                               T.C. Memo. 2013-20



                         UNITED STATES TAX COURT



      AIMEE A. CVANCARA AND RYAN A. CVANCARA, Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 24377-09.                          Filed January 17, 2013.



      Aimee A. Cvancara and Ryan A. Cvancara, pro sese.

      Alicia E. Elliott and Jan Robert Cuatto, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      MARVEL, Judge: Respondent determined deficiencies in petitioners’

Federal income tax of $6,791 and $5,982 for 2005 and 2006, respectively, and
                                         -2-

[*2] accuracy-related penalties under section 6662(a)1 of $1,208 and $887 for 2005

and 2006, respectively. As discussed infra pp. 7-8, respondent lodged an amended

answer and moved to amend the answer after trial in this case. We previously

denied respondent’s motion but, upon due reconsideration, see infra p. 9, we will

grant respondent’s motion in part and decide in this opinion two of the issues raised

by the amended answer. After concessions2 and the foregoing, the issues for

decision are: (1) whether Desert Academy, LLC (Desert Academy), petitioners’

jointly owned limited liability company, failed to report gross receipts of $24,483

and $21,025 for 2005 and 2006, respectively; (2) whether Desert Academy is

entitled to cost of goods sold of $46,822 for 2005;3 (3) whether petitioners had

sufficient bases in Desert Academy at the end of 2005 and 2006 to


      1
        Unless otherwise indicated, all section references are to the Internal Revenue
Code (Code) as amended and in effect for the years at issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure. Some monetary amounts
have been rounded to the nearest dollar.
      2
        Petitioners concede that they failed to report on their 2005 Federal tax return
a 2004 State income tax refund of $1,315. Respondent concedes that (1) petitioners
are entitled to a deduction for educator expenses of $250 for 2005 and 2006; (2)
petitioners did not receive unreported taxable income from Desert Academy in the
form of fringe benefits (i.e., reduced tuition for petitioners’ children) for 2006; and
(3) petitioners are entitled to a deduction for home mortgage interest of $29,633 for
2006.
      3
        Respondent concedes that Desert Academy is entitled to deduct $30,548 of
the disallowed cost of goods sold for 2005.
                                        -3-

[*3] deduct Desert Academy’s losses for those years; (4) whether, under section

1401, petitioners are liable for self-employment tax on the ordinary income, if any,

from Desert Academy for 2005 and 2006; and (5) whether petitioners are liable for

accuracy-related penalties under section 6662(a) for 2005 and 2006.

                               FINDINGS OF FACT

      Some of the facts have been stipulated and are so found. The stipulations of

fact are incorporated herein by this reference. Petitioners resided in Arizona when

they petitioned this Court.

Background

      Petitioners formed Desert Academy in 2003 to operate a private early-

elementary school. Petitioners elected to treat Desert Academy as a partnership for

Federal income tax purposes.4 Desert Academy did not indicate whether it was

using an accrual or a cash method of accounting on its 2003 Form 1065, U.S.


      4
       The unified audit and litigation procedures of the Tax Equity and Fiscal
Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-248, sec. 402, 96 Stat. at 648,
do not apply to Desert Academy. Desert Academy qualifies as a small partnership
under sec. 6231(a)(1)(B)(i) and did not elect, pursuant to sec. 6231(a)(1)(B)(ii), to
have TEFRA apply. See Wadsworth v. Commissioner, T.C. Memo. 2007-46, 93
T.C.M. (CCH) 940, 943-944 (2007) (“The small partnership exception permits this
Court to review in a deficiency suit items that otherwise would be subject to
partnership-level proceedings.”); see also New Phoenix Sunrise Corp. v.
Commissioner, 132 T.C. 161, 173 n.3 (2009), aff’d, 408 Fed. Appx. 908 (6th Cir.
2010).
                                         -4-

[*4] Return of Partnership Income, but it indicated that it was using an accrual

method of accounting on its 2004-06 Forms 1065. The school closed in 2008.

      During 2005-06 petitioners had three minor children. Their two oldest

children attended Desert Academy’s school during 2005-06, and their youngest

child was born in 2005 and did not attend Desert Academy’s school during 2005-

06.

