Davis v. Comm'r , 92 T.C.M. 514 ( 2006 )

T.C. Memo. 2006-272
UNITED STATES TAX COURT
W. BRADFORD DAVIS AND TEDDE M. RINKER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 6313-04. Filed December 26, 2006.
W. Bradford Davis, pro se.
Bruce C. Janke, for petitioner Tedde M. Rinker.1
Christian A. Speck, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: Respondent determined a deficiency of
$40,109 in petitioners’ 1999 Federal income tax as well as an
1
Dr. Tedde M. Rinker was represented at trial by Kenneth
P. Fehl. Mr. Janke entered an appearance in this case after the
close of trial, at which point the Court granted Dr. Rinker’s
motion for an order granting leave to withdraw Mr. Fehl’s
appearance on her behalf.
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$8,022 section 6662 penalty.2 After concessions by both parties,
the issues that remain for decision are: (1) Whether petitioners
are deemed to have admitted the statements in respondent’s
requests for admission by not timely responding to those
requests, (2) whether petitioners are entitled to deduct expenses
claimed on Schedule C, Profit or Loss From Business, in amounts
greater than respondent allowed for petitioner Tedde M. Rinker’s
(Dr. Rinker) medical practice, (3) whether petitioners are
entitled to deduct personal medical expenses incurred in 1999 and
claimed on Schedule A, Itemized Deductions, (4) whether
petitioners may deduct prepaid interest paid in 1999 in excess of
the amounts conceded at trial by respondent, (5) whether
petitioners may deduct amounts allegedly contributed to a SEP-IRA
account in 1999, and (6) whether petitioners are liable for the
penalty imposed under section 6662.3
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
3
Petitioner W. Bradford Davis attached to his pretrial
memorandum a Form 8857, Request for Innocent Spouse Relief. Mr.
Davis did not file any briefs with the Court, and the petition
makes no reference to sec. 6015 relief. The record does not
establish that he ever filed a Form 8857 with respondent.
Therefore, assuming that Mr. Davis has even raised the issue, we
find that he has abandoned his claim for sec. 6015 relief. See
Petzoldt v. Commissioner, 92 T.C. 661, 683 (1989).
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Some of the facts have been stipulated and are so found.
The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time they filed
their petition, petitioners resided in California.
For convenience, we have consolidated our findings of fact
and opinion.
During 1999, petitioners were married. In 1999, Dr. Rinker
carried on a medical practice in Burlingame, California. During
1999, W. Bradford Davis (Mr. Davis) worked for three employers,
earning $104,583 in wages. At some point in 1999, Mr. Davis
ended his employment with the last of those three employers, a
company called Wind River, and was not employed by another
concern for the rest of the year. Mr. Davis and Dr. Rinker have
since divorced.
I. Deemed Admissions
On December 13, 2004, respondent served requests for
admission on Mr. Davis and Dr. Rinker. Respondent filed the
requests with the Court on December 14, 2004. The requests asked
petitioners to admit two facts: (1) That Mr. Davis’s 1999
photography activity was not entered into for profit, and (2)
that the gross receipts of Dr. Rinker’s medical practice were
$120,531 in 1999.
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The parties do not dispute that neither Mr. Davis nor Dr.
Rinker timely responded to respondent’s requests for admission.
Counsel for Dr. Rinker did eventually serve a response to the
requests for admission. The response was, as Dr. Rinker
admitted, untimely.
Under Rule 90, a party may serve upon an opposing party a
written request to admit the truth of any matters that relate to
statements or opinions of fact or of the application of law to
fact. Estate of Allensworth v. Commissioner, 66 T.C. 33 (1976);
Hersch v. Commissioner, T.C. Memo. 1992-222. Each matter is
deemed admitted unless the party to whom the request is directed
serves a response on the requesting party within 30 days after
the date of service of the request, or within such shorter or
longer time as the Court may allow. Rule 90(c). When a matter
is admitted, whether deemed admitted or actually admitted, it is
conclusively established for the purposes of the pending case
unless the Court on motion permits withdrawal or modification of
the admission. Rule 90(f).
In her posttrial brief, Dr. Rinker argued that the Court
should extend petitioners’ time for responding to respondent’s
requests. Dr. Rinker argued that the Tax Court traditionally
looks to the Federal Rules of Civil Procedure when interpreting
its own Rules of Practice and Procedure and that under the
Federal rules the period otherwise prescribed for responding to a
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document is extended by 3 days if the document is served by mail.
See Fed. R. Civ. P. 6(e).4
This Court does consult the Federal Rules of Civil Procedure
when there is no applicable Tax Court Rule. Rule 1(a). When a
Tax Court Rule has been derived from a Federal Rule of Civil
Procedure, we also look to the principles enunciated by the
Federal courts in the interpretation and application of the
Federal Rules of Civil Procedure. See Evans Publg., Inc. v.
Commissioner, 119 T.C. 242, 249 (2002); Estate of Fulmer v.
Commissioner, 83 T.C. 302, 309 (1984). But Congress enacted
section 7453 to authorize the Tax Court to “prescribe” “rules of
practice and procedure”, and we have acted on that authority by
promulgating and applying the Tax Court Rules of Practice and
Procedure. Those Rules, and not the Federal rules, apply to all
cases and proceedings before this Court. Rule 1(a). Indeed, we
have responded to the concerns underlying rule 6(e) of the
Federal Rules of Civil Procedure with Rule 25(a). That Rule
provides that if service is made by mail, then a period of time
computed with respect to the service shall begin on the day after
the date of mailing. Applying our Rules, it is clear that Dr.
4
In support of this argument, Dr. Rinker also cited the
California Code of Civil Procedure, which contains a similar
provision. The California Code is not an authority with respect
to the Tax Court’s Rules of Practice and Procedure.
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Rinker did not timely respond to respondent’s requests for admission.
Dr. Rinker also argues that respondent’s first request for
admission--that Mr. Davis’s photography activities were not
entered into for profit--is improper because it requests
admission of a matter of law, not fact. That is not correct.
Whether a taxpayer is primarily engaged in an activity for profit
is a question of fact to be resolved from all relevant facts and
circumstances. King v. Commissioner, 116 T.C. 198, 205 (2001);
Golanty v. Commissioner, 72 T.C. 411, 426 (1979), affd. per
curiam without published opinion 647 F.2d 170 (9th Cir. 1981).
At no point did petitioners request that the Court extend
the time for responding to respondent’s requests. Nor did either
petitioner move to withdraw or modify the deemed admissions
despite ample opportunity to do so. The matters in respondent’s
requests for admission are therefore deemed admitted.5
II. Business Deductions for Dr. Rinker
A. Generally
Petitioners claimed $102,265 of business expenses for Dr.
Rinker’s medical practice on Schedule C of their 1999 return.
5
We do note, however, that in the notice of deficiency,
respondent allowed $5,700 of deductions for Mr. Davis’s
photography expenses--an amount which fully offset his claimed
income from photography. Respondent also adjusted Dr. Rinker’s
gross receipts to the amount in the requests for admission solely
on the basis of records created and maintained by Dr. Rinker.
