UNITED STATES TAX COURT
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T.C. Memo. 2003-152
UNITED STATES TAX COURT
DAVID M. AND TERI L. SAYKALLY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
COMPUTER POWER SOFTWARE GROUP, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 555-00, 1821-00.
Filed May 27, 2003.
P has extensive technical expertise in the
computer software industry. P’s wholly owned
corporation, C, was engaged in the marketing of
software products. P and C entered into an agreement
whereby P agreed to have research and development (R&D)
done in order to create developed technology. Under
the agreement, P would own the developed technology and
license it to C in exchange for royalties. P intended
that C would market the developed technology to its
customers. P deducted his 1995 and 1996 R&D
expenditures on Schedules C. R disallowed P’s R&D
deductions on the ground that they were not incurred in
a trade or business.
Held: At all times, P intended to market the
developed technology through C. P did not have the
objective intent to use the developed technology in an
activity that would constitute his own trade or
- 2 business and is not entitled to a current deduction for
his R&D expenses.
Held, further, Ps did not adequately substantiate
other deductions disallowed by R.
Held, further, Ps are not liable for accuracyrelated penalties associated with the deduction of R&D
expenses. Ps are liable for accuracy-related penalties
with respect to their failure to substantiate other
disallowed deductions.
Robert R. Rubin, for petitioners.
Kathryn K. Vetter, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
RUWE, Judge:
These cases were consolidated by motion of the
parties for purposes of trial, briefing, and opinion.
In docket
No. 1821-00, respondent determined a deficiency in Federal income
tax of $103,250 and a section 6662(a)1 accuracy-related penalty
of $20,650 for the taxable year 1996 with respect to
petitioner Computer Power Software Group, Inc. (CPSG, Inc.).
In
docket No. 555-00, respondent determined deficiencies in
petitioners David M. and Teri L. Saykally’s2 income taxes, an
addition to tax pursuant to section 6651(a)(1), and accuracy-
1
All section references are to the Internal Revenue Code in
effect for the taxable years at issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure.
2
Petitioners David M. and Teri L. Saykally filed joint
Federal income tax returns for the taxable years at issue.
- 3 related penalties pursuant to section 6662(a) for the taxable
years 1994, 1995, and 1996 as follows:
Year
Deficiency
Addition to Tax
Sec. 6651(a)(1)
Penalties
Sec. 6662(a)
1994
$11,729
$253
$2,346
1995
16,769
--
3,354
1996
634,289
--
126,858
For convenience, we refer to David M. and Teri L. Saykally as
petitioners and David M. Saykally as petitioner throughout this
opinion.
After concessions,3 the remaining issues to be decided are
as follows:
(1) Whether petitioners are entitled to deduct expenses
claimed for research and development for taxable years 1995 and
1996 in the respective amounts of $67,534 and $1,421,645;
(2) Whether petitioners are entitled to deduct certain
expenses on their Schedules C, Profit and Loss From Business, for
the taxable years 1994, 1995, and 1996; and
3
The parties have conceded that there will be no deficiency
in tax due from or overpayment in tax due to petitioner CPSG,
Inc. Therefore, an accuracy-related penalty under sec. 6662(a)
will not be imposed. Accordingly, the parties have resolved all
the issues in docket No. 1821-00.
With respect to petitioners in docket No. 555-00, respondent
has conceded, inter alia, that petitioners are not liable for the
sec. 6651(a)(1) addition to tax for the taxable year 1994.
- 4 (3) Whether petitioners are liable for accuracy-related
penalties pursuant to section 6662 for the taxable years 1994,
1995, and 1996.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts, stipulations of settled issues, and the
attached exhibits are incorporated herein by this reference.
At
the time of filing the petition, petitioners resided in Granite
Bay, California.
Research and Development Expenses
Petitioner has extensive familiarity with, and technical
expertise in, the computer software industry spanning more than
30 years.
In 1991, Computer Power Group Limited (CPG) hired
petitioner on a contract basis to provide it with consulting
services.
CPG is a large professional services company organized
under the laws of Australia.
CPG was in the business of
providing professional computer programmers to companies to
create business software.
Additionally, CPG was involved in the
worldwide marketing of several lines of business software
applications.
CPG was losing money on the marketing of its
software applications.
Petitioner was hired on a short-term
- 5 basis to provide consulting services to CPG to identify why CPG
was losing money and how to stop such losses.4
After conducting onsite inspections and reviewing pertinent
information, petitioner reported to CPG’s chief executive officer
regarding his ideas on how to stop the “profit bleed”.
In
response, CPG attempted to hire petitioner to implement his
ideas.
Instead of becoming an employee of CPG, the parties
agreed to move the marketing of CPG’s software out from under CPG
and agreed that petitioner would organize his own corporation to
market CPG’s software products for a stated royalty.
Consequently, petitioner organized CPSG, Inc.
CPSG, Inc. is a computer software corporation that was
organized in November 1992, pursuant to the laws of the State of
California.
During the taxable years at issue, petitioner owned
all the outstanding shares of CPSG, Inc., and was its president,
chief operating officer, and sole director.
Beginning in 1992, CPG was a party to contracts with three
Australian syndicates that were engaged in software development
(the syndicates).
The syndicates were Australian tax-advantaged
research and development partnerships.
The syndicates provided
financing to CPG for the development of new software technology.
The syndicates raised approximately $20 million for CPG’s
4
Petitioner was known in the computer industry as a
turnaround specialist.
- 6 software research and development work.
Approximately 75 percent
of the money raised, or $15 million was supposed to be used for
the development of CPG’s software.
In return, the syndicates
owned the rights to the software technology and licensed those
rights to CPG.
On August 10, 1993, petitioner, CPSG, Inc., and CPG entered
into a Software Marketing and Management Agreement (the
management agreement) whereby CPSG, Inc. licensed certain rights
to market CPG’s software technology and products, including
InTEXT, Today, and Operating Control Systems.5
The management
agreement contemplated that CPSG, Inc. would form three
subsidiaries, InTEXT Systems, Inc., Today Systems, Inc., and
Operating Control Systems, Inc., to market specific lines of
CPG’s software products.
The management agreement purported to grant CPSG, Inc. the
right to market CPG’s software products as they existed before
the development work funded by the syndicates.
CPSG, Inc. agreed to pay CPG a royalty.
In exchange,
Under the terms of the
management agreement, CPG agreed to use its best efforts to
provide funds for software product development; the funds were to
be obtained from the syndicates.
5
The agreement had a retroactive effective date of Sept. 30,
1992.
