Sam Fagenboym & Oksana Fagenboym

• Court: United States Tax Court
• Decided: July 19, 2021
• Docket: 15894-19
• Status: Unpublished

Opinion

T.C. Summary Opinion 2021-19

UNITED STATES TAX COURT

SAM FAGENBOYM AND OKSANA FAGENBOYM, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 15894-19S. Filed July 19, 2021.

Sam Fagenboym and Oksana Fagenboym, pro sese.

Daniel Z. Nettles, for respondent.

SUMMARY OPINION

PANUTHOS, Special Trial Judge: This case was heard pursuant to the

provisions of section 7463 of the Internal Revenue Code in effect when the

petition was filed.1 Pursuant to section 7463(b), the decision to be entered is not

1 Unless otherwise indicated, subsequent section references are to the (continued...)

Served 07/19/21 -2-

reviewable by any other court, and this opinion shall not be treated as precedent

for any other case.

In a statutory notice of deficiency dated June 13, 2019, respondent

determined a deficiency in petitioners’ Federal income tax for taxable year 2015

(year in issue) of $21,635. The deficiency was based upon the disallowance of a

portion of the nonpassive loss deduction that petitioners claimed on their 2015

Schedule E, Supplemental Income and Loss. The sole issue for decision is

whether petitioners have provided sufficient substantiation regarding expenses

incurred by Alcor Electric, Inc. (Alcor Electric), an S corporation, to be entitled to

deduct claimed passthrough losses in excess of those already allowed for the year

in issue.

Background

Some of the facts have been stipulated, and we incorporate the stipulation of

facts by this reference. Petitioners lived in California when the petition was timely

filed. At all relevant times petitioners were married and resided together.

1 (...continued) Internal Revenue Code (Code) in effect at all relevant times, and all Rule references are to the Tax Court Rules of Practice and Procedure. -3-

I. Alcor Electric’s Business Activity

During the year in issue, Mr. Fagenboym held a 50% shareholder interest in

Alcor Electric, which provided electrical installation for midsize commercial

industrial projects. As of 2015 the company had been in business for several years

working on projects for the State of California and other government entities. The

company generally worked on three or four projects concurrently, completing

most of the work for each project during the summer months. To complete its

industrial projects, Alcor Electric hired contract electricians from various

electrical agencies.2 The funds for each project were issued from the government

entity client to a general contractor; the general contractor then distributed a

portion of the total project funds to Alcor Electric. Alcor Electric would directly

pay subcontractor electrical agencies that provided the company’s contract

electricians as well as the companies that provided project materials.

On a 2015 Form 1120S, U.S. Income Tax Return for an S Corporation,

Alcor Electric reported $6,755,527 in gross receipts and $6,379,331 in cost of

goods sold, resulting in a gross profit of $376,196. Of the amount reported as cost

of goods sold, Alcor Electric reported $2,230,988 in purchases. Alcor Electric

2 The term “electrical agencies” used by Mr. Fagenboym during his testimony was not further explained in the record. In the context of this record, we understand the term to mean subcontractor electrical agencies. -4-

also reported $628,496 in total deductions on line 20. Accordingly, Alcor

Electric’s Form 1120S reported a $252,300 ordinary business loss for the year in

issue. That year, Alcor Electric issued to Mr. Fagenboym a Schedule K-1,

Shareholder’s Share of Income, Deductions, Credits, etc., reporting Mr.

Fagenboym’s share of loss as $109,774.3

Respondent selected Alcor Electric’s 2015 Form 1120S for examination.

During the examination the S corporation’s representatives provided to respondent

documentation substantiating certain amounts reported as purchases. At the

conclusion of the examination respondent disallowed any deduction for $250,648

in claimed purchases, resulting in a corrected ordinary loss of $1,652 for Alcor

Electric’s 2015 tax year. As further discussed below, respondent’s adjustment to

Alcor Electric’s 2015 Form 1120S resulted in an adjustment to petitioners’

distributive share of Alcor Electric’s loss as reported on their 2015 Schedule E.

