T.C. Memo. 2020-48
UNITED STATES TAX COURT
HENRY C. WILLIAMS AND SONJA L. JOHNSON, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 22528-14, 8947-15, Filed April 16, 2020. 23676-16.
Joseph M. Bray, Sandeep Singh, and Clifford A. Capdevielle, for
petitioners.
Jeffery D. Rice and Janice B. Geier, for respondent. -2-
[*2] MEMORANDUM FINDINGS OF FACT AND OPINION
VASQUEZ, Judge: In these consolidated cases respondent determined
deficiencies in petitioners’ Federal income tax and section 6662(a)1 accuracy-
related penalties as follows:
Penalty Year Deficiency sec. 6662(a)
2010 $62,050 $12,410 2011 29,583 --- 2013 142,004 28,401 2014 166,778 33,356
1 All section references are to the Internal Revenue Code in effect for the years at issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. -3-
[*3] After concessions,2 the issues for decision are whether petitioners:
(1) failed to report $5,936 of short-term capital gain income for 2014, (2) are
entitled to deductions claimed on Schedules C, Profit or Loss From Business, for
the years at issue, and (3) are liable for the 10% additional tax on early
distributions from qualified retirement plans for 2010 and 2011.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. We incorporate
the first stipulation of facts, first supplemental stipulation of facts, and
2 These cases were tried in San Francisco, California. A substantial amount of trial time pertained to respondent’s disallowance of petitioners’ rental real estate losses for the years at issue. Respondent has since conceded that petitioners are entitled to deduct $47,944, $49,994, $66,411, and $74,270 as nonpassive losses for 2010, 2011, 2013, and 2014, respectively. Respondent’s concession for 2010 is $50 less than the amount disallowed in the deficiency notice. Because this discrepancy is not addressed in respondent’s simultaneous opening brief, we conclude this is an error and that respondent concedes $47,994 for 2010. Respondent also concedes on brief that petitioners: (i) did not have unreported capital gain income for 2013, (ii) did not fail to report short-term capital gain income of $63,566, (iii) did not fail to report $131 of taxable qualified dividends for 2010 and $10 of taxable interest from the State of California for 2011, and (iv) are not liable for sec. 6662(a) accuracy-related penalties for 2010, 2013, and 2014. Petitioners concede that they received taxable retirement income of $71,625 and $42,858 in 2010 and 2011, respectively. For some of the issues that remain in dispute, the parties have made partial concessions, which we address in the body of this opinion. Other adjustments are computational and will be resolved under Rule 155. -4-
[*4] accompanying exhibits by this reference. Petitioners resided in California
when they timely filed their petitions.
Petitioner Husband’s Background
Petitioner husband started working for Washington Mutual Insurance Co.
(Washington Mutual) in 2003. As regional manager he oversaw the sales of
insurance and commercial banking products. In 2008 Washington Mutual merged
into J.P. Morgan Chase Bank (J.P. Morgan), which retained petitioner husband as
part of a transition team to integrate the two businesses. J.P. Morgan relieved
petitioner husband of his responsibilities in January 2010. Although his official
termination date was June 2010, petitioner husband did not perform services for
J.P. Morgan after January 2010.
GSE Financial
In 2007 petitioner husband formed GSE Financial (GSE) as a sole
proprietorship. Petitioner husband intended for GSE to operate as a holding
company for insurance businesses he hoped to acquire. In 2010 petitioner
husband’s sole focus with respect to GSE was expansion. Petitioner husband
spent his GSE-related time pursuing deals with several potential targets. In late
December 2010 petitioner husband purchased an interest in one of those targets,
insurance brokerage firm Bernall & Jones. Thereafter, beginning in January 2011, -5-
[*5] GSE provided business development, marketing, and other support to the
newly acquired firm.
In 2010, 2011, and 2013 GSE engaged law firms Donahue, Gallagher &
Woods and Michelman & Robinson. These firms provided legal advice and
counsel pertaining to licensing, State insurance requirements, acquisitions, and
business planning.
GSE leased office space in Oakland, California, during the years at issue.
During 2014 petitioner husband paid $677 for that office space.
In 2013 petitioner husband paid $4,465 for GSE-related taxes and licensing
fees, postage, bank charges, printing, telephone, and internet. Petitioner husband
also paid $390 for supplies used in connection with his GSE-related activities. In
2014 petitioner husband paid $289 for GSE-related online marketing efforts.
Petitioners reported GSE’s expenses on Schedules C for 2010 and 2011.
For 2013 and 2014 they reported GSE’s expenses on Schedules C2. GSE’s
reported expenses are summarized below: -6-
[*6] Expense 2010 2011 2013 2014 Meals and entertainment $1,531 $1,161 $563 $346 Rent/lease--Other business property 4,140 7,500 533 --- Depreciation 1,600 --- 33,875 --- Other 1,707 5,262 4,945 --- Car and truck 3,600 5,327 5,506 --- Legal and professional 12,204 1,000 850 --- Travel 14,785 8,489 3,465 401 Supplies --- --- 390 --- Interest --- --- 4,532 --- Office --- --- --- 677 Advertising --- --- --- 289
In the notices of deficiency respondent disallowed some of the above-listed
deductions for 2011 and all of the deductions for 2010, 2013, and 2014. We set
forth infra p. 24 the specific deductions (or portions thereof) that respondent
disallowed for 2011.