- 7 Appendix II to the management agreement was a Software
Marketing Agreement (submarketer agreement) by and between CPSG,
Inc. and CP Software Export Pty Ltd., an entity affiliated with
CPG.
Under this agreement, CPSG, Inc. would acquire a sublicense
to market certain software products developed with funding from
the syndicates in exchange for royalty payments.
Despite
extensive negotiations, this agreement was never executed by the
parties.
Although the agreement was never executed, the parties
decided to operate as if it had been.
In or about May 1995, CPG informed CPSG, Inc. that the
syndicates’ development funding would terminate in July 1995.
In
or about July 1995, the syndicates’ development funding
terminated.
The planned development and improvement of the
software was not completed.
No new marketable and competitive
products resulted from the underfunded and unfinished
development.
Without additional development funding, CPSG, Inc.
and its subsidiaries would lose their current customers and would
not have software products to attract new customers.
On July 7, 1995, the syndicates notified CPSG, Inc. to cease
and desist marketing CPG’s software technology purportedly
licensed from CPG.6
6
The syndicates took the position that CPSG,
By the terms of the submarketer agreement, CPSG, Inc. was
granted an exclusive license to the newly developed software
technology. However, pursuant to par. 2.4, the management
agreement provided that its terms could not violate the operating
(continued...)
- 8 Inc. had no rights to the technology for which they had provided
funding.
Essentially, the syndicates, through their
representative, informed CPSG, Inc. that the management agreement
by and between CPG and CPSG, Inc. to market the software
technology conferred no rights on CPSG, Inc. as the syndicates
had not approved the agreement.
Petitioner decided to continue the development without
funding from the syndicates.
Petitioner believed he would have
more negotiating leverage with respect to the developed software
if he finished development in his own name, instead of in the
name of CPSG, Inc.
were:
Petitioner’s reasons supporting this decision
(1) CPSG, Inc., as a marketing entity, had no development
capability; petitioner was the only person who had the skill set
to do the development; (2) it was prudent to create intellectual
rights outside of CPSG, Inc. because (i) CPG could cancel the
submarketer agreement in 1997 for no reason and, at other times
as stated in the agreement; (ii) the syndicates took the position
that they could modify or terminate CPSG, Inc.’s rights to the
newly developed software technology because the grant from CPG
was in conflict with the rights of the syndicates; and (iii) CPG
controlled the syndicates and could cause the syndicates to
6
(...continued)
terms governing the syndicates. The terms of the syndicates
forbade the grant of exclusive rights to the improved technology
without explicit permission of the syndicates.
- 9 require CPG to terminate the management agreement; (3) CPSG, Inc.
did not have the financial resources to fund the development; and
(4) petitioner had the financial resources to develop the
software technology.
On October 1, 1995, petitioner, in his individual capacity,
entered into a development agreement with his wholly owned
corporation, CPSG, Inc.
According to the terms and conditions of
the development agreement, petitioner covenanted to provide
software research and development to improve, enhance, modify,
and change the software technology in his reasonable discretion
and at his sole expense.
The contract granted CPSG, Inc. the
right to cancel the agreement at anytime with 1 month’s notice.
The product of petitioner’s R&D efforts was what the parties
termed the “developed technology”.
Pursuant to the terms of the
contract, petitioner retained all rights, title, and interest in
the developed technology.7
Simultaneously, under the development
agreement, petitioner granted CPSG, Inc. a nonexclusive license
to the developed technology in exchange for 36 quarterly payments
in an amount equal to the greater of 10 percent or $26,250 from
the sale, grant of licenses, or commercialization of products
that incorporated the developed technology during the period
7
Petitioner testified that this was one of the primary
reasons for conducting the development on his own behalf;
personal ownership rights, outside of CPSG, Inc., would give him
leverage over CPG and the syndicates.
- 10 January 31, 1997, through December 31, 2005.8
Petitioner
intended that the developed technology would be marketed through
CPSG, Inc.
On October 1, 1995, CPSG, Inc., Computer Power Software
Group Australia Pty Ltd.9 (CPSGAus), and petitioner entered into
a service agreement whereby CPSGAus agreed to provide
administrative and payroll services to petitioner in his efforts
to develop the software technology.
CPSGAus hired some of the
Australian development staff that had been formerly employed by
the syndicates to continue the research and development on
petitioner’s behalf.
costs.
CPSGAus invoiced CPSG, Inc. for these
CPSG, Inc. paid the costs associated with the research
and development on petitioner’s behalf and recorded petitioner’s
indebtedness for the expenses on CPSG, Inc.’s accounting system.
Petitioner monitored the work performed by the Australian
development “team” via telephone, a visit to Australia, and
electronic mail communications.
Additionally, petitioner helped
solve technical programming problems, prioritized tasks of the
8
The minimum quarterly payments of $26,250 were due and
owing to petitioner regardless of whether CPSG, Inc. generated
any income from the developed technology. The development
agreement contemplated that petitioner would receive, at the very
least, $945,000 over the term of the agreement (36 quarters).
9
Petitioner formed CPSGAus in 1994 to manage CPSG, Inc.’s
business activities in Australia. CPSGAus provided development,
sales, support, and administrative services to CPSG, Inc.’s
subsidiaries: InTEXT Systems, Inc., Operating Control Systems,
Inc., and Today Systems, Inc.
- 11 programmers, and was involved in beta testing the developed
software.
Petitioner chose to secure development funding through CPSG,
Inc.
In order to memorialize his indebtedness to CPSG, Inc., on
October 1, 1995, petitioner signed an unsecured, interest-bearing
promissory note in favor of CPSG, Inc. for an amount not to
exceed $1.4 million.
According to the terms of the note,
petitioner is personally liable for the amounts expended by CPSG,
Inc. up to the stated maximum ($1.4 million), the principal of
which is due on October 1, 2005.
The interest rate was set
quarterly to the prime rate and was payable in annual
installments beginning on December 31, 1996.
CPSG, Inc. did not have sufficient cash to advance all the
research and development costs to which petitioner obligated
himself.
Accordingly, petitioner arranged for Uniplex Software,
Inc.10 (Uniplex Software) to lend funds to CPSG, Inc.
Uniplex
Software advanced to CPSG, Inc. a total of $1.15 million in
payments of $750,000 and $400,000 on February 5 and July 11,
1996, respectively.
On October 1, 1996, CPSG, Inc. executed a
promissory note to memorialize the loans made by Uniplex
Software, not to exceed $1.15 million.
10
Pursuant to the terms of
CPSG Ventures owned 50.1 percent of Uniplex Software, and
IMI owned 49.9 percent. IMI is a United Kingdom publicly traded
corporation. Petitioner owned 70 percent of CPSG Ventures, a
general partnership, and Karan Erickson, an officer of CPSG,
Inc., owned 30 percent.