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Respondent disallowed $60,509 of the claimed deductions because
petitioners were unable to substantiate the existence and
business purpose of most of the deductions.
Preliminarily, we note that several issues in the dispute
regarding these deductions revolve around petitioners’ inability
to produce the source documents on which their 1999 income tax
return was allegedly based. Petitioners engaged Howard Hertz
(Mr. Hertz) to prepare their 1999 return. Mr. Hertz also
represented petitioners during the subsequent examination of the
1999 return. Dr. Rinker alone assisted Mr. Hertz in preparing
the 1999 return and in gathering documents for the subsequent
examination of that return. Dr. Rinker claimed that she gave the
documents which substantiated many of the figures on petitioners’
1999 tax return to Mr. Hertz after Dr. Rinker, Mr. Hertz, and Dr.
Rinker’s assistant organized the records at Dr. Rinker’s home one
evening in 2002. Dr. Rinker claims that Mr. Hertz then lost the
documents while the examination was being reviewed by
respondent’s Appeals officer. Mr. Hertz testified that he never
left Dr. Rinker’s home with the source documents after their
meeting in 2002. Respondent takes the position that petitioners,
and not Mr. Hertz, lost the records, or that they never
maintained the records to begin with.
As was true in Diaz v. Commissioner, 58 T.C. 560, 564
(1972):
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This case epitomizes the ultimate task of a trier
of the facts--the distillation of truth from falsehood
which is the daily grist of judicial life. He must be
careful to avoid making the courtroom a haven for the
skillful liar or a quagmire in which the honest
litigant is swallowed up. Truth itself is never in
doubt, but it often has an elusive quality which makes
the search for it fraught with difficulty. That this
is so is clearly illustrated by the situation herein.
* * *
We decide whether a witness is credible on the basis of
objective facts, the reasonableness of the testimony, and the
demeanor of the witness. Quock Ting v. United States, 140 U.S.
417, 420-421 (1891); Wood v. Commissioner, 338 F.2d 602, 605 (9th
Cir. 1964), affg. 41 T.C. 593 (1964); Dozier v. Commissioner,
T.C. Memo. 2000-255.
From our observation of petitioners at trial, we found Dr.
Rinker’s testimony on this point to be credible, sufficiently
detailed, and reasonable. Dr. Rinker’s demeanor on the stand was
forthright and earnest. While petitioners at times lacked
detailed memories of some of their financial activities in 1999,
Dr. Rinker recalled her meeting with Mr. Hertz at her house in
2002 with relative precision. She testified that at the
conclusion of that meeting, she gave Mr. Hertz a box containing
the bulk of her source documents, and that she never saw them
again.
Mr. Hertz testified that he gave the box of records back to
Dr. Rinker at the conclusion of that meeting. According to Mr.
Hertz’s testimony, the entire purpose of the meeting was to
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organize documents for Mr. Hertz to present to respondent’s
Appeals officer. However, Mr. Hertz admitted that he may have
kept the box of documents after his meeting with respondent’s
Appeals officer.
In contradistinction to Dr. Rinker’s, Mr. Hertz’s testimony
was not persuasive. Mr. Hertz testified that he showed the
source documents, which were voluminous, to the revenue agent
conducting the exam. Yet the revenue agent recalled seeing only
a few receipts and canceled checks. Mr. Hertz lacked any
detailed memory of when he last possessed petitioners’ source
documents and was unable to recall basic facts of the chronology
and events of his representation of petitioners.
We therefore find that Mr. Hertz, and not petitioners, lost
the box of petitioners’ original documents.
Petitioners prayed that the Court excuse their inability to
produce most of their contemporaneous records on the grounds that
Mr. Hertz, and not petitioners, lost most of their records.
Petitioners asked the Court to allow deductions for Dr. Rinker’s
business expenses on the basis of Dr. Rinker’s testimony and the
documents that they were able to produce at trial under the rule
in Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930).
They also argue that they should be allowed to deduct business
expenses to which section 274 applies because they have satisfied
the substantiation requirements of section 1.274-5T(c)(5),
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Temporary Income Tax Regs., 50 Fed. Reg. 46022 (Nov. 6, 1985),
which allow taxpayers to reasonably reconstruct their business
expenses when original documents are lost or destroyed through no
fault of the taxpayers.
Respondent argues that petitioners failed to present
credible evidence to substantiate that they incurred business
expenses in excess of the amount allowed by the notice of
deficiency, and that petitioners have not provided the Court with
a sufficient basis on which to make a Cohan estimation. Also,
respondent argues that several of the claimed deductions were for
nondeductible, personal expenses. Finally, respondent argues
that petitioners have not met the heightened substantiation
burden imposed by section 274 for those deductions to which
section 274 applies.
At trial, petitioners managed to produce a smattering of
canceled checks, receipts, and other records from 1999.
Petitioners also presented exhibits containing reconstructions of
various categories of expenditures for 1999 that Dr. Rinker made
with the computer program Quicken (Quicken reports). In their
testimony, petitioners related to the Court their memories of
their financial activities during 1999, the transactions
underlying the source documents, and the way they arrived at the
amounts contained in their 1999 return and in the exhibits they
prepared in anticipation of trial.
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Section 162 generally allows a deduction for ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on a trade or business. Generally, no deduction is
allowed for personal, living, or family expenses, nor is
deduction proper for expenditures that are properly categorized
as capital expenditures. See secs. 262 and 263. The taxpayer
bears the burden of proving that he or she is entitled to the
deduction. See Rule 142(a); Welch v. Helvering, 290 U.S. 111
(1933).6
When a taxpayer establishes that he or she has incurred
deductible expenses but is unable to substantiate the exact
amounts, we can estimate the deductible amount, but only if the
taxpayer presents sufficient evidence to establish a rational
basis for making the estimate. See Cohan v. Commissioner, supra
at 543-544; Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).
In estimating the amount allowable, we bear heavily upon the
taxpayer where the inexactitude of the record is of his or her
own making. See Cohan v. Commissioner, supra at 544.
It is well established that the Tax Court may permit a
taxpayer to substantiate deductions through secondary evidence
where the underlying documents have been unintentionally lost or
destroyed. Boyd v. Commissioner, 122 T.C. 305, 320-321 (2004);
6
Petitioners do not contend, nor have they shown, that
sec. 7491(a), which shifts the burden of proof to the
Commissioner in some circumstances, applies to this case.
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Malinowski v. Commissioner, 71 T.C. 1120, 1125 (1979); Furnish v.
Commissioner, T.C. Memo. 2001-286; Joseph v. Commissioner, T.C.
Memo. 1997-447; Watson v. Commissioner, T.C. Memo. 1988-29.
Moreover, even though Congress imposed heightened substantiation
requirements for some business deductions by enacting section
274, the regulations under that section allow a taxpayer to
substantiate a deduction by reasonable reconstruction of his or
her expenditures when records are lost through no fault of the
taxpayer. Sec. 1.274-5T(c)(5), Temporary Income Tax Regs.,
supra.
