Ernesto P. Patacsil & Marilyn E. Patacsil ( 2023 )

United States Tax Court
T.C. Memo. 2023-8ERNESTO P. PATACSIL AND
MARILYN E. PATACSIL,
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket No. 21902-19. Filed January 17, 2023.
—————
Ernesto P. Patacsil and Marilyn E. Patacsil, pro se.
Caitlin A. Homewood and Brian A. Pfeifer, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HOLMES, Judge: In 2015, 2016, and 2017, Ernesto and Marilyn
Patacsil owned a business that ran group homes in which they cared for
adults with developmental disabilities. Running these homes was
expensive, and the Patacsils claimed many business expenses and a net-
operating-loss carryforward. They also faced financial reverses during
those years, and lost some real property to foreclosure. This case is about
whether they can prove insolvency to avoid recognition of cancellation-
of-indebtedness income (COI income) on the properties lost to
foreclosure, as well as whether they can substantiate the other
deductions and loss carryforwards that the Commissioner disallowed.
The Commissioner argues that they can’t, and that they got it so
wrong that he’s entitled to accuracy-related penalties.
Served 01/17/23
2
[*2] FINDINGS OF FACT
I. The Cost of Caring
California encourages its adult citizens who have severe
developmental disabilities to live in group homes in their communities. 1
These homes are licensed as “adult residential facilities” 2 by the
California Department of Health and Human Services. They are
operated by social-service entrepreneurs like the Patacsils, who have to
somehow balance income, expenses, and compassion to provide for the
adults they care for all day long and throughout the year. The Patacsils
got into this business in 1986, and taught their own children how to
provide proper care to their “consumers” with intellectual or physical
maladies. 3
Setting up the group homes was a challenge. The Patacsils began
by buying rundown houses, repairing them, and adding features to
accommodate their clients with disabilities. While they restored these
properties, they also applied for their homes to be licensed as residential
facilities. This meant continual testing, background checks, and
interviews with Community Care Licensing, the state agency that
regulates the group-home industry. They also had to negotiate a
contract to receive clients from Valley Mountain Regional Center, a
state-run facility with its own extensive eligibility requirements. The
Patacsils built their business application by application, and client by
client, and by 2014 they had around seven group homes, each with up to
six employees.
Group homes are much more expensive than boarding houses. To
ensure a safe and stable environment for their clients, the Patacsils kept
on staff a registered nurse and a behavioral analyst. They provided
transportation in their own fleet of vehicles so their clients could get to
appointments and activities. They also paid for their employees to be
fingerprinted, have their backgrounds checked, and receive continuing
1 See Disability and Aging Community Living Advisory Committee, Cal. Health
& Hum. Servs. Agency, https://www.chhs.ca.gov/home/committees/disability-and-
aging-community-living-advisory-committee/ (last visited Oct. 28, 2022).
2 See Cal. Code Regs. tit. 22, § 80001(a)(5) (2022).
3 The Patacsils referred throughout trial to the residents of their homes as
“consumers”, and this is apparently a common term in the industry in California. That
seems vaguely dehumanizing to someone outside the trade, and we refer to them as
“clients” throughout.
3
[*3] education. And to provide entertainment for their clients, they even
paid for playing cards, trips to festivals, and holiday gifts.
The cash for this operation flowed almost entirely from a single
spigot—the State of California. Once California licenses a home and its
operator, this spigot is opened. But what flows out is, according to the
Patacsils, more a trickle than a stream: The current nonmedical out-of-
home care payment amounts to only $1,365 per month for each client in
2022. 4 Mrs. Patacsil testified that in over 20 years, the state has
increased its funding to group-home businesses only once. Payments can
be slow as well as low, but the Patacsils went to great lengths to keep
providing these essential services, and would even refinance their
mortgages to make ends meet.
Theirs was a business that was always in danger of toppling into
failure if income fell or expenses rose by even a bit. The Patacsils had
already lost an investment property they owned to foreclosure when a
tenant refused for more than five years to pay rent and utilities. And
while their debts continued to rise, Mrs. Patacsil indulged in the high-
risk hobby of gambling at casinos. This hobby was expensive and her
losses worsened their business’s chance of survival. All together the
Patacsils bore many financial burdens, but Mrs. Patacsil has tried
throughout the years to organize their expenses and debts to keep their
business afloat using her resources, her accountants, and her old-school
accounting system.