- 12 the note, interest was set quarterly at the prime rate and was to
be paid during the term of the note with the principal due on
October 1, 2005.
Effective January 1, 1996, petitioner granted Uniplex
Software a nonexclusive worldwide license for a renewable 3-year
term to part of the developed technology.
Effective July 8,
1996, CPSG, Inc. and Uniplex Software entered into a Software
License Agreement (source code license) whereby CPSG, Inc.
provided Uniplex Software with a worldwide, perpetual,
nonexclusive license to the InTEXT proprietary software.
In
exchange, Uniplex Software covenanted to pay CPSG, Inc. $500,000
for the source code license, $350,000 initial license prepayment,
and a 2-percent royalty on Uniplex Software’s net revenue from
the distribution of the software until CPSG, Inc. received
$300,000, and thereafter a 1-percent royalty of the net revenue
from distribution of the software.
The source code license
provided Uniplex Software with security for the $1.15 million
unsecured loan made to CPSG, Inc.
Annual sales of the InTEXT developed technology were
approximately $1.5 million during the years at issue.
Annual
sales of the Operating Control System developed technology were
approximately $1 million for the subject years.
Annual sales of
the Today developed technology approximated $2 million during the
period 1995 through 1997.
- 13 During 1995 and 1996, CPSG, Inc., by and through its wholly
owned subsidiaries, paid $67,543 and $1,361,006 of research and
development costs on behalf of petitioner.
Description
Salaries1
Contract labor
Building rent
Commissions
Telephone
Entertainment
Equipment rental
Repairs/maintenance
Freight
Janitorial
Recruiting fees
Travel
Services
Dues & subscriptions
Electricity
License fees
Small equipment
Office supplies
Postage/misc.
These costs included:
1995
1996
$28,584
20,947
5,644
4,250
428
106
6,052
1,036
497
-0-0-0-0-0-0-0-0-0-0-
$1,076,850
46,451
54,293
3,306
33,001
659
68,379
26,086
265
426
4,187
3,016
13,495
1,500
14,218
12,050
573
1,761
491
1
The category “Salaries” represents the cumulative amount paid to
individuals living in Australia.
CPSG, Inc. used its accounting system to track these costs.
CPSG, Inc. initially deducted these research and development
costs on its Federal income tax return for the year ended
September 30, 1996.
CPSG, Inc. subsequently amended its 1996
return eliminating the deduction.
Petitioners attached Schedules C for a computer software
development business named “DMS Development Co.” to their 1995
and 1996 returns.
For the years at issue, petitioners reported
- 14 no income on these Schedules C.
Petitioners deducted the
following research and development expenses on these schedules:11
Description
Salaries
Contract labor
Building rent
Commissions
Telephone
Meals/entertainment
Equipment rental
Repairs/maintenance
Freight
Janitorial
Recruiting fees
Travel
Services
Dues & subscriptions
Electricity
License fees
Small equipment
Office supplies
Postage/misc.
Interest
TOTAL
1995
1996
$28,584
20,947
5,644
4,250
428
106
6,052
1,036
497
-0-0-0-0-0-0-0-0-0-0-02
67,543
$1,076,850
46,451
54,293
3,306
33,001
329
68,379
26,086
265
426
4,187
3,016
13,495
1,500
14,218
12,050
573
1,761
491
1
60,967
1,421,645
1
The parties agree that $30,020 of this interest is not deductible on
Schedule C, but it is deductible as investment interest.
2
The parties stipulated that petitioners deducted $67,543 in research
and development expenses. However, the column totals to $67,544 and the
notice of deficiency and petitioners’ 1995 return state $67,534 as the amount
deducted.
CPSG, Inc. paid the following amounts to petitioner as
minimum royalties pursuant to the development agreement:
Date
Amount
01/28/97
03/31/97
12/30/98
12/20/99
TOTAL
$52,500
105,000
78,750
1
108,150
344,400
For Period
1/31/97 and 4/30/97 (Advance)
6/30/97 - 3/31/98
6/30/98 - 12/31/98
3/31/99 - 12/31/99
1
The $108,150 amount included the royalty payment of $105,000 plus
interest of $3,150 for the period 03/31/99 to 12/31/99. On or about Aug. 1,
11
The deduction of these research and development expenses
in 1996 substantially eliminated an approximately $1.4 million
capital gain realized from the sale of Unify Corp. stock.
- 15 1997, CPSG, Inc. informed petitioner that it was unable to make the minimum
royalty payments under the development agreement. The $3,150 is presumably
accrued interest for the period of nonpayment of minimum royalties.
The $52,500 paid on January 28, 1997, included the January 31,
1997, minimum royalty payment as contemplated under the
development agreement as well as an advance payment for the April
30, 1997, minimum royalty payment.
Petitioner paid CPSG, Inc. the following amounts as interest
on his $1.4 million indebtedness to CPSG, Inc.:
Date
Amount
12/29/96
03/31/98
12/30/98
12/21/99
TOTAL
$30,947.27
138,541.27
117,092.59
111,595.20
398,176.33
For Period
1
10/1995 - 09/1996
10/1/96 - 12/31/97
1998
1999
1
For the period Oct. 1995 to Sept. 1996, the record fails to state the
actual days upon which interest accrued.
Other Schedule C Expenses
On their Schedules C, petitioners reported the following
amounts as receipts and expenses for a consulting business named
“CPSG Ventures”12 for the years at issue:
Receipts
Expenses
Net profit/loss
1994
1995
1996
$194,317
79,881
114,436
$67,565
30,912
36,653
$72,118
79,349
(7,231)
The receipts reported for CPSG Ventures for 1994 on petitioners’
Schedule C consisted of the following items:
CPSG, Inc. reimbursements1
12
$61,640
“CPSG Ventures” is the name of both a partnership in which
petitioner was a general partner and petitioner’s Schedule C
business. See supra note 10.
- 16 CPSG, Inc.
Walker Interactive Systems3
Uniplex Software Systems, Inc.
Granite Bay Montessori reimbursements
Miscellaneous
TOTAL
2
40,000
16,000
75,000
1,591
86
194,317
1
Petitioner submitted expense reports to CPSG, Inc. for his travel and
other expenses that he incurred on its behalf and CPSG, Inc. reimbursed him
for these expenses.
2
The $40,000 was for a charitable contribution made by CPSG, Inc. on
behalf of petitioner.
3
Petitioner was a member of the board of directors of Walker
Interactive Systems.