BJW Insurance LLC
Founded by Rob Jones and Chris Bernall in 1992, Bernall & Jones was a
surplus line commercial insurance brokerage firm that provided commercial
property liability, general liability, errors and omissions, and other commercial
lines of insurance. Petitioner husband was interested in acquiring the firm because -7-
[*7] it had an established staff capable of handling its daily operation. Bernall &
Jones’ staff had extensive knowledge of the customer base, the accounts, and other
aspects of the business.
Petitioner husband paid $320,000 for an ownership interest in Bernall &
Jones in late December 2010. After the sale Bernall & Jones was renamed BJW
Insurance LLC (BJW). Mr. Jones and Mr. Bernall remained partners in the firm
during the 2011 tax year. In 2012 petitioner husband became the sole owner of
BJW, which continued to operate as a single-member limited liability company.
During 2013 and 2014 BJW employed as its office manager Kendra
Thompson, who assisted existing customers and handled office duties including
sales, billing, accounting, and all portfolio work for the company. In 2013 BJW
also employed Gregory Wessel, who assisted customers and solicited sales. The
following year BJW employed Michael Johnson, who assisted Ms. Thompson with
customer relations, marketing, and various administrative duties. During 2014
petitioner husband paid wages of $58,000 and $7,209 to Kendra Thompson and
Michael Johnson, respectively.
During 2013 petitioner husband (on behalf of BJW) paid $12,723 for
individual sales licenses, California and other local taxes, and entity licensing fees.
During 2014 petitioner husband (on behalf of BJW) paid legal and professional -8-
[*8] fees of $2,979. That year BJW lost several accounts, forcing petitioner
husband to take out several short-term, high-interest loans to keep the company
afloat. As a result, petitioner husband (on behalf of BJW) paid interest of
$28,181.
For 2011 BJW filed a partnership return, and petitioners reported a
nonpassive loss from BJW on a Schedule E, Supplemental Income and Loss, for
that year. Petitioners reported BJW’s income and expenses on Schedules C1 for
tax years 2013 and 2014.3 BJW’s reported Schedule C1 expenses are summarized
below:
3 With respect to these tax years, respondent does not dispute that BJW was a disregarded entity under secs. 301.7701-2(c)(2)(i) and 301.7701-3(b)(1)(ii), Proced. & Admin. Regs. The income and expenses of a disregarded entity are usually reflected on a Schedule C. -9-
[*9] Expense 2013 2014 Other $7,020 --- Wages 55,984 $68,686 Meals and entertainment 270 2,489 Travel 1,410 2,456 Taxes and licenses 12,723 15,317 Rent/lease 20,097 21,135 Legal and professional 2,234 2,979 Interest 3,109 28,181 Insurance 10,634 17,070 Commissions and fees 112,432 125,952 Utilities --- 5,239 Office --- 3,060 Depreciation --- 36,179 Car and truck --- 756 Repairs and maintenance --- 71 Advertising --- 435
Respondent disallowed all of the above-listed deductions in the notice of
deficiency for 2013 and 2014.
Withdrawals From Retirement Accounts
In 2010 and 2011 petitioners withdrew $71,625 and $42,858, respectively,
from their retirement accounts. On their 2010 return petitioners reported that they - 10 -
[*10] received $50,275 in pension and annuity distributions but asserted the
distributions were nontaxable because they were “used to fund their children’s
qualified higher education expenses”. Petitioners reported $49,259 in pension and
annuity distributions on their 2011 return but treated the distributions as
nontaxable for the same reason as for 2010.
Respondent determined that petitioners had taxable retirement income of
$71,625 and $42,858 for 2010 and 2011, respectively. For 2010 respondent
determined an additional tax of $7,162 under section 72(t). Respondent
determined a section 72(t) additional tax of $1,702 for 2011 after subtracting
amounts petitioners used for higher education expenses. Petitioners concede that
their retirement distributions were taxable but contest their liability for the
additional tax under section 72(t).
Stock Options
During 2013 and 2014 petitioner wife was an employee of TW Telecom
Holdings (TW Telecom). Her compensation included salary, commission income,
and stock options that she exercised in 2013 and 2014.
TW Telecom provided petitioner wife Forms W-2, Wage and Tax
Statement, reporting wages of $236,970 and $353,365 for 2013 and 2014,
respectively. For 2014 her Form W-2 wages comprised, among other forms of - 11 -
[*11] compensation, $63,566 for the exercise of the stock options that year.
Petitioners reported petitioner wife’s Form W-2 income on their 2014 income tax
return. Petitioner wife received $69,502 in gross proceeds from the sale of
securities in 2014. E Trade Clearing LLC (E Trade) issued several Forms 1099-B,
Proceeds From Broker and Barter Exchange Transactions, for 2014 reporting that
petitioner wife received those gross proceeds and stating that she had a basis of
zero in the securities sold. In the notice of deficiency for 2014, respondent relied
on the Forms 1099-B to determine that petitioners had unreported short-term
capital gain income of $69,502.4 As discussed below, respondent now alleges that
petitioners failed to report only $5,936 of that amount.
OPINION
I. Short-Term Capital Gain Adjustment
We first address whether petitioners had, as respondent now alleges,
unreported short-term capital gain income of $5,936 for 2014. As a general rule,
the Commissioner’s determination of a taxpayer’s liability in a notice of
deficiency is presumed correct, and the taxpayer bears the burden of proving that
4 Respondent also determined that petitioners had unreported short-term capital gain income of $25,833 on the basis of a 2013 Form 1099-B issued by E Trade. On brief respondent concedes this adjustment. - 12 -
[*12] the determination is incorrect.5 Rule 142(a); Welch v. Helvering, 290 U.S.