II. 2015
This accounting system relied on envelopes. Mrs. Patacsil put
business-expense receipts inside envelopes labeled with the type of
purchase and amount spent. The envelopes went into boxes, and the
boxes went to her tax preparer for 2015, 2016, and 2017, the years at
issue.
The Patacsils did use accountants to prepare their returns for
these years. Gordon Lindstrom prepared their returns for 2015. He
reported numerous “Other Expenses” on the Patacsils’ 2015 tax returns,
including expenses for client activities, supplies, fingerprinting,
continuing education classes, physical exams for employees, referral
fees, client gifts, pharmaceuticals, client transportation costs, gas,
4 See SSI/SSP Rates, Cal. Assisted Living Ass’n,
http://caassistedliving.org/provider-resources/and-more/ssissp-rates/ (last visited Oct.
24, 2022).
4
[*4] monthly payments on a van, and groceries. The Patacsils claimed
nearly $500,000 of these “other expenses,” but the Commissioner
allowed only a bit more than half. Lindstrom also advised the Patacsils
to exclude from their income the debt that foreclosure relieved them
from paying, on the ground that they were insolvent, but the Patacsils
introduced into the record no evidence of any insolvency calculations
that he or they made.
Lindstrom’s return preparation had twice before landed the
Patacsils in our Court. Their first appearance was in 2015 for their 2010,
2011, and 2012 returns. 5 And they were in court only a year later for
their 2013 return. 6 The Patacsils did not enjoy these appearances and
went to a new accountant to prepare their 2016 and 2017 returns. Mrs.
Patacsil believed they were making a change for the better. But moving
to a new accountant did not move her to update her recordkeeping
method.
III. 2016 and 2017
This new accountant was Raymond Young. He is a UC Berkeley
graduate and CPA who for five years early in his career was a revenue
agent for the IRS. When preparing the Patacsils’ tax returns, he heavily
relied, as had Lindstrom, on the numbers Mrs. Patacsil pulled out of her
envelopes. This was not a small chore—Young received approximately
6,000 files from Mrs. Patacsil for 2016 and 2017. He looked inside the
files to doublecheck that the expenses were in the correct category, but
once verified he put the numbers in Excel, categorized them by line
number on the return, and then filled in the Patacsils’ tax forms.
Young did identify a couple unusual issues. He completed Forms
4797, “Sales of Business Property,” for both their 2016 and 2017 returns.
On these forms the Patacsils reported the sale of a group home known
as Hildreth in 2016 and another known as Knickerbocker in 2017. They
had bought Hildreth in 2005 for $622,263; claimed a basis built up to
$921,450; a gross sale price of $416,000; and a canceled loan of $391,080.
They also claimed to have no allowable depreciation even though the
property was used in their business. These numbers led them to claim a
loss of $505,450.
5 See Patacsil v. Commissioner, T.C. Memo. 2017-176, aff’d, 727 F. App’x 453(9th Cir. 2018).
6 See Petition, Patacsil v. Commissioner, No. 3900-16 (T.C. Feb. 17, 2016).
5
[*5] They also reported the sale of their Knickerbocker property in an
unusual way. They reported that in 2017 they sold the property for
nothing but that they did receive $365,000 of loan forgiveness upon the
sale. The Patacsils reported having a total accumulated basis of
$125,587 in the property from which they had taken $101,361 of
depreciation deductions. This left them with a basis of $24,226 in the
property at the time of the sale. Ignoring the cancellation of debt, the
Patacsils reported the $24,226 claimed basis as a loss on their return.
At trial, however, Young testified that the original return had a mistake.
The basis of $7,902 and depreciation of $3,095 that were calculated into
the total figures for the Knickerbocker property should have been
allocated to a separate property. Young’s testimony supports a finding
that the actual basis in the Knickerbocker property built up to only
$117,685 and the allowable depreciation built up to only $98,266. This
means that the Patacsils built-up basis in the property minus the
depreciation was actually $19,419, not $24,226 as was reported on the
2017 return.
Young also advised the Patacsils to exclude any COI income on
the ground that they were insolvent. He gave them this advice in
preparing their 2016 return after Mrs. Patacsil provided his firm with
estimates of the value of her jewelry, furniture, art, and other personal
property as well as information about her credit-card debt, auto loans,
and other liabilities. Young had his employees tote up the assets and
liabilities using those numbers to complete his calculations together
with Zillow.com and Kelly Bluebook to value the Patacsils’ real property
and automobiles. Young himself did a final review and came up with a
total of a bit more than $3 million in assets against $3.9 in liabilities.
