. The memo
for the 2005 and 2006 tax years argued that we should disallow all the losses for
those years for failure to substantiate and because the expenses weren't ordinary
and necessary-but didn't mention anything about the need to capitalize them. The
memo for the 2007 tax year repeated the Commissioner's position in his notice of
deficiency--that we should disallow the loss for failure to substantiate and because
the expenses weren't ordinary and necessary.
At trial, the Commissioner's position shifted yet again. There, the
Commissioner's lawyer asserted that she was "not necessarily" challenging the
items "in particular," but "maybe the proportion of the items, but not the items
individually." We then asked her whether she was also arguing that the items
claimed as deductions were startup expenses and should've been capitalized and
added to basis when the property was sold. She answered, "Exactly". Based on
that representation, we said to the Heinbockels' lawyer that he needn't spend time
proving that the expenses were ordinary and necessary, but could limit himself to
evidence and argument about whether those expenses were currently deductible or
had to be added to basis. The Commissioner's lawyer did not attempt to correct
-40[*40] that statement. In reliance on that direction from us, the Heinbockels'
lawyer ceased to elicit further testimony about whether the expenses for 2005 and
2006 were ordinary or necessary.
The Commissioner's posttrial brief, however, wasn't consistent with that
trial colloquy. In his brief the Commissioner appears to assert two theories. First,
he asserts that the 2005 and 2006 losses should be disallowed "for failure to
adequately substantiate." The Commissioner later concedes, however, that the
Heinbockels "provided sufficient evidence to substantiate that the following
Schedule F expenses were actually incurred," but claimed that "each expense is
personal and fails to qualify" under section 162. In other words, the
Commissioner "contends that despite petitioners providing some receipts for the
claimed expenses, they are personal and all aspects of I.R.C. Section 162 have not
been met."
The Commissioner asserts in the alternative that the Heinbockels never
carried on an active trade or business. He argues that they should therefore "not
be allowed any deductions related to their Schedule F for the years 2005, 2006,
and 2007," and all of the expenses should be capitalized as startup expenses under
section 195. Since the Heinbockels never entered production, the Commissioner
-41[*41] argues, the costs associated with preparing the land for production should be
added to basis when computing gain or loss on the land.
The colloquy we had at trial made clear that the precise issue (at least for
2005 and 2006) was whether the costs associated with the grape farm were
currently deductible or should be capitalized. Because of the Commissioner's
response, we prohibited the Heinbockels' lawyer from proceeding down the
section 162 route for those two years. The Commissioner didn't object to this
prohibition. It would therefore be inequitable to allow the Commissioner to argue
that the expenses that the Heinbockels claimed on their Schedules F for 2005 and
2006 should be disallowed because they were personal or that they weren't
properly substantiated.
So what about the second theory? That theory--which argued for
capitalization and against immediate deductibility--would disallow all of the
claimed deductions on Schedule F for all these years. For 2005 and 2006, the
notice of deficiency had disallowed all the claimed expenses on Schedule F based
on a theory of capitalization--albeit under a different Code section (section 447).
This is just a new theory (a new argument about the existing evidence) as opposed
to a new matter (an argument that reasonably would alter the evidence required),
see Hurst, 124 T.C. at 30, so there's no need to shift the burden of proof for those
-42[*42] two years. 2007 is a different story. Since the Commissioner disallowed
only the $4,908 depreciation expense claimed on the 2007 Schedule F, the second
theory is a new matter for that year, and shifts the burden to the Commissioner.
We finally turn to the substantive analysis of the Heinbockels'
grapefarming. In the midst of the dispute over the theories raised, it's important
not to lose sight of one key fact: The Heinbockels admit they never planted a
single grapevine before selling the property in late 2007. This is a problem for
them. As we've noted, section 162(a) allows a deduction for ordinary and
necessary expenses of carrying on a trade or business. In order for the expenses to
be deductible under that section, however, the expenses must relate to a trade or
business functioning when the expenses were incurred. Hardy v. Commissioner,
93 T.C. 684, 687 (1989). A taxpayer has not "'engaged in carrying on any trade or
business' within the intendment of section 162(a) until such time as the business
has begun to function as a going concern and performed those activities for which
it was organized." Richmond Television Corp. v. United States, 345 F.2d 901,
907 (4th Cir. 1965), vacated and remanded on other grounds, 382 U.S. 68 (1965).
"Carrying on a trade or business" requires a showing of more than initial research
into or investigation of business potential. Dean v. Commissioner, 56 T.C. 895,
902 (1971). The business operations must have actually began. McKelvey v.
-43[*43] Commissioner, T.C. Memo. 2002-63, 2002 WL 341044, at *3, aff'd, 76 Fed.
Appx. 806 (9th Cir. 2003). Until the time the business is "performing the
activities for which it was organized," expenses related to that activity are not
currently deductible under section 162. Glotov v. Commissioner, T.C. Memo.
2007-147, 2007 WL 1702618, at *2. They are instead classified as "startup" or
"pre-opening" expenses. Hardy, 93 T.C. at 687. And startup expenses--which
include those incurred "before the day on which the active trade or business
begins"--are only deductible over time once an active trade or business begins.
See sec. 195.
McKelvey is instructive here. The taxpayer there, a longtime analyst at the
California Department of Forestry, bought 39 acres with a barn and cabin included
on which he planned to start a tree farm. McKelvey, 2002 WL 341044, at *l.