111, 115 (1933).
In the Court of Appeals for the Ninth Circuit, to which an appeal of these
cases presumably would lie absent a stipulation to the contrary, see sec.
7482(b)(1)(A), (2), the presumption of correctness does not attach in cases
involving unreported income unless the Commissioner first establishes an
evidentiary foundation linking the taxpayer to the alleged income-producing
activity, see Weimerskirch v. Commissioner, 596 F.2d 358, 361-362 (9th Cir.
1979), rev’g 67 T.C. 672 (1977). The requisite evidentiary foundation is minimal
and need not include direct evidence. See Rapp v. Commissioner, 774 F.2d 932,
935 (9th Cir. 1985); Banister v. Commissioner, T.C. Memo. 2008-201, aff’d, 418
F. App’x 637 (9th Cir. 2011).
Respondent established the requisite evidentiary foundation linking
petitioners to an income-producing activity. Petitioners stipulated that petitioner
5 Sec. 7491(a) provides that if, in any court proceeding, a taxpayer introduces credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by subtit. A or B and meets other prerequisites, the Commissioner shall have the burden of proof with respect to that issue. See Higbee v. Commissioner, 116 T.C. 438, 440-441 (2001). Because we resolve these cases on the preponderance of the evidence and without regard to the burden of proof, we do not decide whether sec. 7491(a) applies here. - 13 -
[*13] wife received $69,502 in gross proceeds from the sale of securities in 2014.
This amount matches the amount reported by E Trade on the Forms 1099-B.6
Petitioners contend that the proceeds reported on the Forms 1099-B were
included in petitioner wife’s reported Form W-2 income. Respondent now
concedes this issue to the extent of $63,566. This concession leaves in dispute
$5,936, which is the difference between the amount reported on the Forms 1099-B
($69,502) and the amount respondent conceded ($63,566).
Petitioners stipulated that petitioner wife received the $5,936, and the record
does not show that this amount was reported on the return as an amount
attributable to the exercise of petitioner wife’s stock options.7 The record,
6 Under sec. 6201(d), if a taxpayer asserts a reasonable dispute with respect to an item of income reported on an information return filed by a third party and the taxpayer meets certain other requirements, the Commissioner bears the burden of producing reasonable and probative evidence, in addition to the information return, concerning the deficiency attributable to the income item. Assuming arguendo that respondent bears the burden of production under sec. 6201(d), we find that respondent has satisfied it. 7 We understand the parties to agree that the stock options at issue were nonqualified stock options. If a nonqualified stock option does not have a readily ascertainable fair market value at the time of the grant, the exercise of the option gives rise to gross income at the time of the exercise, equal to the amount by which the fair market value of the stock at the exercise date exceeds the option price. Sec. 83(a); Tanner v. Commissioner, 117 T.C. 237, 246 (2001), aff’d, 65 F. App’x 508 (5th Cir. 2003); Svoboda v. Commissioner, T.C. Memo. 2006-235, slip op. at 8; sec. 1.83-7(a), Income Tax Regs. The stock received upon the exercise of (continued...) - 14 -
[*14] therefore, does not support our finding, and we decline to find, that the
exercise of the stock options resulted in a basis sufficient to offset the disputed
gross proceeds of the same amount. Nor does the record show that the $5,936 is
not taxable for another reason. We therefore hold that petitioners have unreported
short-term capital gain income of $5,936 for 2014.
II. Deductions
Deductions are a matter of legislative grace, and taxpayers generally bear
the burden of proving that they have met all requirements to be entitled to any
deductions claimed. See Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S.
79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).
Taxpayers generally must maintain sufficient records to enable the Commissioner
to determine their correct tax liability. Sec. 6001.
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. Such expenses must be directly connected with or pertain to the
taxpayer’s trade or business. Sec. 1.162-1(a), Income Tax Regs. Generally, no
7 (...continued) the option generally has an adjusted basis equal to the option price plus any amount includible in gross income as a result of the option exercise, and any gain or loss computed on the sale of that stock takes that basis into account. See Svoboda v. Commissioner, slip op. at 9. - 15 -
[*15] deduction is allowed for personal, living, or family expenses, nor is a
deduction proper for expenditures that are properly categorized as capital
expenditures. See secs. 262 and 263. The determination of whether an
expenditure satisfies the requirements of section 162 is a question of fact.
Commissioner v. Heininger, 320 U.S. 467, 475 (1943).
When a taxpayer establishes that he incurred deductible expenses but is
unable to substantiate the exact amounts, we can estimate the deductible amounts,
but only if the taxpayer presents sufficient evidence to establish a rational basis for
making the estimate. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir.
1930); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). In estimating the
amount allowable, we bear heavily against the taxpayer whose inexactitude is of
his own making. See Cohan v. Commissioner, 39 F.2d at 544.
Section 274(d) imposes strict substantiation requirements for travel,
entertainment, gift, and listed property (including passenger automobiles)
expenses. Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d per curiam,
412 F.2d 201 (2d Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax Regs., 50
Fed. Reg. 46014 (Nov. 6, 1985). Under section 274(d), the taxpayer generally
must substantiate either by adequate records or by sufficient evidence
corroborating the taxpayer’s own statement: (1) the amount of the expense; (2) the - 16 -
[*16] time and place the expense was incurred; (3) the business purpose of the
expense; and (4) in the case of an entertainment or gift expense, the business
relationship to the taxpayer of each expense incurred. For listed property
expenses, the taxpayer must establish the amount of business use and the amount
of total use for the property. See sec. 1.274-5T(b)(6)(i)(B), Temporary Income
Tax Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985).