We find, however, that he did not include the value of Patacsil Home
Care in these calculations for 2016, and we also specifically find that no
one updated any of these figures to recalculate the Patacsils’ solvency in
2017.
His work on the Patacsils’ claimed net operating loss (NOL) was
similarly eccentric. On their 2017 return, Young carried forward about
$450,000 as an NOL from the 2016 return. He claims to have calculated
this by adding the Patacsils’ business income on Line 12 with the other
gains or losses on Line 14 and business-rental loss from Line 17 of the
2016 return. There are some rather obvious errors in these calculations.
On their 2016 return Young offset the NOL in part with Mrs. Patacsil’s
gambling income but then reported a deduction in the full amount of
that income as a miscellaneous deduction on the Patacsils’ Schedule A.
Young’s carryforward calculations on the 2017 return began with
6
[*6] −$373,476 on Line 21, an amount that Young testified at trial did
not include a rental loss of $25,000 that he should have carried forward.
He recalculated a total loss of −$424,726.
The Commissioner’s computer whirred and spotted these
anomalies. There was an audit, followed by a notice of deficiency for all
three years. The case headed to trial after the Patacsils, then as now
residents of California, filed their third petition with our Court. They
were able to settle some issues, and the parties conceded others. What
we have left to decide:
• Should the Patacsils have reported COI income for 2015
and 2016?
• Are they entitled to additional Schedule C expenses for
2015, 2016, and 2017?
• Did they overstate their losses from the sales of the
Hildreth and Knickerbocker properties?
• Did they incur an NOL of $450,000 in 2016 that they are
entitled to carry forward to 2017?
• Do they owe any penalties?
We tried the case remotely, and there were a couple oddities. One
was that the Patacsils did not introduce evidence of their election to
waive carryback of their alleged net operating loss. We explained the
importance of such evidence—and explain it again below in this Opinion
—and held the record open for them to introduce any documentary
evidence of the election even after trial. They submitted an NOL
Worksheet and a screenshot of an explanation statement from
ProSeries, a program for preparation of tax returns that Young had
used. This screenshot states that the Patacsils elected to waive the
carryback of an NOL. A second oddity was that, for all the testimony
about envelopes filled with receipts and the Patacsils’ prior visits to our
Court, they introduced nothing but testimonial evidence about their
expenses and what those receipts would have shown, but they did not
produce the receipts themselves.
7
[*7] OPINION
We’ll start with income, move on to deductions, and finish with
penalties.
I. Cancellation-of-Indebtedness Income
Tax Year Amount Reported Amount Adjustment
Determined
2015 — $39,115 $39,115
2016 — 7,080 7,080
Section 61(a) 7 defines income to include any income from the
discharge of indebtedness. § 61(a)(12). “The general theory is that to the
extent that a taxpayer has been released from indebtedness, he has
realized an accession to income because the cancellation effects a freeing
of assets previously offset by the liability arising from such
indebtedness.” Cozzi v. Commissioner, 88 T.C. 435, 445 (1987) (citing
United States v. Kirby Lumber Co., 284 U.S. 1 (1931)). Canceled debt
creates income that is usually equal to the face value of that debt minus
any amount paid to satisfy it. Rios v. Commissioner, 103 T.C.M. (CCH)
1713, 1716 (2012), aff’d, 586 F. App’x 268 (9th Cir. 2014); see also Merkel
v. Commissioner, 192 F.3d 844, 849 (9th Cir. 1999), aff’g 109 T.C. 463(1997). A taxpayer has to recognize the income in the year the debt is
canceled. Montgomery v. Commissioner, 65 T.C. 511, 520 (1975).
As always in tax law, there are exceptions to the general rule. The
Patacsils seek shelter in the Code’s exception for those debtors who are
insolvent when their debts are forgiven. Section 108(a) limits this
exclusion to the amount of the insolvency, § 108(a)(1)(B), (3), and defines
an insolvent taxpayer as one who has an “excess of liabilities over the
fair market value of assets.” § 108(d)(3). The Code also acknowledges
that people’s financial situation changes from day to day, and so tells us
7 Unless otherwise indicated, all statutory references are to the Internal
Revenue Code (Code), Title 26 U.S.C., in effect at all relevant times, all regulation
references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all
relevant times, and all Rule references are to the Tax Court Rules of Practice and
Procedure.
8
[*8] to focus on the day the debt is canceled: The decisive moment is
immediately before that cancellation. Id.
The burden is on the Patacsils to prove that they were insolvent.