II. Tax Return

Petitioners timely requested and were granted an extension of time to file

their 2015 Form 1040, U.S. Individual Income Tax Return, to October 15, 2016.

3 It is unclear why Mr. Fagenboym’s $109,774 distributive share of loss as shown on the 2015 Schedule K-1 was less than 50% of Alcor Electric’s $252,300 reported ordinary loss for that year. Following respondent’s adjustment to Alcor Electric’s 2015 Form 1120S, Mr. Fagenboym’s corrected $826 share of loss for the year in issue is 50% of the S corporation’s $1,652 corrected ordinary loss. -5-

Petitioners timely filed their 2015 tax return and selected a filing status of married

filing jointly. The tax return was prepared by a certified public accountant and

signed by petitioners on October 14, 2016.

Petitioners reported a pro rata share of Alcor Electric’s passthrough losses

on their tax return for the year in issue. Attached to the 2015 Form 1040 was a

Schedule E that reported a $109,774 nonpassive distributive share of loss from

Alcor Electric, based on the aforementioned Schedule K-1.

III. Notice of Deficiency and Petition

Respondent selected petitioners’ 2015 tax return for examination on June 8,

2018. As a result of the examination of Alcor Electric’s 2015 tax return,

respondent determined that the correct amount of petitioners’ distributive share of

Schedule E loss should be $826 for the year in issue. On June 13, 2019,

respondent issued to petitioners a notice of deficiency disallowing $108,948 of

petitioners’ reported passthrough loss and resulting in an increase in tax of

$21,635.

On August 29, 2019, petitioners timely petitioned this Court for

redetermination of their income tax deficiency for the year in issue, asserting that

the “IRS erred in disallowing purchases on 2015 Alcor Electric, Inc S-Corporation

return and as result adjusting taxpayers’ share of the S-Corporation losses.” -6-

Discussion

I. Burden of Proof

In general, the Commissioner’s determination set forth in a notice of

deficiency is presumed correct, and the taxpayer bears the burden of proving that

the determination is in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933). The taxpayer likewise bears the burden of proving his or her entitlement

to deductions and of substantiating the amounts of items underlying claimed

deductions. See sec. 6001; INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); sec. 1.6001-1(a), Income Tax Regs. At a minimum petitioners must

produce business records or other evidence substantiating the amounts and the

purpose of the deductions that they assert respondent improperly disallowed. See

Higbee v. Commissioner, 116 T.C. 438, 440 (2001). Pursuant to section 7491(a),

the burden of proof as to factual matters shifts to the Commissioner under certain

circumstances. Petitioners did not allege or otherwise show that section 7491(a)

applies as to any relevant factual issue. See sec. 7491(a)(2)(A) and (B).

Therefore, petitioners bear the burden of proof. See Rule 142(a). -7-

II. Disallowance of the Schedule E Deduction

Generally, an S corporation is not subject to Federal income tax at the entity

level. Sec. 1363(a); see also Taproot Admin. Servs., Inc. v. Commissioner, 133

T.C. 202, 204 (2009), aff’d, 679 F.3d 1109 (9th Cir. 2012). S corporation items of

income, gain, loss, deduction, and credit flow through to the S corporation

shareholders, who report their pro rata shares of such items on their respective

returns. See sec. 1366(a).

An S corporation’s taxable income is generally computed in the same

manner as an individual’s. Sec. 1363(b). Deductions are a matter of legislative

grace, and the taxpayer must prove his or her entitlement to deductions.

INDOPCO, Inc. v. Commissioner, 503 U.S. at 84; New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934). The taxpayer has the burden of

substantiating any deduction. Hradesky v. Commissioner, 65 T.C. 87, 89-90

(1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976); see also Rule 142(a).

Section 162(a) allows deductions for all ordinary and necessary business

expenses paid or incurred during the taxable year in carrying on a trade or

business. Boyd v. Commissioner, 122 T.C. 305, 313 (2004). In the notice of

deficiency respondent disallowed $108,948 of the Schedule E loss deduction

attributable to Mr. Fagenboym’s interest in Alcor Electric during the year in issue. -8-

The disallowance was a result of the disallowance of deductions related to

$250,648 in business purchases reported on Alcor Electric’s 2015 Form 1120S.

