UNITED STATES TAX COURT
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T.C. Memo. 1996-318
UNITED STATES TAX COURT
CHARLES R. BOWDEN AND SUE I. BOWDEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14318-93.
Filed July 15, 1996.
Charles R. Bowden and Sue I. Bowden, pro sese.
Lisa W. Kuo, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge:
Respondent determined deficiencies in and
additions to petitioners’ Federal income tax, and an accuracyrelated penalty as follows:
Additions to Tax
Year
1986
1989
Deficiency
$41,891
42,764
Sec.
6651(a)(1)
$10,473
10,691
Sec.
6653(a)(1)(A)
$2,095
---
Sec.
6653(a)(1)(B)
1
---
Sec.
6661
$10,473
---
Penalty
Sec.
6662(a)
--$8,553
- 2 1
50 percent of the interest due on $41,891.
All section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
After concessions, the issues remaining for our
consideration are:
(1) Whether petitioners are entitled to
depreciation deductions of $154,986 and $207,060 for their 1986
and 1989 taxable years, respectively; (2) whether petitioners are
entitled to other Schedule C deductions for 1986 and 1989;
(3) whether petitioners failed to include income of $163,001 and
$72,817 received during their 1986 and 1989 tax years,
respectively; (4) whether petitioners are liable for selfemployment tax on any part of the $163,001 and $72,817 amounts;
(5) whether petitioners are liable for an addition to tax for
negligence under section 6653(a)(1)(A) and (B) for 1986 and the
accuracy-related penalty under section 6662(a) for 1989; (6)
whether petitioners are liable for the substantial understatement
addition to tax under section 6661 for 1986, and (7) whether
petitioners are liable for the late filing addition to tax under
section 6651(a)(1) for 1986 and 1989.1
1
The notice of deficiency reflects an investment tax credit
carryforward issue involving $98,660 for 1986. Since the time of
the pleadings, the parties have not addressed this issue.
Therefore, for purposes of this case, the investment tax credit
(continued...)
- 3 FINDINGS OF FACT2
Petitioners resided in Laguna Hills, California, at the time
their petition was filed.
Petitioners’ 1986 Federal income tax
return was filed on July 29, 1988.
Petitioners' 1989 Federal
income tax return was filed during October 1990.3
Charles R.
Bowden and Sue I. Bowden were the sole officers and shareholders
of approximately 12 corporations.4
Petitioners and their
corporations were primarily engaged in the business of buying,
selling, financing, and operating water vending machines (vending
machines).
These vending machines purified water by reverse
osmosis.
Mr. Bowden, as president of each corporation (with the
exception of C.B. Crest), managed the salespeople, promoted
1
(...continued)
carryforward issue is deemed conceded by petitioners.
142.
See Rule
2
The parties’ stipulations of facts and exhibits are
incorporated by this reference.
3
The filing date on petitioners’ 1989 return is clear as to
the month and year (Oct.--1990) but the exact day is not clear.
Petitioners signed their 1989 return on Oct. 14, 1990.
4
For our purposes, the corporations involved in this case
included but were not limited to: (1) Purified Water Inv. Corp.
(PWIC); (2) Purified Water Manufacturing Corp. (PWMC); (3)
Aqualator Vending Corp. (AVC); (4) Aqualator Intl. Corp. (AIC);
(5) Aqualator Serv. Corp. (ASC); (6) Aqualator Manufacturing
Corp. (AMC); (7) Aqualator R&D Corp. (Aqualator R&D); (8) C.B.
Crest, Inc. (C.B. Crest); (9) Septech, Inc. (Septech); (10) PacTech Capital Corp. (Pac-Tech); and (11) The Water Doctor, Inc.
(Water Doctor, Inc.).
- 4 public relations, and arranged and negotiated various financing
agreements with financial institutions concerning the vending
machines.
Mr. Bowden was named president and secretary of PWIC
on April 10, 1987.
As a corporate officer, Mrs. Bowden’s primary activity was
to maintain the corporate bank accounts by reviewing the cash
balances on a daily basis.
She also performed such tasks as the
disbursing of funds, signing of checks, and transferring of funds
between corporate accounts.
Mrs. Bowden held the position of
president of C.B. Crest, and she was president, secretary, and
chief financial officer of PWIC from June 11, 1985, until April
10, 1987.
Mr. Bowden had worked as an accountant, controller, and
management consultant before becoming self-employed.
He received
a bachelor's of business administration in accounting and a
master of sciences in accounting.
However, he had not practiced
as an accountant for many years.
Mrs. Bowden is a bookkeeper.
PWIC and PWMC
Petitioners incorporated PWIC and PWMC for the purpose of
consolidating the operations of AVC, ASC, AIC, and Aqualator
R&D.5
In connection with the consolidation, the Aqualator
corporations were not dissolved.
PWIC was on a fiscal year
ending April 30.
5
Collectively referred to as the Aqualator corporations.
- 5 During its 1986 fiscal year, PWIC leased and occasionally
sold vending machines for home, office, and commercial water
purification use.
During 1986, PWIC operated 490 vending
machines and collected the revenues and incurred expenses in
connection with the machines.
- 6 During the years under consideration, PWIC made payments to
petitioners and paid certain of their expenses, as follows:
Payee
Amount
Mrs. Bowden
$6,700.00
Mrs. Bowden
579.92
Transamerica Occidental
Life Ins. Co.
1,500.00
Stated Reason
Date
Auto expenditures
June 1986
Entertainment
July 1986
Life Ins. policy
for Mr. Bowden
July 1986
Mrs. Bowden
700.00
Travel
Oct. 1986
Mrs. Bowden
500.00
Interco-Aqualator Serv.
Oct. 1986
Transamerica Occidental
Life Ins. Co.
1,500.00
Life Ins. policy
for Mr. Bowden
Nov. 1986
Crocker Natl. Bank
11,495.98
For Mrs. Bowden
1986
Pentech Financial Servs. 1,590.00
For Mrs. Bowden
1986
San Bernardino County
tax collector
For Mrs. Bowden
1986
353.00
Mrs. Bowden
12,346.67
Unidentified
1986
Mr. Bowden
399.56
Entertainment
Dec. 1986
Mrs. Bowden
500.00
Consulting fee
Dec. 1986
VISA
7,314.58
Mr. Bowden’s
credit card bill
1986
American Express
447.63
Mr. Bowden’s
credit card bill
1986
American Express
4,548.81
Mr. Bowden’s
credit card bill
1989
American Express
3,858.61
Mr. Bowden’s
credit card bill
1989
Newport Vending1
44,250.00
Mrs. Bowden
1989
Salary
1989
Mrs. Bowden
4,100.00
1
Newport Vending is a partnership between Mr. Bowden's brother, Hollis
Bowden, and Cathy M. Smith Handel, Mrs. Bowden's daughter.
Petitioners provided respondent with PWIC’s general ledgers
for the periods:
(1) May 1 through December 31, 1986;
- 7 (2) January 1 through May 21, 1989; and (3) the month of October
1989.