See Rule 142(a); see also Newman v. Commissioner, 111 T.C.M. (CCH)
1599, 1600 (2016). That’s a double burden here: They contest two
inclusions of COI income, one for 2015 and one for 2016.
We’ll take them in order.
A. 2015
We begin with the report of Ocwen Loan Servicing LLC that the
Patacsils received a discharge of a $39,115 debt on August 18, 2015. The
Patacsils don’t dispute that they received this income. 8
There are some problems, however, with their proof of insolvency.
Remember that they owned real estate both as an investment and to use
in their group-home business. Mrs. Patacsil testified that she went to
Zillow to look up the value of all her properties. Because we need to look
at the time immediately before the Patacsils realized their COI income
(i.e., August 2015) to determine whether they were insolvent, we need
to know exactly when the Patacsils looked up these values on Zillow and
some evidence of any change or lack of change in those values between
the date of discharge and the time they checked. Neither Mrs. Patacsil
nor Young was clear on exactly when she did her research. Without that,
we don’t have enough information to find they were insolvent at the key
time.
We also note that from 2012 to 2020 the Patacsils were engaged
in a wage-and-hour lawsuit filed by some of their employees. Although
Mrs. Patacsil testified about this lawsuit, she could not estimate a worst-
case scenario for it because she was confident that she would win. It
would have been helpful to them to have some estimate of this liability
8 Ocwen is a mortgage-servicing company, and the discharged debt was
possibly for a mortgage. Ocwen reported it to the IRS on Form 1099–C, Cancellation
of Debt, leading to another unsolved mystery in this case: We can find nothing on the
Patacsils’ 2015 return that shows anything like a disposition of property through sale
or foreclosure, so we can make no finding that this discharge was of a nonrecourse debt
—something that would usually lead to the addition of the discharged debt to the sale
price of a sold or foreclosed property and thus the size of a capital loss or gain. (We
explain this principle of tax law below, in Section III.) The parties have instead treated
this as a fight about recognition of COI income and the insolvency exception, and so
will we.
9
[*9] as of August 2015—it would have bolstered their claim of
insolvency—but in its absence we have nothing to use. The Patacsils
provided no other information regarding their liabilities as of August
2015, and likewise gave us no evidence of the value (or lack of value) of
their operating business in 2015.
Without evidence of the Patacsils’ total assets and liabilities, we
cannot figure out if their liabilities exceeded their assets. We therefore
find that they have not met their burden of proving the existence and
extent of their insolvency in August 2015. We therefore also find that
they must recognize the entire amount shown on their Form 1099–C as
COI income for 2015.
B. 2016
The Patacsils’ proof of insolvency is similarly sparse for 2016. But
here they benefit from a problem in the Commissioner’s case. The notice
of deficiency identified $7,080 in unreported COI income for 2016. We
accord the notice of deficiency a presumption of correctness, Becker v.
Commissioner, 115 T.C.M. (CCH) 1364, 1385 (2018), but we have a
transcript of all the third-party reports of income. Those reports include
the COI income from Ocwen in 2015, but there is no report of any COI
income in the amount of $7,080 or amounts that would add up to $7,080.
While we acknowledge that the Patacsils didn’t specifically identify this
problem in their petition we are loath to find that they have to include
this in their income. Our Rules allow us to consider issues tried by
consent, which can be either explicit or implicit. Rule 41(b)(1). Implicit
consent exists when one party puts on evidence about an item relevant
to the correct computation of a deficiency even if not raised in the
pleadings so long as the consent does not result in “unfair surprise or
prejudice to the consenting party [or] prevent[] that party from
presenting evidence that might have been introduced if the issue[] had
been timely raised.” Phillips v. Commissioner, 106 T.C.M. (CCH) 288,
291 (2013) (citing Bulas v. Commissioner, T.C. Memo. 2011-201, slip op.
at 2 n.2); see, e.g., Siegel v. Commissioner, 50 T.C.M. (CCH) 880, 886
(1985) (respondent’s failure to amend pleading doesn’t necessarily mean
issue not tried by consent). That’s what happened here—the
Commissioner chose to enter evidence of all the third-party reports he
had, and it turned out to refute any finding that the Patacsils got $7,080
of COI income in 2016.
The Patacsils win on this issue.