Before buying the land, he conducted an economic and market feasibility study of
its commercial viability, and made several visits to the property to survey the
forest's health and learn about insects, wildfire hazards, and other risks he might
face. Id. He continued to prepare for his tree-farm business for two years after he
bought the property. He had a forest-management plan prepared, and test planted
51 pine trees. Id. at *1-*2. All this cost money, and he claimed about $20,000 in
expenses. Id. at *2. By the time of trial, though, he still hadn't commercially
-44[*44] harvested any trees, hadn't planted any more trees, and hadn't decided what
species of tree to plant. Id.
We agreed with the Commissioner that this all meant that the taxpayer did
not yet have a functioning business. Id. at *3. All his expenses were therefore
start-up expenses for which we allowed no current deduction. Id. at *3-*4.
The taxpayer in McKelvey at least planted a few test trees. The
Heinbockels admit that they never planted a single vine. Thus, all of the expenses
the Commissioner has disallowed (including those for 2007 on which he had the
burden of proof) should have been deferred under section 195 until an active trade
or business began. And, since the Heinbockels sold the property in 2007 without
ever beginning business, those costs should have been capitalized and added to the
basis of the property for computing their gain or loss upon sale. See sec. 1016(a);
Diaz v. Commissioner, T.C. Memo. 2012-241, at *4-*7; sec. 1.1012-1(a), Income
Tax Regs.1°
'° The Heinbockels' argument to the contrary isn't convincing. They
contend that section 1.162-12(a), Income Tax Regs., gives them the option to
either deduct or capitalize their ordinary and necessary expenses during the
preproduction period. Since they elected not to capitalize the amounts expended
(other than the cost of the tractor) in developing the farm, the Heinbockels say that
they should be allowed to expense those amounts. And they also assert that the
uniform capitalization rules of section 263A, which generally apply to property
produced by a taxpayer that has a preproduction period of more than two years (as
(continued...)
-45[*45] We still need to examine the consequences of this conclusion on how the
Heinbockels should have reported the sale of their property on their 2007 return.
They claimed a sale price of $800,000 and a basis of $620,951, which produced a
capital gain of $179,049. Although the Commissioner never challenged the
Heinbockels' claimed basis, he contends--in a footnote in his posttrial brief-that
the Heinbockels "arguably" had already increased their basis in the property by the
amount of their startup costs deducted on the 2005 through 2007 Schedules F.
The record, however, indicates otherwise. The closing statement that the
Heinbockels received when they bought the property shows their purchase price
was $550,000 with about $1,000 in closing costs. The "seller final closing
statement" in 2007 when they sold the property for $800,000 shows that they paid
$40,000 in commissions and another $1,000 or so in other closing costs. The final
page of that statement also contains a handwritten itemized list of "additional
1°(...continued)
grapes do)--and which require capitalization of'direct and indirect costs incurred
during the preproduction period shouldn't apply because their "farming activities
were dead-stopped as a result of the property owners association's before any
planting occurred." The problem for the Heinbockels is that even if we were to
buy their argument, their activity had not entered even the preproduction period.
The preproduction period doesn't begin before a taxpayer plants the seed. See sec.
1.263A-4(b)(2)(C), Income Tax Regs. And it's undisputed that the Heinbockels
hadn't planted any grapes. The Heinbockels were in a prepreproduction period,
and so the regulation that they cite doesn't apply.
-46[*46] selling expenses" (e.g., contracting fees, legal supplies, and various
supplies) totaling $24,117. Although no corroboration was provided for those
amounts, the Commissioner has not challenged that sum. Adding the
commissions, closing costs, and additional selling expenses to the original basis of
the property comes to approximately $615,000--within $5,000 of the adjusted
basis claimed by the Heinbockels. In any event, in light of the closing statements
in the record, we don't agree with the Commissioner that the Heinbockels
doublecounted the Schedule F expenses by also adding them to their basis. And
because the Commissioner never put the adjusted basis at issue (absent that one
footnote), we conclude that all amounts claimed on the Schedules F between 2005
and 2007--as well as the additional items the Heinbockels claimed at trial--should
be added to the property's adjusted basis.
V.
Lydia's World
A.
Lydia's Business
Before engaging the merits of the disputed deduction the Heinbockels
claimed for Lydia's World, there's actually a dispute over whose Schedule C
business this really was. Each of the three Schedules C for Lydia's World listed
Ed as the proprietor. And on brief the Heinbockels continued to assert that this
-47[*47] was Ed's business and thus any self-employment tax incurred due to income
from Lydia's World should be allocated to him." So whose business was this?
With a business named Lydia's World, it wouldn't seem to be a stretch to
conclude that this was, in fact, Lydia's business. It certainly wasn't Ed's.
Throughout trial, Lydia testified that this was her business. When asked to
describe Lydia's World, she described it as "my business;" and her testimony was
threaded throughout with the first-person singular: "I got the idea," "I sent out
invitations," "I have many trips," "I purchase [from] designers," "I have kind of a
mishmash of all kinds of [inventory]," "I'm marketing myself," "I'm constantly
* * * advertising my business," "I have a trunk show business that's called Lydia's
World of Personal Shopping Services," and "I'm constantly promoting myself."
Only when it was convenient--such as when a dining receipt claimed as a
deduction was paid using Ed's credit card--did Lydia suddenly change and assert
that Ed "was very much involved." But even that comment was revealing-because she said that Ed "was very much involved in my business." Thus, we
have no doubt this was Lydia's Schedule C business, and any self-employment tax
incurred as a result of income from Lydia's World should be attributed to her.
" Since Ed had already hit the Social Security tax threshold for all of the
years at issue, if he were the owner of Lydia's World it would mean that the
Heinbockels wouldn't owe any additional FICA taxes on that business income.
-48[*48] B.
Expenses
Now we turn to the items in dispute. Lydia deducted a wide range of
business.and nonbusiness expenses on the Schedule C for Lydia's World. The
disputes over some of the expenses are nothing more than routine substantiation.
