CHARLES REYNOLDS and BEATRICE REYNOLDS, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
No. 00-2966
United States Court of Appeals For the Seventh Circuit
ARGUED NOVEMBER 30, 2001—DECIDED JULY 18, 2002
Before FLAUM, Chief Judge, CUDAHY, and MANION, Circuit Judges.
Appeal from the United States Tax Court. No. 12112-97—John F. Dean, Special Trial Judge.
The Reynolds appeal the following: (1) the evidentiary weight given to the no-liability letters, (2) the classification of certain legal defense costs as personal costs rather than as business expenses related to Charles Reynolds’ private law practice, (3) the denial of various automobile and travel expenses related to the private law practice, farming activity and the rental properties, and (4) the imposition of the accuracy-related penalties. We affirm the judgment of the Tax Court.
I.
Charles Reynolds joined the IRS in 1976, where he worked as a revenue officer in the Chicago office. Several years later, Reynolds graduated from law school and was promoted to a supervisory position, which involved a caseload of taxpayer audits. In 1987 and 1988, Reynolds received permission from the IRS to practice law in addition to his primary employment with the IRS. However, in 1992, the IRS commenced an investigation of Reynolds springing from concerns that he may have been conducting his private law practice during his workday at the IRS. To defend himself, Reynolds hired a major Chicago law firm and incurred legal expenses. The investigation was officially terminated in 1995.
During 1993 and 1994, which is the time period relevant to this dispute, Charles Reynolds operated a small part-
In addition to the reclassification of the legal expense, IRS auditors also denied various other deductions, including automobile and travel expenses allegedly related to the law practice, to a family farm and to rental properties. Only the auto and travel expenses, however, are currently before us on appeal. From our own inspection of the record, we estimate the total amount of the deductions now in dispute to be approximately $3,359.3 Included in this amount
Nonetheless, the IRS denied the automobile and travel deductions on various grounds, including failure to comply with the substantiation requirements of
In August of 1997, the Reynolds petitioned the U.S. Tax Court for a redetermination of their 1993 and 1994 tax liability. In March of 1998, while this matter was still pending before the Tax Court, the Reynolds apparently sent a letter of inquiry to the IRS problem resolution office in Kansas City, Missouri, with respect to their 1993 and 1994 tax liabilities. It is important to note that this inquiry was not directed to the district counsel for the IRS, who was representing the respondent in the ongoing dispute before the Tax Court. A month later, the Reynolds received two short letters from the IRS, one pertaining to 1993 and the other to 1994, that were identically worded with the exception of the specific tax amounts peculiar to each. After listing credit adjustments for each year, both letters listed “the amount you now owe” as “none.”
In April 1999, the case went to trial, and the Reynolds asserted that the IRS correspondence was tantamount to a binding admission by the government that estopped it from litigating the present case. The Tax Court rejected this argument as contrary to well-established law. The court went on to consider various testimony and exhibits, issuing a decision in part for the Reynolds and in part for
II.
Pursuant to
Before considering each issue in turn, we note that a decision of the Tax Court is subject to the same standards of review “that we apply to district court determinations in a civil bench trial: We review factual determinations, as well as applications of legal principles to those factual determinations, only for clear error.” Cline v. Commissioner, 34 F.3d 480, 484 (7th Cir. 1994); accord Toushin v. Commis-sioner, 223 F.3d 642, 645-46 (7th Cir. 2000); Fruit of the Loom, Inc. v. Commissioner, 72 F.3d 1338, 1343 (7th Cir. 1996). However, deficiencies determined by the Commissioner are presumed to be correct and the taxpayer bears the burden of proving otherwise. Pittman v. Commissioner, 100 F.3d 1308, 1313 (7th Cir. 1997).
A.
