T.C. Memo. 2019-36
UNITED STATES TAX COURT
AMES D. RAY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14052-16. Filed April 15, 2019.
J. Winston Krause, for petitioner.
Donald D. Priver and Brock E. Whalen, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
NEGA, Judge: Respondent determined a deficiency in petitioner’s Federal
income tax and an accuracy-related penalty under section 6662(a)1 for tax year
1 Unless otherwise indicated, all section references are to the Internal Revenue Code (Code) in effect for the year at issue, and Rule references are to the Tax Court Rules of Practice and Procedure. All monetary amounts are rounded to (continued...) -2-
[*2] 2014 (year at issue) of $53,988 and $9,883, respectively. The issues for
decision are whether petitioner is: (1) entitled to a deduction for legal expenses of
$267,224 and (2) liable for an accuracy-related penalty under section 6662(a).
FINDINGS OF FACT
Some of the facts are stipulated and are so found. The stipulation of facts
and the attached exhibits are incorporated herein by this reference. Petitioner
resided in Texas when the petition was filed.
I. Petitioner’s Background
At a time not established by the record petitioner began attending Michigan
State University (Michigan State) to pursue an advanced degree in physics.
During that time petitioner met and started dating Christina I. Ray (Ms. Ray), who
was also pursuing an advanced degree in physics at Michigan State. In 1972
petitioner married Ms. Ray. At a time not established by the record petitioner and
Ms. Ray opened joint credit card and bank accounts.
In 1976 petitioner and Ms. Ray moved to New York to begin their
respective careers. They rented a residence on East 87th Street, New York, NY
1 (...continued) the nearest dollar. -3-
[*3] (87th Street residence). Only Ms. Ray’s name was on the lease for the 87th
Street residence.
In 1977 petitioner and Ms. Ray divorced. Despite their divorce they
continued to live together at the 87th Street residence, continued to share bank
accounts, and did not divide their assets. After their divorce they kept track of
their joint expenses by way of a ledger system (ledger system).
In 1981 petitioner and Ms. Ray jointly purchased property in Sagaponack,
New York (Sagaponack property). Petitioner and Ms. Ray purchased that property
with the intent to build a vacation home on it. In 1984 petitioner sold his interest
in the Sagaponack property to Ms. Ray. Petitioner lent Ms. Ray the money so that
she could purchase his interest in the Sagaponack property (Sagaponack property
loan), and petitioner and Ms. Ray memorialized the Sagaponack property loan in
their ledger system.
In 1987 the 87th Street residence became a co-op. At a time not established
by the record Ms. Ray lent to petitioner money so that he could purchase shares of
the co-op. At a time not established by the record petitioner repaid Ms. Ray that
loan in the amount of $54,905. Thereafter, petitioner and Ms. Ray purchased
shares in that co-op; however, the shares were issued only in Ms. Ray’s name.
Despite that, petitioner and Ms. Ray memorialized their joint ownership of the -4-
[*4] 87th Street residence. In 1991 petitioner sold his interest in the 87th Street
residence to Ms. Ray. Petitioner and Ms. Ray memorialized Ms. Ray’s debt to
petitioner with respect to the 87th Street residence in their ledger system.
At a time not established by the record petitioner and Ms. Ray stopped
maintaining their joint bank accounts and using their ledger system and instead
memorialized their debts to one another through signed letters.
On November 25, 1991, Ms. Ray executed a note to petitioner in the amount
of $432,428. Of that amount, approximately $350,000 was allocated to Ms. Ray’s
purchase of petitioner’s interest in the Sagaponack property, with the remainder
allocated to Ms. Ray’s purchase of petitioner’s interest in the 87th Street
residence.
On November 25, 1991, Ms. Ray also executed a separate agreement with
petitioner in which she stated that she would be solely liable for, and agreed to pay
the outstanding balances due on, petitioner’s Discover Card, 1st Nationwide
account, Marine Midland account, Monogram Bank account, Bank of New York
account, and American Express TRS & Optima accounts as those balances were
the result of her spending.
In 1992 petitioner moved out of the 87th Street residence and moved to
Florida. -5-
[*5] On April 13, 1993, Ms. Ray executed a confession of judgment to petitioner
in the Supreme Court of New York, County of New York (confession of
judgment). That confession stated in pertinent part:
[D]efendant [Ms. Ray] hereby confesses judgment herein and authorizes entry thereof against defendant in the sum of $532,288.10. * * * This confession of judgment is for a debt justly due to the plaintiff [petitioner] arising from the following facts: Default on a promissory note dated November 25, 1991 in the principal amount of $432,427.67. I failed to pay the amount due notwithstanding due demand therefor. Of the total amount confessed to herein, $99,860.43 represents my share of credit card debt which plaintiff paid or will pay on my behalf, as well as legal and associated expenses incurred in connection with the enforcement of the note, and interest through March 22, 1993.