      During the years at issue Ryan Cvancara was employed as a special agent in

respondent’s Criminal Investigation Division and Aimee Cvancara, who had earned

a degree in political science from the University of Arizona, managed the day-to-day

activities of, and occasionally taught classes for, Desert Academy. Mrs. Cvancara

also maintained Desert Academy’s records and prepared its returns.

      At some point before the years at issue, Mr. Cvancara filed with respondent a

Form 7995, Outside Employment or Business Activity Request, requesting

permission to be involved in Desert Academy’s financial management. Respondent

denied Mr. Cvancara’s request, and accordingly, Mr. Cvancara did not participate in

Desert Academy’s financial management or prepare its returns. However, Mr.

Cvancara did teach an afterschool science club for Desert Academy.

      Petitioners reported the ordinary income or loss from Desert Academy on

Schedules E, Supplemental Income and Loss, attached to their Forms 1040, U.S.
                                         -5-

[*5] Individual Income Tax Return, for 2003-07.5 Petitioners reported losses of

$64,413 and $50,135 from Desert Academy on their Schedules E for 2003 and

2004, respectively.

Petitioners’ 2005 and 2006 Returns

      Petitioners claimed passthrough losses from Desert Academy of $41,497 and

$10,073 for 2005 and 2006, respectively. Mrs. Cvancara filed Desert Academy’s

2005 and 2006 returns on or about May 19, 2008.6 Desert Academy reported the

following amounts on its Forms 1065 for 2005 and 2006:

                    Gross         Cost of                         Ordinary
          Year     receipts      goods sold     Deductions     income or loss

          2005    $195,873         $46,822       $190,548        ($41,497)
          2006     203,565          38,451        175,188         (10,073)

Mr. Cvancara authorized Mrs. Cvancara to prepare and file their joint 2005 and

2006 returns, but he did not review those returns before signing them.




      5
        Petitioners used a Schedule C, Profit or Loss From Business, attached to
their Form 1040 for 2008.
      6
        On the returns, Mrs. Cvancara wrote that they were “recreated per IRS
request”; however, Mrs. Cvancara testified that she did not recall filing the original
returns.
                                          -6-

[*6] Notice of Deficiency

      On August 21, 2009, respondent issued to petitioners a notice of deficiency

for 2005 and 2006. With respect to Desert Academy, respondent included a Form

4605-A, Examination Changes--Partnerships, Fiduciaries, S Corporations, and

Interest Charge Domestic International Sales Corporations. The Form 4605-A made

the following adjustments and determinations with respect to Desert Academy’s

2005 and 2006 returns:

             Adjustment     Adjustment          Total     Corrected ordinary,
              to gross       to cost of     adjustments   distributable net, or
      Year    receipts      goods sold       to income      taxable income

      2005       -0-          ($46,822)         $46,822           $5,325
      2006     $21,025              42           20,983           10,910

Respondent adjusted Desert Academy’s gross receipts for 2006 after respondent’s

revenue agent performed a bank deposits analysis of Desert Academy’s bank

accounts and determined that it had not reported all payments it received in 2006,

but respondent did not adjust Desert Academy’s gross receipts for 2005 because

respondent’s revenue agent erroneously determined that Desert Academy had

reported all payments it received in 2005. Additionally, on the Form 4605-A,

respondent determined that Desert Academy’s corrected income constituted net

earnings from self-employment to petitioners.
                                        -7-

[*7] With respect to petitioners, respondent included a Form 4549-A, Income Tax

Discrepancy Adjustments, for 2005 and 2006. The Form 4549-A adjusted

petitioners’ 2005 and 2006 income to reflect respondent’s adjustments to Desert

Academy’s 2005 and 2006 returns.

Amended Answer

      After trial we held the record open to allow petitioners to produce to

respondent documents underlying certain summary exhibits and to substantiate

Desert Academy’s cost of goods sold for 2005. Petitioners timely produced certain

documents which were later included as exhibits in a supplemental stipulation of

facts and admitted into evidence. On February 22, 2011, respondent lodged an

amended answer with the Court and moved to amend the answer to conform the

pleadings to the evidence.