The receipts reported for CPSG Ventures for 1995 on petitioners’
Schedule C consisted of the following items:
CPSG, Inc. reimbursements
Walker Interactive Systems
Airline ticket refund
TOTAL
$53,187
10,500
3,878
67,565
The receipts reported for CPSG Ventures for 1996 on petitioners’
Schedule C consisted of the following items:
CPSG, Inc. reimbursements
Walker Interactive Systems
TOTAL
$53,618
18,500
72,118
Petitioners claimed as deductions the following expenses on their
Schedules C for CPSG Ventures for the taxable years listed:
Description
Depreciation
Car & truck
Interest
Legal/professional
Office expense
Supplies
Travel
Meals
Utilities
Auto-Std rate
Auto taxes
Miscellaneous
TOTAL
1994
1995
1996
$5,017
-386
1,374
905
970
54,644
2,353
9,995
4,133
104
-79,881
$10,053
5,799
-79
-865
-4,439
9,457
--220
30,912
-0$5,807
-30
202
12,604
41,870
1,900
16,861
--75
79,349
- 17 The above-listed expenses included amounts that were reimbursed
by CPSG, Inc. for expenses such as travel and entertainment,
supplies, and telephone.
Additionally, these expenses included
amounts not reimbursed by CPSG, Inc.
In the notice of
deficiency, respondent allowed deductions for expenses to the
extent they were reimbursed by CPSG, Inc.
Additionally,
respondent allowed the car and truck expenses as itemized
deductions.
Charitable (Double) Deduction
On December 29, 1996, petitioners donated $60,000 to the
Granite Bay Montessori School.
On their 1996 income tax return,
petitioners erroneously claimed a double deduction of $120,000.
The parties have stipulated that petitioners are entitled to
claim only a $60,000 charitable deduction with respect to the
donation to the school for 1996.
The only issue that remains
with regard to this item is whether petitioners are liable for
the accuracy-related penalty associated with the erroneous
deduction.
OPINION
Determinations of the Commissioner in a notice of deficiency
are generally presumed correct, and the burden is on the taxpayer
to show that the determinations are incorrect.13
13
Rule 142(a);
Sec. 7491 does not apply in this case to shift the burden
of proof or production to respondent because the examination of
(continued...)
- 18 Welch v. Helvering, 290 U.S. 111, 115 (1933).
Deductions are a
matter of legislative grace, and the taxpayer generally bears the
burden of proving entitlement to such claimed deductions.
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New
Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
Furthermore, a taxpayer is required to maintain records
sufficient to establish the amount of his income and deductions.
Secs. 274(d), 6001; sec. 1.6001-1(a), (e), Income Tax Regs.
A.
Section 174--Research and Development Deductions
With regard to the claimed research and development (R&D)
expenses for 1995 and 1996, the notice of deficiency states:
Schedule C - DMS Loss
Year
9512
Claimed on return
$67,534
Allowed per audit
-0Adjustment
67,534
9612
$1,421,645
-01,421,645
You have not shown that these expenses were
ordinary and necessary expenses paid or incurred
in connection with carrying on a trade of
business.
Since you have not established that the expenses
claimed were paid or incurred for research and
experimental expenditures in connection with your
trade or business, they are not deductible.
Loss is limited to amount of capital you have at
risk.
13
(...continued)
the returns at issue commenced before the statute’s effective
date.
- 19 To resolve this issue, we must look to the statute granting
deductions for expenses related to R&D and the cases interpreting
it.
Section 174(a)(1) provides:
SEC. 174(a).
Treatment as Expenses.--
(1) In general.--A taxpayer may treat research or
experimental expenditures which are paid or incurred by him
during the taxable year in connection with his trade or
business as expenses which are not chargeable to capital
account. The expenditures so treated shall be allowed as a
deduction.
To qualify for a deduction, the expenditures must be (1)
qualifying, (2) paid or incurred in connection with the
taxpayer’s trade or business, and (3) reasonable.
sec. 1.174-2, Income Tax Regs.
Sec. 174(e);
R&D expenditures which are not
deductible under section 174(a) must be charged to a capital
account.
Sec. 1.174-1, Income Tax Regs.
The term “research or experimental expenditures” as used in
section 174 means expenditures “incurred in connection with the
taxpayer’s trade or business which represent research and
development costs in the experimental or laboratory sense.”
1.174-2(a)(1), Income Tax Regs.
Sec.
Section 174 allows a taxpayer to
claim a deduction for expenditures paid or incurred for research
carried on in his behalf by another person or organization.
Sec.
1.174-2(a)(8), Income Tax Regs.
In this case, respondent does not argue or allege that the
expenses in question are not “research and development costs in
the experimental or laboratory sense” or that the amounts claimed
- 20 are unreasonable.
Respondent’s position is that petitioner did
not pay or incur the research expenses in connection with his own
trade or business and that petitioner did not have the objective
intent to prospectively enter into his own trade or business with
the developed technology.
Petitioners argue that “There was a realistic prospect that
* * * [petitioner] would enter a trade or business involving the
software he developed.”
(Emphasis added.)
Petitioners do not
argue that at the time petitioner incurred the R&D expenses, he
was already engaged in a trade or business; petitioners’ focus is
solely upon the prospective probability that petitioner would
engage in a trade or business with the developed technology.14
In its petition, CPSG, Inc. alleged that if the Court determines
that Mr. and Mrs. Saykally are not entitled to the claimed R&D
deductions, then CPSG, Inc. is so entitled.
CPSG, Inc. abandoned
this argument. Ryback v. Commissioner, 91 T.C. 524, 566 n.19
(1988).
Therefore, we express no opinion as to this issue.
The Trade or Business Requirement
With respect to section 174, the U.S. Supreme Court has
interpreted the trade or business requirement expansively.
14
Snow
Petitioners argue that petitioner was “capable of
exploiting the new products;” “At the time the section 174
expenses were paid, there was a realistic prospect that
petitioner would enter a trade or business involving the new * *
* products;” and that he “intended to market the Developed
Technology to new customers as well as existing customers of
CPSG.” (Emphasis added.)
- 21 v. Commissioner, 416 U.S. 500 (1974).
The Court held that
section 174 allowed deductions for R&D expenditures not only for
“on-going” and established businesses, but also for new
businesses despite the fact that no trade or business was being
conducted at the time the expenses were incurred.15
Id.
This expansive interpretation allowing R&D deductions for
expenses incurred prior to engaging in a trade or business is
tempered by the requirement that there must be a “realistic
prospect” that the taxpayer will subsequently enter into a trade
or business utilizing the technology developed.
Diamond v.