Substantiation by adequate records requires the taxpayer to maintain an
account book, a diary, a log, a statement of expense, trip sheets, or a similar record
prepared contemporaneously with the expenditure and documentary evidence
(e.g., receipts or bills) of certain expenditures. Sec. 1.274-5(c)(2)(iii), Income Tax
Regs.; sec. 1.274-5T(c)(2), Temporary Income Tax Regs., 50 Fed. Reg. 46017
(Nov. 6, 1985). Substantiation by other sufficient evidence requires the
production of corroborative evidence in support of the taxpayer’s statement
specifically detailing the required elements. Sec. 1.274-5T(c)(3), Temporary
Income Tax Regs., 50 Fed. Reg. 46020 (Nov. 6, 1985).
A. GSE
For 2010 and 2011 respondent argues that petitioners’ GSE-related
expenditures are nondeductible startup expenses under section 195. Respondent
also contends that petitioners failed to substantiate many of GSE’s reported - 17 -
[*17] expenses. With respect to 2013 and 2014, the parties agree that GSE was an
active trade or business. However, respondent contends that petitioners failed to
substantiate many of GSE’s reported expenses.
1. Startup Expenses
We first consider whether GSE’s 2010 and 2011 expenditures should be
classified as nondeductible startup expenses under section 195.
To qualify for deduction under section 162 or 212, expenses must be
associated with a trade or business or other income-producing activity that is
functioning as a going concern. See Woody v. Commissioner, T.C. Memo.
2009-93, aff’d, 403 F. App’x 519 (D.C. Cir. 2010); Glotov v. Commissioner, T.C.
Memo. 2007-147; Walsh v. Commissioner, T.C. Memo. 1988-242, aff’d without
published opinion, 884 F.2d 1393 (6th Cir. 1989). Although a taxpayer may be
committed to entering into a business and invest considerable time and money in
preparing to do so, the activity does not constitute a trade or business for section
162(a) purposes until the business is actually functioning and performing the
activities for which it was organized. Richmond Television Corp. v. United
States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds,
382 U.S. 68 (1965); see also Glotov v. Commissioner, T.C. Memo. 2007-147.
Business operations with respect to the activity must have actually commenced. - 18 -
[*18] See McKelvey v. Commissioner, T.C. Memo. 2002-63, aff’d, 76 F. App’x
806 (9th Cir. 2003). “Until that time, expenses related to that activity are not
‘ordinary and necessary’ expenses currently deductible under section 162 (nor are
they deductible under section 212) but rather are ‘start-up’ or ‘pre-opening’
expenses.” Woody v. Commissioner, slip op. at 9-10.
Section 195(a) provides the general rule that no current deduction shall be
allowed for startup expenditures. Section 195(c)(1) defines a “start-up
expenditure” as:
(1) * * * any amount--
(A) paid or incurred in connection with--
(i) investigating the creation or acquisition of an active trade or business, or
(ii) creating an active trade or business, or
(iii) any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business, and
(B) which, if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the trade or business referred to in subparagraph (A)), would be allowable as a deduction for the taxable year in which paid or incurred. - 19 -
[*19] However, under section 195(b)(1)(A), a taxpayer may elect to deduct for the
taxable year in which the active trade or business begins up to $5,000 of startup
expenditures, reduced by the amount by which those expenditures exceed $50,000.
The remainder is allowable as a deduction ratably over the 180-month period
beginning with the month in which the active trade or business begins. Sec.
195(b)(1)(B). This election must be made no later than the time prescribed for
filing the return for the taxable year in which the trade or business begins. Sec.
195(d)(1). Section 1.195-1(b), Income Tax Regs., provides that a “taxpayer is
deemed to have made an election under section 195(b) to amortize start-up
expenditures as defined in section 195(c)(1) for the taxable year in which the
active trade or business to which the expenditures relate begins.”8 A taxpayer may
forgo this deemed election by affirmatively electing to capitalize startup
expenditures on a timely filed return for that year. Sec. 1.195-1(b), Income Tax
Regs.
8 This regulation applies to startup expenditures paid or incurred after August 16, 2011. Sec. 1.195-1(d), Income Tax Regs. Taxpayers may apply the final regulation to expenses paid or incurred after October 22, 2004, provided the applicable limitations period has not expired for the year the sec. 195 election is deemed made. Sec. 1.195-1(d), Income Tax Regs. A nearly identical temporary regulation applies to expenditures paid or incurred after September 8, 2008. See sec. 1.195-1T(b), (d), Temporary Income Tax Regs., 73 Fed. Reg. 38913 (July 8, 2008). - 20 -
[*20] Respondent contends that section 195 applies because GSE’s only activity
during 2010 and 2011 was pursuing target companies it did not actually purchase.
Respondent also asserts that GSE did not report income until 2013 when it shifted
its business purpose from acquiring target companies to providing support to
BJW. Petitioners counter that GSE was operational in 2010 and 2011, performing
its trade or business of providing support to BJW.
At trial petitioner husband credibly testified that his GSE-related activities
in 2010 involved the pursuit of three target entities. He recalled at trial: “[W]e
were meeting with our lawyers. We were meeting with business people. Fully
engaged with seeking to acquire established companies to merge the operations.”
