Probandt v. Comm'rProbandt v. Comm'r
Steven Ray Mather and Lydia Turanchik, for petitioner.
Michael K. Park, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GALE, Judge: Respondent determined the following deficiencies, additions to tax, and penalties with respect to petitioner‘s 2001 and 2002 Federal income
| Year | Deficiency | Addition to tax | Penalty |
|---|---|---|---|
| 2001 | $525,164 | $131,291 | $105,033 |
| 2002 | 230,125 | 57,460 | 46,025 |
Following concessions by the parties,1 the issues for decision are:
- whether petitioner received unreported income in 2001 and 2002 from A&G Precision Parts, LLC (A&G), a partnership in which he was a partner;
- whether petitioner is entitled to deduct expenses reported on Schedules C, Profit or Loss From Business, for 2001 and 2002;
- whether petitioner is liable for an addition to tax under
section 6651(a)(1) 2 for failure to timely file returns for 2001 and 2002; and
-
whether petitioner is liable for accuracy-related penalties under section 6662(a) and (b)(1) and (2) for 2001 and 2002.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. We incorporate by this reference the stipulation of facts and the accompanying exhibits. Petitioner resided in Washington State at the time he filed his petition.
I. Petitioner‘s Education and Professional Experience
Petitioner received a degree in business administration in the mid-1970s. He worked initially for an accounting firm and then for a public company auditing financial statements. For approximately 10 years during the 1980s petitioner worked for a securities brokerage firm. In the first half of the 1990s petitioner worked at two money management firms managing investments for clients. In approximately 1995 or 1996 petitioner began investing in small startup companies for his own account. Around 1998 petitioner discovered one such company. He became interested in acquiring A&G Precision Parts (the predecessor of A&G), a company headquartered near Portland, Oregon, because it had good cashflow and offered him an opportunity to earn a salary.
Before and during the years at issue, A&G developed parts and other prototype components for semiconductor manufacturers. Sometime in 1998 petitioner and four other individuals acquired A&G. Petitioner and the other four individuals were designated 20% partners of A&G; petitioner became managing and tax matters partner while the remaining partners functioned as passive investors. During the years at issue A&G had five partners, all of whom were individuals. Petitioner made all financial and sales decisions for A&G and frequently traveled to meet potential A&G clients in an effort to develop A&G‘s business relationships.
Sometime after petitioner and his partners acquired A&G, two individuals were hired to manage A&G‘s day-to-day operations. One of them, Mark Herz, was initially hired as A&G‘s vice president and operations manager of its production facility. He became president sometime around 2001 while still overseeing operations.
A&G maintained approximately $30,000 in an account for use in purchasing equipment at auction. In 2001 these funds were transferred to petitioner to purchase equipment on behalf of A&G. Petitioner did not purchase any equipment at auction in 2001 or thereafter.
During 2001 and 2002 petitioner explored business opportunities in China and traveled there extensively. His goal was to acquire exclusive rights to distribute certain Chinese manufactured products in the United States. To that end, petitioner often spent a great deal of time developing business relationships with the executives of target companies over meals. He conducted these activities for himself and not as part of A&G‘s semiconductor parts manufacturing and sales.
IV. Petitioner‘s Financial Institutions and Records During 2001 and 2002
Petitioner maintained two accounts at Bank of America during 2001 and 2002. The first was a joint checking account that he held with his then spouse; the second was a business checking account in the name of Probandt Associates that he maintained to support his business endeavors in China. In addition to the business checking account at Bank of America, petitioner maintained a credit card account at Capital One that he used to pay for his travels to, and expenses incurred in, China.3
Petitioner leased a storage unit in which he placed his handwritten financial records and other personal effects for safekeeping during his travels; he prepaid two years’ rent on the unit before he left on a trip to China sometime in 2005. Petitioner received notice in early December 2005 while in China that the Portland Development Commission had acquired the site of the storage facility by eminent domain and that he had to arrange to move the contents of his storage unit to another storage unit by December 31, 2005, or risk their destruction. The Portland Development Commission offered petitioner (and other unit lessees) assistance including free moving services and the identification of a mover and a new storage facility that would arrange for the moving and re-storage of his contents, respectively, without petitioner‘s needing to appear before either in person, so
V. Tax Returns
A. A&G‘s Returns
A&G filed Forms 1065, U.S. Return of Partnership Income, for 2001 and 2002, which petitioner signed as tax matters partner. These returns were prepared by a certified public accountant. For 2001 A&G claimed total deductions of $2,061,195, including travel expense deductions of $39,946 and meals and entertainment expense deductions of $5,335. For 2002 A&G claimed total deductions of $2,470,500, including travel expense deductions of $65,899 and meals and entertainment expense deductions of $10,275.