The Code and the regulations thereunder required petitioners and Alcor Electric to

maintain records sufficient to establish the amount of any claimed deduction. See

sec. 6001; sec. 1.6001-1(a), Income Tax Regs.

Petitioners acknowledge that they have failed to substantiate certain of

Alcor Electric’s business expenses. They argue, however, that under Cohan v.

Commissioner, 39 F.2d 540 (2d Cir. 1930), the Court should estimate Alcor

Electric’s deductible expenses. Under the Cohan rule, when a taxpayer establishes

that he or she has incurred a deductible expense, but is unable to substantiate the

exact amount, the Court is permitted to estimate the deductible amount. Id. at 543-

544. But we can do so only to estimate the amount of the deductible expense

when the taxpayer provides evidence sufficient to establish a rational basis upon

which the estimate can be made. See Vanicek v. Commissioner, 85 T.C. 731, 743

(1985). In estimating the amount allowable the Court bears heavily upon the

taxpayer who failed to maintain required records and to substantiate expenses as

the Code requires. See Cohan v. Commissioner, 39 F.2d at 544; Keenan v.

Commissioner, T.C. Memo. 2006-45, aff’d, 233 F. App’x 719 (9th Cir. 2007).

Respondent asserts that the Cohan rule is not applicable in this case because -9-

petitioners have neither provided sufficient credible evidence to establish a

satisfactory basis for estimating Alcor Electric’s expenses nor shown that any

expenses were sustained in excess of the amounts already allowed.

We begin by summarizing our evaluation of the evidence proffered at the

trial. Mr. Fagenboym submitted four pages of handwritten calculations that

attempt to reconstruct Alcor Electric’s purchases and other expenses related to

four alleged business contracts. Mr. Fagenboym testified that he created the

handwritten document because he was unable to produce original records of the

amounts paid to one of Alcor Electric’s electrical suppliers, Alameda Electrical

Distributors (AED), on the four business contracts. In support of his calculations

Mr. Fagenboym testified that he was able to estimate the amount paid to AED by

Alcor Electric during the year in issue by taking the total amount paid to the S

corporation on each of the four contracts and subtracting a 12% profit margin to

produce an estimated total for the hard costs of each project. Mr. Fagenboym then

subtracted all known labor and materials costs from the resulting total hard costs

to produce the estimated total paid to AED on each contract. During the trial Mr.

Fagenboym did not produce contemporaneous records or any other business

records pertaining to Alcor Electric’s operations. He testified that he had - 10 -

previously provided substantiating documents to respondent for all hard costs on

the four contracts except for the amounts paid to AED.

Although Mr. Fagenboym’s testimony about industry operations was

generally reliable, the amounts included in the handwritten calculations proffered

are not backed by any underlying bank statements, receipts, or other

documentation. Mr. Fagenboym testified that the 12% profit margin on which his

calculations hinge was a rough estimate based on similar contracts in the industry.

He stated that the 12% figure was “potential profit” but noted that Alcor Electric’s

actual profit was “much less than that”.

Although we have no doubt that Mr. Fagenboym produced his calculations

in good faith, the reconstruction of expenses on the basis of an individual’s

estimate of industry standard profit margins does not take the place of

substantiation or provide a rational basis upon which an estimate can be made

under the Cohan rule. The record includes no reliable evidence establishing error

in respondent’s determinations in the notice disallowing petitioners’ claimed loss

deductions related to certain expenses reported by Alcor Electric during the year in

issue. On the record before us, we conclude that petitioners have failed to carry

their burden of establishing that Alcor Electric paid or incurred the expenses

underlying the deductions that respondent disallowed for its 2015 tax year. We - 11 -

therefore sustain respondent’s determination in the notice of deficiency

disallowing a portion of petitioners’ claimed Schedule E loss deductions for the

year in issue.

We have considered all of the parties’ arguments, and, to the extent not

addressed herein, we conclude that they are moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered for

respondent.