Commissioner, 92 T.C. 423, 439 (1989), affd. 930 F.2d 372 (4th
Cir. 1991); see I-Tech R&D Ltd. Pship. v. Commissioner, T.C.
Memo. 2001-10, affd. sub nom. Lewin v. Commissioner, ___ Fed.
Appx. ___ (4th Cir. 2003).
“If those prospects are not
realistic, the expenditures cannot be ‘in connection with’ a
business of the taxpayer” so as to satisfy section 174.
Spellman
v. Commissioner, 845 F.2d 148, 149 (7th Cir. 1988), affg. T.C.
Memo. 1986-403.
15
“Whether activities in connection with a product
In Commissioner v. Groetzinger, 480 U.S. 23, 36 (1987),
the Court stated that to determine whether or not an incomeproducing endeavor constitutes a trade or business “‘requires an
examination of the facts in each case.’” (quoting Higgins v.
Commissioner, 312 U.S. 212, 217 (1941)). “We accept the fact
that to be engaged in a trade or business, the taxpayer must be
involved in the activity with continuity and regularity and that
the taxpayer’s primary purpose for engaging in the activity must
be for income or profit. A sporadic activity, a hobby, or an
amusement diversion does not qualify.” Id. at 35.
- 22 are sufficiently substantial and regular to constitute a trade or
business” is a factual determination.
I-Tech R&D Ltd. Pship. v.
Commissioner, supra; see Green v. Commissioner, 83 T.C. 667, 687
(1984).
However, in no event is a deduction appropriate where
the taxpayer acts solely in an investor capacity.
Green v.
Commissioner, supra; see Higgins v. Commissioner, 312 U.S. 212
(1941); I-Tech R&D Ltd. Pship. v. Commissioner, supra; Universal
Research & Dev. Pship. No. 1, et al. v. Commissioner, T.C. Memo.
1991-437.
Whether a taxpayer has a realistic prospect of using the
fruits of R&D expenditures in a future business of his own
involves a two-part test.
“[A] taxpayer demonstrates such a
[realistic] prospect by manifesting both the objective intent to
enter such a business and the capability of doing so.”16
Kantor
v. Commissioner, 998 F.2d 1514, 1518 (9th Cir. 1993), affg. in
part and revg. in part T.C. Memo. 1990-380; see Zink v. United
States, 929 F.2d 1015 (5th Cir. 1991); Spellman v. Commissioner,
supra; Levin v. Commissioner, 832 F.2d 403, 406-407 (7th Cir.
1987), affg. 87 T.C. 698 (1986).
Generally, in determining
whether there is a “realistic prospect,” we look solely to the
period during which the expenditures were incurred.
16
Kantor v.
A taxpayer manifests his “capability” to enter into a
business by his technical expertise to market the new technology
and his financial ability to conduct the business. Scoggins v.
Commissioner, 46 F.3d 950, 953 (9th Cir. 1995), revg. T.C. Memo.
1991-263.
- 23 Commissioner, supra at 1520 (“our inquiry is limited to the tax
year in which a taxpayer incurs its research expenditure and
claims the section 174 deduction”); Diamond v. Commissioner, 930
F.2d 372, 374-375 (4th Cir. 1991), affg. 92 T.C. 423, 439 (1989);
Levin v. Commissioner, supra at 406 n.3 (“The tax treatment in
1979 depends on circumstances in 1979, not on what happened
later”).
“In order to qualify for the section 174 deduction, a
taxpayer’s existing or prospective business must be its own and
not that of another entity.”
Kantor v. Commissioner, supra at
1519; see Levin v. Commissioner, supra; Green v. Commissioner,
supra.
There is a distinction drawn in tax law between engaging
in one’s own business and investing in a business of another.
Kantor v. Commissioner, supra at 1519; see Whipple v.
Commissioner, 373 U.S. 193, 202 (1963); Higgins v. Commissioner,
supra at 218.
When it appears “at the time of the research that
a taxpayer’s activities in connection with a new technology were
unlikely to amount to any more than those of an investor, courts
have denied the deduction.”
Kantor v. Commissioner, supra at
1519; see Zink v. United States, supra; Spellman v. Commissioner,
supra; Levin v. Commissioner, supra; Diamond v. Commissioner,
supra; I-Tech R&D Ltd. Pship. v. Commissioner, supra.
To determine whether the taxpayer manifests the objective
intent to enter into a business of his own with the fruits of
- 24 R&D, we look to the facts and circumstances of the case.
Of
course, we examine any and all contracts and agreements in the
record.
See Kantor v. Commissioner, supra at 1519 (the
“agreements, and other facts which existed at that time,
sufficiently establish” that the taxpayer did not have the
objective intent of entering into a business); Levin v.
Commissioner, supra at 406.
“[T]he ‘right question’ is ‘whether
the * * * [taxpayer] reasonably anticipated availing [itself] of
the privileges [it] possessed on paper.’” LDL Research & Dev. II,
Ltd. v. Commissioner, 124 F.3d 1338, 1345 (10th Cir. 1997)
(quoting Levin v. Commissioner, supra at 406), affg. T.C. Memo.
1995-172.
We must examine “the expectations of the parties”.
Levin v. Commissioner, supra at 406.
“The legal entitlement must
be backed by a probability of the firm’s going into business.
This ordinarily will be so only when it is in the venture’s
private interest to manufacture and sell any products that the
development effort produces.”
Id. at 407.
“Courts have
repeatedly held that while the probability of a firm’s going into
its own business will satisfy section 174, the mere possibility
of its doing so will not.”
Kantor v. Commissioner, supra at
1520.
At the time petitioner incurred the R&D expenditures, he did
not have the objective intent to enter into a future business of
his own with the developed technology.
Rather, petitioner’s
- 25 purpose for engaging in the R&D was to create the developed
technology that could be licensed to CPSG, Inc. for use in CPSG,
Inc.’s existing business.17
For example, petitioner testified as
follows:
Q:
Okay. And had no further development had
taken place, what would have happened to CPSG?
A:
It would have been literally out of business.
Our [software] products would have been 1992 ilk.
I’m sure you appreciate just reading the trade
press how quickly technology moves in this
industry, and it would have had obsolete products
that they could no – not only could they not have
sold them to any new customers, their own customer
base would have immediately started looking for
alternative technology. A large part of the
revenue for these companies came from customer
support, customer upgrade kinds of revenue, and if
they hadn’t – if they hadn’t had any improvement
to the product, the customers would have no reason
to spend that money, so CPSG would have simply
been out of business.
*
*
*
*
*
*
*
Q:
How did you decide whether to do * * * [the
development work] as an employee of CPSG or –- or
as your Schedule C?
