Jian Dong Sun and Ming-Yan Shen v. Commissioner , 2011 T.C. Summary Opinion 107 ( 2011 )

T.C. Summary Opinion 2011-107UNITED STATES TAX COURT
JIAN DONG SUN AND MING-YAN SHEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15044-10S. Filed August 31, 2011.
Edward M. McElroy, for petitioners.
Donald D. Priver, for respondent.
JACOBS, Judge: This case was heard pursuant to the
provisions of section 7463 of the Internal Revenue Code in effect
when the petition was filed. Pursuant to section 7463(b), the
decision to be entered is not reviewable by any other court, and
this opinion shall not be treated as precedent for any other
case. Unless otherwise indicated, all section references are to
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the Internal Revenue Code in effect for 2007, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
Respondent determined a deficiency of $4,757 in petitioners’
2007 Federal income tax and a section 6662(a) accuracy-related
penalty of $951.40. The issues for decision are: (1) Whether
respondent’s disallowance of deductions for various alleged
business expenses should be sustained, and if so (2) whether
petitioners are liable for the section 6662(a) accuracy-related
penalty.
Background
Some of the facts have been stipulated, and they are so
found. We incorporate by reference the parties’ stipulation of
facts and the accompanying exhibits. At the time they filed
their petition, petitioners resided in northern California.
I. Petitioners’ Business
Petitioners, husband and wife, emigrated to the United
States from China in the early 1990s. Jian Dong Sun (Mr. Sun)
graduated from medical school in China and practiced medicine
there as a surgeon for 15 years.
During 2007 Mr. Sun was employed part time as a dialysis
technician at Satellite Dialysis Center. He began working there
in 1994. He also worked part time in 2007 at El Camino Hospital.
During 2007 Ming Yan Shen (Ms. Shen) worked for Stanford
University Medical School as well as Kaiser Permanente.
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Through his employment as a dialysis technician, Mr. Sun
became aware of a number of shortcomings in both the equipment
and techniques used in kidney dialysis. Mr. Sun devised four
inventions.
The first of the inventions, a “Roller bed surface”, was a
“medical bed” designed to reduce the likelihood of the patients
developing bedsores as well as to enable the user to move easily
from the bed to a wheelchair and back again. In 2003 Mr. Sun
attempted to patent this device, but his application was denied
because (1) a similar device already existed and (2) his patent
application was not in the proper form.
Mr. Sun’s second invention was an “Emergency Disengagement
Device for Patients Undergoing Hemodialysis” or a “cut-and-run”
device. This device permitted the user to quickly and safely
disconnect himself/herself from the dialysis machine in case of
emergency. On June 24, 2006, Mr. Sun submitted a patent
application for this device. On April 23, 2009, the patent
office rejected Mr. Sun’s application request, again on the
grounds that his patent submission was not in proper form and
another party had previously patented a similar device. In the
rejection letter the patent office noted Mr. Sun’s lack of
familiarity with patent application procedures and remarked
that he should seek the services of a registered patent attorney.
Mr. Sun’s third invention was an “Apparatus to Assist with
Disconnecting Dialysate Tubing”. This device was designed to
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ease the connecting and disconnecting of the dialysis tubes. The
patent office rejected this patent application.
Mr. Sun’s fourth invention involved a “Baggage claim
assistance device” designed to assist individuals in wheelchairs
in removing their luggage from airport luggage carousels. This
device currently is in the development stage.
Mr Sun organized Sun Pioneer in 2001 to further his interest
in developing devices that could be used in kidney dialysis. Ms.
Shen worked part time for Sun Pioneer, often acting as Mr. Sun’s
interpreter or speaking with others on his behalf.
Mr. Sun obtained a business license for Sun Pioneer. He
opened a checking account for the company and applied for an
employer identification number from the Internal Revenue Service.
However, because of his lack of knowledge of bringing products to
market and his lack of knowledge of good business practices, Mr.
Sun did not initially develop a business plan or keep adequate
business records.
To improve his entrepreneurial skills, Mr. Sun attended
classes taught by the Small Business Administration and the
Silicon Valley Small Business Development Center. He read
literature and sought the assistance of Adrian Pelkus, the
president of A Squared Technologies, Inc., with respect to
obtaining a U.S. patent for his medical inventions.
Additionally, Mr. Sun sought advice with respect to certain
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technical aspects of his medical device inventions from Nengli
Zhang of NASA and Dr. Cindy Xin Huang of Tufts Medical Center.
Mr. Sun sought legal advice from an unnamed U.S. patent
attorney. He did not engage the services of that attorney for
economic reasons. Mr. Sun did, however, engage the services of
an attorney to obtain a patent in China.1
In connection with each of his inventions, Mr. Sun drafted
diagrams and explanatory notes (all in Chinese) with regard to
the device’s design, construction, and functionality. With
regard to several of his inventions, Mr. Sun had prototypes built
in China, and he partnered with an undisclosed individual to
facilitate arrangements with Chinese contract manufacturers. Mr.