Petitioners did not provide respondent with PWIC’s general
ledgers for the periods:
(1) June 1 through September 30, 1989;
and (2) November 1 through December 31, 1989.
Petitioners provided respondent with PWIC’s canceled checks
from May 29 through December 31, 1986.
Petitioners did not
provide respondent with PWIC’s canceled checks from January 1
through December 31, 1989.
C.B. Crest
Petitioners purchased C.B. Crest with the intention of
consolidating or merging the Aqualator corporations into it.
No
consolidation or merger took place.
During the 1989 fiscal year, C.B. Crest used the assets of
the Aqualator corporations.
C.B. Crest rented out and
occasionally sold vending machines, as well as home, office, and
commercial water purification systems.
In 1989, C.B. Crest
operated (including collecting the revenues and paying the
expenses) 551 water vending machines.
C.B. Crest paid petitioners the following amounts during the
taxable year 1989:
Payee
Amount
Reason
Date
Mrs. Bowden
$16,710.83
Unidentified
Jan.-July 1989
Mrs. Bowden
105.04
Postage
Jan. 1989
Mrs. Bowden
127.02
Rent
July 1989
Mrs. Bowden
51,679.84
Salary
Jan.-July 1989
- 8 Mr. Bowden
17,479.84
Salary
Jan.-July 1989
Petitioners provided respondent with C.B. Crest’s general
ledgers for the periods:
(1) January 1 through July 31, 1989;
(2) parts of the month of August 1989; and (3) the month of
October 1989.
Petitioners did not provide respondent with C.B.
Crest’s general ledgers for:
(1) Parts of the month of August
1989, and (2) the months of September, November, and December
1989.
Petitioners provided respondent with C.B. Crest’s canceled
checks for January 1 through July 26, 1989.
Aqualator Vending Corp. (AVC)
Between January 1 and June 31, 1986, Mrs. Bowden received
$1,500 from AVC.
The amount was paid in five checks.
Petitioners provided respondent with AVC’s general ledgers for
January 1 through July 31, 1986.
Petitioners did not provide
respondent with AVC’s general ledgers for the periods:
(1) August 1 through December 31, 1986; and (2) January 1 through
December 31, 1989.
Petitioners did not provide respondent with AVC's canceled
checks for the periods:
(1) May 17 through December 31, 1986;
and (2) January 1 through December 31, 1989.
Transactions
During the years under consideration, petitioners and their
various corporations were involved in transactions with Ocean
Leasing (Ocean Leasing), MDFC Equipment Leasing Corp. (MDFC),
- 9 Bank of Whittier, National Bank of Southern California (NBSC),
Southern Pacific Thrift and Loan (Southern Pacific), and
Concordia Federal Bank for Savings (Concordia Bank).
Each of
these entities lent funds to petitioners and their corporations.
Mr. Bowden was personally involved in the negotiations and
arrangements for the loan transactions.
Petitioners were
involved in about 200 lawsuits involving their corporations,
vending and water purifier activity, and loans.
1.
Ocean Leasing
In 1983, petitioners, through their proprietorship, Vista
Vending, entered into an agreement to lease two vending machines
from Ocean Leasing.
Ocean Leasing.
Originally, AVC sold the vending machines to
Petitioners claimed a $6,996 depreciation
deduction for the vending machines on their Schedule C for Vista
Vending on the 1984 and 1985 tax returns.
2.
MDFC
On September 12, 1984, AIC and Septech, petitioners’
corporations, entered into a transaction with a company, MDFC.
This transaction involved 10 vending machines.
On the same date,
MDFC paid $167,000 to Septech for the 10 vending machines, and
then leased them to AIC for a 60-month period.
At the end of the
lease, AIC had the option to purchase the machines for fair
market value.
Prior to the MDFC lease, Septech sold the 10
- 10 vending machines to AIC.
When the MDFC lease occurred, AIC gave
the same 10 vending machines to Septech to sell to MDFC.
In 1986, MDFC sued petitioners and their corporations for
defaulting on the MDFC lease.
On August 27, 1986, a settlement
favoring MDFC was entered by the California superior court.
Under the settlement, MDFC was to receive:
(1) $199,000, (2)
possession of the 10 vending machines in question, and (3) a
second priority judgment lien on property owned by petitioners in
San Bernardino County.
The $199,000 was payable $10,000 on or
before July 15, 1986, and $3,150 per month for 60 months,
beginning August 1, 1986.
During October 1989, MDFC filed papers
in court reflecting full satisfaction of the settlement in the
California superior court.
On September 20, 1989, MDFC’s lawyers wrote to Arthur Handel
(Mr. Handel), petitioners’ attorney, indicating that upon the
payment of the personal property taxes escrow amounts, “your
client will be the owner of the Aqualator vending machines
originally leased.”
On October 18, 1994, MDFC informed Mr.
Bowden by letter that he was entitled to possession of the 10
vending machines as part of the satisfaction of judgment between
MDFC and AIC.
MDFC also stated that it did not take possession
of the vending machines.
MDFC by an October 25, 1994, letter
advised respondent’s agents that MDFC’s judgment against AIC and
petitioners had been fully satisfied on September 6, 1989.
As a
- 11 result of the satisfaction, petitioners retained possession and
title to the equipment.
3.
Bank of Whittier
On August 20, 1985, the Bank of Whittier loaned petitioners
$250,000.
On January 15, 1986, petitioners gave the Bank of
Whittier a security interest in 16 vending machines to secure the
loan.
The Bank of Whittier caused notice of the security
interest to be filed under provisions of the California Uniform
Commercial Code.
According to the security interest documents,
petitioners’ corporations owned the vending machines.
The loan
was guaranteed by the corporations and, ultimately, was
defaulted.
On February 24, 1986, petitioners and the Bank of Whittier
agreed that the $241,066.01 unpaid principal loan balance would
be satisfied from a new loan to be issued to Mrs. Bowden and
guaranteed by Mr. Bowden.
In turn, the Bank of Whittier released
all corporate guaranties and assigned its security interest in
the 16 vending machines to Mrs. Bowden.
Also pursuant to the
same agreement, Mrs. Bowden assigned her one-third interest in
LBJ Properties to the Bank of Whittier.6
The settlement
agreement is silent as to the ownership of the vending machines.
Payments on this loan were made by petitioners individually and
6
The record does not otherwise divulge further information
about LBJ Properties.
- 12 by their corporations.
As of the time of the commencement of
this case, the new loan to Mrs. Bowden remained outstanding.
4.
NBSC
In 1985 and 1986, petitioners’ corporation Pac-Tech obtained
a loan from NBSC.
NBSC took, as security, assignments on a
number of the vending machine leases.7
Funds were disbursed to
Pac-Tech in return for the assignments.
Pac-Tech defaulted on
the notes.
On February 24, 1986, petitioners agreed with NBSC to pay
the outstanding loan balance of $442,595.29 with a new loan
issued to Mrs. Bowden and guaranteed by Mr. Bowden.