B. Petitioner‘s Returns
Petitioner filed delinquent Federal income tax returns for 2001 and 2002 on April 10, 2004. The returns were prepared by a certified public accountant. Petitioner did not provide the accountant with copies of his 2001 and 2002 Schedules K-1. However, petitioner provided the accountant with summary sheets of his travel, meals and entertainment, printing, and consulting expenses derived from his handwritten records.
| Expense | 2001 | 2002 |
|---|---|---|
| Rent | $12,500 | --- |
| Travel | 87,900 | $103,000 |
| Meals & entertainment1 | 18,000 | 16,500 |
| Other--consulting | 65,000 | |
| Other--printing | 18,000 | 24,500 |
| Total | 201,400 | 194,000 |
Petitioner did not attach a Schedule E, Supplemental Income and Loss, to his 2001 or 2002 return, nor did he report any partnership income on those returns.
VI. Notice of Deficiency
Respondent issued a notice of deficiency to petitioner with the following adjustments to petitioner‘s 2001 and 2002 returns:
- respondent determined that petitioner had failed to report his distributive shares and guaranteed payments from A&G7 for 2001 of $216,322 (a $81,322 distributive share and $135,000 in guaranteed payments) and for 2002 of $379,067 (a $234,067 distributive share and $145,000 in guaranteed payments8);
- respondent disallowed, with the exception of the rent expense reported on petitioner‘s 2001 Schedule C, the deductions claimed for all expenses reported on petitioner‘s Schedules C for 2001 and 2002; and
-
respondent determined that petitioner was liable for section 6651(a)(1) additions to tax andsection 6662(a) and (b)(1) and (2) accuracy-related penalties for 2001 and 2002.
Petitioner filed a timely petition for redetermination.
OPINION
I. Unreported Income
The parties are far apart in their dispute over unreported income for 2001 and 2002. Petitioner filed a Schedule C for each year for an unnamed sole proprietorship. The proprietorship‘s principal business was reported as “Investments“. The 2001 and 2002 Schedules C reported gross income of $231,000 and $201,900, respectively. Respondent‘s position, reflected in the notice of deficiency, is that the foregoing gross income is from a Schedule C business that petitioner conducted separate and apart from his activities as the managing partner of A&G and that petitioner failed to report his distributive share of the partnership income and guaranteed payments from A&G as reflected on the Schedules K-1--$216,322 for 2001 and $379,067 for 2002.
Petitioner now concedes that these distributive share and guaranteed payment figures for his A&G partnership interest are--with one exception--correct but contends that the income he reported on the Schedule C for each year was his
A comparison of petitioner‘s Schedules C and Schedules K-1 for the years at issue substantially corroborates his contentions. The total of petitioner‘s guaranteed payments and cash distributions from A&G in 2001 was $260,000. Petitioner reported Schedule C gross receipts for that year of $231,000. Petitioner
A&G‘s president and operations manager, Mark Herz, corroborated petitioner‘s testimony concerning the $30,000. Mr. Herz confirmed in his testimony that an account for the purchase of used equipment at auction had been set up at A&G, that the account‘s $30,000 balance had been transferred to petitioner, and that he (Mr. Herz) did not know what happened to the funds. According to petitioner‘s 2002 Schedule K-1 from A&G, the total of his guaranteed payments and cash distributions from the partnership for that year was $170,000. Petitioner reported Schedule C gross receipts for that year of $201,900. When the $30,000 disbursement that petitioner claims he received from A&G in 2001 but did not treat as income until 2002 is accounted for, the discrepancy remaining between petitioner‘s cash distributions from A&G and the gross receipts he reported on his Schedule C is $1,900. Petitioner describes this remaining $1,900 as “little checks” he received from A&G for miscellaneous items, and we note that petitioner‘s 2002 Schedule K-1 from A&G lists as an income item, immediately above his cash distributions, $2,055 in “nondeductible
We are persuaded that the near match of the Schedule K-1 items that represent A&G‘s cash disbursements to petitioner and the gross receipts he reported on Schedules C for 2001 and 2002 is too close to be mere coincidence. While incorrect as a matter of partnership taxation, petitioner‘s belief that he needed to report only cash distributions he received from the partnership and not undistributed partnership income was plausible. Aside from the inference that might be drawn from petitioner‘s having reported gross receipts on Schedules C for each year, there is no evidence that the Chinese venture generated any income. There is also no evidence, such as a bank deposits analysis or spending well in excess of reported income, that would suggest petitioner underreported his income to the extent that respondent‘s position in the notice of deficiency necessarily implies. On balance, considering all of the foregoing factors, we are persuaded on the preponderance of the evidence that the income petitioner reported on the
Given that there is no dispute that petitioner was engaged in an income-producing activity in connection with A&G during the years at issue, respondent has provided the necessary evidentiary foundation for his determination that petitioner failed to report income from that activity. Thus, the notice of deficiency was presumptively correct. See Weimerskirch v. Commissioner, 596 F.2d 358, 361-362 (9th Cir. 1979), rev‘g 67 T.C. 672 (1977). However, the Court of Appeals for the Ninth Circuit, to which an appeal in this case would lie absent stipulation to the contrary, see
Instead, petitioner having now conceded that he failed to correctly report his partnership taxable income from A&G for 2001 and 2002, we must redetermine the unreported income amounts by comparing what petitioner reported on his Schedules C with what his partnership taxable income from A&G was for those years. See Cohen v. Commissioner, 266 F.2d at 11.