Sun’s relationships with his Chinese partner and contract
manufacturers were informal; there were no written contracts.
Mr. Sun conducted market research for each of his
inventions. He approached medical equipment distributors, such
as Baxter Healthcare, Dialysis Parts and Supplies, and DaVita,
Inc., as well as potential consumers (doctors and hospitals), to
discuss their interest in his inventions. In 2010 Mr. Sun
stopped working as a dialysis technician in order to focus
exclusively on his inventive interests.
Mr. Sun’s inventive activities have not as yet generated
gross receipts. Petitioners reported losses, all of which relate
1
The Chinese patent was obtained in Mr. Sun’s brother’s
name.
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to Mr. Sun’s inventive activities, on Schedule C, Profit or Loss
From Business, of their Federal income tax returns as follows:
Year Net Loss
2002 $14,724
2003 18,992
2004 14,490
2005 14,791
2006 13,372
2007 16,518
2008 11,395
Petitioners reported wage and salary income as follows:
Year Wages
2002 $113,468
2003 123,970
2004 140,773
2005 125,536
2006 141,453
2007 152,225
2008 127,138
Petitioners reported gross receipts, all of which were from
Mr. Sun’s consulting activities, on Schedules C of their Federal
income tax returns as follows:
Year Gross Receipts
2002 -0-
2003 -0-
2004 -0-
2005 -0-
2006 $3,600
2007 2,400
2008 7,500
At the conclusion of trial, the Court remarked that on the
totality of the evidence and after observing Mr. Sun’s demeanor
while he was testifying, the Court was satisfied that he had an
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honest intent to earn a profit from his inventive activities.
The Court found as a fact that during 2007 Mr. Sun engaged in his
inventive activities primarily for profit.
II. Petitioners’ Expenses
During 2007 petitioners deducted numerous expenses which
allegedly related to Mr. Sun’s inventive activities. On
Schedule C, petitioners made the following expense claims:
Schedule C Expense Amount
Automobile $3,396
Section 179 property 323
Legal & professional services 4,075
Office 100
Rent or lease of vehicles, 60
machinery, & equipment
Supplies 511
Taxes & licenses 150
Travel 7,208
Meals & entertainment 1,324
Utilities 1,367
Other 404
Petitioners attached a Form 8829, Expenses for Business Use
of Your Home, to their 2007 Federal income tax return. On Form
8829, petitioners claimed utility expenses of $552. However, on
line 35, “Allowable expenses for business use of your home”,
petitioners reported zero with respect to expenses for the
business use of their home.
During 2007 Ms. Shen and Mr. Sun separately traveled to
China. Ms. Shen visited China from March 4 to March 29, 2007.
Mr. Sun visited China from April 23 to May 23, 2007. While in
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China, Mr. Sun met with his partner and several contract
manufacturers. He also visited friends and family members. The
record does not reveal the business purpose for Ms. Shen’s visit.
Mr. Sun candidly admitted that Ms. Shen most likely visited
friends and family members during her trip to China.2
Petitioners took a 7-day cruise to Hawaii in July 2007. The
record does not reveal the business purpose for the cruise.
Petitioners also twice traveled to Los Angeles and San Diego
(southern California) in 2007. Again, the record does not reveal
the business purpose of the trips. We note, however, that
petitioners’ daughter lived in San Diego.3
At trial respondent’s counsel conceded that petitioners
expended the dollar amounts claimed with respect to the deducted
expenses. However, respondent’s counsel stated that respondent
did not concede that the amounts petitioners expended and
deducted were for ordinary and necessary business expenses.
Respondent disallowed petitioners’ expense deductions on two
alternative theories. First, respondent avers that Mr. Sun was
not engaged in a “for profit activity” with respect to his
inventive work and therefore he could not deduct his expenses
pursuant to the provisions of section 183(a). Alternatively,
2
Ms. Shen did not testify.
3
In their posttrial brief petitioners concede the amount
($3,179.92) for their Hawaiian cruise and two trips to southern
California is not deductible.
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respondent maintains that petitioners failed to establish that
the deducted expenses were “ordinary and necessary” business
expenses within the purview of section 162(a).
On the basis of our finding that Mr. Sun was engaged in an
activity for profit, see supra p. 7, the only basis on which
respondent’s deficiency determination can be sustained is that
petitioners’ expenses were not ordinary and necessary business
expenses.
Discussion
I. Petitioners’ Business Expense Deductions
Section 162(a) allows a deduction for ordinary and necessary
business expenses paid or incurred during the taxable year in
carrying on a trade or business. For an expense to be “ordinary”
the transaction that gives rise to it must be of a common or
frequent occurrence in the type of business involved. Deputy v.
du Pont, 308 U.S. 488, 495 (1940). To be “necessary” an expense
must be “appropriate and helpful” to the taxpayer’s business.
Welch v. Helvering, 290 U.S. 111, 113-114 (1933).