II. Ms. Ray’s Proposal and Trading Activities
In 1993 Ms. Ray approached petitioner with a plan for the two of them to
make money. Ms. Ray proposed using petitioner’s capital to trade commodities
futures and options using market theories and trading methods she had developed
and wished to develop further.2
2 Ms. Ray held herself out as an expert in options trading and risk management. In fact from 1977 through 1993 Ms. Ray worked as an officer for eight different employers that were involved in the securities industry in New York. Further, in 1992, Ms. Ray published a book on the topic, titled “The Bond Market: Trading and Risk Management”. -6-
[*6] After a series of proposals and counterproposals, petitioner agreed to
participate and settled the terms of the arrangement with Ms. Ray. On May 24,
1993, petitioner and Ms. Ray formalized the terms of their arrangement with
respect to Ms. Ray’s proposal in a written document (commodities account
agreement). That agreement allowed Ms. Ray the sole discretion to trade on
petitioner’s commodities account with his capital (petitioner’s account). In return
the agreement provided that petitioner had the right to publicize or advertise the
results of Ms. Ray’s trading. Notwithstanding the value of that advertising right
and his desire to help Ms. Ray develop her theories and methods, petitioner was
primarily motivated to enter the commodities account agreement because he
believed it would yield significant profits and returns on his investment.
On June 14, 1993, petitioner proposed an amendment to the commodities
account agreement that stated in pertinent part:
I agree to have you continue your trading for my account under the following condition: You’ll pay to me the amount of money that my account falls below $350M [i.e., $350,000]. Otherwise, trade my account to liquidate positions when my account’s value falls below $350M [i.e., $350,000].
On September 4, 1993, Ms. Ray agreed to that amendment. In the months
between the amendment proposal and agreement Ms. Ray stopped trading on -7-
[*7] petitioner’s account because the cash in the account was insufficient to allow
any further trades.
Ms. Ray did not manage anyone else’s funds when she was managing
petitioner’s account. At no time did petitioner ever trade on his own account.
On September 5, 1993, petitioner and Ms. Ray entered into an agreement
wherein Ms. Ray agreed to provide to petitioner notarized financial statements that
would detail her assets and liabilities as if she were applying for a bank loan,
including a statement of her net worth as of September 15 and March 15 of every
year until she paid in full the debts detailed in the confession of judgment. Ms.
Ray was to provide petitioner those statements on or before October 15 and April
15 of each respective year and would incur a $50-per-day penalty for failing to
timely submit those financial statements.
On August 10, 1994, Ms. Ray sent two signed letters to petitioner. The first
stated that, as of August 15, 1994, Ms. Ray owed petitioner $590,223, comprising
amounts related to her confession of judgment, failure to timely submit financials,
unpaid credit card debts, and associated interest (collectively, Ms. Ray’s
damages). The second letter stated that as of August 15, 1994, Ms. Ray would
owe petitioner $384,388, consisting of $348,715 for funds management losses and
$35,673 of interest (Ms. Ray’s funds management losses). In both letters Ms. Ray -8-
[*8] also stated that she would pay those respective amounts to petitioner before
June 1, 1999, plus additional interest.
III. Petitioner’s Lawsuits Against Ms. Ray and/or her Attorneys
A. Ray v. Ray Index No. 604381/98
On September 9, 1998, petitioner filed a lawsuit against Ms. Ray in the
Supreme Court of the State of New York, New York County (Supreme Court of
New York), Ray v. Ray, Index No. 604381/98 (Ray I). In his complaint petitioner
alleged, for our purposes, two causes of action arising from Ms. Ray’s failure to
pay petitioner any part of (1) Ms. Ray’s damages (i.e., those resulting from the
confession of judgment, late financials, and credit card debt) or (2) Ms. Ray’s
funds management losses. On January 11, 2008, the Supreme Court of New York
dismissed petitioner’s complaint in Ray I. On April 7, 2009, the Supreme Court of
New York, Appellate Division, overturned that dismissal. As of the time of trial in
this case, Ray I is still a pending case. During the year at issue petitioner spent
$77,724 on legal fees with respect to that case.