While the notices of deficiency disallowed certain expenses, the parties made
additional arguments (and some concessions) both at trial and in posttrial briefing,
which placed many other amounts in dispute. We cut them into categories and
sew up each in turn.
1.
Section 274 expenses
Some deductions demand more substantiation than others. See secs. 274,
280F. These include travel, meals and entertainment, and certain forms of "listed
property." "Listed property" includes any passenger automobile. Sec.
280F(d)(4)(A). To deduct items in these categories, a taxpayer must show that the
item claimed is directly related to or associated with the active conduct of her
trade or business. Sec. 274(a). She must also provide "adequate records" showing
the amount of the expense, the time and place of the expense, the business purpose
of the expense, and the business relationship to her of the persons entertained.
Sec. 274(d); sec. 1.274-5T(c)(2)(I), Temporary Income Tax Regs., 50 Fed. Reg.
46017 (Nov. 6, 1985). "A contemporaneous log is not required," but we will
-49[*49] afford a statement that isn't made at or near the time of the expenditure the
same degree of credibility only if the corroborative evidence has "a high degree of
probative value." Sec. 1.274-5T(c)(1), Temporary Income Tax Regs., 50 Fed.
Reg. 46016 (Nov. 6, 1985); see also Reynolds v. Commissioner, 296 F.3d 607,
615-16 (7th Cir. 2002) (noting that keeping written records is not the only method
to prove section 274 expenses but "alternative methods are disfavored"), _a_ff'g
T.C. Memo. 2000-20. These strict substantiation requirements don't allow us to
use the Cohan doctrine to estimate expenses. See Sanford, 50 T.C. at 827.
We'll march each category of section 274 expense down the runway for a
closer look.
a.
Car expenses
Year
Claimed P claimed R allowed R allowed
on return in brief
in NOD
in brief
2005
2006
2007
$12,6791 $12,2202
13,430
16,103
8,759
6,6553
$788
-0-0-
-0-0-0-
1 This is the sum of $788 in car and truck expenses and $11,891 in vehicle
rent.
2 This is the sum of $788 in car and truck expenses and $11,432 in vehicle
rent. The Heinbockels on brief also concede that it wasn't proper to claim a
depreciation deduction.
-50[*50] 3 In addition to conceding $2,104 in car-and-truck expenses, the Heinbockels
on brief concede that it wasn't proper to claim the depreciation deduction ($2,565)
for the vehicle.
Consistent with her sense of fashion, Lydia cruised in style. For the first 11
months of 2005, she leased a Mercedes for approximately $1,000 per month, and
deducted 100% of those payments. When Lydia began leasing this vehicle in
September 2002, however, the lease stated that the primary use was for "personal,
family, or household purposes." In December 2005 when that lease ended, she
bought a Land Rover for just under $70,000. She claimed a standard mileage
deduction for 100% of the miles driven with this car for 2005 and 2006, and 90%
of the 2007 miles.
Lydia justified writing off substantially all of the vehicles' expenses by
saying "if you understand my business and the marketing involved, you will pretty
much see that I'm marketing myself 24-seven, and I use that car for everything to
do with the business. I'm constantly dropping off clothes, you know, advertising
my business, because I'm a walking, talking testimonial [of] who I am." When
asked to give an example of what she did to rack up the business miles, she said
she would "wake up in the morning and go to the gym," a place she said she did
"30 to 40 to 50 percent" of her business. After her workout, if somebody was
waiting at the gym for an order, she would "have it in the car." After that, Lydia
-51[*51] said she would shower, "get dressed in something fabulous," then "drive and
* * * drop off two or three pieces of clothing to people that have ordered stuff." In
summary, Lydia said "it's hard to divide between the business and me, and me and
the business, I mean, I'm constantly promoting myself 24-seven. There's not a
time when I'm not."
We mostly agree with her that it was often difficult to distinguish her
business and personal activities. But Lydia's proclivity to knit together these two
sides of her life--combined with her lack of recordkeeping--doom her under section
274. She didn't provide any contemporaneous logs or records indicating the time
or number of miles driven, much less bring forth any records that detailed the
business purpose of each trip she made. Although she indicated that she logged all
of her appointments in Outlook, she didn't provide any documents to support this
assertion. And because we can't just estimate these expenses, we disallow them in
their entirety.
-52[*52]
b.
Year
Travel and meals and entertainment
Claimed P claimed R allowed R allowed
on return in brief
in NOD
in brief
2005 Travel
$1,465
$8621
-0-
-0-
2005 M&E
800
-0-1
-0-
-0-
2006 Travel
6,613
6,616
-0-
-0-
2006 M&E
682
682
-0-
-0-
' At trial and on brief, the Heinbockels say that $1,403 of the travel ($603)
and meals and entertainment ($800) expenses for 2005 should be reclassified as
supplies. According to the credit-card summary in the record, it appears those
reclassified amounts are for various purchases from Target and Costco. Although
the Heinbockels say those amounts were not already accounted for in supplies or
costs of goods sold, they haven't proven that to be the case nor have they
adequately substantiated the reclassified amounts. We therefore disallow the
amount they seek to reclassify.
The Heinbockels did a bit of traveling and dining in 2005 and 2006-purportedly for Lydia's World. They did not, however, support a single one of
these expenses with contemporaneous logs or similar statements that detailed the
time or place of the expense or its business purpose as section 274 generally
requires. This proof consisted instead of Lydia's testimony as she went through
these expenditures one by one--occasionally in some detail--that explained where
she was, what she was there for, and why she thought the expense deductible.