A:
* * * I was concerned that CPSG really didn’t
have any leverage in a discussion with Computer
Power Group. If they cancelled the marketing
agreement, if they cancelled the sublicense –- or
the submarketer agreement, Computer –- CPSG was
out of business.
So, my thought was to create some
intellectual property ownership outside of
Computer Power Software Group, and the idea being
17
CPSG, Inc.’s initial return position was to deduct the R&D
expenditures on its tax return. CPSG, Inc. ultimately amended
its return, eliminating the deduction, which petitioners then
claimed on their individual tax return.
- 26 that, you know, you own the TV but I own the TV
changer, so we better cooperate in resolving any
differences.
And so that was the thought was to kind of
create an ownership that I would have personally
which would help us in protecting CPSG as well.
*
*
*
*
*
*
*
A:
* * * And again, having the intellectual
property ownership in my hands personally meant at
least we were going to have a discussion about it.
A corporate resolution passed by CPSG, Inc.’s board of directors
stated that petitioner “may undertake such reasonable research
and development activities on * * * [CPSG, Inc.’s] behalf in
order to render and maintain the Company’s products as
commercially viable”.
Indeed, on brief petitioners proposed that
we find that “It was clear to petitioner that in order to save
the business of CPSG more development had to be performed;”
“Petitioner believed that by creating intellectual property
rights outside of the CPSG/CPG/Syndicate relationship he would
have more negotiating leverage regarding any technology that he
developed;” and “Petitioner believed that if he had rights to the
technology he developed and CPG had rights to the underlying
technology, CPG and the Syndicates would have to cooperate with
him.”
On brief, petitioners explained that “When Syndicate
funding ended, additional development had to be done for the
business of CPSG to survive.”
- 27 There is no evidence in the record, not even petitioner’s
testimony, that he intended to engage in a business of his own
with the developed technology.
“The fact that a taxpayer may
have taken an active role in directing the research does not, by
itself, place a taxpayer in a trade or business.”
I-Tech R&D
Ltd. Pship. v. Commissioner, T.C. Memo. 2001-10 (citing Green v.
Commissioner, 83 T.C. at 690).
There is no evidence in the
record of any specific plans or forecasts relating to the
probability that petitioner might engage in the marketing of the
developed technology.
Id.
There is no evidence that petitioner
actually marketed the developed technology.
Indeed, it would
have been counterintuitive for petitioner to market the developed
technology to outsiders; CPSG, Inc. was already an established
software marketing entity with existing customers.
All the
publications and marketing materials relating to the developed
technology were created on behalf of CPSG, Inc., not petitioner.
If petitioner himself marketed the developed technology, he would
be competing with his solely owned corporation.
Indeed on brief,
petitioners argued “CPSG was in absolutely the best position in
the universe to market the * * * [Developed Technology].
Not
only was it reasonable for petitioner to attempt to use CPSG to
market the new products, it would have been asinine for him not
to have done so.”
- 28 The record does not demonstrate that petitioner’s R&D
activities amounted to anything more than the development of
property rights that he intended to license to CPSG, Inc. for use
in CPSG, Inc.’s business.
As such, petitioner’s activities
amounted to nothing more than those of a prudent investor.18
“‘[T]he management of investments is not a trade or business for
purposes of section 174.”
Spellman v. Commissioner, 845 F.2d at
150 (quoting Green v. Commissioner, 83 T.C. at 688).
For the aforesaid reasons, we find that at the time
petitioner incurred the R&D expenditures, he did not have an
objective intent to engage in his own trade or business with the
developed technology.
Petitioners argue that the Court of Appeals for the Ninth
Circuit’s19 opinion in Scoggins v. Commissioner, 46 F.3d 950 (9th
Cir. 1995), revg. T.C. Memo. 1991-263, supports their contention
that petitioner had a realistic prospect of using the R&D in a
future business of his own.
The facts in Scoggins are similar to
the instant case in some respects.
Both cases involve R&D where
the person (in Scoggins a partnership) performed the R&D by
18
There is no evidence of how much time petitioner devoted
to this R&D endeavor. Clearly, petitioner monitored the R&D
process via telephone, one visit to Australia, and electronic
mail communications. However, petitioners do not allege, and we
cannot find, that petitioner’s activities during the time the R&D
expenditures were made were sufficient to constitute a trade or
business.
19
To which this case is appealable.
- 29 contracting the work to others.
In both cases property rights to
the technology resulting from the R&D were retained by the person
or partnership responsible for performing the R&D and in both
cases the owner of those property rights in the technology
licensed the technology to a user in return for a royalty.
Both
petitioner and the partners in Scoggins also had expertise in the
type of technology that was the subject of the R&D.
Finally, in
both cases it was clear that neither petitioner nor the
partnership was engaged in a trade or business at the time that
the R&D expenditures were paid or incurred.
Despite these
similarities, we disagree that Scoggins is dispositive of the
section 174 issue.
The primary focus of the Court of Appeals’ opinion in
Scoggins, does not appear to have been whether the taxpayers had
the objective intent to enter into a business of their own with
the fruits of the R&D expenditures. Indeed, after reciting the
facts, the Court stated:
There is no question that Scoggins and Christensen
had the objective intent to enter into the
business of marketing the reactor if the reactor
proved successful. The only question is whether
they had a realistic prospect of engaging in the
business as a partnership, or whether by virtue of
the agreement with the corporation, they had
deprived the partnership of the capability of
doing so. [Id. at 953.]
The Court of Appeals then analyzed the taxpayers’ “capability” of
engaging in a trade or business with the fruits of R&D.
In doing
- 30 so, the Court considered the taxpayers’ technical expertise,
their financial ability to conduct the business, and whether
their contractual obligations precluded the likelihood of using
the R&D in a future business.
Id.
The Court concluded that the
taxpayers had the capability to use the R&D in a future
business.20
In contrast, in the instant case we have found that
petitioner failed the first part of the realistic prospect test
because he had no objective intent to use the R&D in a future
business of his own.
B.
Other Schedule C Expenses
In the notice of deficiency, respondent disallowed some of
the expenses that petitioners claimed and deducted on their
Schedules C for the taxable years 1994 and 1996.21
The amounts
of the adjustments at issue are $18,241 and $25,731,
respectively.
In the notice of deficiency, respondent claimed
that petitioners had not “established a business purpose for the
expenses claimed.”
20
There is a question whether petitioner had the right to
use the developed technology. His use may have depended upon the
enforceability of the terms of the contract between CPG and CPSG,
Inc. which petitioner testified could be canceled by CPG.