      In the lodged amended answer, respondent asserted (1) that both petitioners

had bases of zero in Desert Academy at the end of 2005 and 2006 and were thus not

entitled to deductions for any of Desert Academy’s losses during 2005 and 2006;

(2) that Desert Academy was entitled to claim cost of goods sold of only $30,548

for 2005; and (3) that Desert Academy had gross receipts of $220,356 for 2005.

Accordingly, respondent asserted an increased adjustment to petitioners’

Schedule E income of $41,497 and a revised income tax deficiency of $5,259 for
                                            -8-

[*8] 2005. Additionally, respondent asserted an increased adjustment to petitioners’

Schedule E income of $21,318 and a corresponding increase in the section 6662(a)

penalty of $46.20 for 2006.

      With respect to Desert Academy respondent included an amended Form

4605-A for 2005 and 2006. The amended Form 4605-A made the following

adjustments and determinations with respect to Desert Academy’s 2005 and 2006

returns:

             Adjustment       Adjustment         Total        Corrected ordinary,
              to gross         to cost of    adjustments to   distributable net, or
     Year     receipts        goods sold        income          taxable income

     2005      $24,483          ($16,274)         $40,757             ($740)
     2006       21,360                42           21,318            11,245

      With respect to petitioners respondent included a Form 5278, Statement--

Income Tax Changes, for 2005 and 2006. The Form 5278 adjusted petitioners’

2005 and 2006 income to reflect respondent’s adjustments to Desert Academy’s

2005 and 2006 returns and to reflect respondent’s assertion that petitioners had

bases of zero in Desert Academy at the end of 2005 and 2006 and were thus not

entitled to deductions for Desert Academy’s losses in 2005 and 2006.
                                         -9-

[*9]                                  OPINION

I.     Preliminary Matters

       By order dated January 27, 2012, we denied respondent’s motion to amend

the answer to conform pleadings to the evidence because we concluded that

granting the amendment at such a late stage would prejudice petitioners. See

Howard v. Commissioner, T.C. Memo. 2005-144, 89 T.C.M. (CCH) 1449, 1451

(2005) (“Prejudice to the other party is a key factor in deciding whether to allow an

amendment to the pleadings.”) (citing Kroh v. Commissioner, 98 T.C. 383, 389

(1992)). Respondent fully briefed the issues raised in the lodged amended answer

and urges us to reconsider the motion. After a careful review of the record, we find

that the parties tried by implied consent two of the issues raised in respondent’s

lodged amended answer. See Rule 41(b)(1). Those issues are: (1) whether Desert

Academy failed to report gross receipts of $24,483 for 2005 and (2) whether

petitioners had sufficient bases in Desert Academy at the end of 2005 and 2006 to

deduct Desert Academy’s losses for those years. We find that neither party will be

prejudiced by our deciding these two issues without supplemental briefing.

Accordingly, we will vacate our order denying respondent’s motion to conform

the pleadings to the evidence and decide those issues in this opinion.
                                       - 10 -

[*10] II.     Gross Receipts

       The parties dispute the amount of Desert Academy’s gross receipts for 2005

and 2006. The parties’ contentions can be summarized as follows:

                         Desert Academy’s gross receipts

       Year             Per return         Per respondent        Per petitioners

                                                1                    2
       2005             $195,873                    $220,356             $188,588
                                                    3                    4
       2006              203,565                      224,925              206,805
       1
         This is the amount that respondent asserted in the amended answer. On
brief, however, respondent contends that Desert Academy had gross receipts of
$221,766 for 2005.
       2
         Included in this amount are: (1) $4,213 in advance payments received in
2004 but included in income for 2005; (2) $211,297 in total payments received in
2005; and (3) less $26,921 in advance payments to be included in income for 2006.
Desert Academy’s records for 2005 show receipts received of only $191,660.
Accordingly, petitioners concede that Desert Academy’s records for 2005 omit
receipts of $19,637. Petitioners’ concession is based on their contention that they
deposited $211,297 into Desert Academy’s accounts in 2005. Respondent contends
that petitioners deposited $211,298 into Desert Academy’s accounts (not including
amounts petitioners paid to Desert Academy) in 2005, leaving omitted receipts of
$19,638. This $1 dispute is computational and should be resolved as part of the
Rule 155 computations.
       3
         A review of respondent’s bank deposits analysis and Desert Academy’s
records reveals that respondent erroneously included $380 as receipts recorded in
Desert Academy’s records for 2006 but not deposited into its accounts. In fact, the
item in question was deposited into Desert Academy’s accounts and was thus
already included in respondent’s bank deposits analysis.
       4
         Petitioners stipulated an exhibit in which they calculated Desert Academy’s
gross receipts to be $210,319 for 2006. Respondent subsequently identified
returned checks of $2,673, leaving gross receipts of $207,646. Included in this
amount are: (1) $26,921 in advance payments received in 2005 but included in
income for 2006, (2) $218,345 in total payments received in 2006, and (3) less
                                        - 11 -