B. Ray v. Ray Index No. 652314/2010
On October 20, 2010, petitioner filed a lawsuit against Ms. Ray in the
Supreme Court of New York, Ray v. Ray Index no. 652314/2010 (Ray II). In his
complaint petitioner alleged that Ms. Ray owed him at least $970,000 for Ms. -9-
[*9] Ray’s damages and Ms. Ray’s funds management losses and that Ms. Ray
fraudulently conveyed her property to avoid paying petitioner on those debts. On
July 12, 2011, the Supreme Court of New York dismissed petitioner’s complaint
in Ray II. On July 9, 2013, the Supreme Court of New York, Appellate Division,
First Department, affirmed that decision.3
C. Ray v. Ray, Et Al. Index No. 153945/2014
On April 24, 2014, petitioner filed a lawsuit against Ms. Ray and
Guarnerius Management, LLC (Guarnerius), in the Supreme Court of New York,
Ray v. Ray, Et Al. Index No. 153945/2014 (Ray III). In his complaint, petitioner
alleged that Ms. Ray fraudulently conveyed her property because she obtained a
mortgage on her property of approximately $500,000, used $80,000 of that amount
to pay her former legal counsel, and transferred the remaining $420,000 to
Guarnerius, her own company, all in an attempt to avoid paying the amounts she
owed to petitioner. On December 22, 2014, the Supreme Court of New York
dismissed petitioner’s complaint in Ray III.
During the year at issue petitioner spent $151,500 on legal fees with respect
to that case.
3 The record before us does not establish, nor do the parties contend, that petitioner spent any legal fees with respect to Ray II during the year at issue. - 10 -
[*10] D. Petitioner’s Suit Pursuant to Section 487 of the New York Judiciary Law
In 2012 Ms. Ray hired counsel to represent her in the continuing New York
State court proceedings in Ray I. On January 22, 2016, petitioner filed a
complaint in the U.S. District Court for the Southern District of New York,
alleging that Ms. Ray’s counsel had violated N.Y. Jud. Law sec. 487(1)
(McKinney 2016) (New York 487 complaint). In that complaint petitioner alleged
that Ms. Ray’s attorneys made or consented to the making of a series of deceitful
statements and representations intended to deceive the Supreme Court of New
York and Supreme Court of New York, Appellate Division, in order to obtain an
advantage in litigating the issue of Ms. Ray’s damages.
On April 26, 2016, the U.S. District Court issued an order and decision
dismissing that complaint. Petitioner appealed that decision to the U.S. Court of
Appeals for the Second Circuit. On April 14, 2017, the Court of Appeals affirmed
the order of dismissal.
Although petitioner did not file this lawsuit until 2016, the record
establishes that petitioner paid $38,000 of legal fees with respect to this case
during the year at issue. - 11 -
[*11] IV. Petitioner’s 2014 Return and Notice of Deficiency
Petitioner filed a Form 1040, U.S. Individual Income Tax Return for the
year at issue (2014 return). On line 21 of that form petitioner reported as “Other
income” “legal fees, costs” of “(238,937)”. The parties have stipulated, however,
that petitioner paid $267,224 in legal fees for the year at issue.
Respondent selected petitioner’s 2014 return for examination. The revenue
agent tasked with examining petitioner’s 2014 return determined that petitioner
(1) was not entitled to a deduction for legal fees and (2) was liable for an
accuracy-related penalty under section 6662(a). On September 23, 2015, the
immediate supervisor of that revenue agent approved the revenue agent’s initial
determination to impose the accuracy-related penalty in this case. Subsequently,
on March 16, 2016, respondent issued a notice of deficiency to petitioner,
reflecting the revenue agent’s deficiency and penalty determinations with respect
petitioner’s tax year at issue. Petitioner timely filed a petition for redetermination
with this Court. - 12 -
[*12] OPINION
I. Deductions Generally
Deductions are a matter of legislative grace, and a taxpayer must prove his
or her entitlement to a deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79,
84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). To that
end, taxpayers are required to substantiate each claimed deduction by maintaining
records sufficient to establish the amount of the expense underlying the deduction
and to enable the Commissioner to determine the correct tax liability. Sec. 6001;
Higbee v. Commissioner, 116 T.C. at 438, 440 (2001).