II. Schedule C Expenses
The notice of deficiency disallowed for lack of substantiation the travel, meals and entertainment, consulting, and printing expenses that petitioner reported
Deductions are a matter of legislative grace, and a taxpayer generally bears the burden of proving that he is entitled to the deduction claimed.17 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). The Commissioner bears the burden of proof with respect to any matter that would increase the deficiency beyond that determined in the notice of deficiency. Rule 142(a); Truesdell v. Commissioner, 89 T.C. 1280, 1296 (1987).
827-828 (1968), aff‘d per curiam, 412 F.2d 201 (2d Cir. 1969). If a taxpayer establishes that the failure to produce adequate records for this purpose is due to the loss of such records through circumstances beyond his control, he may substantiate an expense by a reasonable reconstruction of his expenditure.
Petitioner testified that he documented the date, amount, and business purpose of each of his consulting, printing, and travel expenditures by making entries in a spiral notebook at or near the time of the expenditure and that he similarly documented his meals and entertainment expenses in a day timer. These documents were destroyed, however, when he failed to retrieve them within a short deadline from a storage facility which the city of Portland acquired by eminent domain.
A. Travel and Meals and Entertainment Expenses
Petitioner contends that he is entitled to deduct the travel and meals and entertainment expenses he reported for 2001 and 2002 on two grounds. Petitioner claims that he can substantiate a portion of the expenditures with bank statements and that he is entitled to substantiate the remaining expenses through a reasonable reconstruction pursuant to
The bank statements in evidence are from a Bank of America joint checking account in the individual names of petitioner and his then spouse. It is apparent that the account could be accessed by means of a debit card, as most of the statement entries are for “merchant purchases” with the merchant listed (such as an airline, hotel, or restaurant), a transaction date, and an amount. Petitioner testified and contends on brief that the expenditures recorded in the Bank of America joint checking account statements for airlines, hotels, and restaurants were paid in connection with his work on behalf of A&G during 2001 and 2002. By petitioner‘s reckoning, the entries substantiate $22,257 and $449 of travel expenditures for 2001 and 2002, respectively, and $6,144 and $319 of meals and entertainment expenditures for 2001 and 2002, respectively. (He reaches those figures by treating essentially every expenditure of that nature as business related.)
However, because these expenditures were made in conducting A&G‘s business, they are partnership expenses. It is well established that a partner cannot himself deduct the expenses of a partnership, even if he incurred the expenses in furtherance of partnership business. See McLauchlan v. Commissioner, 558 F. App‘x 374 (5th Cir. 2014), aff‘g and remanding on another issue T.C. Memo. 2011-289; Cropland Chem. Corp. v. Commissioner, 75 T.C. 288, 295 (1980), aff‘d
In addition, A&G itself deducted substantial travel and meals and entertainment expenses for 2001 and 2002 on its returns; namely, travel expenses of $39,946 and $65,899 for 2001 and 2002, respectively, and meals and
Petitioner has the burden of proof, and there is no evidence in the record concerning the nature of the travel and meals and entertainment expense deductions that A&G claimed. Petitioner testified that he was not reimbursed, but he had difficulty recalling details with respect to many other matters. We are not
That leaves in dispute reported travel expenses of $65,643 and $102,551 and reported meals and entertainment expenses of $11,856 and $16,181 for 2001 and 2002, respectively. Petitioner testified that these expenses were paid in pursuit of his Schedule C business seeking exclusive distributorship rights for Chinese products.20 Petitioner offered no written substantiation to document these expenses. He relies on his testimony alone, citing
Respondent, pointing to the options available to petitioner for preserving the storage unit‘s contents--he could have used a free moving service or entered into contracts with a mover and a new storage facility without personally appearing--argues that the loss of records was not beyond petitioner‘s control, disqualifying
(5) Loss of records due to circumstances beyond control of the taxpayer. Where the taxpayer establishes that the failure to produce adequate records is due to the loss of such records through circumstances beyond the taxpayer‘s control, such as destruction by fire, flood, earthquake, or other casualty, the taxpayer shall have a right to substantiate a deduction by reasonable reconstruction of his expenditures or use.