[*11] $37,620 in advance payments to be included in income for 2007. Desert
Academy’s records for 2006 show receipts received of only $214,264. Desert
Academy thus omitted receipts of $4,081. However, petitioners contend on brief
that Desert Academy had gross receipts of $206,805 for 2006. This $841 difference
appears to be computational and should be resolved as part of the Rule 155
computations.

      The parties have two principal disputes with respect to Desert Academy’s

gross receipts for 2005 and 2006: (1) whether Desert Academy properly accounted

for advance payments it received in 2005 and 2006; and (2) whether amounts

petitioners paid to Desert Academy in 2005 and 2006 were tuition for petitioners’

children.

      A.     Burden of Proof

      Generally, the Commissioner’s determination of a deficiency is presumed

correct, and the taxpayer bears the burden of proving that the determination is

improper. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).

However, if the Commissioner raises a new issue or seeks an increase in a

deficiency, the Commissioner has the burden of proof as to the new issue or

increased deficiency. Rule 142(a)(1). Additionally, if a taxpayer produces

credible evidence7 with respect to any factual issue relevant to ascertaining the


      7
       “‘Credible evidence is the quality of evidence which, after critical analysis,
the court would find sufficient upon which to base a decision on the issue if no
                                                                         (continued...)
                                         - 12 -

[*12] taxpayer’s liability for any tax imposed by subtitle A or B of the Code and

satisfies the requirements of section 7491(a)(2), the burden of proof on any such

issue shifts to the Commissioner. Sec. 7491(a)(1). Section 7491(a)(2) requires a

taxpayer to demonstrate that he (1) complied with requirements under the Code to

substantiate any item, (2) maintained all records required under the Code, and (3)

cooperated with reasonable requests by the Secretary8 for witnesses, information,

documents, meetings, and interviews. See also Higbee v. Commissioner, 116 T.C.

438, 440-441 (2001).

      The U.S. Court of Appeals for the Ninth Circuit, to which an appeal in this

case would lie absent a stipulation to the contrary, see sec. 7482(b)(1)(A), (2), has

held that for the presumption of correctness to attach to the notice of deficiency in

unreported income cases, the Commissioner must establish some evidentiary

foundation connecting the taxpayer with the income-producing activity, see

Weimerskirch v. Commissioner, 596 F.2d 358, 361-362 (9th Cir. 1979), rev’g 67

T.C. 672 (1977), or demonstrating that the taxpayer actually received unreported

      7
       (...continued)
contrary evidence were submitted (without regard to the judicial presumption of IRS
correctness).’” Higbee v. Commissioner, 116 T.C. 438, 442 (2001) (quoting H.R.
Conf. Rept. No. 105-599, at 240-241 (1998), 1998–3 C.B. 747, 994-995).
      8
       The term “Secretary” means the Secretary of the Treasury or his delegate.
Sec. 7701(a)(11)(B).
                                       - 13 -

[*13] income, Edwards v. Commissioner, 680 F.2d 1268, 1270-1271 (9th Cir.

1982). If the Commissioner introduces some evidence that the taxpayer received

unreported income, the burden shifts to the taxpayer, who must establish by a

preponderance of the evidence that the unreported income adjustment was arbitrary

or erroneous. See Hardy v. Commissioner, 181 F.3d 1002, 1004 (9th Cir. 1999),

aff’g T.C. Memo. 1997-97.