Generally, if a taxpayer establishes that he or she paid or incurred a
deductible expense but fails to establish the amount of the deduction, the Court
may estimate the amount allowable as a deduction. Cohan v. Commissioner, 39
F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742-
743 (1985). This principle is often referred to as the Cohan rule. See, e.g., Estate
of Reinke v. Commissioner, 46 F.3d 760, 764 (8th Cir. 1995), aff’g T.C. Memo.
1993-197. When the Court applies the Cohan rule, the taxpayer must introduce
sufficient evidence to permit us to conclude that the taxpayer paid or incurred a
deductible expense in at least the amount allowed. See Williams v. United States,
245 F.2d 559, 560 (5th Cir. 1957); Vanicek v. Commissioner, 85 T.C. at 742-743. - 13 -
[*13] In estimating amounts allowable pursuant to the Cohan rule, we bear heavily
upon the taxpayer who failed to maintain the required records and to substantiate
deductions as the Code requires. See Cohan v. Commissioner, 39 F.2d at 544.
II. Burden of Proof
The Commissioner’s determinations in a notice of deficiency are generally
presumed correct, and the taxpayer ordinarily bears the burden of proving those
determinations erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933). In order for the Court to shift the burden as to any factual issues relevant
to ascertaining the taxpayer’s tax liability, the taxpayer must introduce credible
evidence with respect to the issues and have complied with all substantiation and
recordkeeping requirements imposed by the Code. Sec. 7491(a)(1) and (2).
Credible evidence is that which the Court would find sufficient upon which to
base its decision if no contrary evidence were submitted. Higbee v.
Commissioner, 116 T.C. at 442. A taxpayer who provides only uncorroborated
testimony and inconclusive documentation does not provide credible evidence. Id.
at 445-446. We decide this case, however, on the preponderance of credible
evidence, and not on any failure to carry the burden of proof. Therefore, we need
not decide whether petitioner satisfied the requirements of section 7491(a).
Knudsen v. Commissioner, 131 T.C. 185, 189 (2008). - 14 -
[*14] III. Section 162(a): Business Expense Deduction
Section 162(a) allows a taxpayer to deduct all ordinary and necessary
expenses paid or incurred during the year in carrying on a trade or business. An
ordinary expense is one that occurs commonly or frequently in the taxpayer’s
business, Deputy v. du Pont, 308 U.S. 488, 495 (1940), and a necessary expense is
one that is appropriate in carrying on the taxpayer’s business, Welch v. Helvering,
290 U.S. at 113. The expense must directly connect with or pertain to the
taxpayer’s business. Sec. 1.162-1(a), Income Tax Regs. A taxpayer may not
deduct personal, living, or family expenses unless the Code expressly provides
otherwise. Sec. 262(a).
Legal expenses are deductible under section 162(a) as ordinary and
necessary business expenses, but only if the expense is directly connected with, or
proximately related to, the taxpayer’s business. Bingham Tr. v. Commissioner,
325 U.S. 365, 373-374 (1945); Rafter v. Commissioner, 60 T.C. 1, 8 (1973), aff’d
without published opinion, 489 F.2d 752 (2d Cir. 1974). In this sense the
deductibility of legal fees depends on the origin and character of the claim for
which the expenses were incurred and whether the claim bears a sufficient nexus
to the taxpayer’s business or income-producing activities. See United States v. - 15 -
[*15] Gilmore, 372 U.S. 39 (1963); see also Test v. Commissioner, T.C. Memo.
2000-362, slip op. at 8-14, aff’d, 49 F. App’x 96 (9th Cir. 2002).
Petitioner contends that he is entitled to a deduction of $267,224 under
section 162(a) with respect to legal expenses related to Ms. Ray’s damages and
Ms. Ray’s funds management losses because petitioner was engaged in the
computer programming business and those legal expenses originated from his
conduct of that business in 1993. Conversely, respondent contends that petitioner
is not entitled to that deduction because: (1) the origin of petitioner’s claim with
respect to Ms. Ray’s damages is not related to a trade or business and
(2) petitioner was not engaged in a trade or business relating to Ms. Ray’s funds
management losses. Should we find that a portion of petitioner’s legal expenses
relates to Ms. Ray’s funds management losses and hold that those expenses are
deductible under section 212, respondent urges the Court to take full account of
petitioner’s failure to establish what portion of his legal expenses was deductible
under section 212.
A. Legal Expenses Related to Ms. Ray’s Damages
We first turn to whether petitioner is entitled to a deduction under section
162(a) with respect to the legal expenses related to Ms. Ray’s damages. - 16 -
[*16] As we stated above, the deductibility of legal fees depends on the origin and
character of the claim for which the expenses were incurred and whether the claim
bears a sufficient nexus to the taxpayer’s business or income-producing activities.