It is well established that deductions are a matter of
legislative grace and that taxpayers bear the burden of proving
they are entitled to the deductions claimed. Rule 142(a);
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New
Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
Taxpayers must substantiate the amount and purpose of the item
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deducted. Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975),
affd. per curiam 540 F.2d 821 (5th Cir. 1976). Taxpayers are
required to maintain records sufficient to enable the
Commissioner to determine their correct tax liability. See sec.
6001; Meneguzzo v. Commissioner, 43 T.C. 824, 831-832 (1965);
sec. 1.6001-1(a), Income Tax Regs.
Automobile, travel, and meals and entertainment expenses are
subject to heightened substantiation requirements. See secs.
280F(d)(4)(A)(i), 274(d)(1) and (2). Petitioners failed to meet
these heightened substantiation requirements. Further, we are
unconvinced that the claimed automobile, travel, and meals and
entertainment expenses constitute ordinary and necessary business
expenses within the purview of section 162(a). Indeed, Mr. Sun
admitted that his and Ms. Shen’s trips to China were for pleasure
as well as business. Petitioners failed to demonstrate that the
primary purpose of their trips to China was to further Mr. Sun’s
inventive activities. Further, they concede the amount for their
Hawaiian cruise and two trips to southern California is not
deductible. See supra note 3. Consequently, petitioners’
expenses for travel to and from China, Hawaii, and southern
California are not deductible. See sec. 1.162-2(b)(1), Income
Tax Regs.
Petitioners’ legal fees relate to the engagement of the
services of an attorney to obtain a patent in China. We are
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mindful that the Chinese patent was obtained in Mr. Sun’s
brother’s name. Mr. Sun credibly testified as to the reason
therefor; i.e., it was “much cheaper than for a foreigner” to do
so. Recognizing that Chinese familial customs and business
practices differ from those of the United States, we are
satisfied that all of the benefits of the patent belong to Mr.
Sun. Consequently, we hold that petitioners’ $4,075 in legal and
professional fee expenses constitute ordinary and necessary
business expenses within the purview of section 162.
As to each of the other types of expenses deducted,
petitioners provided no documentation or testimony which
demonstrated that these expenses were ordinary and necessary
business expenses. Under certain circumstances, if a taxpayer
establishes entitlement to a deduction, but not the amount, the
Court may estimate the amount allowable. Cohan v. Commissioner,
39 F.2d 540, 543-544 (2d Cir. 1930). We generally will not
estimate a deductible expense unless the taxpayer presents
sufficient evidence to provide some basis upon which an estimate
may be made. Vanicek v. Commissioner, 85 T.C. 731, 742-743
(1985). Petitioners have not provided us any basis to estimate
any allocation of expenses to business purposes.
To conclude this portion of our opinion, except for
petitioners’ legal and professional fee expenses of $4,075, we
sustain respondent’s disallowance of the business expense
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deductions claimed on the basis that petitioners failed to carry
their burden of proof.
II. Section 6662(a) Accuracy-Related Penalty
Section 6662(a) imposes a 20-percent penalty on that portion
of an underpayment of tax attributable to, inter alia, negligence
or disregard of rules or regulations, as provided in section
6662(b)(1), or a substantial understatement of income tax, as
provided in section 6662(b)(2). Negligence includes any failure
to make a reasonable attempt to comply with the provisions of the
Internal Revenue Code. Sec. 6662(c); ASAT, Inc. v. Commissioner,
108 T.C. 147, 175 (1997). 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. The term “disregard” includes any careless, reckless or
intentional disregard. Sec. 6662(c).
The section 6662(a) accuracy-related penalty does not apply
where the taxpayer shows that there was reasonable cause for the
underpayment and that he acted in good faith. Sec. 6664(c)(1).
Such a showing depends on the facts and circumstances of each
case and includes the knowledge and experience of the taxpayer
and the reliance on the advice of a professional, such as an
accountant. Sec. 1.6664-4(b)(1), Income Tax Regs.
Respondent has the burden of production pursuant to section
7491(c). To satisfy that burden, respondent must produce
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sufficient evidence showing that it is appropriate to impose the
penalty. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
On the record before us, respondent has satisfied his burden by
producing evidence that petitioners were negligent in failing to
keep books and records and in failing to substantiate their
claimed deductions.
Petitioners have not demonstrated that there was reasonable
cause for their underpayment of tax or that they acted in good
faith. Although Mr. Sun sought advice regarding the technical
aspects of establishing a business, the record does not reveal
that he sought advice from a tax professional regarding the
deductibility of his expenses.
To conclude this portion of our opinion, petitioners have
failed to prove that they are not liable for the section 6662(a)
penalty. Petitioners have neither argued nor offered evidence
that an exception exists which would excuse them from the
penalty. We therefore sustain respondent’s determination that
petitioners are liable for the section 6662(a) penalty. However,
respondent must recompute the amount of the penalty to reflect
the recalculation of petitioners’ 2007 business expenses. This
can be done in the Rule 155 computation.
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We have considered all of petitioners’ contentions, and we
conclude they are without merit, irrelevant, and/or moot.
To reflect the foregoing,
Decision will be entered
under Rule 155.