Because GSE’s only activity in 2010 was the pursuit of potential targets,
petitioners’ GSE-related expenditures were paid in connection with “investigating
the creation or acquisition of an active trade or business”. See sec. 195(c)(1).
Accordingly, for 2010 petitioners are not entitled to deductions for their GSE-
related expenses. See sec. 195(a).
With respect to 2011, petitioner husband credibly testified that he purchased
an interest in a brokerage firm called Bernall & Jones in late December 2010. He
also credibly testified that he had always intended for GSE to provide support and
services to his other companies. GSE provided business development, marketing, - 21 -
[*21] and other support to the acquired firm after the December 2010 purchase.
Because GSE started performing services for which it was intended after
December 2010, we find that GSE’s active trade or business began in January
2011. See Richmond Television Corp., 345 F.2d at 907. Therefore, section
195(a) does not prohibit petitioners from deducting GSE-related expenditures for
2011.
On their 2011 return petitioners did not make an affirmative election to
capitalize their startup expenditures. Accordingly, pursuant to section 1.195-1(b),
Income Tax Regs., petitioners are deemed to have made the election to amortize
startup expenditures under section 195(b) for 2011.
2. 2010 Expenses
Because petitioners are deemed to have made the election to amortize
startup expenses under section 195(b), we must determine the amount of
petitioners’ GSE-related startup expenses for 2010. In the table below, we
summarize the expenses reported on petitioners’ 2010 Schedule C, the amounts
disallowed in the deficiency notice, the amounts respondent concedes on brief, and
the amounts still at issue. - 22 -
[*22] Item Reported Disallowed Conceded At issue
Meals and entertainment $1,531 $1,531 --- $1,531 Rent/lease 4,140 4,140 $3,372 768 Depreciation 1,600 1,600 --- 1,600 Other expenses 1,707 1,707 1,707 --- Car and truck 3,600 3,600 --- 3,600 Legal and professional 12,204 12,201 12,201 --- Travel 14,785 14,785 14,785 ---
i. Meals and Entertainment
The strict substantiation requirements of section 274(d) apply to this
expense. Petitioners provided no document that qualifies as an adequate record
within the meaning of section 274(d) and no other corroborative evidence
sufficient to satisfy the requirements of that section. We therefore hold that
petitioners failed to substantiate GSE’s reported meal and entertainment expenses.
ii. Rent/Lease
The record does not establish that GSE had rental expenses in excess of the
amount respondent has conceded. On the basis of respondent’s concession, we
hold that petitioners substantiated rent/lease expenses of $3,372.
iii. Depreciation
Petitioner husband credibly testified that GSE’s deduction for depreciation
comprised amounts paid for office equipment and a 1996 Jetta. The latter is a
passenger automobile that falls within the definition of listed property under - 23 -
[*23] section 280F(d)(4) and (5). Therefore, petitioners’ depreciation deduction
for this vehicle is subject to the strict substantiation requirements of section
274(d).
Petitioners provided no document that qualifies as an adequate record
within the meaning of section 274(d) and no other corroborative evidence
sufficient to satisfy the requirements of that section. Furthermore, because we do
not know how much of the depreciation deduction is attributable to the
automobile, we have no basis to make an estimate with respect to the office
equipment.
Consequently, although we found petitioners’ testimony credible, we have
no choice but to hold that they failed to substantiate GSE’s reported depreciation
expenses.9
iv. Car and Truck
For the reasons explained supra part II(A)(2)(iii), we hold that petitioners
failed to substantiate GSE’s reported car and truck expenses.
9 We decide this issue as framed by the parties. Given our holding, the Court need not decide the interplay (if any) between secs. 167 and 195. - 24 -
[*24] v. Conclusion
On the basis of respondent’s concessions and our review of the record, we
find that petitioners substantiated GSE-related startup expenses of $32,065.
Petitioners are entitled to a deduction of $5,000 for 2011 and may amortize the
remaining balance of $27,065. See sec. 195(b)(1). This balance is deductible
ratably over the 180-month period beginning with January 2011, which was the
month in which GSE’s active trade or business began, absent an earlier complete
disposition of GSE’s business. See sec. 195(b)(1) and (2).
3. 2011 Schedule C Deductions
The table below summarizes the expenses reported on petitioners’ 2011
Schedule C,10 the amounts disallowed in the deficiency notice, the amounts
respondent concedes on brief, and the amounts still at issue. Respondent contends
petitioners have not substantiated the amounts listed below:
Item Reported Disallowed Conceded At issue
Legal and professional $1,000 $407 --- $407 Travel 8,489 1,054 --- 1,054
10 Petitioners claimed several other Schedule C deductions that respondent did not adjust in the deficiency notice. We do not include those items. - 25 -
[*25] i. Legal and Professional Services
At trial petitioner husband credibly testified that GSE hired several
attorneys throughout the years at issue. Those attorneys provided legal advice and
counsel pertaining to licensing, State insurance requirements, acquisitions, and
business planning. Petitioner husband also credibly testified that the amount
reported on the Schedule C for 2011 was correct as to the portion of the legal fees
that related to GSE’s business.