10
[*10] II. Schedule C Expenses
Section 162 allows a deduction for ordinary and necessary
business expenses, but taxpayers have the burden of proving what they
spent. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). To prove
these deductions, a taxpayer usually must keep sufficient records to
substantiate them. § 6001; Treas. Reg. § 1.6001-1(a). When a taxpayer
fails to substantiate his deductions, we may estimate, but only if he
provides at least some evidence to support an estimate and we are
convinced he incurred them. Finney v. Commissioner, 27 T.C.M. (CCH)
1510, 1516 (1968); see also Williams v. United States, 245 F.2d 559, 560
(5th Cir. 1957); Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir.
1930).
The Patacsils deducted a wide range of business expenses under
section 162 on their Schedules C and claimed they paid them in the
ordinary course of running their homes.
A. Supplies
Tax Year Amount Reported Amount Adjustment
Determined
2016 $296,194 $151,059 $145,135
2017 174,470 88,980 85,490
Materials and supplies that a business uses during a tax year are
generally deductible. See § 162(a); Treas. Reg. § 1.162-3; Bruns v.
Commissioner, 98 T.C.M. (CCH) 30, 36 (2009). Mrs. Patacsil credibly
testified that she buys games, access to iTunes, and pharmaceutical
supplies such as vitamins for her clients. What’s unclear is how much
she spent. The Patacsils introduced no receipts or documents. The
Commissioner had already allowed a very large fraction of the total
expenses. This leads us to find that the Patacsils have not met their
burden of proving that they are entitled to larger deductions for either
of these tax years.
11
[*11] B. Other Expenses
Tax Year Amount Reported Amount Adjustment
Determined
2015 $495,035 $289,679 $205,356
The Patacsils claimed $495,035 in “other expenses.” The
Commissioner allowed $289,679. Mrs. Patacsil vaguely testified about
these “other expenses” as the cost of taking her clients to movies,
carnivals, and festivals, or giving them small allowances for good
behavior. She also paid for her employees’ fingerprinting and continuing
education, and for fees of $150 to $300 that she paid them when they
referred new employees. The Patacsils failed, however, to submit any
receipts or documentation to enable us to find that they are entitled to
larger deductions than the Commissioner already allowed.
III. Loss from Sales of Business Property
Tax Year Amount Reported Amount Adjustment
Determined
2016 (Hildreth) ($505,450) ($105,998) $399,452
2017 (24,226) — 24,226 9
(Knickerbocker)
Section 61(a)(3) includes in gross income gain derived from the
sale of real property. Someone who sells property is taxed on the gain,
not on the sale price. See §§ 1001(a), 1011. The seller gets “basis” for the
amount he paid for the property, and his basis is then adjusted according
to the rules in section 1016. See § 1012. Adjusted basis is typically what
a property owner paid for the property plus what he later spent to
improve it, minus allowed or allowable depreciation. §§ 1011(a), 1012(a),
1016; see also Simonsen v. Commissioner, 150 T.C. 201, 213 (2018). Gain
is the amount the seller receives reduced by the seller’s adjusted basis
in the property. See § 1011.
9 This number is from the notice of deficiency and the Patacsils’ Form 4797
calculation for 2017. However, as we will discuss later, the amount reported and the
adjustment should respectively be ($19,419) and $19,419 based on Young’s testimony
at trial. See infra note 11.
12
[*12] When there’s debt, the general rule is that “the amount realized
from a sale or other disposition of property includes the amount of
liabilities from which the transferor is discharged as a result of the sale
or disposition.” Treas. Reg. § 1.1001-2(a)(1); see Simonsen, 150 T.C. at
211–12. The amount that a taxpayer realizes from a transfer of property
in exchange for discharge or reduction of debt, however, depends on
whether the debt is recourse or nonrecourse. See Frazier v.
Commissioner, 111 T.C. 243, 245 (1998).
“Indebtedness is generally characterized as ‘nonrecourse’ if the
creditor’s remedies are limited to particular collateral for the debt and
as ‘recourse’ if the creditor’s remedies extend to all the debtor’s assets.”
Simonsen, 150 T.C. at 205 (quoting Great Plains Gasification Assocs. v.
Commissioner, T.C. Memo. 2006-276, 2006 WL 3804622, at *24). The
amount realized from the disposition of property secured by recourse
debt is the fair market value of the property. See Bialock v.
Commissioner, 35 T.C. 649, 660–61 (1961).
Foreclosure of property secured by recourse debt does not trigger
recognition of any COI income, unless and to the extent that the amount
of the recourse debt discharged exceeds the fair market value of the
property. Frazier, 111 T.C. at 245; Treas. Reg. § 1.1001-2(a)(2).