Generally, we found Dr. Rinker’s testimony honest,
forthright, and credible. Although Dr. Rinker seemed somewhat
unfamiliar with financial matters, her testimony fundamentally
corresponded with the original documentation and reconstructions
that petitioners provided. She testified credibly as to the
existence and business purpose of many of the deductions claimed
on petitioners’ 1999 return with respect to her medical practice.
For some of those deductions, Dr. Rinker was also able to recall
the approximate amounts of her expenses, but for many of them,
Dr. Rinker lacked any independent recollection of the amounts of
the claimed deductions.
Where Dr. Rinker’s testimony provided a sufficient basis for
the Court to estimate the amounts of her expenditures, we have
done so, weighing against petitioners’ inexactitude where
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appropriate. Where petitioners presented contemporaneous
documents, we have allowed the claimed amounts after adjusting
for any disparities between the documents and Dr. Rinker’s
testimony and for computational errors. Similarly, where the
original documents were lost by Mr. Hertz, but where petitioners
presented credible reconstructions of their expenses which carry
their burden of proof, we have allowed the claimed amounts after
adjusting for minor errors and discrepancies.
B. Particular Deductions
1. Office Liability Insurance
Dr. Rinker testified that she paid for tort liability
insurance for her medical office. Dr. Rinker testified that
during 1999 her expenses for liability insurance may have been
about $250. Premiums paid for business liability insurance are
deductible business expenses. Sec. 1.162-1(a), Income Tax Regs.
Under Cohan v. Commissioner, supra at 544, we allow a deduction
of $125.
2. Malpractice Insurance
Dr. Rinker submitted a receipt for medical malpractice
insurance in the amount of $2,385. The receipt was marked as
“paid” and dated January 31, 1999, and the policy apparently
covered February 1, 1999, through February 1, 2000. Medical
malpractice insurance premiums are deductible business expenses.
Sec. 1.162-1, Income Tax Regs. Although the year-long insurance
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contract extends through a small portion of the next taxable
year, petitioners as cash method taxpayers may nonetheless
currently deduct the entire expenditure. Kauai Terminal, Ltd. v.
Commissioner, 36 B.T.A. 893 (1937); sec. 1.461-1(a)(1), Income
Tax Regs. Petitioners are therefore entitled to a deduction of
$2,385 for Dr. Rinker’s medical malpractice insurance premiums.
3. Disability Insurance
Dr. Rinker testified that she carried a disability insurance
policy on herself. She testified that the reason she carried the
policy was to keep her practice afloat should she become unable
to see her patients for an extended period, and that the policy
amount would cover only the most basic expenses of her business.
This Court has long held that a taxpayer may not deduct his
or her disability insurance premium payments as business expenses
when no limitation is placed on the use of proceeds from the
policy. Blaess v. Commissioner, 28 T.C. 710 (1957); Ferris v.
Commissioner, T.C. Memo. 1986-32; Andrews v. Commissioner, T.C.
Memo. 1970-32. A taxpayer’s “mere declaration of his intent” to
apply potential proceeds from a disability insurance policy
towards office expenses in the event of the taxpayer’s disability
does not convert an otherwise personal expenditure into a
deductible business expense. Blaess v. Commissioner, supra at
715-716. We therefore deny petitioners a deduction for
disability insurance premium payments.
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4. Payments to Employees and Contractors
Petitioners submitted exhibits with copies of canceled
checks written by Dr. Rinker to several payees in 1999. Dr.
Rinker testified that the checks represented payments from her to
several people for legal, accounting, bookkeeping, and
secretarial services rendered in connection with her medical
practice. Some of the payments were made in exchange for
secretarial and bookkeeping expenses which related directly to
Dr. Rinker’s practice at that time; others were made in exchange
for legal and business advice on a future venture proposed to Dr.
Rinker by another doctor. According to Dr. Rinker’s
uncontradicted testimony, the proposed venture never materialized
and she ceased pursuing it. In her testimony, Dr. Rinker
admitted that some of the checks in the exhibits were not for
professional services at all and were mistakenly included. In
addition, Dr. Rinker also admitted that she engaged the same
people to do her personal and business bookkeeping and
accounting.
a. Fees for Advice on the Proposed Venture
We conclude that Dr. Rinker’s payments to financial and
legal advisers were not ordinary and necessary expenses of Dr.
Rinker’s medical practice as it stood in 1999. The evidence does
not establish that the proposed venture was related to Dr.
Rinker’s current business. Petitioners are therefore not
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entitled under section 162 to deductions for these payments as
ordinary and necessary expenses incurred in carrying on Dr.
Rinker’s medical practice. See Hagman v. Commissioner, T.C.
Memo. 1999-42. Nor does the record establish that Dr. Rinker
abandoned her pursuit of the proposed venture during 1999. Her
payments to financial and legal advisers are therefore not
deductible in that year pursuant to section 165. See sec.
165(c)(2); Hagman v. Commissioner, supra.
b. Payments to Secretaries and Bookkeepers
Dr. Rinker testified that she engaged several people for
temporary secretarial work, bookkeeping, and accounting in 1999.
At trial, Dr. Rinker was unable to recall how much she paid her
secretaries, except that in most cases she believed she paid each
of them less than $600. Dr. Rinker did recall, however, that she
hired bookkeepers for $25 an hour, and that they usually worked 6
or 7 hours per week. On cross-examination, Dr. Rinker admitted
that she engaged the same people to perform bookkeeping and tax
accounting services for both her business and personal needs.
Petitioners presented canceled checks written by Dr. Rinker
in 1999 made out to the people about whom she testified. In the
memo section of most of those checks, Dr. Rinker had written
notes identifying the services underlying the payments, such as
“12.5 hours bookkeeping” or “temp. office” or “sec. services.”
However, Dr. Rinker admitted that one of the checks in the
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exhibits was mistakenly included and did not represent a payment
for professional or office services.
The checks for secretarial services related to Dr. Rinker’s
medical practice amount to $1,442. Petitioners are entitled to a
deduction under section 162 for that amount.
The checks for bookkeeping and accounting services add up to
$2,582. Dr. Rinker testified that she paid some of these amounts
for services performed for her medical practice, but petitioners
offered no evidence as to what portion of the payments related to
services performed for her in her personal capacity. On the
basis of Dr. Rinker’s testimony, we believe that at least half of
the fees related to Dr. Rinker’s medical practice. Under Cohan
v. Commissioner, 39 F.2d at 544, we allow a deduction of $1,291.
5. Medical Management Solutions
Dr. Rinker testified that she engaged an outside billing
service called Medical Management Solutions to collect and manage
payments from medical insurance companies. At trial, petitioners
presented an exhibit listing payments to Medical Management
Solutions. Petitioners also presented an additional check made
out by Dr. Rinker to the company which was not included in the
exhibit. The payments to Medical Management Solutions for
billing services are deductible business expenses under section
162. We therefore allow a deduction for the amounts shown by the
exhibit and the additional check, totaling $11,300.
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6. Office Rent
Dr. Rinker testified that she paid office rent to two
different sublessors in 1999. She estimated that she paid the
first of those sublessors between $790 and $800 a month from
January through September 1999, and that she paid the second
sublessor between $800 and $1,000 per month for the rest of 1999.