On the basis of petitioner husband’s credible testimony, we hold that
petitioners are entitled to a Schedule C deduction of $1,000 for legal and
professional services.
ii. Travel
The strict substantiation requirements of section 274(d) apply to travel
expenses. To substantiate $1,054 of travel expenses disallowed by respondent,
petitioners submitted airline itineraries and a construction risk management
conference schedule. These documents do not do not state the amounts petitioners
expended and therefore fail to satisfy section 274(d). Accordingly, we sustain
respondent’s determination with respect to this issue. - 26 -
[*26] 4. 2013 Schedule C2 Deductions
The table below summarizes the expenses reported on petitioners’ 2013
Schedule C2, the amounts disallowed in the deficiency notice, the amounts
respondent concedes on brief, and the amounts still at issue. Respondent contends
that petitioners have not substantiated the amounts listed below:
Other expenses $4,945 $4,945 --- $4,945 Meals and entertainment 563 563 --- 563 Travel 3,465 3,465 --- 3,465 Supplies 390 390 --- 390 Rent/lease 533 533 --- 533 Legal and professional 850 850 --- 850 Interest 4,532 4,532 --- 4,532 Depreciation 33,875 33,875 --- 33,875 Car and truck 5,506 5,506 --- 5,506
i. Other Expenses
We have found that in 2013 petitioner husband, on behalf of GSE, paid
$4,465 for taxes and licensing fees, postage, bank charges, printing, telephone, - 27 -
[*27] and internet.11 Accordingly, we hold that petitioners are entitled to a
deduction of $4,465 for other expenses.
ii. Meals and Entertainment
For the reasons explained supra part II(A)(2)(i), petitioners failed to satisfy
the substantiation requirements of section 274(d). Accordingly, they are not
entitled to a deduction for meals and entertainment.
iii. Travel
To substantiate $3,465 of travel expenses disallowed by respondent,
petitioners submitted airline itineraries. These documents do not substantiate the
amounts or business purposes of the reported expenses. Because petitioners have
failed to satisfy the substantiation requirements of section 274(d), we sustain
respondent’s disallowance of this deduction.
iv. Supplies
Petitioner husband credibly testified that this deduction comprised expenses
for office and computer supplies. We find petitioner husband’s testimony to be
credible evidence that petitioners paid $390 for GSE-related office and computer
11 The difference between the amount reported and the amount we allow is $480. This amount pertains to a charitable donation that petitioners failed to substantiate. See sec. 170(f)(8)(A) (requiring the donor to obtain a contemporaneous written acknowledgment of the donation from the donee for contributions of cash or property over $250). - 28 -
[*28] supplies. Accordingly, we hold that petitioners are entitled to a deduction of
$390 for supplies.
v. Rent/Lease
Petitioner husband testified that this reported expense was for
“miscellaneous equipment”. However, he did not specify how this expense
pertained to GSE’s trade or business. We therefore sustain respondent’s
disallowance of this deduction.
vi. Legal and Professional
For the reasons explained supra part II(A)(3)(i), we hold that petitioners are
entitled to a deduction of $850 for legal and professional services.
vii. Interest
Petitioner husband testified that the reported interest expense was erroneous
and should have been reported on their Schedule C1 for BJW. However, on their
Schedule C1 for BJW, petitioners claimed an interest deduction of $3,109, which
respondent concedes on brief. Petitioners did not present any testimony or other
evidence to substantiate additional interest expenses. We therefore sustain
respondent’s disallowance of this deduction. - 29 -
[*29] viii. Depreciation
At trial petitioner husband explained that the placement of this deduction on
the Schedule C2 for GSE was in error because the deduction pertains to BJW.
According to petitioners, the reported depreciation expense represents the
amortization of goodwill from the purchase of Bernall & Jones for $320,000 at the
end of December 2010.
Section 167(a) provides for depreciation of property used in a trade or
business or held for the production of income. Under section 1.167(a)-3(a),
Income Tax Regs., “[n]o deduction for depreciation is allowable with respect to
goodwill.” However, section 197 provides for the amortization of the acquisition
cost of certain intangibles, including goodwill, over a fixed 15-year period. Sec.
197(a), (d)(1)(A). An amortizable section 197 intangible includes any section 197
intangible acquired by a taxpayer after August 10, 1993, and held in connection
with the conduct of a trade or business. Sec. 197(c)(1). For purposes of
depreciation and amortization, a taxpayer’s basis in purchased property is the cost,
including any valid liabilities incurred in acquiring the property. Crane v.
Commissioner, 331 U.S. 1, 9-11 (1947).
Respondent’s sole argument with respect to this deduction is that petitioners
failed to substantiate the purchase price and the amount allocable to goodwill. - 30 -
[*30] However, petitioner husband credibly testified that the purchase price was
$320,000. He also credibly testified that Bernall & Jones (which was renamed
BJW) did not have any tangible assets of value when he purchased it. Instead the
insurance firm had an established staff with extensive knowledge of the customer
base, the accounts, and other aspects of the business.
On the basis of petitioner husband’s credible testimony, we find that the
$320,000 purchase price was wholly allocable to the insurance firm’s workforce in
place, information base, and goodwill, all of which are amortizable section 197
intangibles.12 See sec. 197(c) and (d). However, the amortization deduction that
petitioners claimed is miscalculated. We find that the proper amortization
deduction is $21,333 (petitioner husband’s cost basis of $320,000, divided by 15).