See Gilmore, 372 U.S. 39; see also Test v. Commissioner, slip op. at 8-14.
Petitioner contends that he is entitled to a deduction under section 162(a) with
respect to legal expenses related to Ms. Ray’s damages because he was engaged in
a computer programming business with Ms. Ray (purported business) and that the
legal expenses related to the claims underlying Ray I find their origin in that
business. Respondent, however, contends that the origin and character of those
claims lack a sufficient nexus to the purported business or any other income-
producing activity.
Ms. Ray’s damages (i.e., those resulting from the confession of judgment,
late financials, and credit card debt) are the subject of petitioner’s first cause of
action against Ms. Ray, in Ray I. With respect to the portion of that first cause of
action related to the confession of judgment, petitioner alleged that Ms. Ray failed
to pay him for money that she owed him related to the Sagaponack property, the
87th Street residence, and outstanding credit card debt before they executed the
commodities account agreement. The facts relating to the Sagaponack property
and the 87th Street residence lack any nexus to petitioner’s purported business. - 17 -
[*17] With respect to the credit card debt, there is nothing in the record to support
petitioner’s contention that debt related to the purported business. Further, we
find that certain material aspects of petitioner’s testimony with respect to these
issues went uncorroborated and lacked credibility. Accordingly, we decline to
rely on petitioner’s testimony to establish his position that he is entitled to a
deduction under section 162(a) with respect to the legal expenses related to Ms.
Ray’s damages for credit card debt. See, e.g., Tokarski v. Commissioner, 87 T.C.
74, 77 (1986).
With respect to the portion of that first cause of action related to damages
for late financials, the record lacks any credible evidence that those damages
related to or otherwise originated from the purported business. Petitioner contends
that the portion of Ms. Ray’s damages for late financials related to the purported
business because the agreement dated September 5, 1993, that gave rise to those
damages occurred “shortly after the recent losses from testing the trading program
which significantly increased the debt * * * [Ms.] Ray owed [p]etitioner.”
However, the fact that the parties executed the agreement shortly after “recent
losses from testing the trading program” does not override the explicit text of that
agreement, which stated in pertinent part: “The Statements will be of my net - 18 -
[*18] worth as of each September 15 and March 15 until the debt as reflected in
my Confession of Judgment sworn to April 13, 1993 (‘the Debt’) is paid in full.”
The explicit text of that agreement only contemplates the confession of
judgment and, as discussed above, lacks any nexus to the purported business.
Accordingly, we find petitioner’s contention to be without merit.
Ms. Ray’s damages also serve as the origin of the claim underlying
petitioner’s New York 487 complaint. The additional context, there, does not alter
our assessment of the relevant facts: The record does not support a finding of any
nexus between Ms. Ray’s damages and the purported business.
On the record before us, we find that none of the claims giving rise to Ms.
Ray’s damages underlying the first cause of action in Ray I bear a sufficient
relation to petitioner’s purported business. We find similarly with respect to
petitioner’s New York 487 complaint. Accordingly, petitioner is not entitled to a
deduction under section 162(a) with respect to the legal expenses related to Ms.
Ray’s damages. - 19 -
[*19] B. Legal Expenses Related to Ms. Ray’s Funds Management Losses
We next turn to whether petitioner is entitled to a deduction under section
162(a) with respect to the legal expenses related to Ms. Ray’s funds management
losses.
As we stated above, section 162(a) allows a taxpayer to deduct all ordinary
and necessary expenses paid or incurred during the year in carrying on a trade or
business. To be engaged in a trade or business the taxpayer must participate in the
activity with continuity and regularity, and his primary purpose for engaging in the
activity must be for income or profit. Commissioner v. Groetzinger, 480 U.S. 23,
35 (1987). To prove continuity and regularity the taxpayer generally must show
“extensive business activity over a substantial period as opposed to a onetime
venture or investment.” Jafarpour v. Commissioner, T.C. Memo. 2012-165, slip
op. at 15. The management of one’s investments, no matter how extensive, is not
a “trade or business.” Whipple v. Commissioner, 373 U.S. 193, 200 (1963); see
also Beals v. Commissioner, T.C. Memo. 1987-171.
Ms. Ray’s funds management losses are the subject of petitioner’s second
cause of action against Ms. Ray in Ray I. Petitioner contends that he is entitled to
a deduction under section 162(a) with respect to legal expenses related to Ms.