Although there were a few receipts in the records to refresh her memory, most of
the recollection came from Lydia's year-end credit-card summary statement.
-53[*53] Is that kind of memory jogging years later--supported by evidence such as a
credit-card statement (or occasionally a receipt)--enough to meet the strict
substantiation requirement to provide "adequate records?" See sec. 274(d); sec.
1.274-5T(c)(1), Temporary Income Tax Regs., supra. Generally speaking, the
answer is "no", because such testimony is not an "account book, diary, log,
statement of expense, trip sheet, or similar record *.* * made at or near the time of
the expenditure or use," much less a record that explained the business purpose.
Sec. 1.274-5T(c)(2)(ii), Temporary Income Tax Regs., supra.
The regulations however, do provide an exception. If a taxpayer isn't able to
substantially comply with the requirements of section 1.274-5T(c)(2), Temporary
Income Tax Regs., with respect to an element of an expenditure or use, she must
establish that element by pinning two prongs into the record: (1) her own
statement--whether written or oral--"containing specific information in detail as to
such element"; and (2)"other corroborative evidence sufficient to establish such
element." Sec. 1.274-5T(c)(3)(I), Temporary Income Tax Regs., 50 Fed. Reg.
46020 (Nov. 6, 1985). The regulation continues, in greater detail, if that element is
the cost or amount, time, place, or date of an expenditure or use, the corroborative
evidence shall be direct evidence, such as a statement in writing setting forth
detailed information about such element, or documentary evidence such as a
-54[*54] receipt. Id. If that element is either the business relationship to the taxpayer
of persons entertained, or the business purpose of an expenditure, the corroborative
evidence may be circumstantial. Id. The corroborative evidence supporting a
noncontemporaneous statement "must have a high degree of probative value to
elevate such statement and evidence to the level of credibility reflected by a record
made at or near the time of the expenditure or use supported by sufficient
documentary evidence." Sec. 1.274-5T(c)(1), Temporary Income Tax Regs., supra.
In sum, it is possible that documentary evidence such as receipts coupled
with credible testimony can meet section 274's strict requirements. See Efron v.
Commissioner, T.C. Memo. 2012-338, at *18. While reserving our decision as to
whether Lydia established the amount, time, and place of the expenditure, we focus
our analysis on the business-purpose element.
In 2005 and 2006, Lydia (usually accompanied by Ed) took various trips,
including ones to Los Angeles, Santa Barbara, Long Beach, San Diego, Santa Fe,
and New York. The Commissioner alleges that these were all personal trips, and
that many of them were suspiciously timed to coincide with birthdays and other
special occasions.
We look at each.
-55[*55]
I.
Los Angeles
Lydia testified that her trips to Los Angeles were to attend the California
Mart, and on one occasion to hold one of her trunk shows there. The California
Mart was where Lydia said she went four or five times a year to do her "primary
buying." She said she would analyze clothing from hundreds of designers and sit
down with them to figure out whether the clothing lines were "bohemian" enough
to attract her upscale clientele. While she was in LA, she would often dine with
various designers and (curiously, inasmuch she was their potential customer) would
pick up the tab. These outings, Lydia said, led to great relationships with the
designers. As for the trunk show she held in LA, she said she invited several of her
"friends and colleagues and friends of friends" to an "actual beautiful room" at the
Hyatt Regency. Although she said it was successful, she "realized it was too much
of a schlep to schlep all the clothes to Los Angeles," and she never did another one
after that.
Although she was able to recite in detail some of these expenditures, we
often found her explanations about these alleged business trips a bit off. For
example, when referring to a receipt from the Avalon Hotel in Beverly Hills, she
talked about how she stayed there for a few nights while buying inventory at the
California Mart. The receipt, however, detailed four restaurant outings and two
-56[*56] overnight parking charges over a three-day span--and not one charge for a
room. For another one of her alleged buying trips to Los Angeles, the hotel receipt
was under Ed's name and indicates that three persons stayed in the room, and the
charges consist solely of private dining and valet parking. As we noted earlier,
Lydia--when questioned about why a hotel bill that Ed had paid had been written
off as a business expense--argued that Ed "was very much involved" in her
business. As we explained earlier, we find this assertion inconsistent with her
other testimony throughout the record. We therefore find that many of these trips
mixed business with pleasure, and with neither contemporaneous statements of
business purpose nor the ability to estimate, we find that none of the Los Angeles
trips and related meals are deductible.
ii.
San Diego
Lydia testified that she went down to La Jolla (an affluent resort community
in San Diego) to check out several designers. She indicated that her trip yielded "a
lot of great, great new designers" because their stores had "the same type of beachy
kind of attire, very casual, that goes over well in San Luis Obispo." Lydia said she
had to rent a car during this trip because she and Ed flew down. On cross-
examination, however, she admitted that she had claimed deductions for the cost of
two rental cars. The credit-card summary statements show the Heinbockels also
-57-
[*57] visited Sea World. That same statement showed minimal clothing purchasesno more than a couple hundred dollars--leading us to find this trip was more
personal shopping than buying inventory for a personal-shopping business. The
hotel receipt was again in Ed's name--and included multiple charges for room
service, a spa fee, and various other nonoccupancy charges. When asked about the
spa charge, Lydia said it was a charge for her to work out before an appointment.
Then when asked whether the workout was personal or business, Lydia answered:
"Well, let's see, I think I have to make myself look good so I look good in the
clothes, so I'll say business."
We'll say personal. And we'll disallow the amounts deducted in connection
with this trip.
iii.
Santa Barbara
Lydia said she went to Santa Barbara "every couple months to check out the
new stores and what kind of lines they're carrying and anything that's any interest."