Mrs. Bowden
assigned her interest in the 1 Crestwood Drive, Newport Beach
property (Crestwood property) to NBSC via a deed of trust.
In
return, NBSC agreed to release all corporate guaranties.
Paragraph 6 of the settlement agreement states:
Bank will release to Hollis Bowden its security
interest in 41 water vending machines and 3rd party
leases presently held as collateral for the original
obligation.
On February 25, 1986, Hollis Bowden, who is the brother of
petitioner Charles R. Bowden, executed an agreement subordinating
7
A typical lease submitted for the record states that AVC
is the “supplier of equipment”. Pac-Tech is denominated as
“lessor” and “secured party”. An unrelated third party is
“lessee”. NBSC is the “assignee” of the “secured party”.
- 13 his lien on the Crestwood property in favor of NBSC.8
On the
same date, NBSC recorded its security interest on the Crestwood
property.
Subsequently, Hollis Bowden transferred the security
interest in the 41 vending machines to petitioners in return for
stock in the Aqualator corporations.
On October 19, 1994, NBSC notified petitioners that its
records showed payment in full of the $442,595 secured by “a lien
on your home and 41 vending machines”.
On October 20, 1994, NBSC
advised petitioners that the bank’s records indicated that the
“lien” on the 41 vending machines was transferred, along with an
assignment of certain lease proceeds, to Hollis Bowden.
Clement Smith (Mr. Smith), a senior commercial lending
officer for NBSC, believed that when NBSC took assignments from
Pac-Tech on a number of leases, the financial institution became
the owners of the leases.
It was Mr. Smith’s belief that the
lease documents conveyed ownership to NBSC.
Mr. Smith believed
that by filing a security interest on the vending machines NBSC
acquired a titled interest.
Mr. Smith also believed that NBSC
was entitled to take depreciation on the vending machines in
question.
He also stated that NBSC had the right to sell the
vending machines, absent default on the part of petitioners, to
third parties.
8
On Oct. 29, 1985, Hollis Bowden had given Mr. Bowden
special power of attorney over his interest in the Crestwood
property.
- 14 5.
Southern Pacific
On December 28, 1984, Southern Pacific agreed to purchase
vending machine leases between Pac-Tech and various third
parties.
Monthly rentals were to be collected by Pac-Tech, which
would in turn remit them to Southern Pacific.
In early 1985,
Southern Pacific, pursuant to the agreement, purchased
assignments to approximately 40 leases.
Each lease was for a
term of 5 years and provided for $437 monthly rental payments.
Each lease provided that, in the event of default, the entire
balance due under the lease could be accelerated.
Mr. Bowden
guaranteed the payment of the leases.
On June 30, 1986, Southern Pacific lent $554,417.61 to PacTech.
The revenue from the vending machines, however, was not
sufficient to make the monthly lease payments.
deficiency grew each month.
Consequently, the
At some point, the leases went into
default.
Subsequently, Southern Pacific renegotiated the debt,
including the pledge of approximately 100 vending machines as
collateral.
Southern Pacific filed a security interest for each
vending machine.
Christopher Forman (Mr. Forman), then acting president of
Southern Pacific, believed that it had purchased a stream of
payments on individual leases.
Mr. Forman thought that Southern
Pacific was entitled to collect all or a portion of the payments
- 15 that were being made by the lessees on the equipment.
It was Mr.
Forman’s understanding that Southern Pacific’s purchase of the
vending machine leases was the same as obtaining a titled lien
interest on a motor vehicle through the certificate of ownership.
In other words, Southern Pacific would be seen as the lienholder
on the equipment.
Any rights Southern Pacific had in the
purchased leases would come into play only if there was a default
by the individual lessee on the lease payments.
On July 16, 1987, Prudential Bancorp, as an assignee of
Southern Pacific, sued petitioners, alleging that petitioners
were liable for an amount in excess of $550,000 on personal
guaranties furnished to Southern Pacific.
On June 30, 1989,
petitioners offered the Crestwood property to Prudential Bancorp
in exchange for extinguishment of liens, unpaid taxes, and
satisfaction of Prudential Bancorp’s claims.
On September 15,
1989, petitioners conveyed the Crestwood property to Prudential
Bancorp.
Under the settlement stipulation, Prudential Bancorp
was entitled to the proceeds from the sale of the Crestwood
property, which it sold to unrelated third parties for
$2,525,000.
Prudential Bancorp used the proceeds to satisfy the
Southern Pacific loan, the NBSC loan, a $1.4 million loan from
Concordia Bank, the debt owed to Hollis Bowden, and all
mechanic's liens.
- 16 On August 21, 1989, petitioners’ attorney, Mr. Handel, wrote
to Prudential Bancorp’s attorney to confirm his understanding
that pursuant to the settlement, Prudential Bancorp would
“immediately release any and all interests” in the vending
machines.
6.
Crestwood Property
Petitioners purchased the Crestwood undeveloped land during
1983 for $375,000 and in 1984 borrowed $1.4 million from
Concordia Bank to construct a residence.
Concordia Bank received
a security interest in the Crestwood property.
Petitioners
completed construction of a 12,000-square-foot, three-story,
four-car-garage residence in October 1986.
The Crestwood property was flooded twice during December
1987.
On or about December 6, 1987, a few days after petitioners
moved in, sewage backed up, contaminating the first floor of the
house.
Within a week, a windstorm caused flooding and wind
damage to the property.
For example, it blew out all the windows
in the house.
During June 1988, another flooding incident occurred at the
Crestwood property.
The floods destroyed some of petitioners’
personal and corporate records as well as personal property.
The
destroyed records were discarded by workers who were cleaning up
the flood damage.
- 17 On or about December 6, 1987, petitioners filed a claim with
their insurance company for damage caused by the sewer backup.
Petitioners received $48,480 in satisfaction of their claim.
On
or about December 16, 1987, petitioners filed a second claim with
their insurance company for flood damage caused by rain.
The
insurance company paid petitioners $75,200 to satisfy their
second claim.
On or about June 15, 1988, petitioners filed the
third claim for alleged vandalism that caused interior damage to
their home.
Petitioners received $135,626 in satisfaction of
that claim.
Finally, petitioners filed an insurance claim for
loss of corporate papers in connection with the floods.
Petitioners received $25,000 in satisfaction for corporate
records stored in a portion of their residence leased to one of
their corporations.
The loss of the corporate papers was not
covered under petitioners’ homeowner’s policy.
Petitioners reported on their 1986 Schedule C gross receipts
of $163,001 and deductions for:
Insurance--$100, mortgage
interest--$69,860, taxes--$340, and contract labor expenses-$69,850.
Petitioners’ reported, on their 1989 Schedule C gross
receipts of $72,817 and deductions for:
Insurance--$7,945,
mortgage interest--$65,639, taxes--$8,050, and repairs--$14,490.