Office rent is a deductible expense. Sec. 162(a)(3). Under
Cohan, we allow a deduction of $9,600.
7. Repairs
Dr. Rinker testified about two expenditures for alleged
repairs she incurred in maintaining her medical office in 1999.
Dr. Rinker hired a technician two times to fix her office
computers in 1999, paying approximately $400 for each visit.
Also, Dr. Rinker hired Levi Moore, a builder, to construct
countertops and cupboards in her office. Dr. Rinker testified
that the construction work cost $2,500.
Petitioners argue that payments to Levi Moore for the
construction of countertops and cupboards in Dr. Rinker’s office
are deductible expenses. That argument is incorrect. Generally,
under section 263, no deduction is allowed for capital
expenditures. Capital expenditures include any amount paid for
permanent improvements or betterments made to increase the value
of any property. Sec. 263(a)(1). Particularly, the cost of
constructing furniture and fixtures or similar property having a
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useful life substantially beyond the taxable year is a capital
expenditure. Sec. 1.263(a)-2(a), Income Tax Regs. Petitioners
are therefore not entitled to a deduction for payments to Levi
Moore. Petitioners have not raised--and we do not address--
whether Dr. Rinker is entitled to capitalize and depreciate the
cost of the improvements made by Levi Moore.
Petitioners also argue that payments to the computer
technician were deductible repair expenses. Under section 1.162-
4, Income Tax Regs.,
The cost of incidental repairs which neither materially
add to the value of the property nor appreciably
prolong its life, but keep it in an ordinarily
efficient operating condition, may be deducted as an
expense * * *. Repairs in the nature of replacements,
to the extent that they arrest deterioration and
appreciably prolong the life of the property, shall
either be capitalized and depreciated in accordance
with section 167 or charged against the depreciation
reserve if such an account is kept.
Petitioners have not provided the Court with sufficient
evidence to determine whether the work done by the technician
should be deducted as a current expense or capitalized into the
cost of Dr. Rinker’s office computer and depreciated. Therefore,
petitioners are not entitled to a deduction for the technician’s
fees. See Rule 142(a). Petitioners have not raised the issue of
whether they are entitled to a deduction for depreciation or
amortization with respect to the equipment. We therefore do not
address it.
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8. Supplies
Petitioners presented an exhibit listing expenses for
patient supplies incurred in connection with Dr. Rinker’s medical
practice. The exhibit contained some of Dr. Rinker’s financial
records, invoices from a company named MedQuest Pharmacy, and two
checks written by Dr. Rinker. The exhibit showed total
expenditures of $8,117.80. Dr. Rinker testified that the records
related to purchases of drugs and hormones for her patients. At
trial, Dr. Rinker admitted that one of the two checks in the
exhibit was miscategorized and actually represented a personal
medical expenditure. The other check appears to duplicate a
payment recorded on one of the invoices.
A doctor’s expenditures for her patients’ medical supplies
are deductible under section 162. Sec. 1.162-6, Income Tax Regs.
Eliminating the payment for personal medical supplies and the
duplicate payment, we allow a deduction of $6,801.11 for Dr.
Rinker’s purchases from MedQuest.
Petitioners also presented an exhibit purporting to
substantiate office expenditures Dr. Rinker incurred during 1999.
This exhibit contained canceled checks that Dr. Rinker wrote out
to various payees, including consumer retailers such as Costco
and Office Depot, during 1999. The checks contained the
following information:
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No. Payee Amount Memo
2001 Victoria Pickett $6.00 Palm pilot case
2093 Giovane 148.60 Supplies reimbursement
8087 Cost Plus 702.27 Office furniture
8234 Fry’s Electronics 625.38 Offc equipment fax
printer
8259 Andy Musgrave 202.50 (Illegible)
8332 Labels Dept 6657 11.90 Labels stionary (sic)
9002 Office Max 39.34 Writing pads, pens
9035 Computerware 97.39 USB cable
9061 Costco 411.86 Food, office $50.89 for
ofc suppl.
9108 Office Depot 83.73 Supplies, fax, etc.
9167 Price Costco 472.59 $188.50 Supplies Costco
member supplies &
gifts
Dr. Rinker testified that the checks related to purchases of
office supplies for her medical practice, but that in several of
the transactions she had also purchased items for personal use as
well. In the “memo” section of some of those checks, Dr. Rinker
specified the portion of the payment that represented a business
expenditure, but on other checks, the “memo” section was blank or
illegible, or did not specify the purpose and nature of the
purchase.
All of the retail payees listed in the exhibit sell goods
that can be used for both business and personal purposes.
Moreover, for those checks written to individuals, the items that
Dr. Rinker purchased can be used for both business and personal
purposes.
As noted supra, no deduction is generally allowed for
personal, living, or family expenses. Sec. 262. To show that an
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expense was not personal, the taxpayer must show that the expense
was incurred primarily to benefit his business and that there was
a proximate relationship between the claimed expense and the
business. Walliser v. Commissioner, 72 T.C. 433, 437 (1979).
Dr. Rinker testified as to the business purpose of some of
the expenditures, and the notes on the checks set forth an
adequate basis for allowing some deduction for purchases of
office supplies. At least two of the checks written to Fry’s
Electronics for $625.38 and to Cost Plus for $702.27 represent a
purchase of assets the cost of which should be capitalized, not
deducted. See sec. 1.263(a)-2(a), Income Tax Regs. We therefore
allow petitioners deductions for the full amount of check No.
2093, as well as for portions of check Nos. 9061 and 9167, which
represent deductible business expenditures. These amount to
deductions of $387.99 in total.
9. Child Care Expenses
At trial and on the brief, petitioners asserted that they
paid $8,951 for day care expenses of Dr. Rinker’s two children.
Dr. Rinker testified that she would not have been able to conduct
her medical practice without placing her children in day care.
Petitioners argued that the day care expenditures were deductible
business expenses.
We have consistently held that two-earner married couples
may not deduct, as a business expense under section 162, the cost
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of care for their child during working hours. See, e.g.,
O’Reilly v. Commissioner, T.C. Memo. 1974-261 (and cases cited
therein). Congress has enacted a separate credit for child care
expenses, which is currently embodied in section 21. Indeed,
petitioners took advantage of that provision to claim a $30
credit on their 1999 tax return in addition to their Schedule C
deductions. However, the rule set forth in O’Reilly still
stands, and petitioners may not deduct the costs of child care as
section 162 expenses.
10. Bank Charges
Dr. Rinker testified that she incurred charges for the
processing of patients’ credit card payments and for maintaining
her business checking accounts. Petitioners provided no evidence
of the amounts of those bank charges. At trial, Dr. Rinker was
unable even to estimate the bank charges she incurred in 1999.
We therefore lack a sufficient basis upon which to estimate an
appropriate deduction. See Cohan v. Commissioner, 39 F.2d at
544.
11. Dues
Dr. Rinker testified that she paid dues and licensing fees
to several organizations related to her medical practice in 1999.