The first issue we address is whether the Tax Court erred when it refused to treat the two no-liability letters from the IRS (pertaining to the 1993 and 1994 tax years, respectively) as binding admissions. The Reynolds claim that these two documents are “uncontroverted binding admissions of no deficiency,” thus mandating a judgment in their favor. However, the cases relied upon by the Reynolds in this regard all deal with “judicial admissions,” which enter the litigation either through the pleadings or under Rule 36 of the Federal Rules of Civil Procedure. See, e.g., Kohler v. Leslie Hindman, Inc., 80 F.3d 1181, 1185 (7th Cir. 1996) (“When a party in a lawsuit makes an admission in its pleadings or in its answer to a request for admissions, it makes a judicial admission that can determine the outcome of that lawsuit.” (citing
Although a judicial admission has the effect of settling an issue of fact for the purposes of the current litigation, nothing of that exalted significance is present here. The alleged admissions in this case were not furnished by the IRS as part of the record before the Tax Court. In fact, the
The story unfolds as follows. The Tax Court scheduled the matter before us now for a trial to commence on March 2, 1998. On the day of trial, the district counsel for the IRS learned that the Reynolds had been subject to a premature deficiency assessment for the 1993 and 1994 tax years and motioned the Tax Court to return the case to its general trial docket. According to the court transcript for that date, the parties appeared to be close to settlement. The Reynolds offered no objection to the government‘s motion, and a continuance was granted. Shortly thereafter, the Reynolds apparently sent an inquiry to the IRS problem resolution office in Kansas City, Missouri. On April 13, 1998, that office generated the two no-liability letters, which respectively credited the Reynolds’ 1993 and 1994 tax years in the exact amount at issue before the Tax Court. Both of these very short letters contained the following sentence: “This [action] is the result of your correspondence of March 18, 1998.” However, a copy of the March 18, 1998 letter is not part of the record, presumably because it was sent to the IRS problem resolution office in Kansas City. If the Reynolds wanted the IRS to stipulate or to admit that the couple owed no taxes for 1993 and 1994, they should have directed their correspondence to the district counsel for the IRS, who was based in Chicago and apparently was well known to the Reynolds through previous settlement negotiations and court appearances. The Reynolds cannot obtain a judicial admission on the cheap.
At most, the two no-liability letters are extrajudicial admissions, which are admissible as evidence and may be weighed by the factfinder according to their probative value. See Murrey v. United States, 73 F.3d 1448, 1455 (7th Cir. 1996) (distinguishing between a “judicial admission” and an “extrajudicial admission“); Keller, 58 F.3d at 1199 n.8 (distinguishing between “judicial admission” and other ad-
Further, the settlement or closure of a civil tax dispute with the IRS is a matter controlled by statute. See
The next issue before us is whether the Tax Court erred when it ruled that legal defense costs incurred by Charles Reynolds during the 1993 and 1994 tax years were miscellaneous itemized deductions, which are subject to the 2% floor contained in
The Reynolds’ primary argument is that Charles Reynolds’ ability to practice law on a part-time basis had to be approved through appropriate IRS channels. Thus, an adverse ruling could have led to the withdrawal of this approval and thus terminated his practice of law. The Reynolds also claim that an adverse ruling would have negatively affected Charles Reynolds’ legal reputation, which would have caused him to lose law-related business. Following this logic, the Reynolds maintain that all of the legal defense costs for 1993 and 1994 ($5,615 and $2,380, respectively) were properly listed as Schedule C business expenses.
In response, the government correctly argues that this issue is governed by the “origin of the claim” doctrine, which was first articulated by the Supreme Court in United States v. Gilmore, 372 U.S. 39 (1963). In Gilmore, the taxpayer attempted to deduct substantial legal expenses incurred in protracted divorce litigation with his estranged wife as a “business” expense related to income-producing property rather than as a “personal” expense. The taxpayer justified his position by arguing that the divorce litigation involved the disposition of three car dealerships owned by the taxpayer. He contended that the conservation of
[T]he characterization, as “business” or “personal,” of the litigation costs of resisting a claim depends on whether or not the claim arises in connection with the taxpayer‘s profit-seeking activities. It does not depend on the consequences that might result to a taxpayer‘s income-producing property from a failure to defeat the claim, for . . . “that would carry us too far” and would not be compatible with the basic lines of expense deductibility drawn by Congress.