Petitioners’ attorney, Mr. Handel, believed that the
settlement agreements with the financial institutions provided
- 18 that title and ownership of the vending machines passed to
petitioners or their various corporations.9
Mr. Handel contended
that it was “always clear” that these financial institutions had
no interest in the machines other than obtaining paybacks of
loans.
Mr. Handel believed that either petitioners or their
corporations would have the right to pursue a stolen vending
machine.
OPINION
The controversies here, to a great extent, focus on the
ownership of numerous water purification machines leased, sold,
and used for business purposes by petitioners’ corporations.
The
questions are substantially factual and have been complicated
because of petitioners’ relationships with their numerous
interrelated corporate entities.
This case is further
complicated by a myriad of transactions, including sales, sales
and lease backs, loans and security interests, and other
interrelated transactions and settlements of controversies and
lawsuits.
The absence of business records (both corporate and
individual) for key periods further exacerbates the situation.
The record in this case is patchy and, in many instances, vague.
Respondent determined that petitioners were not entitled to
deduct expenses claimed on the Schedules C attached to their 1986
9
Mr. Bowden waived the attorney-client privilege so that
Mr. Handel could testify before this Court. Also, it appears
that Mr. Handel is Mr. Bowden’s son-in-law.
- 19 and 1989 income tax returns.
Respondent challenges the claimed
depreciation with respect to certain vending machines because
petitioners failed to establish their ownership of or basis in
those machines.
In that same vein, respondent also determined
that petitioners are not entitled to certain other deductions
related to the vending machines for the 1986 and 1989 tax years.
Respondent also determined that petitioners failed to report
income paid to them by or on their behalf by their corporations.
Conversely, petitioners contend that they are entitled to
depreciate, as well as to deduct all related expenses with
respect to, the vending machines in question.
A.
Depreciation
Petitioners contend that the assignments of security
interests in the vending machines gave them title and, therefore,
ownership.
Consequently, petitioners contend that in 1986 they
owned approximately 70 out of the 490 vending machines operated
by their corporations.
Respondent counters that:
(1) Petitioners have no capital
investment in the vending machines; (2) there are no documents in
the record which prove that petitioners owned the vending
machines; and (3) the vending machines have not been shown to
have a useful life exceeding 1 year.
Deductions are a matter of legislative grace, and the
taxpayer bears the burden of proving that he or she is entitled
- 20 to any claimed deductions.
Rule 142(a); New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 (1934); Welch v. Helvering, 290 U.S.
111, 115 (1933).
This includes the burden of substantiating the
amount and purpose of the item claimed.
Hradesky v.
Commissioner, 65 T.C. 87, 90 (1975), affd. per curiam 540 F.2d
821 (5th Cir. 1976); sec. 1.6011-1(a), Income Tax Regs.
Section 167 provides, in part, for a depreciation deduction
with respect to property used in a trade or business.
Depreciation allows the taxpayer to recover the cost of the
property used in a trade or business or for the production of
income.
United States v. Ludey, 274 U.S. 295, 300-301 (1927);
Durkin v. Commissioner, 872 F.2d 1271, 1276 (7th Cir. 1989),
affg. 87 T.C. 1329 (1986).
"'[D]epreciation is not predicated upon ownership of
property but rather upon an investment in property.'"
Estate of
Franklin v. Commissioner, 544 F.2d 1045, 1049 (9th Cir. 1976)
(quoting Mayerson v. Commissioner, 47 T.C. 340, 350 (1966)
(emphasis added)), affg. 64 T.C. 752 (1975); see also Helvering
v. F. & R. Lazarus & Co., 308 U.S. 252 (1939).
The taxpayer who
is entitled to the depreciation deduction is the one who suffers
the economic loss of his investment by virtue of the wear and
tear or exhaustion of the property--the one who has the economic
benefits and burdens of ownership.
Frank Lyon Co. v. United
States, 435 U.S. 561 (1978); Leahy v. Commissioner, 87 T.C. 56
- 21 (1986).
Consequently, a stockholder normally is not entitled to
depreciate property of his corporation because he lacks a direct
economic interest or investment in the property itself.
See
Hunter v. Commissioner, 46 T.C. 477, 489-490 (1966).
Generally, a taxpayer’s capital investment in the property
is the cost of acquiring the depreciable property.
See Durkin v.
Commissioner, supra; secs. 167(c), 1011, 1012; sec. 1.1012-1(a),
Income Tax. Regs.
Petitioners contend that their depreciable
basis is derived from the lenders' assignments to them of
security interests in the property.
This presents a question of
whether, under State law, a security interest affords petitioners
an ownership interest sufficient to entitle them to claim
depreciation.
State law is determinative of the parties' rights and
interests, and Federal law is determinative of the Federal income
tax consequences of those rights or interests.
Morgan v.
Commissioner, 309 U.S. 78, 80 (1940); Lucas v. Earl, 281 U.S. 111
(1930); Sampson v. Commissioner, 81 T.C. 614, 618 (1983), affd.
without published opinion 829 F.2d 39 (6th Cir. 1987).
Generally, California law provides that a security interest
in personal property is given to secure a payment or performance
of an obligation and not to acquire personal property.
Com. Code sec. 1201(37)(a) (West Supp. 1996).
See Cal.
The holder of a
security interest is denominated a secured party.
The priority
- 22 of a secured party’s security interest in collateral is dependent
on the time of filing a financing statement in relation to the
filing of other secured interests.
See generally Cal. Com. Code
secs. 9302, 9312, 9105(m), 9401 (West 1990).10
The purpose of a
financing statement is to inform existing or prospective
creditors of the extent to which an existing or prospective
debtor has encumbered
assets.
Borg-Warner Acceptance Corp. v.
Bank of Marin, 111 Cal. Rptr. 361 (Ct. App. 1973).
Petitioners and their corporations have engaged in a series
of transactions prior to defaulting on several loans.
The
vending machines owned by petitioners’ corporations were the
security for the loans.
Petitioners and the financial
institutions entered into settlement agreements in which the
security interests were assigned from the lenders to
petitioners.11
10
California law provides that a financing statement is a
document which satisfies the requirements of Cal. Com. Code sec.
9402(1) (West 1990). This section provides:
A financing statement is sufficient if it gives the
names of the debtor and the secured party, is signed by
the debtor, gives an address of the secured party from
which information concerning the security interest may
be obtained, gives a mailing address of the debtor, and
contains a statement indicating the types, or
describing the items, of collateral. * * *
11
In the settlement with NBSC and petitioners, the security
interests were assigned from NBSC to Hollis Bowden, who in turn
assigned them to Mrs. Bowden. In some of the settlement
(continued...)
- 23 Petitioners argue that those security interests provide them
with an ownership interest in the vending machines.
Generally, a
security interest is not equivalent to a capital investment.
Helvering v. F. & R. Lazarus & Co., supra; see Cal. Com. Code
sec. 1201(37)(a).
The security interests provided petitioners
with an interest in property designed to secure the payment or
performance of an obligation.
A security interest does not,
without further action, transfer title or an ownership interest
in property.
