Michael Torres

• Court: United States Tax Court
• Decided: June 2, 2021
• Docket: 6954-19
• Status: Unpublished

Opinion

T.C. Memo. 2021-66

UNITED STATES TAX COURT

MICHAEL TORRES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6954-19. Filed June 2, 2021.

Christopher P. Housh, for petitioner.

Amy B. Ulmer, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

KERRIGAN, Judge: Respondent determined a deficiency of $7,475, an

addition to tax pursuant to section 6651(a)(1) of $2,736, and an accuracy-related

penalty pursuant to section 6662(a) of $1,495 for 2016. Unless otherwise

indicated, all section references are to the Internal Revenue Code in effect for

Served 06/02/21 -2-

[*2] 2016, and all Rule references are to the Tax Court Rules of Practice and

Procedure. We round all monetary amounts to the nearest dollar.

After respondent’s concessions,1 the issues for consideration are whether

petitioner is: (1) entitled to reduce his flowthrough income from his wholly

owned S corporation, Water Warehouse, Inc. (Water Warehouse), for a theft loss

deduction pursuant to section 165 or, in the alternative, a deduction for

nonemployee compensation and (2) liable for an addition to tax for failure to

timely file a return pursuant to section 6651(a)(1) for 2016.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. Petitioner resided

in California when he timely filed his petition.

Petitioner and Elizabeth Ruzendall cofounded Water Warehouse, an

S corporation for Federal income tax purposes. During 2016 petitioner was the

sole shareholder, president, and chief executive officer. Around 2010 Ms.

Ruzendall was no longer an owner, but she continued to manage Water

Warehouse’s books and records.

1 The issue of whether petitioner is required to repay advance payments of the premium tax credit is computational. -3-

[*3] During 2016 petitioner suffered from an illness that left him unable to work

for Water Warehouse for most of the year and prevented his filing a timely Federal

income tax return. At this time he was unable to read and relied upon others to

handle the taxes of Water Warehouse. Pursuant to the advice of a bookkeeper,

Water Warehouse issued Ms. Ruzendall Form 1099-MISC, Miscellaneous Income,

reporting $166,494 in nonemployee compensation for 2016. In 2018 petitioner

learned to read and started handling Water Warehouse’s tax matters.

On July 18, 2018, petitioner filed a civil suit against Ms. Ruzendall in the

Superior Court of California, County of Santa Clara. This suit included Water

Warehouse as a plaintiff. On February 20, 2019, petitioner amended this suit by

removing Water Warehouse as a plaintiff. Petitioner alleged in the amended

complaint as well as the original complaint that Ms. Ruzendall had

misappropriated funds from Water Warehouse. In his complaint petitioner alleged

that on October 1, 2017, he had discovered Ms. Ruzendall’s actions. Petitioner’s

civil suit remained pending in November 2020.

Petitioner’s Federal income tax return for 2016 was due on April 18, 2017,

but he filed his income tax return on or about July 8, 2018. On his 2016 Form

1040, U.S. Individual Income Tax Return, petitioner reported flowthrough income

from Water Warehouse of $319,214. Water Warehouse did not timely file Form -4-

[*4] 1120S, U.S. Income Tax Return for an S Corporation, for 2016. On July 23,

2018, Water Warehouse filed Form 1120S for 2016.

On April 1, 2019, respondent issued petitioner a notice of deficiency. On

April 16, 2019, Water Warehouse submitted an amended 2016 Form 1120S, which

respondent neither accepted nor filed. On its amended 2016 Form 1120S, Water

Warehouse reported an additional $166,494 in expenses for “outside services” for

an alleged theft loss due to Ms. Ruzendall’s embezzlement.

On April 16, 2019, petitioner submitted Form 1040X, Amended U.S.

Individual Income Tax Return, for 2016, which was not accepted and filed. On

his 2016 Form 1040X petitioner reduced his reported flowthrough income from

Water Warehouse by $166,494 to $152,720, reflecting the increase in Water

Warehouse’s reported expenses.

OPINION

Generally, the Commissioner’s determinations in a notice of deficiency are

presumed correct, and a taxpayer bears the burden of proving those determinations

are incorrect. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Petitioner does not contend that the burden of proof should be shifted to

respondent under section 7491(a), and the record does not suggest any basis for a

shift. -5-

[*5] 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 deduction and to enable the

Commissioner to determine the correct tax liability. Sec. 6001; see Higbee v.

Commissioner, 116 T.C. 438, 440 (2001).