      With respect to the unreported income adjustment for 2005, respondent

concedes that he bears the burden of proof because that issue was not raised in

the notice of deficiency. See Rule 142(a)(1). With respect to the unreported

income adjustment for 2006, the parties agree that Desert Academy received the

payments at issue. Accordingly, to the extent that any factual issues remain,

petitioners would bear the burden of proof with respect to the unreported income

adjustment for 2006, see Hardy v. Commissioner, 181 F.3d at 1004, unless they

satisfy the requirements of section 7491(a)(1) and (2). However, to the extent

such issues remain, we decide those issues on the preponderance of the evidence.

Accordingly, we need not decide whether petitioners satisfy the requirements of

section 7491(a)(1) and (2). See Knudsen v. Commissioner, 131 T.C. 185, 188-189

(2008); see also Estate of Morgens v. Commissioner, 133 T.C. 402, 409 (2009)
                                        - 14 -

[*14] (burden of proof irrelevant where only legal issues remain), aff’d, 678 F.3d

769 (9th Cir. 2012).

      B.     Desert Academy’s Accrual Method

      Respondent contends that advance payments of $26,922 and $37,620

received by Desert Academy in 2005 and 2006, respectively, should be included in

Desert Academy’s income for the years of receipt. Petitioners contend that these

payments were properly included in income for 2006 and 2007, respectively, under

Desert Academy’s accrual method of accounting.

             1.    Advance Payments Generally

      Section 446(a) provides that “[t]axable income shall be computed under the

method of accounting on the basis of which the taxpayer regularly computes his

income in keeping his books.” A taxpayer may adopt any permissible method of

accounting on the first income tax return on which an item appears. Once a

permissible method is chosen, the taxpayer must secure the consent of the

Secretary before adopting a new method. Sec. 446(e). A change in the method of

accounting includes a change in the overall plan of accounting or a change in the

treatment of any material item used in the overall plan. See sec.

1.446-1(e)(2)(ii)(a), Income Tax Regs. (made applicable on or after December 30,

2003, by section 1.446-1(e)(4)(i), Income Tax Regs.). Section 446(b) grants the
                                        - 15 -

[*15] Commissioner broad discretion to require a taxpayer to use a method of

accounting that, in the Commissioner’s opinion, clearly reflects income.

      Section 1.446-1(c)(ii)(A), Income Tax Regs., provides that “[g]enerally,

under an accrual method, income is to be included for the taxable year when all the

events have occurred that fix the right to receive the income and the amount of the

income can be determined with reasonable accuracy.” The Commissioner maintains

that the “all events” test is satisfied when “(1) the required performance occurs, (2)

payment therefor is due, or (3) payment therefor is made, whichever happens

earliest.” Rev. Rul. 74-607, 1974-2 C.B. 149, 150.

      In a trilogy of cases, the Supreme Court upheld the Commissioner’s

determinations that unrestricted, advance payments for services were to be included

in income for the year of receipt. See Schlude v. Commissioner, 372 U.S. 128

(1963); Am. Auto. Ass’n v. United States, 367 U.S. 687 (1961); Auto. Club of

Mich. v. Commissioner, 353 U.S. 180 (1957); see also Johnson v. Commissioner,

108 T.C. 448, 491 (1997), aff’d in part, rev’d in part on another issue, 184 F.3d

786 (8th Cir. 1999). However, in Artnell Co. v. Commissioner, 400 F.2d 981

(7th Cir. 1968), rev’g and remanding 48 T.C. 411 (1967), the U.S. Court of

Appeals for the Seventh Circuit held that the deferral of income realized

from advance sales of season tickets to, and the broadcasting rights for,
                                        - 16 -