The regulation does not comprehensively define what constitutes circumstances beyond the taxpayer‘s control, providing instead a nonexclusive example; namely, “such as destruction by” various casualties. As to whether this loss of records was beyond petitioner‘s control, we observe that petitioner took reasonable steps to safeguard his records by prepaying two years’ rent on his storage unit. Once in China, he encountered unforeseeable circumstances: the imminent destruction of the storage facility on account of an eminent domain acquisition and the need to arrange for the transfer of his storage unit‘s contents on short notice. While it is true that the Portland Development Commission offered various accommodations to the storage unit lessees it was abruptly displacing, the fact remains that it was still necessary for petitioner--in less than a month, from China--to find an
As a consequence, petitioner “ha[s] a right” under the regulations to substantiate his claimed deductions by means of a “reasonable reconstruction“. The Cohan rule comes back into play in these circumstances. See Scully v. Commissioner, T.C. Memo. 2013-229, at *17. Where records have been lost because of circumstances beyond a taxpayer‘s control, he must still undertake a “reasonable reconstruction“, which includes substantiation through secondary evidence. See, e.g., Boyd v. Commissioner, 122 T.C. 305, 320 (2004); Cox v. Commissioner, T.C. Memo. 2013-75; DeLima v. Commissioner, T.C. Memo. 2012-291; Chong v. Commissioner, T.C. Memo. 2007-12.
The evidence establishes that there were two accounts through which petitioner paid the expenses of his Schedule C business. Petitioner testified that he paid expenses of his Schedule C business through a business checking account at Bank of America held in the name of Probandt Associates. Petitioner also
We are satisfied that there was a reasonable effort to reconstruct, through third-party sources, any expenses that were paid through the Capital One account (though that reconstruction effort was unsuccessful). The same cannot be said for the Bank of America business checking account established in the name of Probandt Associates. There is no evidence of any efforts made to reconstruct expenditures through the records of that account.21
We find guidance for the unusual circumstances surrounding the Capital One account, where a reasonable reconstruction has been thwarted by a third party‘s failure, in
(4) Substantiation in exceptional circumstances. If a taxpayer establishes that, by reason of the inherent nature of the situation-
- (i) He was unable to obtain evidence with respect to an element of the expenditure or use which conforms fully to the “adequate records” requirements of paragraph (c)(2) of this section,22
(ii) He is unable to obtain evidence with respect to such element which conforms fully to the “other sufficient evidence” requirements of paragraph (c)(3) of this section,23 and
(iii) He has presented other evidence, with respect to such element, which possesses the highest degree of probative value possible under the circumstances, such other evidence shall be considered to satisfy the substantiation requirements of section 274(d) and this paragraph.
We believe petitioner has satisfied the regulation with respect to any expenses paid through the Capital One account. He is unable to satisfy the “adequate records” records requirements because his day timers and spiral notebook wherein he contemporaneously documented expenditures and their purpose were lost when his storage unit contents were destroyed. He is unable to satisfy the “other sufficient evidence” requirements because the Capital One credit
That leaves the question of whether the third requirement for “exceptional circumstances” substantiation has been satisfied; namely, whether petitioner presented evidence to substantiate the deduction “which possesses the highest degree of probative value possible under the circumstances“. We conclude that he has. Petitioner was a credible witness in this regard. We are persuaded that he traveled extensively to China during 2001 and 2002. The evidence he has proffered is his own statement concerning the trips to China and their purpose, as well as testimony to the effect that he consulted his now destroyed records to provide information to his return preparer for the preparation of his 2001 and 2002 returns in 2004. The amounts reported as travel and meals and entertainment expenses on the Schedule C for each year thus reflect those now destroyed records. The impracticality of petitioner‘s obtaining written statements or testimony from the myriad vendors involved in typical travel and meals and entertainment expenditures persuades us that the return figures, coupled with petitioner‘s testimony concerning their source, constitute evidence “which possesses the highest degree of probative value possible under the circumstances“.