372 U.S. at 48 (emphasis in original) (footnote omitted) (quoting Lykes v. United States, 343 U.S. 118, 125 (1952)).
In the case before us, the origin of the claim lies in Charles Reynold‘s conduct as an IRS employee, not in his trade or business as a self-employed attorney. Charles Reynolds incurred these legal costs because an IRS investigation had been commenced to determine whether he was
C.
The Reynolds next assert that the Tax Court erred when it denied deductions for various automobile and travel expenses that were purportedly made in connection with the law practice, the rental properties or farming activity. The Tax Court ruled that none of the expenses at issue were deductible because the Reynolds had failed to satisfy the substantiation requirements of
Here, the Reynolds fall far short of the necessary showing. Based on the regulations under § 274(d), the Reynolds cannot avail themselves of the “adequate records” language of § 274(d) because they did not maintain logs for each vehicle in their household to reflect their use in the law practice, rental property management or farming activities. See
[A] taxpayer must substantiate each element of an expenditure or use . . . by [1] adequate records or [2] by sufficient evidence corroborating his own statement . . . . A contemporaneous log is not required, but a record of the elements of an expenditure or of a
business use of listed property made at or near the time of the expenditure or use, supported by sufficient documentary evidence, has a high degree of credibility not present with respect to a statement prepared subsequent thereto when generally there is a lack of accurate recall. Thus, the corroborative evidence required to support a statement not made at or near the time of the expenditure or use must have a high degree of probative value to elevate such statement or evidence to the level of credibility reflected by a record made at or near the time of the expenditure or use supported by sufficient documentary evidence. The substantiation requirements of section 274(d) are designed to encourage taxpayers to maintain the records, together with documentary evidence, as provided in paragraph (c)(2) of this section [entitled “Substantiation by adequate records“].
The implications of this passage are unmistakable. Complete, contemporaneous records are the preferred method of substantiation. Taxpayers who pursue alternative methods will have to present evidence that is equally credible and probative, which will be difficult.
When a taxpayer cannot substantiate his deduction with “adequate records,” the Treasury Regulations specifically lay out the method for substantiation “by other sufficient evidence.” A taxpayer must establish each element of a § 274(d) business expense “(A) By his own statement, whether written or oral, containing specific information in detail as to such element; and (B) By other corroborative evidence sufficient to establish such element.”
This alternate method was utilized by the Reynolds at trial. Specifically, Charles Reynolds testified as to the business purpose of each deduction and attempted to sub-
The Tax Court ultimately found this testimony and evidence unconvincing. For example, Charles Reynolds created a two-page chart entitled “Reconstruction of Mileages Driven,” which categorizes his 1993 auto expenses by month and profit-making activity (i.e., law practice, farm or rental properties). At the bottom of the chart, 3,715 miles were attributed to the “farm” for trips on April 22, June 13, July 28 and October 11. However, the only elaboration of the business purpose of the trips was the term “crops,” which appears next to the dates. Charles Reynolds’ testimony on his farming activities also undermined his case, since the Tax Court found it “vague, confusing, and evasive.” But perhaps the most damaging detail was an admission by Reynolds that no crops were grown on his farm during the 1993 tax year.
Expenses attributed to the rental properties suffered similar problems. For the 1993 tax year, the Reynolds attributed 3,646 miles and $995.30 in hotel bills to two trips to Virginia, where they own rental property. Yet, the only business explanation for this substantial deduction is the elliptical phrase “cleaning, leasing.” The corroborating evidence, in combination with Charles Reynolds’ testimony on the nature of these trips, simply does not have the “high degree of probative value” necessary to put it on a par with “adequate records” documentation.