Moreover, the assignment or release of a security
interest eliminates the secured party's ability (in this case the
financial institutions) to take possession of the property in the
event of default.
Additionally, a security interest is not the
equivalent of “cash or other property” used to acquire the
property.12
See sec. 1.1012-1(a), Income Tax Regs.
The transfer of the Crestwood property to Prudential Bancorp
pursuant to the settlement agreement did not create a capital
investment in the vending machines.
Instead, it resulted in an
exchange or sale of that property, as discussed infra pp. 30-33.
Prudential Bancorp received the Crestwood property in exchange
11
(...continued)
agreements, petitioners provided property or funds in exchange
for the assignment of security interests in the vending machines.
12
This would be so even though, as part of the settlement
agreements in which petitioners received assignment of the
security interests, they did give cash or property to the
financial institutions.
- 24 for the release of petitioners’ obligations to the financial
institutions.
No vending machines were transferred to
petitioners in exchange for the Crestwood property.
It is significant that petitioners have failed to
substantiate their ownership of the vending machines.
They have
not been able to demonstrate that through their proprietorship,
Vista Vending, they owned the vending machines leased from Ocean
Leasing and, thus, were entitled to claim depreciation.
Petitioners also argue that there were corporate agreements that
transferred ownership of the vending machines from their
corporations to them in the event that petitioners were required
to pay on their guaranties of corporate debt.
Petitioners
contend that the records lost in connection with the floods
provided that petitioners would be entitled to the vending
machines if they paid corporate debts pursuant to individual
guaranties.
Alternatively, petitioners allege the existence of
oral agreements that would have accomplished the same result.
Petitioners have also argued that their corporations did not
depreciate the vending machines as proof of the existence of the
oral agreements.
In this regard, some of petitioners’
corporations’ returns are in the record.
A review of those
returns reflects an inconsistent pattern where depreciation on
vending machines was claimed in some years and not in others.
This evidence is inconclusive.
- 25 In the absence of direct evidence, we could consider
credible, secondary evidence.
T.C. 1120, 1125 (1979).
Malinowski v. Commissioner, 71
The only evidence offered by petitioners
to carry their burden is their own testimony.
We found
Mr. Bowden’s testimony on this subject to be vague, conclusory,
uncorroborated, and in many respects, contradictory.13
Petitioners’ attorney, Mr. Handel, did not know who owned
the machines after the Prudential Bancorp transaction.14
Mr. Handel disclaimed any personal knowledge of the agreements or
their purported contents.
Petitioners also relied on a September 20, 1989, letter from
the law firm of Glass, Alper, Goldberg & Cohn, which contains a
statement that ownership of the vending machines will vest in
Mr. Handel’s client.
This letter, by itself, is inconclusive
13
In an effort to establish their ownership of the
machines, petitioners attempted to introduce into evidence “recreations” of these purportedly lost documents. At trial, we
held that those documents were not admissible because they were
hearsay.
14
The following exchange between respondent’s counsel and
Mr. Handel is instructive:
Q: Okay. And are there any documents showing that the
ownership went to the * * * [petitioners] -- clearly
stating ownership went to the * * * [petitioners]?
A: No. I don’t think so. I think they only alluded
to. There is a release of the UCC interest in the
machines by MDFC.
Respondent followed the same line of questioning with various
financial institutions with consistent responses by Mr. Handel.
- 26 because Mr. Handel’s clients consisted of petitioners and their
corporations.
Our conclusion is also supported by the October
25, 1994, letter written by MDFC to respondent’s agents that
contains the statement that the judgment against AIC and
petitioners was satisfied on September 6, 1989.
We believe that
the essence of these letters is that the financial institutions
regarded petitioners as the officers and shareholders of their
wholly owned corporations.
We found Mr. Forman’s (the acting president of Southern
Pacific) testimony to be both credible and consistent with
California law and the record.
He characterized Southern
Pacific’s rights or interest in the vending machines as those of
the holder of a security interest that could develop into a
possessory or other property interest upon default on the lease
payments.
See generally Cal. Com. Code sec. 1201(37)(a).
On the
other hand, Mr. Smith (a senior commercial lending officer for
NBSC) testified that NBSC became the owner of certain leases that
were assigned to it through transactions with petitioners’
corporations.
Mr. Smith misconstrued the effect and character of
the transactions between NBSC and petitioners’ corporation.
NBSC
possessed nothing more than any other security holder involved as
a lender with petitioners’ corporations.
The assignment of the
leases was to provide a source of repayment of outstanding loans.
- 27 Finally, petitioners submitted a confused jumble of
corporate records that have not been properly organized,
reconciled, or explained.
For example, PWIC’s records for 1989
extend only from January through May 21 and for the month of
October.
The record reflects that petitioners were paid $25,000
by the insurance company for missing corporate documents in a
room leased to one of their corporations at the Crestwood
property.15
However, in this instance, we are confronted with a
multiplicity of missing documents from three different
corporations owned by petitioners.
Under these circumstances, petitioners’ testimony, without
further corroboration, is insufficient to carry petitioners’
burden.
See Geiger v. Commissioner, 440 F.2d 688, 689 (9th Cir.
1971), affg. per curiam T.C. Memo. 1969-159; Mills v.
Commissioner, 399 F.2d 744, 749 (4th Cir. 1968), affg. T.C. Memo.
1967-67; Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).
We hold that petitioners have failed to prove their
ownership of and/or depreciable basis in the vending machines and
that respondent’s determination regarding the depreciation is
sustained.16
15
The record is silent about which corporation leased the
room in the Crestwood property.
16
Our holding negates the need to reach respondent’s
argument that petitioners have not shown that the vending
machines have a useful life exceeding 1 year.
- 28 B.
Failure To Substantiate Other Schedule C Deductions
Petitioners contend that in 1986 and 1989, they owned
certain vending machines from which their corporations collected
the revenue.
In connection with those vending machines,
petitioners claimed the operating and related expenses.
Respondent determined that petitioners are not entitled to
deductions.
Section 162(a) allows a deduction for “all ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business”.
See also sec. 1.162-1(a),
Income Tax Regs.
Taxpayers are required to maintain records that are
sufficient to enable the Commissioner to determine their correct
tax liability.
See Meneguzzo v. Commissioner, 43 T.C. 824, 831-
832 (1965); sec. 6001; sec. 1.6011-1(a), Income Tax Regs.
Also,
the taxpayer bears the burden of substantiating the amount and
purpose of the item claimed.
Hradesky v. Commissioner, 65 T.C.
at 90; sec. 1.6001-1(a), Income Tax Regs.
Under certain
circumstances, if a taxpayer establishes the entitlement to a
deduction but does not establish the amount of the deduction, we
may estimate the amount allowable.
Cohan v. Commissioner, 39
F.2d 540 (2d Cir. 1930).
Finally, “the trade or business of the corporation must be
considered separately from the trade or business of the
- 29 shareholders.”
Markwardt v. Commissioner, 64 T.C. 989, 995
(1975).