Ray’s funds management losses because he was engaged in a computer - 20 -
[*20] programming business. In support of his position he claims that his history
of creating computer programs for Wall Street shows that he was engaged in the
computer programming business with respect to the purported business because:
(1) he collected a multimillion dollar settlement with respect to one of his prior
Wall Street computer programs, (2) he used a portion of that money to
“collaborate with * * * [Ms.] Ray to develop * * * a trading program”, and
(3) “the fact that he immediately put a portion of his business profit at risk [from
his multimillion dollar settlement] to continue developing programs for Wall
Street show[ed] he was ‘involved in the activity with continuity and regularity.’”
Respondent, however, contends that petitioner is not entitled to that deduction
because he was not engaged in a trade or business. We agree with respondent.
The facts establish that the purported business was in actuality Ms. Ray’s
management of a hedge fund and that petitioner’s involvement in her management
of that fund extended no further than his initial investment. See Whipple v.
Commissioner, 373 U.S. at 200; Beals v. Commissioner, T.C. Memo. 1987-171.
The following facts support such a conclusion. In 1993 Ms. Ray approached
petitioner with a plan to make money. Ms. Ray’s plan proposed using petitioner’s
capital to trade commodities futures and options to test the market theories and
trading methods that she had developed. On May 24, 1993, petitioner and Ms. - 21 -
[*21] Ray executed the commodities account agreement allowing Ms. Ray the sole
discretion to trade on petitioner’s commodities account. At no time did petitioner
ever trade on his account. After a few months, Ms. Ray stopped trading on
petitioner’s account because there was too little cash in the account to allow any
further trades.
On the record before us, we find that the purported business did not
constitute, and petitioner was not engaged in, a computer programming trade or
business.4 Accordingly, petitioner is not entitled to a deduction under section
162(a) with respect to the legal expenses related to Ms. Ray’s funds management
IV. Section 212: Expenses for Production of Income
Since we have found that petitioner is not entitled to a deduction under
section 162(a) with respect to legal expenses for Ms. Ray’s damages and Ms.
4 To this extent, we also find that petitioner was not engaged in trade or business because the record does not establish that he participated in the purported business with continuity and regularity. See Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987); Jafarpour v. Commissioner, T.C. Memo. 2012-165, slip op. at 15-18. The mere fact that petitioner had earned income from working in the computing programming industry and then invested that money in another venture does not mean that the latter venture (i.e., the purported business) is automatically a computer programming business. Nor do such actions indicate that the purported business is a continuation of petitioner’s former work as a computer programming professional. - 22 -
[*22] Ray’s funds management losses, we must determine whether petitioner is
entitled to a deduction under section 212 for any portion of that amount.
Section 212 allows an individual to deduct all of the ordinary and necessary
expenses paid or incurred: (1) for the production of income; (2) for management,
conservation, or maintenance of property held for the production of income; or
(3) in connection with the determination, collection, or refund of a tax.5
As we found above, petitioner was not engaged in a trade or business with
respect to the purported business. We do find, however, that petitioner engaged in
that purported business with the intent of generating a profit. See Johnson v.
Commissioner, 72 T.C. 340, 347 (1979); see also Commissioner v. Groetzinger,
480 U.S. at 35. Accordingly, a portion of the legal expenses related to Ms. Ray’s
funds management losses may be deductible under section 212. Since petitioner,
5 We note that in his answering brief petitioner cites portions of respondent’s opening brief as well as the fact that the commodities account agreement provided to him the ability to “advertise the results of * * * [Ms. Ray’s] trading in * * * [his] account”, as support for the proposition that petitioner’s purported business must be for income or profit. We agree, but the determination of whether a taxpayer is engaged in a trade or business is not based solely on whether that taxpayer had a profit-seeking motive. See Commissioner v. Groetzinger, 480 U.S. at 35. Petitioner’s contentions are relevant, however, because under sec. 212(1), individuals may deduct all ordinary and necessary expenses paid or incurred during the tax year for the production or collection of income. Our analysis is similar to that used for sec. 162(a), the difference being that the profit-seeking or income-producing activity need not amount to a trade or business. Johnson v. Commissioner, 72 T.C. 340, 347 (1979). - 23 -
[*23] however, did not establish the amount of those losses with respect to section
212, we will apply the Cohan rule. In Ray I petitioner had two causes of action
and sought damages as follows: approximately $590,223 with respect to the first
cause of action stemming from Ms. Ray’s damages and approximately $384,388
with respect to the second cause of action stemming from Ms. Ray’s funds
management losses. Because we find that only the second cause of action related
to the production of income under section 212(1), our application of the Cohan
rule allows petitioner to deduct the corresponding percentage of legal expenses
(i.e., $384,388/974,611 or approximately 39.5%) with respect to those incurred in
Ray I. We apply the same rationale and ratio with respect to the legal expenses
incurred in Ray III. Accordingly, petitioner is entitled to deduct 39.5% of the
legal expenses paid with respect to Ray I and Ray III for the year at issue.