Accordingly, petitioners are entitled to an amortization deduction of $21,333 for
2013.13
12 Sec. 197 intangibles do not include an interest in a partnership. Sec. 1.197-2(c)(1), Income Tax Regs. Thus, amortization under sec. 197 is generally not available for the cost of acquiring a partnership interest. Id. Respondent did not contend in the deficiency notice or at any point in this proceeding that petitioner husband purchased a nonamortizable partnership interest in Bernall & Jones. We deem the argument waived. 13 Respondent does not dispute petitioners’ contention that this deduction, if allowed, belongs on the Schedule C1 for BJW rather than the Schedule C2 for GSE. We expect the parties to treat the deduction as BJW’s in the Rule 155 (continued...) - 31 -
[*31] ix. Car and Truck
For the reasons explained supra part II(A)(2)(iii), we hold that petitioners
failed to substantiate GSE’s reported car and truck expenses. We therefore sustain
5. 2014 Schedule C2 Deductions
The table below summarizes the expenses reported on petitioners’ 2014
Schedule C2, the amounts disallowed in the deficiency notice, the amounts
respondent concedes on brief, and the amounts still at issue. Respondent contends
that petitioners have not substantiated the amounts listed below:
Meals and entertainment $346 $346 --- $346 Travel 401 401 --- 401 Office expenses 677 677 --- 677 Advertising 289 289 --- 289 i. Meals and Entertainment
For the reasons explained supra part II(A)(2)(i), petitioners failed to satisfy
the substantiation requirements of section 274(d). Accordingly, they are not
13 (...continued) computation to the extent this correction has any effect thereon. - 32 -
[*32] ii. Travel
Petitioners rely on petitioner husband’s testimony to substantiate travel
expenses of $401. Having failed to submit adequate records or other sufficient
evidence corroborating the amount, time, and business purpose of petitioner
husband’s reported travel expenses, petitioners have not satisfied the requirements
of section 274(d). We sustain respondent’s disallowance of this deduction.
iii. Office Expenses
We have found that petitioner husband, on behalf of GSE, paid $677 in
2014 to lease part-time office space at the Oakland location. We hold that
petitioners are entitled to a deduction of $677 for office expenses.
iv. Advertising
We have found that petitioner husband paid $289 for GSE-related online
marketing efforts in 2014. We hold that petitioners are entitled to a deduction of
$289 for advertising.
B. BJW
For 2013 and 2014 petitioners reported BJW’s income and expenses on
Schedules C1. Respondent disallowed petitioners’ Schedule C1 deductions for
both years. - 33 -
[*33] 1. 2013
The table below summarizes the expenses reported on petitioners’ 2013
Schedule C1, the amounts disallowed in the deficiency notice, the amounts
respondent concedes on brief, and the amounts still at issue. Respondent contends
that petitioners failed to substantiate the expenses listed below that have not been
conceded:
Other expenses $7,020 $7,020 $6,850 $170 Wages 55,984 55,984 55,984 --- Meals and entertainment 270 270 --- 270 Travel 1,410 1,410 --- 1,410 Taxes and licenses 12,723 12,723 11,458 1,265 Rent/lease 20,097 20,097 20,097 --- Legal and professional 2,234 2,234 2,234 --- Interest 3,109 3,109 3,109 --- Insurance 10,634 10,634 10,634 --- Commissions and fees 112,432 112,432 112,432 ---
On brief respondent concedes that petitioners have substantiated all but
$170 of this reported expense. After careful review of the record, we find that
petitioners substantiated the remaining $170 of other expenses. We therefore hold
that petitioners are entitled to a deduction of $7,020. - 34 -
[*34] ii. Meals and Entertainment
For the reasons explained supra part II(A)(2)(i), petitioners failed to satisfy
the substantiation requirements of section 274(d). Accordingly, they are not
To substantiate petitioner husband’s BJW-related travel expenses,
petitioners rely on petitioner husband’s testimony, along with canceled checks, a
summary travel log, and an Expedia itinerary. Because none of these documents
establishes the business purposes of the reported expenditures, petitioners have
failed to satisfy the substantiation requirements of section 274(d). Accordingly,
we sustain respondent’s disallowance of this deduction.
iv. Taxes and Licenses
Petitioners reported tax and licensing expenses of $12,723. On brief
respondent concedes that petitioners have substantiated all but $1,265 of these
expenses. The $12,723 deduction comprised expenses for individual sales
licenses, California and other local taxes, and entity licensing fees. As we have
found that petitioner husband paid the remaining $1,265 on behalf of BJW, we
hold that petitioners are entitled to a deduction of $12,723 for tax and licensing
expenses. - 35 -
[*35] 2. 2014
The table below summarizes the expenses reported on petitioners’ 2014
Schedule C1, the amounts disallowed in the deficiency notice, the amounts
respondent concedes on brief, and the amounts still at issue. Respondent contends
that petitioners failed to substantiate the expenses listed below that have not been
Wages $68,686 $68,686 $65,208 $3,478 Meals and entertainment 2,489 2,489 --- 2,489 Travel 2,456 2,456 --- 2,456 Taxes and licenses 15,317 15,317 15,317 --- Rent/lease 21,135 21,135 21,135 --- Legal and professional 2,979 2,979 2,700 279 Interest 28,181 28,181 5,965 22,216 Insurance 17,070 17,070 12,351 4,719 Commissions and fees 125,952 125,952 125,952 --- Utilities 5,239 5,239 5,239 --- Office expenses 3,060 3,060 3,060 --- Depreciation/sec. 179 expense 36,179 36,179 --- 36,179 Car and truck expenses 756 756 --- 756 Advertising 435 435 435 --- Repairs and maintenance 71 71 71 ---
i. Wages
On brief respondent concedes that petitioners have substantiated BJW-
related wages of $65,208, leaving the remaining $3,478 at issue. The record
establishes (and we have found) that petitioner husband paid wages of $58,000 - 36 -
[*36] and $7,209 to Kendra Thompson and Michael Johnson, respectively. The
record does not establish that BJW paid wages in excess of the sum of those
amounts, $65,209. Accordingly, petitioners are entitled to a deduction of $65,209.