Petitioners on their 1986 Schedule C claimed deductions for:
Insurance--$100, mortgage interest--$69,860, taxes--$340, and
contract labor--$69,850.
Petitioners, on their 1989 Schedule C
claimed deductions for:
Insurance--$7,945, mortgage interest--
$65,639, taxes--$8,050, and repairs--$14,490.
Petitioners have not demonstrated that the expenses were
incurred for the vending machines that petitioners have claimed
they owned.
The record does not reflect that the expenses were
paid or incurred during the tax years 1986 and 1989.
In
addition, petitioners have not shown that any such items were
ordinary and necessary business expenses.
Sec. 1.162-1(a),
Income Tax Regs.
Petitioners contend that, in 1986, they owned 70 vending
machines out of the total of 490 and that they prorated all
corporate operating expenses between the vending machines alleged
to be theirs and the total.
However, petitioners presented no
evidence demonstrating the proration or allocation between the
vending machines claimed by petitioners and the corporate vending
machines.
It should also be noted that PWIC, PWMC, and C.B. Crest, in
addition to commercial water purification, leased systems for
home use.
Petitioners conceded on brief that they failed to
- 30 identify and prorate those expenses of home use water
purification systems.
They explained that the home use aspect
was “overlooked” in their Federal income tax returns because it
was no more than 2 percent of the total revenue.
Because petitioners have not been able to substantiate the
amounts of expenses or establish their ownership and operation of
the approximately 70 vending machines, we hold that they are not
entitled to deduct the claimed expenses.
C. Petitioners’ Obligation To Report Gross Income From the
Vending Machines
Petitioners contend, in the alternative, if they are not
entitled to deduct vending machine depreciation and deductions
claimed on their Schedules C for 1986 and 1989, then they
incorrectly reported the gross receipts from those same vending
machines.
Petitioners reported gross receipts from the vending
machines of $163,001 and $72,817 on their 1986 and 1989 Schedules
C, respectively.
Respondent contends that petitioners
constructively received income from their corporations.
The notice of deficiency makes no determination concerning
the income or its source reported on petitioners’ Schedules C.
Respondent’s determination regarding the Schedules C simply
involved the disallowance of the claimed deductions.
For
purposes of trial and briefing, respondent argues that
petitioners did not establish their entitlement to the
depreciation or other deductions in connection with the vending
- 31 machines, in part, because they did not own or show their
ownership of the machines.
Respondent proposed several arguments in response to
petitioners’ argument that they are not required to report the
income if we find, as we did, that they did not own the vending
machines.
Respondent argued that payments made to third parties
on behalf of a corporation’s sole shareholder are income to the
shareholder.
That argument is inapposite with respect to the
amounts petitioners reported on their 1986 and 1989 returns as
income from the vending machines that they believed they owned.
In another part of this opinion we address the question of
whether payments made to or on behalf of petitioners are income
to them and should have been reported by them.
Respondent also argued that petitioners constructively
received the income from the vending machines and income from the
sale of the Crestwood property.
As to the constructive receipt,
respondent does not contend that petitioners specifically
received the $163,001 or $72,817 amounts from the corporations or
that those amounts are constructive dividends.
Although the
record reflects that petitioners are required to report certain
income they received as compensation or because the
corporation(s) paid petitioners’ obligations, that matter is also
addressed in another portion of this opinion.
Attribution of the
amounts reported as vending machine receipts to the amounts
- 32 specifically received by petitioners or paid on their behalf
would result in duplication of the items.
Respondent also argued that a series of bookkeeping entries
on October 31, 1989, constituted a set-aside of income, which
support respondent's argument that petitioners should have
reported the $163,001 and $72,817 amounts of income for 1986 and
1989, respectively.
The bookkeeping entries involved the
$150,316 reduction to an account entitled "Loans Payable-S.
Bowden" and a equal increase to an account "SalariesSupervision".
Respondent contends that the $150,316 could have
constituted a constructive receipt of funds.
From the record,
the nature of these bookkeeping entries is not apparent, and it
is not evident that petitioners had an unrestricted right to
withdraw money or that it was available to be withdrawn.
Finally, respondent apparently argues that petitioners built
a large and luxurious house and that the two tax returns under
consideration do not support their ability to build such a house.
We cannot agree with respondent’s conclusion without further
evidence and analysis.
In particular, respondent has not
performed a reconstruction of petitioners’ income for the 1986 or
the 1989 tax year in order to provide a starting point from which
a comparison of income and/or worth could be made.
Accordingly, we hold that petitioners were not required to
report the income from the vending machines on their 1986 and
- 33 1989 Schedules C, based on our findings and holdings that
petitioners did not own certain of the vending machines and that
they were not entitled to depreciation and other deductions.
D.
Transfer of Crestwood Property to Prudential Bancorp
On September 15, 1989, petitioners transferred the Crestwood
property to Prudential Bancorp.
In exchange, petitioners were
released from their obligations to Southern Pacific and NBSC, the
debt owed Hollis Bowden, and the $1.4 million loan obligation to
Concordia Bank.
In addition, all debt giving rise to mechanic's
liens on the property was satisfied.
The obligations to Southern
Pacific and NBSC were in connection with petitioners’
corporations' debts and petitioners’ personal guaranties.
Prudential Bancorp, after obtaining the Crestwood property from
petitioners, sold it to unrelated third parties for $2,525,000,
its fair market value.
Petitioners reported, on their 1989 income tax return, that
the sale price of the Crestwood property was $1,786,000, with a
cost basis of $1,872,776.17
It appears that petitioners derived
the “sale price” from their computation or estimate of the amount
of debt canceled by means of the settlement.
Petitioners
therefore reported a loss of $86,776 on their 1989 tax return.
On brief, petitioners contend that the sale price should be
17
On brief, petitioners erroneously state a “total cost of
$1,786,000" and “a sales price * * * of $1,872,776".
- 34 derived from the total of all claims paid by Prudential Bancorp
in the settlement agreement, rather than the ultimate sale price
to third parties.18
Generally, a transfer of property by a debtor to a creditor
in satisfaction, in whole or in part, of an indebtedness
constitutes a “sale or exchange” under section 1001, and the
excess of the fair market value over the basis of the property
applied against the indebtedness constitutes taxable gain.
Gehl
v. Commissioner, 102 T.C. 784, 786 (1994), affd. without
published opinion 50 F.3d 12 (8th Cir. 1995); Allan v.
Commissioner, 86 T.C. 655, 659-660 (1986), affd. 856 F.2d 1169,
1172 (8th Cir. 1988); Freeland v. Commissioner, 74 T.C. 970
(1980).
The sale price represents the fair market value of the
property at the time of sale.
Sec. 1.1001-1(a), Income Tax Regs.
Petitioners, on brief, argue that they understated the cost
basis reported on their return because they calculated the
Concordia Bank loan as $1 million instead of $1,400,000.
Petitioners contend that the addition of the omitted amount
brings the cost basis to $2,186,000.