Section 1366(a) provides that income, losses, deductions, and credits of an

S corporation are passed through pro rata to its shareholders on their individual

income tax returns. The character of each item of income is determined as if it

were realized directly from the source from which the corporation realized it or

incurred in the same manner as it was by the corporation. Sec. 1366(b). A

shareholder’s gross income includes his or her pro rata share of the S corporation’s

gross income. Sec. 1366(c). Where, as here, a notice of deficiency includes

adjustments for S corporation items with other items unrelated to the

S corporation, we have jurisdiction to determine the correctness of all adjustments.

See Winter v. Commissioner, 135 T.C. 238 (2010). -6-

[*6] Theft Loss Deduction

Section 165(a) allows a deduction for losses sustained during the taxable

year and not compensated for by insurance or otherwise. Generally, to

substantiate a theft loss deduction, the taxpayer must prove that a theft actually

occurred under the law of the relevant State and the amount of the loss. See

Nichols v. Commissioner, 43 T.C. 842, 884-885 (1965). The term “theft” is

broadly defined to include larceny, embezzlement, and robbery. Normally, a loss

will be regarded as arising from theft only if there is a criminal element to the

appropriation of the taxpayer’s property. See Edwards v. Bromberg, 232 F.2d

107, 110 (5th Cir. 1956).

In order to claim a theft loss deduction, the taxpayer must prove (1) that a

theft occurred under the law of the jurisdiction wherein the alleged loss occurred,

Monteleone v. Commissioner, 34 T.C. 688, 692 (1960); (2) the amount of the loss;

and (3) the date the taxpayer discovered the loss, see sec. 165(e); Elliott v.

Commissioner, 40 T.C. 304 (1963). The taxpayer bears the burden of proving by a

preponderance of evidence that a theft actually occurred. Jones v. Commissioner,

24 T.C. 525, 527 (1955). -7-

[*7] The alleged theft occurred in California. Certain requirements must be met

under California law for a theft to have occurred. Cal. Penal Code sec. 484(a)

(West 2021) provides:

Every person who shall feloniously steal, take, carry, lead, or drive away the personal property of another, or who shall fraudulently appropriate property which has been entrusted to him or her, or who shall knowingly and designedly, by any false or fraudulent representation or pretense, defraud any other person of money, labor or real or personal property * * * is guilty of theft. * * *

This statute consolidates the historic categories of larceny, theft by false pretenses,

and embezzlement into the general crime of theft. People v. Gonzales, 392 P.3d

437, 441-442 (Cal. 2017). Proving a theft requires evidence meeting the elements

of one of the consolidated offenses. Id. at 442.

Petitioner alleges that he suffered a loss from embezzlement, which is

defined under California law as “the fraudulent appropriation of property by a

person to whom it has been intrusted”. Cal. Penal Code sec. 503 (West 2021).

Pursuant to California law, embezzlement requires the following elements: (1) the

owner entrusted his or her property to the defendant; (2) the owner did so because

he or she trusted the defendant; (3) the defendant fraudulently converted that

property for his or her own benefit; and (4) when the defendant converted the -8-

[*8] property, he or she intended to deprive the owner of its use. People v.

Fenderson, 116 Cal. Rptr. 3d 17, 26 (Ct. App. 2010).

Intent to defraud is a question of fact to be determined from all the

circumstances of the case and usually must be proved circumstantially. People v.

Fujita, 117 Cal. Rptr. 757, 765-766 (Ct. App. 1974). Courts must examine the

evidence to determine whether an alleged thief behaved in a manner consonant

with an intent to defraud; a record establishing a mere ordinary breach of contract

or fiduciary duty will be insufficient to support a finding of a party’s intent to

defraud. See People v. Ashley, 267 P.2d 271, 282 (Cal. 1954).

During 2016 Ms. Ruzendall was involved with running Water Warehouse.

She testified that she ran the business in 2016 and that she paid herself. Petitioner

testified that Ms. Ruzendall had “dr[awn] what she felt was her pay” for 2016.

Petitioner did not offer evidence that Ms. Ruzendall acted with the intent to

defraud. Petitioner has not shown Water Warehouse experienced a theft meeting

the elements of embezzlement under California law.

Even if a theft pursuant to California law had occurred, petitioner would not

be entitled to a flowthrough loss deduction for 2016. To claim a theft loss

deduction, the taxpayer must also establish the amount of the loss and the year in

which the loss was sustained. See sec. 1.165-1(c) and (d)(1), Income Tax Regs. A -9-

[*9] loss arising from theft is generally treated as “sustained during the taxable

year in which the taxpayer discovers such loss”. Sec. 165(e). If in the year of

discovery, the taxpayer has a “reasonable prospect of recovery” on a claim for

reimbursement, the loss will not be sustained until “the taxable year in which it

can be ascertained with reasonable certainty whether or not such reimbursement

will be received”. Sec. 1.165-1(d)(3), Income Tax Regs.