She said she deducted two meal expenses during trips to Santa Barbara. She said
one of those was at a place called Senor Lucky's. However, Senor Lucky's is in
Santa Fe--not Santa Barbara. Substantiation fails there. The other meal was for her
lunch with her assistant when they were "check[ing] out several stores." The
aroma of personal expense is strong here, and we find the lack of detail required to
-58[*58] prove a business purpose. We will allow no deductions for any Santa
Barbara meals.
iv.
Santa Fe
Lydia traveled with Ed to the Santa Fe area in both 2005 and 2006 around
the date of Ed's birthday. Lydia claims they went to "a big kind of like festival
where they have a lot of different vendors." Although she forgot what the festival
is called, she indicated "it's like a really great time to go to Santa Fe." She
indicated that during this trip, she considered expanding into men's clothing
lines--"with the cowboy style that San Luis Obispo likes"--but decided against it.
Although she deducted the costs of various meals she said she had with suppliers
during that time, there were also expenses claimed for meals apparently with just
her and Ed--including at Senor Lucky's. Such obvious elements of personal
pleasure lead us to disallow these expenses.
v.
New York
Lydia also deducted a hotel stay with Ed in New York, as well as various
limousine charges during their time there. She claimed this trip was to attend the
Coterie show, which is a "fantastic show that has all the designers from all over the
world." And because she was in New York, Lydia decided that "it would be safer"
to take a limo instead of catching a cab. She said that it was in New York she
-59[*59] found the Vivian Uchitel line from Buenos Aires and the Heike Jarick line
from Germany. However, she had testified earlier that she found the Vivian
Uchitel line at a designer at the California Mart, and that she had recommended
Heike Jarick to a designer in Santa Fe (who subsequently carried that line) the year
before she claimed to have found her in New York. Without contemporaneous
records, this testimony--in addition to being inconsistent--does not contain the
detail needed to claim a deduction under section 274.
vi.
Long Beach.
Lydia deducted some expenses related to a trip back to Long Beach--her
"stomping ground" where she was born and raised. She said she went down on that
occasion to "check out some of the boutiques on Second Street." She didn't,
however, provide any.details about the designers or meetings that occurred when
she was visiting. This doesn't come close to meeting section 274's requirements.
vii.
Wine tasting
Lydia deducted close to $500 for a wine tasting tour in a limo--an "incredible
trip" on which she initially said she invited three of her "best customers that spent
* * * over $10,000" in 2006 with Lydia's World. On cross-examination, she
admitted that there were eight people (four couples)--including her and Ed, as well
as her assistant, Karen Barcelas, and her husband. Although Lydia initially
-60[*60] claimed that Karen was one of her top clients, she had no idea how much
Karen actually spent. This vague (and inconsistent) testimony also doesn't cut it.
viii.
Summary
Lydia deducted a few other expenses for meals she said she had with
designer representatives in and around San Luis Obispo, but we likewise find the
testimony describing those occasions falls short of section 274's strict standard.
The absence of contemporaneous logs combined with Lydia's often inconsistent
testimony, and the numerous occasions where these alleged business trips appeared
to be draped with personal pleasure, cause us to find that none of the travel and
meals and entertainment expenses met the business purpose requirement of section
274.
c.
Advertisina/Gifts
Claimed P claimed R allowed R allowed
Year
on return
in brief
in NOD
in brief
2007
$11,054
$11,054
-0-
$75
Lydia's World claimed over $11,000 of advertising expenses for 2007. That
amount, though, didn't jibe with Lydia's testimony. She testified that "I don't
spend money on ads, I don't--it's all based upon word of mouth, on me, and
promoting myself." We agree with the essence of that testimony. And we find
-61[*61] those expenses were really gifts to those who helped her with her shows.°
Her accountant for 2007, Harold Ritter, testified that "it was common practice to
dispose of some of the leftover inventory as gifts, and * * * record these as
marketing expenses."
The cost of gifts "may be an ordinary and necessary business expense if the
gifts are connected with the taxpayer's opportunity to generate business income."
Bruns v. Commissioner, T.C. Memo. 2009-168, 2009 WL 2030886, at *8.
Business gift deductions pursuant to section .162 are restricted to $25 per donee per
taxable year. Sec. 274(b)(1). Section 274's onerous requirements also apply. See
sec. 274(d). A taxpayer who claims a deduction for a business gift is required to
substantiate it with adequate records or sufficient evidence corroborating his own
testimony as to (1) the cost of the gift; (2) the date and description of the gift; (3)
the business purpose of the gift; and (4) the business relationship of the person
receiving the gift. Sec. 1.274-5T(b)(5), Temporary Income Tax Regs., 50 Fed.
Reg. 46016 (Nov. 6, 1985). Although Lydia detailed in some cases what was given
" After claiming only $45 of advertising expenses on Lydia's World's 2005
Schedule C, the Heinbockels on brief claimed $4,712 for that year. But because
we find that the amounts claimed for 2005 were not advertising expenses masked
as gifts, we don't subject them to section 274's strict requirements but rather deal
with them later when discussing a variety of miscellaneous expenses in dispute for
2005.
-62[*62] away, she didn't indicate the recipient of the gift, much less its business
purpose. On brief, the Commissioner allowed the Heinbockels to deduct $75: $25
per donee for gifts to three individuals--her secretary Karen Barcellas and the two
other clients that Lydia claimed attended the wine tasting event. Because of the
failure to adequately substantiate any of the amount claimed, we will not allow a
deduction greater than the Commissioner has.
d.