18
Petitioners also contend
It is not likely that the total of all debts settled with
Prudential Bancorp approximated $1.8 million. That is so because
the minimum amount of debt on the Crestwood property, as
contended by respondent, is $1.75 million. In addition to the
debt outstanding on the Crestwood property, petitioners settled
their obligations relating to the corporate debt. It is likely
that the total or overall amount of debt settled exceeded the
eventual sale price of the Crestwood property, or $2,525,000.
- 35 that the sale price was properly $2,272,776.
Based on these
amended figures, petitioners argue they would be entitled to
claim a loss.19
Respondent contends that petitioners should recognize gain
from the transfer of the Crestwood property computed as the
difference between the fair market value of the Crestwood
property and petitioners’ cost basis.
Specifically, respondent
contends that the deemed gain is $750,000, which is the
difference between $2,525,000, the fair market value of the
property (the gross sale proceeds of the property received by
Prudential Bancorp) and petitioners’ basis in the property.
Respondent determined petitioners’ basis in the Crestwood
property to be $1,775,000, comprising two amounts--$375,000 and
$1.4 million.
These amounts represent the loan from Concordia
Bank, the proceeds of which were used by petitioners to construct
a residence on the property, and the cost of the land.
Based on the documentary evidence and petitioners’s
testimony, it is apparent that petitioners’ basis in the
Crestwood property exceeded the outstanding balance of the
mortgage and the cost of the land.
The additional amount is
attributable to the outstanding mechanic's liens.
In these
circumstances, petitioners’ testimony, along with other related
19
Assuming petitioners' amended figures to be correct, the
transaction would have resulted in a gain of $86,776. See sec.
1.1001-2(a), Income Tax Regs.
- 36 evidence, reflects that their basis in the property would have
originally been more than $1.75 million.
Therefore, we hold that
petitioners’ basis, as determined by respondent, was understated.
Accordingly, we hold that petitioners’ basis in the Crestwood
property was $2 million.
Cir. 1930).
Cohan v. Commissioner, 39 F.2d 540 (2d
Accordingly, petitioners must recognize $525,000 of
gain on the transfer of the property to Prudential Bancorp.
E.
Unreported Income
1.
Salaries
Petitioners have stipulated that they failed to report
salaries and self-employment income in varying amounts for 1986
and 1989.
Those amounts will be considered in the Rule 155
computation.
Petitioners reported $42,000 of income subject to Social
Security on Schedule SE of their 1986 Federal income tax return.
Respondent contends that Mrs. Bowden omitted $18,000 in
compensation from PWIC in the 8-month period ending December 31,
1986.
Petitioners contend that the $18,000 was, in fact,
included in the $42,000 already reported on the aforementioned
Schedule SE.
From the record in this case, we have no reason to
doubt petitioners’ testimony that the $18,000 amount was already
included in the total of $42,000 that respondent determined
should be reported.
Accordingly, the $18,000 is deemed to be
part of the $42,000 already reported by petitioners.
- 37 2. Reimbursements and Other Items
During 1986, Mrs. Bowden received $21,626.59 from PWIC and
AVC for auto expenses, entertainment, consulting, and other
unidentified items.
Also, in the same year, petitioners’
corporations paid $14,138.48 on behalf of Mrs. Bowden to a travel
agency, Crocker National Bank, Pentech Financial Services, and
the San Bernardino County tax assessor.
Petitioners’
corporations also made payments on loans still outstanding to
both the Bank of Whittier and NBSC, respectively.
In 1986,
petitioners’ corporations paid $10,762.21 for Mr. Bowden’s life
insurance and credit card charges.
In the same year, Mr. Bowden
received $399.56 from PWIC as reimbursement of entertainment
expenses.
In 1989, Mrs. Bowden received $16,942.89 from C.B. Crest
for postage expenses, rental income, and other unidentified
items.
Petitioners’ corporations paid on behalf of Mrs. Bowden a
debt owed to Newport Vending in the amount of $44,250.
Payments
were also made to the Bank of Whittier and NBSC on the loans
still outstanding.
In 1989, petitioners’ corporations paid on
behalf of Mr. Bowden $8,407.42 for his credit card charges.
Generally, taxpayers are required to maintain adequate and
complete records to substantiate their expenses.
Sec. 6001;
Meneguzzo v. Commissioner, 43 T.C. 824 (1965).
Also, it is well
settled that if a taxpayer’s obligation is paid by a third party,
- 38 the effect is the same as if the third party had paid the
taxpayer who in turn paid his creditor.
Commissioner, 279 U.S. 716 (1929).
Old Colony Trust Co. v.
Moreover, transactions
between closely held corporations and their shareholders warrant
close scrutiny.
Paula Constr. Co. v. Commissioner, 58 T.C. 1055,
1058 (1972), affd. without published opinion 474 F.2d 1345 (5th
Cir. 1973); Electric & Neon, Inc. v. Commissioner, 56 T.C. 1324,
1339 (1971), affd. without published opinion 496 F.2d 876 (5th
Cir. 1974).
In this instance, all of these aforementioned items were
charged as corporate expenses.
on their income tax returns.
Petitioners did not report them
They contend that these items were
not items of income but were reimbursements for their payments of
corporate expenses.
Petitioners have submitted incomplete corporate records for
the taxable years in question.
The checks submitted as evidence
merely represent payment by the corporations to petitioners.
Also, petitioners did not offer as exhibits any substantiation of
the expenses allegedly incurred on behalf of the corporations.
For example, Mr. Bowden did not proffer any of his credit card
bills that were paid by the corporations which would have
provided an opportunity to scrutinize the basis for the payments.
Paula Constr. Co. v. Commissioner, supra.
items were facially questionable.
Some of the disputed
For example, PWIC paid $700
- 39 for Mrs. Bowden’s travel to Japan where she had relatives and
allegedly explored business opportunities.
We do not accept
petitioners’ uncorroborated testimony on these items.
We also find it telling that petitioners were able to submit
complete corporate records for certain time periods but that
records were incomplete for other time periods.
Even factoring
in a loss of records due to the Crestwood property floods, there
remain unexplained inconsistencies concerning the corporate
records.
For example, petitioners did not present a coherent
explanation why particular corporate records were located at the
Crestwood property and not at other business locations.
Also,
petitioners were able to submit to respondent the complete
general ledgers for PWIC’s 1986 calendar year.
We do not
understand why these particular ledgers were unaffected by the
Crestwood property floods while PWIC’s records for 1989 are
incomplete.
Also, petitioners do not address the fact that C.B. Crest’s
records do not include the months of September, November, and
December 1989 as well as the complete month of August 1989.
Petitioners cannot attribute the absence of these records to the
December 1987 and June 1988 Crestwood property floods.
Accordingly, we sustain respondent’s determination that
petitioners are liable for tax on the expenditures paid by the
corporations.
Petitioners have failed to show that these
- 40 expenditures represent reimbursement of corporate business
expenses.
F.
Self-Employment Tax
Section 1401 imposes a tax on the “self-employment income”
of every individual.