Indeed, this potential problem was one of the reasons why
petitioner decided to structure the R&D contract the way he did.
21
Additionally, respondent determined that petitioners were
entitled to deduct an additional $22,275 from their 1995 return.
We presume 1995 is not at issue, since respondent allowed
petitioners a greater deduction than was claimed.
- 31 Respondent argues that petitioners failed to substantiate
the expenses deducted in excess of the amount allowed by
respondent.22
Petitioners argue that:
(1) The notice of
deficiency and respondent’s court papers do not provide
petitioners with notice of which expenses were denied, and (2)
petitioners have sufficiently substantiated the deduction of
expenses claimed.
For the reasons detailed below, we believe
petitioners failed to carry their burden.
Petitioner testified that he received payments for, inter
alia, consulting services performed on behalf of CPSG Ventures.23
Assuming this to be true, we find that petitioners have not
proven entitlement to the disallowed deductions.
We do not find
petitioners’ argument that respondent failed to identify which
deductions were denied persuasive.
Respondent allowed
petitioners to deduct expenses to the extent that they received
reimbursement from CPSG, Inc.
Petitioners are in the unique
position to know those expenses for which they received
22
Respondent permitted deductions for reimbursed employee
expenses to the extent such reimbursements were included in
petitioners’ Schedules C gross receipts for the years at issue.
The amounts reimbursed by CPSG, Inc. were $61,640 and $53,618 for
1994 and 1996, respectively.
23
For example, on their 1994 return, petitioners reported
$194,317 in gross receipts for CPSG Ventures on which petitioners
claimed an expense deduction of $79,881, leaving a net profit of
$114,436. From the $79,881 in expenses claimed, respondent
allowed $61,640 as a deduction, an amount equal to that which
petitioners included in gross income as reimbursements received
from CPSG, Inc.
- 32 reimbursement.
The difference between the reimbursed expenses
and the claimed expenses is the expenses for which respondent
denied a deduction.
The category of expenses denied becomes an
important matter as the substantiation requirements vary
depending upon the type of expense claimed as a deduction.
Generally, ordinary and necessary expenses paid or incurred
in carrying on a trade or business are deductible by an
individual engaged in the trade or business.
1.162-1(a), Income Tax Regs.
Sec. 162(a); sec.
“The determination of whether an
expenditure satisfies the requirements of section 162 is a
question of fact.”
Shea v. Commissioner, 112 T.C. 183, 186
(1999) (citing Commissioner v. Heininger, 320 U.S. 467, 475
(1943)).
Deductible expenses are subject to substantiation.
6001, 274(d).
Secs.
The basic substantiation requirement is set forth
in section 6001 and provides in pertinent part:
SEC. 6001. NOTICE OR REGULATIONS REQUIRING
RECORDS, STATEMENTS, AND SPECIAL RETURNS.
Every person liable for any tax imposed by
this title, or for the collection thereof, shall
keep such records * * * and comply with such rules
and regulations as the Secretary may from time to
time prescribe. * * *
The regulations provide that “any person subject to tax * * *
shall keep such permanent books of account or records * * * as
are sufficient to establish the amount of * * * deductions.”
Sec. 1.6001-1(a), Income Tax Regs.
In the event that a taxpayer
- 33 establishes that deductible expenses have been paid, but he is
unable to substantiate the precise amount, the court may estimate
the amount of such deduction bearing heavily against the
taxpayer.
1930).
Cohan v. Commissioner, 39 F.2d 540, 543-44 (2d Cir.
However, the court cannot make such an estimate unless
the taxpayer presents sufficient evidence to provide a reasonable
basis upon which to make the estimate.
Vanicek v. Commissioner,
85 T.C. 731, 743 (1985).
The court’s ability to estimate reasonably the amount of a
deduction is curtailed in the case of certain classes of
expenses.
Section 274(d) limits the Court’s estimating ability.
Sanford v. Commissioner, 50 T.C. 823, 827 (1968), affd. per
curiam 412 F.2d 201 (2d Cir. 1969); see Golden v. Commissioner,
T.C. Memo. 1993-602.
Section 274(d) provides:
SEC. 274(d) Substantiation Required.--No deduction or
credit shall be allowed-(1) under section 162 or 212 for any traveling
expense (including meals and lodging while away from
home),
(2) for any item with respect to an activity which
is of a type generally considered to constitute
entertainment, amusement, or recreation * * *
(3) for any expense for gifts, or
(4) with respect to any listed property (as
defined in section 280F(d)(4)),
unless the taxpayer substantiates by adequate records
or by sufficient evidence corroborating the taxpayer’s
own statement * * *. [Emphasis added.]
- 34 See sec. 1.274-5T, Temporary Income Tax Regs., 50 Fed. Reg. 46014
(Nov. 6, 1985).
As applicable here, “listed property” includes
expenses associated with computer equipment and cellular
telephones.
Sec. 280F(d)(4).
To substantiate a deduction under section 274(d), a taxpayer
must maintain adequate records or present other corroborative
evidence to show, inter alia, the amount of the expense, the date
upon which it was incurred, and the business purpose for the
expenditure.
Sec. 1.274-5T(b), Temporary Income Tax Regs., 50
Fed. Reg. 46014 (Nov. 6, 1985).
To substantiate a deduction by
means of adequate records, the taxpayer must present some type of
documentary evidence.
Sec. 1.274-5T(c)(2)(i), Temporary Income
Tax Regs., 50 Fed. Reg. 46017 (Nov. 6, 1985).
The parties stipulated that reimbursements received from
CPSG, Inc. were “primarily” for travel and entertainment,
supplies, and telephone expenses.
Respondent allowed as a
deduction the full amount of the expenses associated with the
reimbursements.
Additionally, respondent allowed petitioners to
deduct their automobile expenses as an itemized deduction.
The substantiation requirements of sections 6001 and 274(d)
require, at a minimum, that petitioners substantiate the expenses
deducted.
Some of the items for which deductions were claimed
- 35 are section 280F(d)(4) “listed property”.24
These items, as
previously stated, require strict substantiation.
Here,
petitioners failed to detail the expenses denied, the amounts of
those expenses, and the business purpose for those expenses.
We
are not required to, and shall not, guess.
Petitioners have failed to substantiate sufficiently the
expenses claimed in excess of the amount respondent allowed in
the notice of deficiency.
Furthermore, petitioner’s vague
testimony that all the expenses claimed were for business
purposes is not sufficient.
“It is well settled that we are not
required to accept petitioner’s self-serving testimony in the
absence of corroborating evidence.”
Jacoby v. Commissioner, T.C.