V. Section 6662(a): Accuracy-Related Penalty
Section 6662(a) and (b)(1) and (2) imposes an accuracy-related penalty on
any portion of an underpayment of tax that is attributable to the taxpayer’s
“negligence or disregard of rules or regulations” or “substantial understatement of
income tax”. Negligence occurs when the taxpayer fails to make a reasonable
attempt to comply with the provisions of the Code, while disregard of the rules or
regulations means any careless, reckless, or intentional disregard thereof. Sec. - 24 -
[*24] 6662(c); sec. 1.6662-3(b), Income Tax Regs. An understatement of income
tax is substantial if the amount of the understatement for the taxable year exceeds
the greater of 10% of the tax required to be shown on the return or $5,000. Sec.
6662(d)(1)(A).
The Commissioner bears the burden of production with respect to the
accuracy-related penalty under section 6662 and must produce sufficient evidence
to establish that it is appropriate to impose such a penalty. Sec. 7491(c); Higbee v.
Commissioner, 116 T.C. at 446. In order to do so the Commissioner must offer
into the record evidence of his compliance with the written supervisory approval
requirement of section 6751(b)(1). Graev v. Commissioner, 149 T.C. 485, 493
(2017), supplementing and overruling in part 147 T.C. 460 (2016). On the record
before us we find that the Commissioner has met this aspect of his burden of
production.6 Accordingly, if the Rule 155 computations confirm a
6 On November 30, 2016, the Court issued its Opinion in Graev v. Commissioner (Graev II), 147 T.C. 460 (2016), holding that the Commissioner was required to comply with the written supervisory approval requirement of sec. 6751(b)(1) before the actual assessment of applicable penalties. The record in this case was initially closed on June 28, 2017, and briefing was completed on October 26, 2017. At the close of the record and through the completion of briefing, Graev II was controlling in this case. See Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff’d, 445 F.2d 985 (10th Cir. 1971). Accordingly, the parties did not attempt to introduce evidence with respect to, or brief the Court on the applicability of, sec. 6751(b)(1). (continued...) - 25 -
[*25] substantial understatement for the taxable year at issue, then respondent has
6 (...continued) On December 20, 2017, this Court released Graev v. Commissioner (Graev III), 149 T.C. 485 (2017), supplementing and overruling in part 147 T.C. 460 (2016). In Graev III, 149 T.C. at 493, as pertinent here, this Court reconsidered its position in Graev II and held that establishing compliance with the written supervisory approval requirement of sec. 6751(b)(1) was part of the Commissioner’s burden of production with respect to penalties in a deficiency case. On February 13, 2018, respondent filed a motion to reopen the record (respondent’s motion) that offered an additional exhibit for the purpose of establishing the Commissioner’s compliance with the requirements of sec. 6751(b)(1) (respondent’s exhibit). That motion’s exhibit comprised a case history report related to the examination that gave rise to this case and a foundational declaration prepared by the immediate supervisor of the revenue agent who administered that examination (revenue agent’s supervisor). Subsequently, we afforded petitioner the opportunity to object to respondent’s motion and to engage in additional discovery. Petitioner objected to respondent’s motion and advanced an argument that questioned the credibility of respondent’s exhibit (petitioner’s credibility argument) but declined to engage in further discovery. On October 16, 2018, this Court issued an order that granted respondent’s motion and reopened the record for the purpose of admitting respondent’s exhibit into evidence. In that same order we also afforded the parties the opportunity to file a supplemental brief with the Court for the limited purpose of advancing any factual or legal argument with respect to the requirements of sec. 6751(b)(1). Petitioner supplemented his brief and there argued that respondent’s exhibit failed to establish that the revenue agent’s supervisor adequately considered the merits of the accuracy-related penalty, as applied to this case, before deciding to approve that penalty’s imposition (petitioner’s merit argument). We are unpersuaded by petitioner’s credibility argument, especially in the light of petitioner’s decision not to engage in additional discovery with respect to that issue. Further, we are unmoved by petitioner’s merit argument as it invites the Court to contravene the rule stated by this Court in Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324 (1974), and we decline to do so. See Raifman v. Commissioner, T.C. Memo. 2018-101, at *61 n.46 (citing Lorillard v. Pons, 434 U.S. 575, 580 (1978)). - 26 -
[*26] met his burden of producing evidence that the penalty is justified. See sec.