But for nonrecourse debt, the rule is different: The amount
realized upon foreclosure of a property secured by nonrecourse debt
includes the full amount of that debt. See Commissioner v. Tufts, 461
U.S. 300, 313 (1983).
The Patacsils owned many properties, a few of which they used to
earn rental income and some they used in their home-care business.
There are two at issue here: the Hildreth and Knickerbocker properties.
A. Hildreth
Year of Basis Claimed Depreciation Sales Price Loss Reported
Foreclosure Reported
2016 $921,450 — $416,000 ($505,450)
The Patacsils bought Hildreth in 2005 and lost it to foreclosure in
2016. Ocwen reported on a Form 1099–C that a $391,080 mortgage on
4638 E. Hildreth Lane with a fair market value of $370,000 was canceled
on February 25, 2016. On their 2016 Form 4797, the Patacsils reported
13
[*13] its disposition, basis, and sale price. The numbers neither matched
those on the 1099–C nor were reconciled to them. Mrs. Patacsil could
not recall the specific documents about the Hildreth foreclosure that she
gave to Young. What we do have in the record allows us to find it more
likely than not that the claimed basis is inflated. The settlement
statement from the purchase of the house shows that the Patacsils
received a credit of $127,736.50 when they bought the property. This
means they paid a net of only $622,263.50 back in 2005. They introduced
no evidence to substantiate the additional $300,000 in basis. They also
did not include any allowed or allowable depreciation in their calculation
of the loss. Since the Patacsils failed to provide any records of the basis
of Hildreth or how much depreciation was allowable for the property
during the years they owned and used it in their business, we find that
they have failed to substantiate any loss on the sale of the Hildreth
property.
They also did not properly report the information on the 1099–C.
A report on a Form 1099–C does not automatically trigger recognition of
COI income. See, e.g., Simonsen, 150 T.C. at 211. The reason is that tax
law treats recourse and nonrecourse debt differently. And California’s
antideficiency statutes “bar[] a deficiency judgment following
nonjudicial foreclosure of real property.” Cal. Bank & Tr. v. Lawlor, 166
Cal. Rptr. 3d 38, 42–43 (Ct. App. 2013) (quoting Tr. One Mortg. Corp. v.
Inv. Am. Mortg. Corp., 37 Cal. Rptr. 3d 83, 88 (Ct. App. 2005)); see Cal.
Civ. Proc. Code § 580d (West 2022). Because the Hildreth property was
nonjudicially foreclosed, it was a nonrecourse debt under California law.
The general rule is that a disposition of property encumbered
with nonrecourse debt triggers inclusion of the discharged debt only in
the amount realized and not in a taxpayer’s gross income. See, e.g., Est.
of Delman v. Commissioner, 73 T.C. 15, 31–33 (1979) (holding
nonrecourse debt satisfied upon repossession generated gain is not COI
income); Coburn v. Commissioner, 90 T.C.M. (CCH) 563, 565 (2005)
(with nonrecourse debt, “any income realized . . . on the abandonment of
the collateral in satisfaction of the loan is properly treated . . . as a gain
on the sale or other disposition of the collateral rather than discharge of
indebtedness income”); Treas. Reg. § 1.1001-2(a)(1). 10
10 This is tax law. There are always exceptions. See, e.g., Gershkowitz v.
Commissioner, 88 T.C. 984, 1011 (1987) (cancellation of nonrecourse debt without
surrender of secured property results in COI income to extent canceled debt exceeds
cash payment).
14
[*14] We therefore find that when the Patacsils lost Hildreth to
foreclosure, the amount of the discharged nonrecourse debt should have
been added to the amount they realized. This means the Patacsils should
probably have reported a gain on the sale, but the Commissioner didn’t
catch this possible problem. He has the burden of proof if he wants to
assert an increased deficiency. See Rule 142(a)(1). So we’ll exit this part
of the opinion with just a continued disallowance of the Patacsils’
claimed loss.
B. Knickerbocker
Year of Basis Claimed Depreciation Sales Price Loss Reported
Foreclosure Reported
2017 $117,685 $98,266 — ($19,419)
The Patacsils lost the Knickerbocker property to foreclosure in
2017. They reported a loss of $19,419 11 on its sale, but failed to provide
any records of their basis in the property, any allowable depreciation, or
even its sale price. We must therefore also find that they have failed to
substantiate any loss on its sale.