Year
Home Office
Claimed P claimed R allowed
on return in brief
in NOD
R allowed
in brief
2005
-0-
$2,802
-0-
-0-
2006
-0-
2,040
-0-
-0-
Although the Heinbockels didn't claim a home-office deduction on any of
the returns at issue, they now argue that they did incur home-office expenses in
2005 and 2006 in connection with Lydia's World.
Section 280A(a) states: "Except as otherwise provided in this section, in the
case of a taxpayer who is an individual * * *, 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." The Code then
provides an exception to this general rule to permit a deduction for home-office
-63[*63] expenses "allocable to a portion of the dwelling unit which is exclusively
used on a regular basis * * * as the principal place of business for any trade or
business of the taxpayer." Sec. 280A(c)(1)(A). A taxpayer may deduct
home-office expenses if she shows her home office is:
042
used for a trade or business;
042
used exclusively for that purpose; and
her
042 principal place of business.
Although Lydia had a bit of difficulty recalling where she lived during the
years in question, the spreadsheets detailing the home-office deductions indicate
the Heinbockels lived in three different residences. They started 2005 in a 2,200-
square-foot house (204 square feet allocated to the home office), then later that
year downsized to an 1,850-square-foot apartment (150-square-foot allocation).
. Then, sometime in 2006, they moved to a 4,100-square-foot home (255-square-foot
allocation). Although she didn't describe those locations separately, Lydia testified
that in each of those locations "there was always one room pretty much dedicated
to * * * Lydia's World" where she would store "tissue paper, bags, some inventory,
[and] boxes." When asked whether there were any other items in that room,
however, her answer wasn't unequivocal: Lydia said that "[i]t's kind of a room
designated for a lot of stuff, like the closets full of clothes and there's, yes, boxes. I
-64[*64] kind of designate it to kind of close the door." In light of that testimony, we
find that none of these spaces were used exclusively for Lydia's World, and the
Heinbockels can't deduct home-office expenses for them under section
280A(c)(1)(A).
The Heinbockels, however, point out that section 280A's general prohibition
on deducting home-office expenses doesn't apply to the extent that an expense is
allocable to space within the dwelling unit which is used "on a regular basis as a
storage unit for the inventory or product samples" and is the "sole fixed location of
[the] trade or business." Sec. 280A(c)(2); see also Banatwala v. Commissioner,
T.C. Memo. 1992-483, 1992 WL 203306, at *4. We find Lydia's testimony on this
issue questionable at best. The Commissioner confirmed with Lydia that the 1,800square-foot apartment that she, Ed, and their son rented had only two bedrooms.
Although Lydia denied that her son lived in the same room as she and Ed, she
didn't explain where her son slept. Even if we accepted Lydia's testimony, though,
she would still need to establish that she maintained a bonaffde inventory to
qualify for the section 280A(c)(2) exception. Ritter testified, however, that Lydia
didn't have a "running inventory"--rather, she would just order for her shows
whatever would sell. Although there would be some inventory left over, Ritter
credibly said she gave most of it away to those that helped her with the shows. We
-65[*65] don't think hanging a couple dozen items of clothing in a closet is enough to
make the room that closet is in a "storage unit for inventory." We conclude that
Lydia is not entitled to a home-office deduction under section 280A(c)(2) for 2005
or 2006.
2.
Other Adjustments
a.
2005
Claimed P claimed R allowed R allowed
Item
on return
in brief
Returns
$1,130
$2,916
$1,130
$1,1302
COGS
26,848
91,477
26,848
43,3151
Advertising
45
4,712
45
452
Insurance
834
840
834
8342
Interest: other
-0-
817
in NOD
-0-
in brief
-0_2
Officeexpense
920
48
920
48
R&M
Supplies
Utilities
50
630
1,794
-01,403
2,386
50
630
1,794
-06302
1,7942
Other expenses
6,641
7,179
6,641
6,6412
1 The Commissioner in his brief concedes that 50% of the sales are allowable
as costs of goods sold for 2005. Based on the Heinbockels' brief, gross receipts
were $86,629. Therefore, we construe the Commissioner's concession to be
$43,315.
2 Although the Commissioner didn't specifically disallow each claimed
increase in expense, he generally asserts that the Heinbockels failed to substantiate
the claimed increases.
-66[*66] Other than the section 274 expenses discussed above, the Commissioner's
notice of deficiency allowed all the other expenses that Lydia claimed for 2005.
However, at trial the Heinbockels argued for more (with an occasional concession
for less). (The Heinbockels seem to have hired somebody to go through the
records to try to organize them at some point after 2005. This led to some very
significant changes--they now argue, for example, that the $7,649 net profit as
originally reported on the Schedule C should really be corrected to a net loss of
$38,230.)
The Heinbockels didn't explain these adjustments at trial. They also didn't
do so in their brief; instead referring to them being "summarized in Attachment E."
That attachment contains various computerized spreadsheets that they created. We
treat these spreadsheets as argument--not evidence--and use them only to guide us
to the appropriate underlying document. See Rodriguez v. Commissioner, T.C.
Memo. 2009-22, 2009 WL 211430, at *2.
The records for Lydia's World rivaled Fibber McGee's closet for their
organization. Lydia testified that in 2005 (as well as 2006) she had a "young girl
named Lindsey that was helping [her] do the accounting." But, Lydia explained,
Lindsey "was kind of a babysitter and then she also was just learning Quickbooks."
Ritter--the accountant that Lydia had hired to recreate records for the 2007 tax
-67[*67] year--explained that he inherited records in Quickbooks that were in "a state
of disarray." Ritter said that status "was based on not understanding how to use the
program." With respect to 2005, after attempting to review the claimed increases,
we agree that the records were more than a bit out of order.