For the reasons explained supra part II(A)(2)(i), petitioners failed to satisfy
the substantiation requirements of section 274(d). Accordingly, they are not
To substantiate petitioners’ BJW-related travel expenses, petitioners rely on
petitioner husband’s testimony and a Southwest airlines travel itinerary. The
travel itinerary does not establish the business purpose of the reported expenses.
Accordingly, petitioners have failed to satisfy the substantiation requirements of
section 274(d), and they are not entitled to a deduction for travel.
iv. Legal and Professional
Petitioners reported legal and professional expenses of $2,979. On brief
respondent concedes that petitioners have substantiated all but $279 of these
expenses. At trial petitioner husband credibly testified that BJW had legal and
professional expenses in the amount stated on the return, and we have found that
petitioner husband paid $2,979 during 2014 for BJW’s legal and professional - 37 -
[*37] expenses. We therefore hold that petitioners are entitled to a deduction of
$2,979 for legal and professional expenses.
v. Interest
Petitioners claimed a $28,181 interest expense deduction on their Schedule
C1. On brief respondent concedes $5,965 of this amount but contends that
petitioners failed to substantiate the remaining $22,216.
A taxpayer may deduct interest paid or incurred during the taxable year if
the interest is an ordinary and necessary expense of carrying on a trade or
business. Sec. 162(a); Robinson v. Commissioner, 119 T.C. 44, 48 (2002); see
sec. 163(a) (allowing a deduction for “all interest paid or accrued within the
taxable year on indebtedness”, with certain exceptions).
We have found that petitioner husband paid BJW-related interest of $28,181
during 2014. Accordingly, petitioners are entitled to a deduction of $28,181 for
interest.
vi. Insurance
Petitioners claimed a $17,070 insurance expense deduction on their 2014
Schedule C1. On brief respondent concedes $12,351 of that amount but contends
that petitioners failed to substantiate the remaining $4,719. - 38 -
[*38] The record does not establish that BJW had insurance expenses in excess of
the amount respondent has conceded. On the basis of respondent’s concession and
our review of the record, we hold that petitioners are entitled to a deduction of
$12,351 for insurance.
vii. Depreciation
For the reasons explained supra part II(A)(4)(viii), petitioners are entitled to
an amortization deduction of $21,333 for 2014.
viii. Car and Truck
For the reasons explained supra part II(A)(2)(iii), we hold that petitioners
failed to substantiate BJW’s reported car and truck expenses. We therefore sustain
III. Additional Tax on Early Distribution
Petitioners concede in their opening brief that they received from their
retirement accounts taxable income of $71,625 and $42,858 in 2010 and 2011,
respectively. However, they contend that they are not subject to the additional tax
on early distributions from qualified plans under section 72(t). Respondent argues
that portions of petitioners’ early withdrawals are subject to the additional tax.
Where, as here, a taxpayer receives a distribution from a qualified
retirement plan, section 72(t)(1) generally provides that his tax shall be increased - 39 -
[*39] “by an amount equal to 10 percent of the portion of such amount which is
includible in gross income.” Section 72(t)(2)(A) provides several exceptions to
this rule, e.g., where the taxpayer receiving the distribution has attained the age of
59-1/2 or is disabled. See sec. 72(t)(2)(A)(i), (iii). A further exception appears in
section 72(t)(2)(E), captioned “Distributions from individual retirement plans for
higher education expenses.” It provides, with exceptions not relevant here, that an
early distribution from an individual retirement plan is not subject to the 10%
additional tax to the extent it does not exceed “the qualified higher education
expenses * * * of the taxpayer for the taxable year.”14
Petitioners do not dispute that they were under the age of 59-1/2 when they
received the distributions at issue or that they were not disabled at those times.
Petitioners are thus liable for the 10% additional tax unless another exception in
section 72(t) applies. The only exception they have raised is the exception for
“higher education expenses.”
Petitioners received early distributions from their retirement accounts
totaling $71,625 in 2010 and $42,858 in 2011. Petitioners submitted evidence of
14 The term “qualified higher education expenses” means qualified higher education expenses (as defined in sec. 529(e)(3)) for education furnished to the taxpayer, the taxpayer’s spouse, or any child (as defined in sec. 152(f)(1)) or grandchild of the taxpayer or the taxpayer’s spouse, at an eligible educational institution (as defined in sec. 529(e)(5)). Sec. 72(t)(7)(A). - 40 -
[*40] tuition payments of $30,557 for 2010, and respondent has conceded that this
amount is not subject to the additional tax. The record contains no evidence of
additional qualified education expenses paid for 2010 or any qualified education
expenses paid for 2011.15
Accordingly, we find petitioners liable for the 10% additional tax under
section 72(t) on $41,06816 of their early retirement distribution for 2010. We also
sustain respondent’s determination of additional tax under section 72(t) for 2011.
We have considered all other arguments made by the parties, and to the
extent not discussed above, find those arguments to be irrelevant, moot, or without
merit.
To reflect the foregoing,
Decisions will be entered
under Rule 155.
15 We note that respondent determined a sec. 72(t) additional tax of $1,702 for 2011 after subtracting amounts used for higher education expenses in the notice of deficiency. 16 Total distributions of $71,625 minus education expenses of $30,557.