IV. Net Operating Loss
Tax Year Amount Reported Amount Adjustment
Determined
2017 ($449,446) — $449,446
Section 172(a) allows a deduction for an NOL for any tax year in
an amount equal to the sum of (1) the NOL carryovers to such year and
(2) the NOL carrybacks to such year. The Code defines an NOL as the
excess of deductions allowed by chapter 1 of the Code over the gross
income, subject to certain modifications. See § 172(c). For the years at
11 In the notice of deficiency and the Patacsils’ 2017 Form 4797, the loss
reported was $24,226. Young testified, however, that he mistakenly included the sale
of 335 Prado Way on the entry for sale of property in 2017 when computing the claimed
losses. In other words, the claimed loss should be only $19,419 to reflect the sale of
only the Knickerbocker property, the improvements made to it, and the depreciation
allowed.
15
[*15] issue 12 a taxpayer must generally carry back any NOL to each of
the two tax years before the year of the loss, and then carry it forward
to each of the twenty tax years after the year of the loss. See
§ 172(b)(1)(A), (2). Taxpayers can elect to forgo a carryback, but without
a timely election they must carry NOLs back before they can carry them
forward. § 172(b)(2) and (3). They also have to make an election to waive
a carryback by the due date of their return “for the taxable year of the
net operating loss for which the election is to be in effect.” § 172(b)(3).
The Patacsils bear the burden of proving that they suffered an
NOL in 2016 as well as the amount of that NOL that they may carry
forward to 2017. See Rule 142(a); Powers v. Commissioner, 105 T.C.M.
(CCH) 1798, 1809 (2013). As part of that burden, the Patacsils needed
to file with their tax return a concise statement stating the amount of
the NOL deduction claimed and all material and pertinent facts,
including a detailed schedule that showed how they computed their
NOL deductions. See Treas. Reg. § 1.172-1(c). This means that they at
least needed to show that:
• they had an NOL for at least one tax year before 2017;
• they elected to waive a carryback of that NOL, or if not,
that the NOL could not be fully applied against the income
of the two years immediately preceding the tax year of the
NOL;
• the NOL could not be applied against income for the tax
years immediately following the tax year of the NOL; and
• 2017 is no more than twenty years after the tax year of the
NOL they want applied.
See § 172(b)(1)(A), (2); Green v. Commissioner, 86 T.C.M. (CCH) 273,
275–76 (2003).
The only proof the Patacsils gave us that they had made the
election to carry forward any NOL was a screenshot from ProSeries.com,
stating that they “elect[ed] not to carryback NOL 172(b)(3). Elected
172(B)(3) carryover loss” for 2017. They did not file this statement with
12 The Tax Cuts and Jobs Act of 2017, Pub. L. No. 115-97, § 13302, 131 Stat.
2054, 2121, effective January 1, 2018, amended section 172(b) by repealing the NOL
carryback and allowing for an indefinite carryforward. These new rules do not apply
here.
16
[*16] their tax return, as required by Treasury Regulation § 1.172-1(c),
which means that we find that they failed to substantiate their NOL
deduction.
V. Accuracy Related Penalty
The Commissioner has both a burden of proof and a burden of
production here. His burden of proof is to show that he complied with
section 6751. There is no doubt that he did. Group Manager Patrick
Lunny approved in writing Revenue Agent Steven Dake’s determination
to assert accuracy-related penalties on the ground of substantial
understatement of income tax or negligence on April 19, 2019. The
notice of deficiency was issued on September 13, 2019, which was after
Revenue Agent Dake received his approval from Manager Lunny. See
Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir. 2017); see also Graev
v. Commissioner, 149 T.C. 485, 493 (2017).
The Commissioner has the burden of production on the merits of
the section 6662 penalty. See § 7491(c). He easily shoulders it here with
simple arithmetic: the tax that the Patacsils should have shown on their
returns for each of the three years at issue compared to what they did
show reveals understatements of much more than the 10% of the tax
due or $5,000 that the section requires.
The Patacsils argue that they have a defense. They claim that
they had reasonable cause and acted in good faith in taking the return
positions that they did. See § 6664(c)(1). Reasonable cause requires that
a taxpayer exercise ordinary business care and prudence as to the
disputed items. See United States v. Boyle, 469 U.S. 241, 244 (1985);
see also Hatfried, Inc. v. Commissioner, 162 F.2d 628, 635 (3d Cir. 1947);
Girard Inv. Co. v. Commissioner, 122 F.2d 843, 848 (3d Cir. 1941); Est.
of Young v. Commissioner, 110 T.C. 297, 317 (1998).