We start with the very large increase in cost of goods sold. Though cost of
goods sold is technically an adjustment to gross income and not a deduction, Lydia
still has to substantiate the amounts she claimed. See Rodriauez, 2009 WL
211430, at *2. Lydia is now claiming an amount---over $90,000--that is more than
triple what the Heinbockels claimed on the 2005 return. In support, she cites a
mishmash of Quickbooks entries, credit-card statements, bank statements, invoices,
and the occasional receipt--but nothing that would allow us to even come close to
tying the invoices and various statements provided to any schedules. Moreover,
this revised amount exceeds their revised calculation of gross receipts by almost
$5,000. In light of Lydia's testimony that she generally marks up her clothing
somewhere between 100% and 120%--and that the change in inventory (and
inventory generally) was basically nil--we find that adjusted cost of goods sold
amount is simply incredible. Because we can use the Cohan doctrine here, on the
basis of Lydia's testimony, we think that allowing 50% of gross receipts would be
appropriate. See Cohan, 39 F.2d at 543-44. Therefore, based on $86,629 of gross
-68[*68] receipts, we allow $43,315 for cost of goods sold (with no adjustment for the
increase in returns and allowances). Any inexactitude in this estimate is of the
Heinbockels' own making and is due to their failure to maintain adequate business
records. See id.
It's a similar story for the remainder of the adjustments the Heinbockels
made for Lydia's World's 2005 tax year. Substantially all of the increased amounts
are supported either by a Quickbooks entry or a credit-card summary statement-but without any testimony to support the claimed the increases. Even when they
provided an invoice, the Heinbockels kept such incomplete and disorganized
records as to ensure that we can't tell.whether those amounts were already allowed
as deductions elsewhere. We therefore find that the Heinbockels have not met their
burden to substantiate any deductions that the Commissioner didn't already allow
for 2005. And to the extent that the Heinbockels conceded amounts lower than
those reported on Lydia's World's 2005 Schedule C, we accept those concessions.
b.
2006
The only remaining adjustments the Heinbockels made for Lydia's World for
2006 were in the "other expenses" category. The Commissioner allowed all of the
"other expenses" they claimed on the Schedule C, but in their posttrial brief the
Heinbockels made the following adjustments:
-69[*69]
Item
Claimed P claimed R allowed
on return in brief
in NOD
R allowed
in brief
Bank card fees
Dues &
memberships
$1,636
$275
$1,636
N/A
2,418
50
2,418
N/A
Internet
1,200
2,601
1,200
N/A
Merchandising
4,931
3,536
4,931
N/A
Outside services
110
756
110
N/A
Postage
Service charges
Total
86
612
10,993
-0-07,218
86
612
10,993
N/A
N/A
N/A
The Heinbockels provided no support for these adjustments--simply noting
in a spreadsheet attached to their opening brief that these items "were not
challenged by respondent." In his brief the Commissioner didn't respond to these
various increases and decreases. We will accept the concessions the Heinbockels
made but, because they didn't provide anything to substantiate the increased
expenses, we have to disallow the claimed increases.
c.
Item
2007
Claimed P claimed R allowed
on return in brief
in NOD
R allowed
in brief
COGS
$73,062
$79,715
-0-
$73,0621
Legal
1,200
900
-0-
9002
Taxes
Wages
9,595
30,398
16,419
-0-
-0-0-
9,595
-0_2
-70[*70] Interest
Other expenses
2,992
7,218
2,992
7,418
2,992
-0-
?
4,1201
1 The Commissioner's brief includes two separate tables for his concessions
with respect to the 2007 expenses at issue for Lydia's World. For the most part,
these two tables were in accord. However, the tables differed on concessions for
cost of goods sold ($61,246 vs. $73,062) and other.expenses ($4,120 vs. $3,536).
We construe the Commissioner's inconsistencies in the light most favorable to the
Heinbockels.
2 Because the Heinbockels and the Commissioner agree in their respective
briefs on these amounts, we allow the agreed-upon amounts and won't discuss
them any further.
As noted earlier, Lydia's World's records were in shambles for 2007 when
she hired Ritter. Ritter said that when he came on board, he "basically * * * took
all the papers and recreated the whole year." From a combination of "bank
statements, credit card statements, receipts, the check register, * * * and
* * * actual invoices," he said he was able to create a profit and loss statement.
Even after this process, Ritter said he wasn't necessarily able to track a particular
invoice to an entry made in Lydia's books.
i.
. COGS
After initially disallowing the entire cost of goods sold adjustment--a tad
over $73,000--in his notice of deficiency the Commissioner now concedes that
amount. But Lydia wants more, albeit not as much of an increase as she asked for
2005. Several obstacles stand in the way, however. First off, Lydia didn't properly
-71[*71] track inventory. Ritter testified that Lydia's World didn't have a running
inventory and the Heinbockels didn't use Quickbooks to do inventory control.
Even Ritter couldn't figure out how they traced the inventory's value. He also
concluded that he had no way of knowing whether Lydia's personal purchases were
included in cost of goods sold. The support for the new amount--another
combination of Quickbooks entries, bank statements, credit-card statements,
invoices, and the occasional receipt--doesn't provide any way to show whether
purchases were double counted, or even if they were purchases for business and not
for personal use. In light of gross receipts of about $130,000, the increased claim
for cost of goods sold--almost $80,000--suggests that Lydia marked up her clothing
only a tad over 60%, a far cry from her testimony that she generally had a markup
of 100% to 120%. We find that Lydia has not adequately substantiated the claimed
increase, but because the Commissioner conceded the amount originally claimed on
the return, we do allow that amount.
ii.