Dr. Rinker was unable to recall the precise amounts, but she
estimated that her State medical license fee for 1999 was $500
and that she paid dues to several medical colleges and
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associations of approximately $1,185. On their 1999 return,
petitioners deducted $700 for “Taxes and licenses” on the
Schedule C for Dr. Rinker’s medical practice. Respondent allowed
this amount in full. It appears likely that petitioners included
the cost of Dr. Rinker’s medical license fee in the deduction for
“Taxes and licenses.” Petitioners have therefore not established
that they paid any amount relating to Dr. Rinker’s medical
license in excess of the amount respondent allowed. See Rule
142(a); Welch v. Helvering, 290 U.S. 111 (1933).
Dues to professional organizations are generally deductible
under section 162. Sec. 1.162-6, Income Tax Regs. Pursuant to
Cohan v. Commissioner, supra at 544, we allow a deduction of $550
for the remaining expenditures for Dr. Rinker’s professional
dues.
12. Internet Services
Dr. Rinker testified that she paid approximately $24 per
month for Internet access in 1999. She testified that she
maintained the account so that she could communicate with
patients via e-mail, but that she also used the account for
personal purposes. Dr. Rinker also testified that she paid
another charge in connection with her business use of the
Internet, but she could not recall whether she incurred the
charge in 1999 or 2000.
- 25 -
Petitioners did not offer evidence to demonstrate any
allocation of Dr. Rinker’s Internet fees between personal and
business uses. Petitioners have therefore not provided the Court
with an adequate basis upon which to make a Cohan estimation, and
we allow petitioners no deduction for the claimed expenditures.
See Cohan v. Commissioner, supra at 544.
13. Office Cleaning
On their Schedule C for Dr. Rinker’s medical practice for
1999, petitioners claimed a deduction of $598 for cleaning
services. Dr. Rinker testified that she engaged a cleaning
service company to clean both her office and her home during
1999, and that her total payments to the cleaning service
exceeded $5,000. Dr. Rinker testified that she based the $598
figure on the number of times the service visited her office and
the amount of the weekly payments she made to the company in
1999.
Dr. Rinker’s expenditures for office cleaning were ordinary
and necessary expenditures directly connected with her medical
practice. See sec. 1.162-1, Income Tax Regs. We therefore allow
a deduction of $598.
- 26 -
14. Deductions to Which Section 274 Applies
a. Car and Truck Expenses
On their 1999 Schedule C for Dr. Rinker’s medical practice,
petitioners claimed deductions for car and truck expenses of
$6,077. Respondent disallowed the deduction.
Certain business deductions described in section 274 are
subject to strict rules of substantiation that supersede the
doctrine in Cohan v. Commissioner, supra at 544. See sec. 1.274-
5T(c)(2), Temporary Income Tax Regs., 50 Fed. Reg. 46017 (Nov. 6,
1985). Section 274(d)(4) disallows deductions with respect to
“listed property” unless the taxpayer satisfies the section 274
substantiation requirements. Under section 280F(d)(4)(A)(i),
“listed property” includes, among other items, passenger
automobiles. If a taxpayer cannot satisfy the substantiation
burden imposed by section 274(d) with respect to a deduction to
which it applies, he fails to carry his burden of establishing
that he is entitled to deduct that expense, regardless of any
equities involved. Sec. 274(d); Nicely v. Commissioner, T.C.
Memo. 2006-172; sec. 1.274-5T(a), Temporary Income Tax Regs., 50
Fed. Reg. 46014 (Nov. 6, 1985). Generally, taxpayers must
substantiate each required element of an expenditure or use.
Sec. 1.274-5T(b)(1), Temporary Income Tax Regs., 50 Fed. Reg.
46014 (Nov. 6, 1985). For deductions stemming from uses of
listed property, the elements that must be substantiated include
- 27 -
the amount of each business use (using mileage or other approved
measures) as well as the total use of the listed property for the
taxable period; the date of the use; and the business or
investment purpose of the use. Sec. 1.274-5T(b)(6), Temporary
Income Tax Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985).
Where section 274 applies, a taxpayer must substantiate the
expenditure by “adequate records” or by “sufficient evidence
corroborating the taxpayer’s own statement”. Sec. 274(d); sec.
1.274-5T(c)(1), Temporary Income Tax Regs. The “adequate
records” requirement is generally satisfied where a taxpayer
presents documentary evidence, such as receipts, paid bills, or
similar evidence sufficient to support deduction of an
expenditure. Sec. 1.274-5(c)(2)(iii), Income Tax Regs. For
deductions relating to uses of listed property, a taxpayer may
also satisfy the “adequate records” requirement by maintaining an
account book, diary, log, statement of expense, trip sheets, or
similar record, and documentary evidence which, in combination,
are sufficient to establish each required element of an
expenditure or use to which section 274(d) applies. Sec. 1.274-
5T(c)(2)(i), Temporary Income Tax Regs., 50 Fed. Reg. 46017 (Nov.
6, 1985).
If a taxpayer has not substantially complied with the
“adequate records” standard, he may substantiate an element of an
expenditure by presenting “sufficient evidence corroborating the
- 28 -
taxpayer’s own statement.” Sec. 274; sec. 1.274-5T(c)(1) and
(3)(i), Temporary Income Tax Regs., 50 Fed. Reg. 46016 (Nov. 6,
1985). That requirement is satisfied where a taxpayer presents
both his own statement containing specific information in detail
as to the element, as well as other corroborative evidence
sufficient to establish the element. Sec. 1.274-5T(c)(3)(i),
Temporary Income Tax Regs., supra. Generally, the corroborative
evidence must be direct evidence, such as a statement in writing
or the oral testimony of witnesses involved in the deductible
event, or documentary evidence such as described in section
1.274-5T(c)(3), Temporary Income Tax Regs., 50 Fed. Reg. 46020
(Nov. 6, 1985). In proving the business purpose of an
expenditure, the corroborative evidence may be circumstantial
evidence. Sec. 1.274-5T(c)(3)(i), Temporary Income Tax Regs.,
supra.
In lieu of substantiating the actual amount of an
expenditure relating to the business use of a passenger
automobile, a taxpayer may use a standard mileage rate
established by the Internal Revenue Service. See sec. 1.274-
5(j)(2), Income Tax Regs.; Rev. Proc. 98-63, 1998-2 C.B. 818.
Use of the standard mileage rate establishes the amount deemed
expended with respect to the business use of a passenger
automobile, but such use does not relieve a taxpayer of his
burden of substantiating the other elements required by section
- 29 -
274 and the regulations issued thereunder. Sec. 1.274-5(j)(2),
Income Tax Regs.
At trial, Dr. Rinker testified that she used her car to
travel to various business appointments and business-related
events in 1999. Dr. Rinker testified that she documented her
business travel mileage in her appointment book, which also
contained the names of her patients. However, Dr. Rinker did not
think it prudent to offer her 1999 appointment book as evidence
because she was concerned that doing so might violate her duty of
confidentiality towards her patients. Instead, petitioners
presented a computer report that Dr. Rinker prepared in
connection with the examination of the return which purported to
summarize the contents of her 1999 appointment book. That
document purported to show that Dr. Rinker traveled 3,740 miles
in connection with her medical practice.