The problem for the Patacsils is their recordkeeping: boxes of
folders with envelopes stuffed with receipts. This may work for
taxpayers with fewer records or greater organizational skills, but the
Patacsils had used this method for years where it had already caused
them some trouble back in 2013—a deficiency in income tax and
penalties for failure to substantiate. Choosing to keep their records in
the same way after an audit that did not go well is not the exercise of
ordinary business care and prudence. Their past experiences of being
audited and going to trial should have signaled to them the importance
17
[*17] of keeping their receipts and records in a way more likely to
substantiate their claims.
The Patacsils also did not reasonably rely on the advice of a tax
professional. The key distinction here is the difference between tax
preparation and tax advice. A tax preparer is “any person who prepares
[the return] for compensation.” § 7701(a)(36)(A). A tax adviser, in
contrast, is a person who analyzes an issue and communicates his
conclusions to the taxpayer. See Treas. Reg. § 1.6664-4(c)(2); see also
Woodsum v. Commissioner, 136 T.C. 585, 592–93 (2011) (advice reflects
adviser’s analysis or conclusion and taxpayer relied in good faith on
adviser’s judgment).
The caselaw lists three factors we look at to decide whether this
defense exists. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43,
99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
• First, was the adviser a competent professional who had
sufficient expertise to justify reliance?
• Second, did the taxpayer provide necessary and accurate
information to the adviser?
• Third, did the taxpayer actually rely in good faith on the
adviser’s judgment?
Whether a taxpayer relied on advice and whether his reliance was
reasonable hinge on the facts and circumstances of the case. See Treas.
Reg. § 1.6664-4(c)(1).
Mrs. Patacsil testified that Lindstrom prepared their 2015 tax
return. But there is no record or testimony about Lindstrom’s
qualification as a tax adviser, and we cannot find that he qualifies as a
competent professional under Neonatology. There was also no evidence
that the Patacsils sought his advice, and not simply his skills as a tax
preparer. They have not, therefore, shown reasonable reliance on the
advice of a tax professional for 2015.
Our analysis is slightly different for tax years 2016 and 2017.
Young, the Patacsils’ preparer for those years, is a licensed CPA and
worked as an IRS revenue agent in the past. We find that this qualifies
him as a competent tax professional. But the Patacsils did not give him
necessary and complete information on some of the items that created
their deficiencies, and didn’t get advice from him on others.
18
[*18] Begin with the COI income. We do believe Young’s testimony that
he advised them not to recognize COI income because they were
insolvent, but Mrs. Patacsil herself testified that she didn’t include in
the list of assets that she prepared for him the values of either the
business or the real properties that she and her husband held for
investment. This information was necessary to any advice regarding
their entitlement to the insolvency exception to recognition of COI
income for both years.
Then there was the question of the Patacsils’ entitlement to
additional business expenses. Here the problem was that they did not
seek Young’s advice, but only his help in filling out their returns.
Throughout his testimony, Young consistently referred to his employees
who would’ve done the calculations for the tax returns based on the
documents they received from the Patacsils, and he would review their
work afterwards. Put differently, Young gave no advice about the
deductibility or amounts of their claimed expenses. And we also find it
more likely than not that Mrs. Patacsil’s recordkeeping system would
not have given him necessary and accurate information about those
expenses.
We also find them not to have given Young necessary and
accurate information about the foreclosure sales of the Hildreth and
Knickerbocker properties that led to their claimed losses on the
disposition of those two assets. The absence of any records of their basis
or allowable depreciation on Hildreth, and their failure to produce the
1099–C for the Knickerbocker property guaranteed that Young would
be reporting bad numbers for these items on the Patacsils’ returns. And
again, on these items Young didn’t provide advice, he provided only tax-
preparation services through his staff.
We do find reasonable reliance, however, as to the portion of the
Patacsils’ 2017 understatement attributable to the NOL. The
computations of NOLs are complex; the rules on carrying them
backwards and forwards are not intuitive and are often changed by
Congress. And in reporting an NOL carryforward, we find that the
Patacsils did not withhold any information that Young would have
needed to compute whether and how much of an NOL carryforward they
could claim for their 2017 tax year. We also find that, although the
problem in Young’s computations and failure to include the required
proof of election to waive a carryback of any NOL were plain to us, they
would not have been evident to people like the Patacsils with their
limited knowledge of tax-law arcana. They’re not entitled to an NOL
19
[*19] carryforward, but we do find them to have reasonably and in good
faith relied on Young in claiming one.
This is a split result, so
Decision will be entered under Rule 155.