Taxes
The notice of deficiency disallowed the entire $9,595 deduction for taxes and
licenses, but the Commissioner allowed that amount on brief. But the Heinbockels
now claim an additional $6,824. The Commissioner argues that they haven't
substantiated the increase, but Lydia did provide two canceled checks, both payable
-72[*72] to the California State Board of Equalization, for the full amount. Lydia
credibly testified that those checks paid sales tax due from Lydia's World, and this
is adequate substantiation. We therefore allow the entire $16,419.
iii.
Interest
Although the Commissioner's brief would lead us to think otherwise, the
notice of deficiency didn't disallow any of the $2,992 in interest claimed on Lydia's
World's Schedule C. Now, however, the Commissioner does seem to challenge that
amount, and he asserts that because the interest was charged by Lydia's personal
credit-card issuers, the percentage of business use compared to her personal use is
unknown. This particular item results in an increase in deficiency, so the
Commissioner has the burden of proof. See Rule 142(a)(1). Although.we share his
concern with Lydia's commingling (as we discuss below), his mere allegation that
the interest deduction should be.disallowed because breakdown is "unknown" isn't
sufficient to meet his burden of proof. We allow the entire amount
-73[*73]
iv.
Other expenses
The "other expenses" category is made up of the following items:
Item
Claimed P claimed R allowed
on return in brief
in NOD
R allowed
in brief
Bank-card fees
$275
$275
-0-
$2751
Dues &
memberships
50
50
-0-
-0-1
Postage
Credit card fees
2,601
3,536
2,601
3,536
-0-0-
309
3,5361
756
656
-0-
-0-
Misc
Promo donation
-0-
300
-0-
-0-
Total
7,218
7,418
-0-
4,120
1 Because the Heinbockels and the Commissioner agree in their respective
briefs on these amounts, we allow them and won't discuss them any further.
On brief, the Commissioner concedes only $309 of the $2,601 in postage fees
that Lydia deducted on her Schedule C. Lydia supported much of the rest with a
noncontemporaneous spreadsheet and by pointing to items on her credit-card or
bank statements. She did, however, support a handful of the expenses totaling
$1,015 with invoices and receipts. We allow all of that amount. Of the remaining
$1,586 claimed but only substantiated by credit-card statements or bank statements,
we use Cohan but also recognize Lydia's admission that she commingled business
and personal charges on that credit card, so we will allow only half of that
-74[*74] remaining amount--$793. Therefore, the total amount of postage we allow is
$1,808.
Lydia didn't provide any invoices or receipts to support her miscellaneous
expenses or newly claimed promotional-donation expense. Without invoices or
receipts for any of these amounts, we won't use Cohan to estimate. We disallow
them all.
VI.
Penalties
The Commissioner determined that an accuracy-related penalty of 20% under
section 6662 should apply to the underpayment of tax for each of the tax years at
issue because the entire underpayment was attributable either to the Heinbockels'
"negligence or disregard of rules or regulations" or to a "substantial
understatement" of their income-tax liability.
We start with the first. "Negligence" includes any failure to make a
reasonable attempt to comply with the provisions of the Code, including any failure
to keep adequate books and records or to substantiate items properly. See sec.
6662(c); sec. 1.6662-3(b)(1), Income Tax Regs.
Under section 7491, the Commissioner bears the burden of production with
respect to the section 6662 penalty. This means that the Commissioner must come
forward with sufficient evidence indicating that it's appropriate to impose the
-75[*75] relevant penalty. Higbee, 116 T.C. at 446. The Commissioner certainly
showed here that the Heinbockels kept inadequate books and records. Their
recordkeeping was shoddy, as one can see in the numerous (and sometimes very
large) differences between what the Heinbockels originally claimed on their returns
and what they argued to us. And many of these revisions either significantly
changed the bottom line (e.g., Lydia's World) or significantly altered the character
of the items initially reported (e.g., the lending activity). Even with the revised
amounts, most of the records were insufficient to substantiate the claimed
deductions. And the exceptional extent of commingled business and personal
expenses shows a lack of a good-faith, reasonable attempt to ascertain the
correctness of the deductions claimed. The Commissioner has met his burden of
production.
Once the Commissioner has met his burden, taxpayers must come forward
with persuasive evidence that the Commissioner's determination is incorrect. Rule
142(a); Higbee, 116 T.C. at 446-47. Taxpayers can meet this burden by proving
that they acted with reasonable cause and in good faith. See sec. 6664(c)(1); sec.
1.6664-4(a), Income Tax Regs. But, other than their blanket assertion that they
acted with reasonable cause and in good faith, the Heinbockels haven't produced
any evidence to show why the penalty shouldn't apply to them. Looking at the facts
-76[*76] and circumstances-in light of the experience, knowledge, and education of
the taxpayers-we cannot say that the Heinbockels acted with reasonable cause and
in good faith. See sec. 1.666-4-4(a), Income Tax. Regs. Ed has an MBA, and, in
his previous position as a controller, managed an accounting staff of 30 and a
production staff of 350. He touted himself as really good at finance, and asserted
that he "can do pro-formas until the cows come home." The Heinbockels have not
argued that they relied on the advice of professional adviser, nor could they in good
faith say so, as Ed admitted that their CPA just entered on their returns the
information that Ed had provided him. We therefore sustain the Commissioner's
determination that the Heinbockels are liable for the accuracy-related penalty on the
ground of negligence for the entire amount of the underpayment for each of these
years at issue."
Decisions will be entered
under Rule 155.
" The Commissioner also argued that the Heinbockels are liable for the
section 6662 penalty based on substantial understatements. Our f'mding of
negligence means that we don't need to address this argument--the Commissioner
gets only one 20% penalty.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.