Petitioners have not satisfied the “adequate records”
standard. Petitioners have not presented documentary evidence
such as receipts, paid bills, or other direct evidence of the
required elements. Petitioners have not presented a log book or
other similar record made at or near the time of the expenditures
at issue. Nor may the Court excuse petitioners’ failure to
produce Dr. Rinker’s appointment book because of Dr. Rinker’s
concern for her clients’ confidentiality. Section 1.274-
5T(c)(2)(ii)(D), Temporary Income Tax Regs., 50 Fed. Reg. 46019
- 30 -
(Nov. 6, 1985), provides a way to maintain the confidentiality of
information when recording the elements of business mileage in a
log book or similar document:
Confidential information.--If any information
relating to the elements of an expenditure or
use, such as place, business purpose, or
business relationship, is of a confidential
nature, such information need not be set
forth in the account book, diary, log,
statement of expense, trip sheet, or similar
record, provided such information is recorded
at or near the time of the expenditure or use
and is elsewhere available to the district
director to substantiate such element of the
expenditure or use.
As respondent noted--albeit in another context--petitioners could
have satisfied this requirement by photocopying Dr. Rinker’s
appointment book and redacting her clients’ names. Petitioners
failed to do so.
Petitioners have not presented any evidence to corroborate
Dr. Rinker’s statements regarding her business mileage. They
have therefore failed to substantiate any such expenses. We
allow no deduction for business mileage.
b. Business Travel Away From Home
Petitioners deducted $7,018 for business travel away from
home and $988 for business meals and entertainment. Respondent
disallowed all but $362 of the claimed deductions for travel.
Respondent made no adjustment to petitioners’ deduction for meals
and entertainment of $988.
- 31 -
The heightened substantiation requirements of section 274
apply to deductions for travel expenditures. Sec. 274(d)(1).
Under section 274(d)(1), the elements that must be substantiated
to deduct such expenses generally include the amount of each
separate expenditure, the dates of departure and return for each
trip away from home and the number of days away from home spent
on business, the destinations or places to which the taxpayer
traveled, and the business purpose of the travel. Sec. 1.274-
5T(b)(2), Temporary Income Tax Regs., 50 Fed. Reg. 46014 (Nov. 6,
1985). As with other deductions to which section 274 applies,
taxpayers must generally substantiate deductions for business
travel away from home with “adequate records” or “sufficient
evidence corroborating the taxpayer’s own statement”, discussed
supra. Sec. 1.274-5T(c)(1), Temporary Income Tax Regs., supra.
Petitioners attempted to substantiate a portion of the
claimed business travel deductions in 1999. Petitioners
presented a Quicken report containing Dr. Rinker’s travel
expenditures in 1999, and Dr. Rinker testified that some of the
travel expenditures on the report related to business trips that
she took to attend various medical conferences. In her
testimony, Dr. Rinker specified which trips on the report were
business travel and detailed the business activities she engaged
in during those trips.
- 32 -
Petitioners have not met the generally applicable
substantiation requirements of section 274. Petitioners have not
presented documentary evidence such as receipts, paid bills, or
other direct evidence of the required elements. Petitioners
failed to present any independent corroboration of Dr. Rinker’s
statements which would substantiate the required elements of Dr.
her business travel deductions. Petitioners have therefore
failed to substantiate the claimed deductions with either
“adequate records” or “sufficient evidence corroborating the
taxpayer’s own statement.” However, petitioners argue that
because Mr. Hertz lost their tax records for 1999, they should be
allowed to substantiate Dr. Rinker’s business travel expenses
under section 1.274-5T(c)(5), Temporary Income Tax Regs., supra.
We agree.
Section 1.274-5T(c)(5), Temporary Income Tax Regs., supra,
provides taxpayers with a method of substantiating their section
274 deductions when their records have been lost because of
circumstances beyond their control. Where a taxpayer establishes
that the failure to produce adequate records is due to the loss
of those records through circumstances beyond the taxpayer’s
control, the taxpayer may substantiate a deduction by reasonable
reconstruction of his expenditures or use. Id. If documentation
is unavailable, the Court may, although it is not required to do
so, accept the taxpayer’s testimony to substantiate the
- 33 -
deduction. See Boyd v. Commissioner, 122 T.C. 320; Watson v.
Commissioner, T.C. Memo. 1988-29.
Petitioners have shown that they at one time possessed
adequate documentation to establish the required elements for
deducting Dr. Rinker’s business travel expenditures. Petitioners
have also shown that their failure to produce those records
stemmed from circumstances beyond their control; namely, that Mr.
Hertz lost the records. Petitioners have also provided a
reasonable reconstruction of some of Dr. Rinker’s expenditures
for business travel away from home in 1999. We therefore allow
petitioners’ deductions for which petitioners have provided
adequate reconstructions of Dr. Rinker’s deductible business
travel expenditures.
Deductible traveling expenses include travel fares, meals
and lodging, and expenses incident to travel. Sec. 1.162-2(a),
Income Tax Regs. From the record before us, petitioners have
reconstructed the following deductible travel expenses:
Nature of
Date Expenditure Destination Business Purpose Amount
2/2 Fuel Las Vegas American Academy $19.46
of Anti-Aging
Medicine conference
4/26 Hotel Fresno University pharmacy 77.28
conference
4/27 Car rental Fresno University pharmacy 22.20
conference
4/27 Hotel Fresno University pharmacy 219.02
conference
6/11 Hotel San Francisco Psychiatry 285.36
conference
- 34 -
10/25 Car rental San Francisco American Osteopathic 103.97
Association
convention
11/17 Hotel San Francisco American Osteopathic 109.00
Association
Total $836.29
We therefore allow a deduction for $836.29.
III. Schedule A Deductions
A. Personal Medical Expenditures
On their 1999 tax return, petitioners claimed medical and
dental expenditures of $18,659, of which $11,693 was allegedly
deductible.7 Respondent denied the deduction.
At trial, petitioners offered another Quicken report which
purported to contain their medical expenses for 1999. The report
showed several payments from petitioners’ bank accounts, the
amounts of the payments, the payees, and some details about the
payments and their purposes. Dr. Rinker testified that while she
and Mr. Davis had medical insurance for their family in 1999
through Mr. Davis’s employers, the report included only those
medical expenses which were not reimbursed through their medical
insurance policy. Many of the entries on the Quicken report
contain notes such as “not covered”, “co pay”, or “copayment”.
Section 213(a) generally allows a deduction for expenses paid
during a taxable year, not compensated for by insurance or
7
As discussed below, sec. 213 allows a deduction for
medical or dental expenses to the extent that they exceed 7.5
percent of adjusted gross income.
- 35 -
otherwise, for medical care of the taxpayer, his or her spouse, or
dependents, to the extent that such expenses exceed 7.5 percent of
adjusted gross income.