Whether a reasonable prospect of recovery exists is a question of fact to be

determined upon an examination of all facts and circumstances. Id. subpara.

(2)(i). “A reasonable prospect of recovery exists when the taxpayer has bona fide

claims for recoupment from third parties or otherwise, and when there is a

substantial possibility that such claims will be decided in his favor”. Ramsay

Scarlett & Co. v. Commissioner, 61 T.C. 795, 811 (1974), aff’d, 521 F.2d 786 (4th

Cir. 1975). The determination as to whether there is a reasonable prospect of

recovery is based primarily on objective factors; the taxpayer’s subjective belief

may also be considered, but it is not the sole or controlling criterion. Id.; see also

Jeppsen v. Commissioner, 128 F.3d 1410, 1418 (10th Cir. 1997), aff’g T.C.

Memo. 1995-342.

Petitioner did not provide evidence that he had discovered the loss in 2016.

He testified that near the end of 2017 he had become suspicious of Ms. - 10 -

[*10] Ruzendall’s accounting for Water Warehouse. In his civil suit against Ms.

Ruzendall, petitioner provided October 1, 2017, as the date of his discovery.

Neither did he provide evidence that Water Warehouse had no reasonable prospect

of recovery in 2016. Petitioner’s civil suit against Ms. Ruzendall was filed in

2018 and was still pending in 2020. We sustain respondent’s disallowance of

petitioner’s theft loss deduction.

Nonemployee Compensation

Petitioner contends that Water Warehouse is entitled to deduct the $166,494

that Ms. Ruzendall withdrew as a business expense pursuant to section 162(a)(1).

Section 162 allows a taxpayer to deduct all ordinary and necessary expenses paid

or incurred during the taxable year in carrying on a trade or business. Sec. 162(a);

sec. 1.162-1(a), Income Tax Regs. An expense is “ordinary” if it is “normal,

usual, or customary” in the taxpayer’s trade or business or it arises from a

transaction “of common or frequent occurrence in the type of business involved”.

Deputy v. du Pont, 308 U.S. 488, 495 (1940).

An expense is “necessary” if it is “appropriate and helpful” to the taxpayer’s

business, but it need not be absolutely essential. Commissioner v. Tellier, 383

U.S. 687, 689 (1966) (quoting Welch v. Helvering, 290 U.S. at 113). The

determination of whether an expense satisfies the requirements of section 162 is a - 11 -

[*11] question of fact. Cloud v. Commissioner, 97 T.C. 613, 618 (1991) (citing

Commissioner v. Heininger, 320 U.S. 467, 473-475 (1943)).

Petitioner alleged on his amended claim, filed against Ms. Ruzendall, that

she took funds from Water Warehouse. The amended complaint does not mention

that Ms. Ruzendall was entitled to compensation for services performed on behalf

of Water Warehouse. Ms. Ruzendall testified that she took funds without

petitioner’s authorization.

Petitioner produced no evidence showing that Ms. Ruzendall was entitled to

compensation. Accordingly, petitioner is not entitled to a deduction under section

162.

Section 6651(a)(1) Addition to Tax

Section 6651(a)(1) imposes an addition to tax if the taxpayer fails to file his

or her income tax return by the required due date (including any extension of time

for filing). A taxpayer has the burden of proving that failure to timely file was due

to reasonable cause and not willful neglect. See sec. 6651(a)(1); Higbee v.

Commissioner, 116 T.C. at 447. A showing of reasonable cause requires the

taxpayer to demonstrate that he exercised ordinary business care and prudence but

was unable to file within the prescribed time. Sec. 301.6651-1(c), Proced. &

Admin. Regs. - 12 -

[*12] Under section 7491(c) the Commissioner bears the burden of production

with respect to the liability of the taxpayer for any additions to tax. See Higbee v.

Commissioner, 116 T.C. at 446-447. Petitioner filed his 2016 income tax return

after the due date. Therefore, respondent’s burden of production has been met.

Petitioner testified credibly that he was not capable of handling his business

because of his illness and not being able to read during 2016 and that he relied

upon others. Petitioner’s illness affected his ability to file a timely tax return for

2016. Once petitioner learned of problems regarding his 2016 taxes, he sought a

new tax preparer. He also learned to read in 2018. Petitioner has shown

reasonable cause, and therefore he is not liable for an addition to tax pursuant to

section 6651(a)(1).

We have considered all arguments made by the parties, and to the extent not

mentioned or addressed, they are irrelevant or without merit.

To reflect the foregoing,

Decision will be entered under

Rule 155.