Of the four corroborating summaries presented at trial, the 1993 chart is the most comprehensive breakdown. Unfortunately, it does not contain the type of specific detail mandated by the Treasury Regulations; all of the travel and car maintenance expenses are listed by month rather than by specific trip. See
The automobile and travel expenses for the Reynolds’ farming activities (Schedule F) and rental properties (Schedule E) clearly fail because of inadequate substantiation. See
According to Reynolds, the mileage attributed to his law practice resulted from travel between his home and a title company, where he handled several real estate closings for his clients. In general, commuting expenses between home and work are personal and therefore nondeductible. See Commissioner v. Flowers, 326 U.S. 465, 473-74 (1946); accord H B & R, Inc. v. United States, 229 F.3d 688, 690 (8th Cir. 2000) (”Flowers established the general rule that an employee‘s expenses in commuting from home to work are personal, not deductible business expenses.“);
The final issue on appeal is whether the Tax Court erred in upholding an accuracy-related penalty under
The term negligence includes any failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax return. “Negligence” also includes any failure by the taxpayer to keep adequate books and records or to substantiate items properly.
The Reynolds attempt to rebut the presumption of correctness by claiming that they have satisfied the “good faith” affirmative defense, which is also provided by statute. The relevant provision states that no penalty shall be imposed for underpayment of taxes if the taxpayer can demonstrate “that there was a reasonable cause for such portion and that the taxpayer acted in good faith with respect to such portion.”
The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all pertinent facts
and circumstances. The most important factor is the extent of the taxpayer‘s effort to assess the taxpayer‘s proper tax liability. Circumstances that may indicate reasonable cause and good faith include an honest misunderstanding of fact or law that is reasonable in light of the experience, knowledge and education of the taxpayer.
As evidence of good faith, the Reynolds argue that they classified their 1993 and 1994 using the CCH Master Tax Guide, which is a treatise containing annotations to relevant statutes, regulations and case law. Assuming arguendo that reliance on an established secondary source can be the basis of a § 6664(c) good-faith defense, the Reynolds fail to direct us to the specific passages of the CCH Master Tax Guide upon which they reasonably relied.
The Reynolds next assert that their 1994 tax return was prepared using a commercial software program called Turbo Tax, which they claim is a “tax preparer” and is subject to IRS penalties. See Rev. Rul. 85-187, 1985-2 C.B. 338 (stating that a firm “that furnishes a computerized tax return preparation service to tax practitioners is an income tax preparer when the program used goes beyond mere mechanical assistance“). This argument, however, goes nowhere. In order to demonstrate an “honest misunderstanding of fact or law” under
Finally, the Reynolds defend their failure to allocate their automobile expenses to Schedules C, E and F as the “considered judgment of a tax professional who recognized that absolutely NO tax impact flowed from the allocation itself.” The gist of the Reynolds’ argument is that no tax consequences flow from the apportionment of expenses between the Schedules since they all constitute “above-the line” deductions used to calculate adjusted gross income. Yet, the fact that all the claimed deductions were above-the-line obscures the more fundamental problem that a more precise allocation was not made because the Reynolds’ business records were not adequately organized and thorough. At trial, Charles Reynolds stated that “[a] more rigorous application of the allocation guidelines or the application of the mileage guidelines between Schedules C, Schedules E and Schedule F would have required a substantial amount of work, okay, in terms of . . . tying the receipts back to support the mileage in each of these items.” But without making these allocations, the required elements of substantiation under § 274(d) cannot be met. Because of his substantial education and experience in tax law and administration, we must impute basic knowledge of the elements of substantiation to Charles Reynolds. We therefore uphold the § 6662(a) accuracy-related penalties in their entirety.9
For the forgoing reasoning, the judgment of the Tax Court is AFFIRMED.
A true Copy:
Teste:
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Clerk of the United States Court of Appeals for the Seventh Circuit