As noted above, taxpayers bear the burden of proving that
they are entitled to any deductions claimed on their return, see
Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992), and taxpayers must substantiate amounts claimed as
deductions by maintaining the records necessary to establish such
entitlement.8 See sec. 6001; Hradesky v. Commissioner, 65 T.C. 87
(1975); sec. 1.6001-1(a), Income Tax Regs. To substantiate
medical and dental expenses under section 213, the taxpayer must
furnish the name and address of each person to whom payment was
made and the amount and date of each such payment. See sec.
1.213-1(h), Income Tax Regs. If requested by the Commissioner,
the taxpayer must also furnish an itemized invoice which
identifies the patient, the type of service rendered, and the
specific purpose of the expense. See id. Where a taxpayer fails
to provides adequate substantiation, the Court may uphold the
Commissioner’s determination denying a deduction for medical and
dental expenses. See Hunter v. Commissioner, T.C. Memo. 2000-249;
Nwachukwu v. Commissioner, T.C. Memo. 2000-27.
8
Petitioners do not argue, and we do not find, that sec.
7491(a) applies. See supra note 6.
- 36 -
Petitioners’ evidence regarding their medical expenses is
confusing, contradictory, and incomplete, and we are not convinced
that the expenditures in petitioners’ Quicken report represent
deductible medical expenses. Mr. Davis, who required hearing aids
during 1999, testified that his expenses for hearing aids were
reimbursed by a special fund set up by his employer--yet, judging
from the Quicken report, over $800 of the medical expenses went
towards Mr. Davis’s hearing aids. Petitioners claim to have had
employer-provided medical insurance in 1999, yet they reported
over $18,000 in unreimbursed medical expenses on their tax return
and showed only $357 of insurance reimbursements at trial. Dr.
Rinker attempted to explain this by testifying that she excluded
from the Quicken report those medical expenses which were
reimbursed by insurance. But both the report itself and Mr.
Davis’s testimony indicate otherwise. The Quicken report includes
entries for insurance reimbursements, and Mr. Davis testified that
petitioners’ insurance covered all expenditures for prescription
drugs except a minimal copayment. Contrary to Dr. Rinker’s
testimony, the Quicken report includes several entries for
prescription medications costing hundreds of dollars each.
Moreover, several of the expenditures on the Quicken report
appear to relate to procedures that may have been cosmetic in
nature or to purchases of vitamins and nonprescription drugs.
Those expenditures are not deductible. Sec. 213(d)(9)(A) and (B),
- 37 -
(b). Finally, the Quicken report, even when coupled with
petitioners’ testimony, does not satisfy the requirements imposed
by section 1.213-1(h), Income Tax Regs.9 We therefore disallow the
deduction for medical expenses for 1999.
B. Personal Interest
Petitioners deducted $20,903 of interest related to the
refinancing of their home mortgage. Respondent denied the
deduction.
Petitioners refinanced a preexisting home mortgage loan on
December 17, 1998. The terms of the December 17, 1998, refinance
loan (the 1998 loan) required petitioners to pay a $7,500 “loan
origination fee” at the inception of the 1998 loan. The stated
term of the 1998 loan was apparently 30 years. However, on
March 28, 2000, petitioners again refinanced their home and paid
off the 1998 loan in its entirety.
At trial, petitioners attempted to revive only $5,862 of the
$20,903 deducted on their return. They argued that the loan
origination fee constituted prepaid interest, and that because the
1998 loan lasted only 467 days, the bulk of the loan origination
9
It is unclear whether the dates on the report indicate
the date of payment, as required, or the date on which
petitioners entered the data into their computer. The Quicken
report also fails to adequately substantiate the address of any
payees as required by the regulation.
- 38 -
fee is deductible in 1999. Petitioners calculate that to equal
$5,862.10
Respondent apparently concedes that the “loan origination
fee” represents prepaid interest, and that such interest
constitutes “home equity indebtedness with respect to * * * [a]
qualified residence” under section 163(h)(3)(A)(ii).11 However,
respondent argues that the proper method of allocating prepaid
interest requires a taxpayer to look to the stated term of the
loan--in this case, 30 years--to determine the amount attributable
to a particular tax year. Respondent argues that the effect of a
subsequent refinancing is that a taxpayer may deduct in the year
of the refinancing any prepaid interest not previously deducted.
Respondent accordingly conceded that petitioners are entitled to a
deduction of $250 for prepaid interest in 1999.12
Respondent’s approach to the deductibility of prepaid
interest is correct. Section 461(g)(1) provides:
10
$7,500 divided by the 467-day existence of the loan,
multiplied by the 365 days of 1999.
11
In some instances, “loan origination fees” may include
charges for services, and not prepaid interest. See, e.g.,
Goodwin v. Commissioner, 75 T.C. 424, 440-442 (1980), affd.
without published opinion 691 F.2d 490 (3d Cir. 1982); Lange v.
Commissioner, T.C. Memo. 2005-176; Rev. Proc. 87-15, 1987-1 C.B.
624.
12
For interest of $7,500 on a loan with a stated term of
360 months, the interest allocable to 12 months is $250.
- 39 -
In general.--If the taxable income of the taxpayer is
computed under the cash receipts and disbursements
method of accounting, interest paid by the taxpayer
which, under regulations prescribed by the Secretary,
is properly allocable to any period–-
(A) with respect to which the interest
represents a charge for the use or forbearance of
money, and
(B) which is after the close of the taxable
year in which paid,
shall be charged to capital account and shall be
treated as paid in the period to which so allocable.
The parties do not dispute that petitioners prepaid interest
in 1998. Nor, apparently, do the parties dispute that the
prepaid interest should be amortized over the life of the loan.13
The only dispute is whether the period to which the interest
relates should be determined by the terms of the loan when it was
entered into--in this case, 30 years--or the actual life of the
loan, foreshortened as it was by petitioners’ subsequent
refinancing of March 2000.
The interest which petitioners prepaid “[represented] a
charge for the use or forbearance of money” for the entire
contractual term of the loan. For 1999, petitioners are
13
Under certain circumstances, points paid in connection
with the purchase or improvement of a principal residence may be
deductible. Sec. 461(g)(2). Petitioners have not alleged, and
we do not find, that they paid the loan origination fee in
connection with the purchase or improvement of their principal
residence. We therefore find that the exception of sec.
461(g)(2) does not apply. See, e.g., Kelly v. Commissioner, T.C.
Memo. 1991-605; Fox v. Commissioner, T.C. Memo. 1989-232, affd.
without published opinion 943 F.2d 55 (9th Cir. 1991).
- 40 -
therefore entitled to deduct only that portion of the points
allocable to 1999 as a portion of the 30-year loan. Cf. Square D
Co. & Subs. v. Commissioner, 121 T.C. 168, 194 nn.21 & 22 (2003).
From the record before us, that amounts to $250.
C. SEP-IRA Contributions
At trial, Dr. Rinker testified that she made contributions
to three different SEP-IRA funds in 1999, and petitioners argued
that they should be allowed a deduction for the 1999
contributions. Petitioners did not claim a deduction for the
contributions on their 1999 return because, on the basis of the
Schedule C income shown on the return, no deduction was
permissible. However, petitioners argued that, on the basis of
respondent’s adjustments and petitioners’ concessions with regard
to the Schedule C income, such a deduction would now be allowable
and appropriate.