“[S]elf-employment income” is defined
generally in section 1402(b) as the “net earnings from selfemployment derived by an individual * * * during any taxable
year”.
Section 1402(a) defines the term “net earnings from self-
employment” as the “gross income derived by an individual from
any trade or business carried on by such individual, less the
deductions allowed by this subtitle which are attributable to
such trade or business”.
Section 1.1402(a)-2(b), Income Tax
Regs., provides that “The trade or business must be carried on by
the individual, either personally or through agents or
employees.”
Petitioners reported $42,000 of income subject to Social
Security on Schedule SE of their 1986 Federal income tax return.
Moreover, petitioners have stipulated that $51,679.84 was
received by Mrs. Bowden from C.B. Crest during the 7-month period
ending July 31, 1989.
In the same time period, petitioners have
also stipulated that Mr. Bowden received $17,479.84 in salary.
Also, between January 1 and May 31, 1989, PWIC paid Mrs. Bowden
$4,100 in salary.
- 41 Other than the $42,000, petitioners did not report those
amounts as income on their 1989 Federal income tax return or show
that the amounts constituted salary as opposed to self-employment
income.
Accordingly, we find that petitioners are liable for
self-employment tax on those amounts for the taxable year 1989.
G.
Underpayment Due to Negligence
Respondent determined an addition to tax due to negligence
under section 6653(a)(1)(A) and (B) for petitioners’ 1986 taxable
year.
Respondent also determined an accuracy-related penalty due
to negligence under section 6662(a) for petitioners’ 1989 taxable
year.
The penalty under section 6662(a) for negligence is
decided under a standard similar to that of the addition to tax
for negligence under section 6653(a)(1).
For the 1986 taxable year, section 6653(a)(1)(A) imposes an
addition to tax equal to 5 percent of the underpayment of the tax
required to be shown on a taxpayer’s return if any part of that
underpayment is due to negligence or disregard of rules or
regulations.
Section 6653(a)(1)(B) also provides for an addition
to tax of 50 percent of the interest payable under section 6601
with respect to the portion of the underpayment which is
attributable to negligence or intentional disregard of rules and
regulations.
Section 6653(a)(3) defines the term “negligence” to
include any failure to make a reasonable attempt to comply with
the provisions of the Internal Revenue Code.
This section also
- 42 defines the term “disregard” to include any careless, reckless,
or intentional disregard.
See Neely v. Commissioner, 85 T.C.
934, 947 (1985).
Section 6662(a) and (b)(1) provides that if any portion of
an underpayment of tax is attributable to negligence or disregard
of rules or regulations, then there shall be added to the tax an
amount equal to 20 percent of the amount of the underpayment
which is so attributable.
The term “negligence” includes any
failure to make a reasonable attempt to comply with the statute,
and the term “disregard” includes any careless, reckless, or
intentional disregard.
Sec. 6662(c).
Petitioners have the
burden of proving that respondent’s determination is in error.
Rule 142(a); Welch v. Helvering, 290 U.S. at 115.
Petitioners failed to report various items of income for the
1989 taxable year.
Petitioners also failed to provide respondent
with complete information concerning their corporations’
operations and expenses for the entire 1986 and 1989 calendar
years.
We have previously held, even factoring into account any
missing records caused by the Crestwood property floods, that
petitioners did not maintain adequate records.
For example, the
Crestwood property flood is not an excuse that can be used by
petitioners for the 1989 records of PWIC and C.B. Crest because
the floods occurred in December 1987 and June 1988.
- 43 In addition, petitioners did not present a coherent
explanation of why certain corporate records were apparently
stored in the Crestwood property and other records stored
elsewhere for business purposes, or why only one corporation
leased part of the Crestwood residence, but several corporations’
records were allegedly lost due to floods at the residence.
Further, petitioners did not adequately explain why C.B. Crest’s
records do not include the months of September, November, and
December 1989 as well as the complete month of August 1989.20
Finally, petitioners did not demonstrate any apportionment
between the expenses associated with the operating of the vending
machines and other water purification systems.
Petitioners
concede that they “overlooked” the other business of home water
purification units because it was “an exceedingly small amount of
revenue”.
Mr. Bowden has an accounting background.
He knew or should
have known that he was required to maintain adequate books and
records to support the claimed deductions.
Income Tax Regs.
See sec. 1.6011-1(a),
As noted, petitioners have failed to show that
they maintained adequate books and records to support their
claimed Schedule C deductions.
20
Petitioners testified that “activities in C.B. Crest were
limited”, and thus, activities for August and September 1989 were
recorded in October of that year, and activities for November and
December 1989 were recorded in January 1990.
- 44 Accordingly, we hold, to the extent that underpayments
exist, petitioners are liable for the additions to tax under
section 6653(a)(1)(A) and (B) for the 1986 taxable year and the
accuracy-related penalty under section 6662(a) for the 1989
taxable year.
H.
Substantial Understatement
For 1986, section 6661 provides that if there is an
understatement of income tax for any tax year which exceeds the
greater of 10 percent of the tax required to be shown on the
return for the tax year or $5,000, an addition to tax shall be
imposed.
The understatement is reduced by section 6661(b)(2)(B)
by that portion for which there is “substantial authority” or
that has been “adequately disclosed”.
For 1989, section 6662(a) and (b)(2) provides that if any
portion of an underpayment is attributable to a substantial
understatement of income tax, then there shall be added to the
tax an amount equal to 20 percent of the amount of the
underpayment.
Petitioners have not offered any probative evidence to
support their claimed Schedule C deductions or to show why they
failed to include income and/or disclose liability for all selfemployment tax in 1989.
Therefore, petitioners did not
adequately disclose their earned compensation, and no substantial
- 45 authority has been shown to support petitioners’ deductions and
failure to report income from various sources.
We hold, to the extent that an understatement exists,
petitioners are liable for the addition to tax under section
6661(a) for 1986 and the accuracy-related penalty pursuant to
section 6662(a) and (b)(2) for 1989.
For 1989, a single penalty
of 20 percent is imposed under section 6662 though the
underpayment for that year is attributable to both negligence and
substantial understatement.
I.
Failure To Timely File Their Return
Respondent determined that petitioners are liable for an
addition to tax for the failure to timely file a return.
Section
6651(a)(1) imposes an addition to tax for failure to file a
timely income tax return.
Petitioners bear the burden of showing
respondent’s determination to be in error and that there was
reasonable cause for their failure to timely file.
Rule 142(a).
Petitioners' 1986 and 1989 Federal income tax returns were
filed during July 1988 and October 1990, respectively.
Petitioners contend that they did not file because they were
unable to pay the income tax due in both taxable years due to
“insufficient funds”.
Petitioners have not demonstrated that
their lack of funds was a reasonable cause for their failure to
timely file.
Therefore, to the extent of any tax required to be
shown, which was not shown, petitioners are liable for the
- 46 addition to tax under section 6651(a)(1) for their 1986 and 1989
taxable years.
To reflect the foregoing,
Decision will be entered
under Rule 155.
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