7491(c). Further, we observe that petitioner claimed a deduction under section
162(a) with respect to legal expenses related to Ms. Ray’s damages despite being
aware of the fact that those were not related to the purported business. For that
reason, respondent has also met his burden of production with respect to, and we
find that petitioner’s underpayment of tax was also attributable to, negligence.
The accuracy-related penalty under section 6662(a) does not apply to any
portion of an underpayment if it is shown that there was reasonable cause for, and
that the taxpayer acted in good faith with respect to, such portion. Sec.
6664(c)(1). The determination of whether the taxpayer acted with reasonable
cause and in good faith depends on all the pertinent facts and circumstances,
including the taxpayer’s efforts to assess the taxpayer’s proper tax liability, the
knowledge and experience of the taxpayer, and the reliance on the advice of a
professional, such as an accountant. See sec. 1.6664-4(b)(1), Income Tax Regs.
It is petitioner’s position is that he is not liable for the accuracy-related
penalty for the year at issue because he had reasonable cause and acted in good
faith with respect to his return position. In support petitioner claims that he relied
on a stipulated decision for a different tax year when he evaluated the facts
underlying his return position for the year at issue. Petitioner claims that this - 27 -
[*27] reliance is reasonable. Alternatively, petitioner contends that his return
position was reasonable because he made a mistake as to applicable law.
Petitioner’s contention in this respect draws on respondent’s position with respect
to his eligibility for a section 212 deduction, arguing that respondent’s position
illustrates that he could have “easily been confused about which Code section was
more appropriate * * * [concluding] the reasonable cause here is [p]etitioner’s
mistake as to the law.” We will address each of petitioner’s arguments in turn.
We turn to petitioner’s argument with respect to a stipulated decision for a
different tax year. That document does not state or give rise to an inference that
petitioner was involved in a computer programming business as he claims here.
At best the stipulation might support the drawing of an inference, albeit an
incorrect one, that petitioner engaged in a commodities futures trading business
during that year and was therefore entitled to a section 162(a) deduction for
associated expenses in that year. But petitioner did not argue that he engaged in
such a line of business during the year at issue. Instead, he repeatedly argued that
the purported business was a computer programming business. Accordingly, we
do not understand how, especially when factoring in his high level of education,
petitioner believes that a stipulated decision supports the position he took on his
return and subsequently before this Court. On the record before us, we find that - 28 -
[*28] petitioner’s reliance on a stipulated decision for a different tax year as
support for the position he took on his return does not constitute reasonable cause.
We next to turn to petitioner’s mistake-of-law theory of reasonable cause.
Since filing his petition, petitioner has argued that he is entitled to a deduction
under section 162(a), which, as we noted above, hinges upon whether a taxpayer
was engaged in a trade or business. At no time, including in his posttrial briefs,
did petitioner concede that he was not engaged in a trade or business or even argue
in the alternative that he may only be entitled to a section 212 deduction. Instead,
petitioner’s mistake-of-law theory relies solely on the reality that this Court’s
analysis under section 212, to an extent, bears a similarity to our analysis under
section 162(a), the difference being that the profit-seeking or income-producing
activity need not amount to a trade or business. See Johnson v. Commissioner, 72
T.C. at 347. This, however, does not support the proposition that petitioner’s
return position for the year at issue was based on an honest mistake as to the law.
Accordingly, we find that petitioner has failed to demonstrate such a mistake.
On the record before us, we find that petitioner has failed to carry his
burden of establishing that there was reasonable cause for, and that he acted in
good faith with respect to, the underpayment for the year at issue. On that record
we find that if Rule 155 computations confirm a substantial understatement of - 29 -
[*29] income tax, petitioner has failed to carry his burden of establishing that he is
not liable for the accuracy-related penalty, because his underpayment is
attributable to both negligence and a substantial understatement of income tax
under section 6662(a) and (b)(1) and (2).
We have considered all the other arguments of the parties, and to the extent
not discussed above, find those arguments to be irrelevant, moot, or without merit.
To reflect the foregoing,
Decision will be entered under
Rule 155.