Memo. 1994-612 (citing Lerch v. Commissioner, 877 F.2d 624, 631632 (7th Cir. 1989), affg. T.C. Memo. 1987-295); see Geiger v.
Commissioner, 440 F.2d 688, 689 (9th Cir. 1971), affg. per curiam
T.C. Memo. 1969-159; Niedringhaus v. Commissioner, 99 T.C. 202,
212 (1992).
“There must be sufficient evidence in the record to
permit the Court to conclude that a deductible expense was
incurred in at least the amount allowed.”
Jacoby v.
Commissioner, supra (citing Williams v. United States, 245 F.2d
559, 560 (5th Cir. 1957)) (emphasis added).
24
To permit
Petitioner testified that part of the deductions claimed
and disallowed were for computer equipment and cellular
telephone. See sec. 280F(d)(4)(A)(v); Vaksman v. Commissioner,
T.C. Memo. 2001-165; Nitschke v. Commissioner, T.C. Memo. 2000230.
- 36 petitioners a deduction for the amounts shown on their 1994 and
1996 returns, without definitive evidence showing the amounts
expended and the purposes of the expenditures, would be “unguided
See Jacoby v. Commissioner, supra.
largesse”.
Since petitioners failed to identify their deductions and
the specific amounts, the knowledge of which is unique to them,
we uphold respondent’s determination that petitioners are not
entitled to claim deductions in excess of those amounts
determined in the notice of deficiency.
C.
Accuracy-Related Penalties
Respondent determined penalties pursuant to section 6662 in
the amounts of $2,346, $3,354, and $126,858 for the taxable years
1994, 1995, and 1996, respectively.
Respondent based his
determination on negligence or disregard of the tax rules and
regulations and/or a substantial understatement of income tax.
Respondent’s determination is presumed correct, and the burden
lies with petitioners to demonstrate that respondent’s penalty
determination was in error.25
Rule 142(a).
Section 6662(a) imposes a 20-percent penalty on the portion
of an underpayment of tax attributable to, inter alia, negligence
and/or a substantial understatement of income tax.
and (b).
Sec. 6662(a)
“Underpayment” is defined as the amount by which the
tax imposed exceeds the excess of the sum of the amount shown by
25
See supra note 13.
- 37 the taxpayer on his return plus the amounts not so shown
previously assessed (or collected without assessment) over the
amount of rebates made.
Sec. 6664(a).
“Negligence” is defined as “any failure to make a reasonable
attempt to comply with the provisions of this title” and
“disregard” means “any careless, reckless, or intentional
disregard.”
Sec. 6662(c).
Similarly, caselaw defines negligence
as a lack of due care or “‘the failure to do what a reasonable
and ordinarily prudent person would do under the circumstances.’”
Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quoting
Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967),
affg. on this issue 43 T.C. 168 (1964) and T.C. Memo. 1964-299)),
affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991).
Pursuant to the regulations, “‘Negligence’ also includes any
failure by the taxpayer to keep adequate books and records or to
substantiate items properly.”
Sec. 1.6662-3(b)(1), Income Tax
Regs.
There is a “substantial understatement” of tax if “the
amount of the understatement for the taxable year exceeds the
greater of” (1) 10 percent, or (2) $5,000.
Sec. 6662(d)(1)(A).
An “understatement” means the excess of the amount of tax
required to be shown on the return for the year over the amount
of tax shown on the return.
Sec. 6662(d)(2)(A).
However, as
applicable here, the amount of the understatement is reduced by
- 38 that portion of the understatement which is attributable to any
item if the relevant facts affecting the item’s tax treatment are
adequately disclosed on the return or a statement attached to the
return and there is a reasonable basis for the tax treatment of
such item.
Sec. 6662(d)(2)(B).
Section 6664(c) provides an exception to the penalty imposed
under section 6662(a).
“No penalty shall be imposed under this
part with respect to any portion of an underpayment if it is
shown that there was a reasonable cause for such portion and that
the taxpayer acted in good faith with respect to such portion.”
Sec. 6664(c)(1).
The determination of whether the taxpayer acted
with reasonable cause and in good faith is made on a case-by-case
basis, contemplating all of the relevant facts and circumstances.
Sec. 1.6664-4(b)(1), Income Tax Regs.
With respect to the deduction of R&D expenses, we cannot
find under the facts before us that petitioners acted
unreasonably by claiming the section 174 deductions.
The facts
of this case are unique, and petitioner testified that he relied
upon the advice of a tax professional.
See id.
Accordingly,
penalties associated with such deductions are not appropriate.
With respect to the penalties relating to the other
disallowed deductions claimed on petitioners Schedules C for the
tax years 1994 and 1996, petitioners failed to substantiate the
deductions claimed.
As previously stated, petitioners are in the
- 39 unique position to determine for which expenses CPSG, Inc.
reimbursed them.
respondent denied.
The balance are those deductions which
Incomplete copies of credit card statements
and petitioner’s self-serving testimony are not sufficient to
substantiate the deductions claimed.
Accordingly, petitioners
have failed to demonstrate that they were not negligent in
claiming these disallowed deductions.
Xuncax v. Commissioner,
T.C. Memo. 2001-226; see sec. 1.6662-3(b)(1), Income Tax Regs.
Lastly, we turn to whether a penalty is appropriate due to
the double charitable contribution deduction claimed by
petitioners on their 1996 return.
The evidence demonstrates that
petitioners made a mistake in preparing their 1996 return.
On
brief, petitioners argued that, relying upon Rev. Proc. 96-58,
1996-2 C.B. 390, they had made adequate disclosure of the
charitable contribution deduction by completing the charitable
contribution portion of Schedule A, Itemized Deductions.
Rev.
Proc. 96-58, supra, provides that additional disclosure of facts
is not necessary to fall within the auspices of section
6662(d)(2)(B), which allows for the reduction in the amount of
the understatement, provided that the forms and attachments are
completed in a clear manner and in accordance with their
instructions.
Rev. Proc. 96-58, sec. 4.01, supra.
Although Rev.
Proc. 96-58 is applicable to whether a taxpayer has disclosed
sufficient facts to be entitled to reduce the amount of the
- 40 understatement, it “does not apply with respect to any other
penalty provision (including the negligence or disregard
provisions of the §6662 accuracy-related penalty).”
We agree
with respondent that a prudent taxpayer would have been warned of
a potential problem with his return by an additional $60,000
deduction.
Thus, we find that respondent’s imposition of a
penalty for an erroneously claimed double deduction was
substantially justified.
To reflect the foregoing,
Decisions will be entered
under Rule 155.
Reporter’s Note: This report was modified by Order dated Sept. 4, 2003.
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.