Thus, we are left with a situation where the travel and meals and entertainment expenditures made through the Capital One account are eligible for the “exceptional circumstances” substantiation provided for in
| Deductible Expenses | 2001 | 2002 |
|---|---|---|
| Travel | $26,257 | $41,020 |
| Meals & entertainment | 14,742 | 6,472 |
B. Consulting Expenses
On his Schedules C for 2001 and 2002 petitioner reported expenses for consulting fees of $65,000 and $50,000, respectively, the deductions for which respondent disallowed in full. Petitioner testified that these amounts were
We disagree. Even for expenses that do not have to be substantiated pursuant to
C. Printing Expenses
Petitioner reported printing expenses of $18,000 and $24,500 on his Schedules C for 2001 and 2002, respectively, the deductions for which respondent disallowed in full. Petitioner testified that the printed materials were used in his Schedule C business in connection with efforts to secure exclusive U.S. distributorship rights from Chinese manufacturers and that almost all of the expenditures were made at a particular Kinko‘s location in Portland. The record does not establish whether the expenditures were paid through the Capital One account, the Bank of America business account, or some other means. Petitioner again invokes the Cohan rule.
The same principles apply here as with the consulting fees. Given the magnitude of these expenditures at a single vendor, we believe petitioner was obligated to undertake reasonable efforts to obtain secondary evidence to
D. Rent Expense
Petitioner reported a $12,500 rent expense on his 2001 Schedule C, which the notice of deficiency did not disallow. Although respondent did not raise the issue in his answer, we conclude, on the basis of the parties’ stipulations and arguments on brief, that this issue was tried by consent and is properly before the Court. See
There is no documentary substantiation of the reported rent expense. Petitioner testified that the expense reflects rent he paid of approximately $1,000 per month during 2001 for an office in Chicago leased from one of A&G‘s other passive investor partners. Petitioner testified that he paid rent because that partner
III. Additions to Tax and Penalties
Respondent determined additions to tax under
The parties stipulated that petitioner‘s 2001 return was due October 15, 2002, and that his 2002 return was due April 15, 2003. Respondent received and filed both returns on April 10, 2004. See Emmons v. Commissioner, 898 F.2d 50, 51 (5th Cir. 1990), aff‘g 92 T.C. 342 (1989); First Charter Fin. Corp. v. United States, 669 F.2d 1342, 1345-1346 (9th Cir. 1982). These undisputed facts satisfy respondent‘s burden of production under
Petitioner claims that he is not liable for the
Taxpayers who deliberately omit to file returns must use reasonable care to ascertain that no returns are necessary. See Beck Chem. Equip. Corp. v. Commissioner, 27 T.C. 840, 860 (1957); Thomas v. Commissioner, T.C. Memo. 1984-72. Without more, petitioner‘s mistaken belief that no return was required does not constitute reasonable cause for noncompliance. See Beck Chem. Equip. Corp. v. Commissioner, 27 T.C. at 860; Henningsen v. Commissioner, 26 T.C. 528, 536 (1956) (noting that mere uninformed belief, no matter how sincere or innocent, is insufficient to constitute reasonable cause), aff‘d, 243 F.2d 954 (4th Cir. 1957). There is no evidence that petitioner used reasonable care in deciding not to file his 2001 and 2002 returns. Petitioner has provided no evidence that he obtained professional advice as to his filing obligations or that he undertook any
Considering all the facts and circumstances, petitioner has not shown reasonable cause with respect to his failure to timely file returns for 2001 and 2002. Respondent‘s determinations of the additions to tax under
B. Section 6662(a) Accuracy-Related Penalties
No penalty is imposed with respect to any portion of an underpayment if the taxpayer acted with reasonable cause and in good faith with regard to that portion.
Respondent has met his burden of production with respect to petitioner‘s negligence and disregard of rules and regulations as to the underpayment attributable to the unreported partnership income. Petitioner failed to report
Additionally, petitioner has conceded that he failed to report dividend and interest income totaling $7,133 and $1,828 for 2001 and 2002, respectively. The notice of deficiency noted that all of the foregoing amounts were reported to respondent by third parties on information returns, which creates an inference in the absence of any contrary evidence that petitioner also received copies of these information returns. Moreover, the bulk of this unreported income was interest from A&G, for which petitioner served as managing partner. Negligence is strongly indicated where a taxpayer fails to report income reflected on information returns.
Finally, respondent has met his burden of production with respect to the portion of the underpayment attributable to deductions for those Schedule C expenses for printing, consulting, travel, and meals and entertainment that petitioner claimed for 2001 and 2002 in connection with his business endeavors in China and which we have disallowed.24 Negligence includes a failure to keep adequate books and records or to substantiate expenses as required by
In the event the
To reflect the foregoing,
Decision will be entered
under Rule 155.