Even if the Court accepts Dr. Rinker’s uncorroborated
assertions that she contributed money to retirement accounts,
petitioners have failed to provide the Court with any evidence
that Dr. Rinker made the contributions under plans that meet the
qualifications for SEP-IRA’s. See secs. 219, 401, 408. We
therefore conclude that petitioners are not entitled to a
deduction for the contributions in 1999.
- 41 -
IV. Penalties
A. Section 6662(a)
Respondent determined an accuracy-related penalty under
section 6662(a) of $8,021.80. Respondent determined that the
entire underpayment of tax for 1999 was attributable to
negligence or disregard of rules or regulations, a substantial
understatement of income tax, and/or a substantial valuation
misstatement.14 Petitioners argue that the underpayments for 1999
were caused by their reasonable reliance on Mr. Hertz in
preparing their return. This reliance, petitioners argue,
qualifies as “reasonable cause and good faith”, and under section
6664(c)(1), the penalty should not be sustained.
1. Burden of Production
Section 7491(c) provides that the Commissioner will bear the
burden of production with respect to the liability of any
individual for additions to tax and penalties. “The
Commissioner’s burden of production under section 7491(c) is to
produce evidence that it is appropriate to impose the relevant
penalty, addition to tax, or additional amount”. Swain v.
Commissioner, 118 T.C. 358, 363 (2002); see also Higbee v.
14
Although the notice of deficiency includes “substantial
valuation overstatement” (sic) as a basis for applying the
accuracy-related penalty, it appears that respondent did not
determine any tax deficiency based on a valuation overstatement.
We therefore do not address the aspects of the accuracy-related
penalty which relate to a substantial valuation overstatement.
- 42 -
Commissioner, 116 T.C. 438, 446 (2001). Once the Commissioner
has done so, the burden of proof is upon the taxpayer to
establish reasonable cause and good faith. Higbee v.
Commissioner, supra at 449.
2. Section 6662(a) Penalty
Pursuant to section 6662(a), a taxpayer may be liable for a
penalty of 20 percent of the portion of an underpayment of tax
(1) attributable to a substantial understatement of tax or (2)
due to negligence or disregard of rules or regulations. Sec.
6662(b). The term “understatement” means the excess of the
amount of tax required to be shown on a return over the amount of
tax imposed which is shown on the return, reduced by any rebate
(within the meaning of section 6211(b)(2)). Sec. 6662(d)(2)(A).
Generally, an understatement is a “substantial understatement”
when the understatement exceeds the greater of $5,000 or 10
percent of the amount of tax required to be shown on the return.
Sec. 6662(d)(1)(A). The term “negligence” in section 6662(b)(1)
includes any failure to make a reasonable attempt to comply with
the Code. Sec. 6662(c). Negligence has also been defined as the
failure to exercise due care or the failure to do what a
reasonable person would do under the circumstances. See Allen v.
Commissioner, 92 T.C. 1, 12 (1989), affd. 925 F.2d 348, 353 (9th
Cir. 1991); Neely v. Commissioner, 85 T.C. 934, 947 (1985). The
- 43 -
term “disregard” includes any careless, reckless, or intentional
disregard. Sec. 6662(c).
3. Analysis
Respondent has met the burden of production imposed on him
by section 7491(c). Respondent has shown that the underpayments
of petitioners’ 1999 taxes exceeds the greater of $5,000 or 10
percent of the tax required to be shown on the return, and is
therefore due to a “substantial understatement”. Sec.
6662(d)(1)(A). To avoid application of the penalty, petitioners
must therefore demonstrate that the underpayments of tax for 1999
were due to reasonable cause and good faith.15 See Higbee v.
Commissioner, supra at 449.
Whether applied because of a substantial understatement of
tax or negligence or disregard of rules or regulations, the
accuracy-related penalty is not imposed with respect to any
portion of the underpayment as to which the taxpayer acted with
reasonable cause and in good faith. Sec. 6664(c)(1). The
decision as to whether a taxpayer acted with reasonable cause and
in good faith depends upon all the pertinent facts and
circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Relevant
factors include the taxpayer’s efforts to assess his proper tax
liability, including the taxpayer’s reasonable and good faith
15
There is no claim or proof that petitioners may reduce
the amount of the understatement under sec. 6662(d)(2)(B).
- 44 -
reliance on the advice of a professional such as an accountant.
See id. Further, an honest misunderstanding of fact or law that
is reasonable in light of the experience, knowledge, and
education of the taxpayer may indicate reasonable cause and good
faith. See Remy v. Commissioner, T.C. Memo. 1997-72.
At the time the return was prepared, Mr. Hertz was an
enrolled agent. Petitioners had engaged Mr. Hertz to prepare
their income tax returns for 1 or 2 years before 1999.
a. Deductions Relating to Mr. Davis’s Photography
Activities
Petitioners honestly misunderstood Mr. Davis’s photography
expenditures to be deductible business expenses. Although
petitioners are both highly educated in fields that do not relate
to taxation, we find that their misunderstanding was reasonable.
We therefore conclude that petitioners had reasonable cause and
acted in good faith as to the underpayments resulting from
deductions of photography-related expenditures.
b. Gross Receipts and Deductions of Dr. Rinker’s
Medical Practice
Petitioners credibly testified that they provided Mr. Hertz
with all of the necessary records and information with which to
determine the gross receipts and allowable deductions for Dr.
Rinker’s medical practice, and that they relied on Mr. Hertz to
determine the proper figures on their return. We conclude that
for 1999 petitioners had reasonable cause and acted in good faith
- 45 -
as to the underpayments resulting from Dr. Rinker’s claimed gross
receipts and business deductions.
c. Deductions for Home Mortgage Points
The record also indicates that petitioners relied on Mr.
Hertz to determine the proper amount of their deduction for
personal interest. Dr. Rinker testified that she gave Mr. Hertz
all of the records relating to her home mortgage and relied on
him to determine the proper deduction because she had “no idea,
looking at mortgage papers, what is tax-deductible and what
isn’t. And I just told * * * [Mr. Hertz] to figure it out.” We
therefore conclude that petitioners had reasonable cause and
acted in good faith as to the underpayment attributable to
petitioners’ erroneous deduction of home mortgage points.
d. Deductions for Personal Medical Expenditures
The record does not reveal that petitioners had reasonable
cause and acted in good faith with respect to their claimed
$11,693 in deductible medical expenses. Regardless of whether
the erroneous deductions were results of Mr. Hertz’s negligence
or otherwise, petitioners had significant “warning signs” that
their deductions for medical expenditures were improper. As
noted above, petitioners carried employer-provided medical
insurance, and many of the claimed expenditures were covered by
the terms of the insurance policy. See Allen v. Commissioner,
925 F.2d at 353. We therefore sustain respondent’s application
- 46 -
of the section 6662 penalty as it applies to the portion of the
deficiency attributable to claimed deductions for personal
medical expenses.
To reflect the foregoing,
Decision will be entered
under Rule 155.