[*16] professional baseball games until the year in which the games would be

played could clearly reflect income. The Court of Appeals distinguished the

advance payments at issue in Artnell from the advance payments at issue in the

trilogy of Supreme Court cases cited above, “where the time and extent of

performance of future services were uncertain.” Id. at 983-984. By contrast, the

Court of Appeals reasoned, the deferred income at issue in Artnell “was allocable to

games which were to be played on a fixed schedule. Except for rain dates, there

was certainty.” Id. at 984. Since Artnell, we have indicated that we “‘will not

follow the rationale of that case unless the facts present a certainty, of performance

or fixed dates, such as was presented in Artnell Co.”’ Johnson v. Commissioner,

108 T.C. at 492 (quoting T.F.H. Publ’ns, Inc. v. Commissioner, 72 T.C. 623, 644

(1979), aff’d without published opinion, 622 F.2d 579 (3d Cir. 1980)); see also

Tampa Bay Devil Rays, Ltd. v. Commissioner, T.C. Memo. 2002-248, 84 T.C.M.

(CCH) 394, 399 (2002) (finding Artnell applicable).

      Recognizing that limited deferral of advance payments for services is

sometimes appropriate, the Commissioner has permitted accrual method taxpayers

to defer certain prepaid services income for up to one year. See Rev. Proc. 71-21,

1971-2 C.B. 549; see also Rev. Proc. 2004-34, 2004-1 C.B. 991 (allowing limited

deferral for certain other types of income). Rev. Proc. 2004-34, supra, which
                                        - 17 -

[*17] modified and superseded Rev. Proc. 71-21, supra, provides two methods for

accounting for advance payments for accrual method taxpayers: the “Full Inclusion

Method” and the “Deferral Method” (deferral method). See Rev. Proc. 2004-34,

sec. 5, 2004-1 C.B. at 992. Under the deferral method, a taxpayer

       must --

             (i) include the advance payment in gross income for the taxable
       year of receipt * * * to the extent provided in section 5.02(3) of this
       revenue procedure, and

              (ii) * * * include the remaining amount of the advance payment
       in gross income for the next succeeding taxable year.

Id. sec. 5.02(1)(a). Rev. Proc. 2004-34, sec. 5.02(3), 2004-1 C.B. at 993, provides

that

             (a) * * * a taxpayer using the Deferral Method must --

             (i) include the advance payment in gross income for the taxable
       year of receipt * * * to the extent recognized in revenues in its
       applicable financial statement * * * for that taxable year, and

              (ii) include the remaining amount of the advance payment in
       gross income in accordance with section 5.02(1)(a)(ii) of this revenue
       procedure.

              (b) If the taxpayer does not have an applicable financial
       statement * * *, a taxpayer using the Deferral Method must include
       the advance payment in gross income for the taxable year of receipt
       * * * to the extent earned in that taxable year and include the
       remaining amount of the advance payment in gross income in
       accordance with section 5.02(1)(a)(ii) of this revenue procedure. The
                                         - 18 -

      [*18] determination of whether an amount is earned in a taxable year
      must be made without regard to whether the taxpayer may be required
      to refund the advance payment upon the occurrence of a condition
      subsequent. * * *

An applicable financial statement is a

      financial statement listed in paragraphs (1) through (3) of this section
      4.06 that has the highest priority (including within paragraph (2)). A
      taxpayer that does not have a financial statement described in
      paragraphs (1) through (3) of this section 4.06 does not have an
      applicable financial statement for purposes of this revenue procedure.
      The financial statements are, in descending priority --

            (1) a financial statement required to be filed with the Securities
      and Exchange Commission * * *;

             (2) a certified audited financial statement that is accompanied by
      the report of an independent CPA * * * that is used for --

             (a) credit purposes,

             (b) reporting to shareholders, or

             (c) any other substantial non-tax purpose; or

            (3) a financial statement (other than a tax return) required to be
      provided to the federal or a state government or any federal or state
      agencies (other than the SEC or the Internal Revenue Service).

Id. sec. 4.06, 2004-1 C.B. at 992.

             2.    Desert Academy’s Use of the Deferral Method

      Petitioners contend that Desert Academy elected to use an accrual method

of accounting and that it was thus entitled to defer recognizing the advance
                                       - 19 -

[*19] payments it received in 2005 and 2006. Further, petitioners contend that

Desert Academy should be allowed to use its accrual method of accounting because

respondent’s revenue agent, Pauline Cox, testified that an accrual method of

accounting would more clearly reflect Desert Academy’s income.

      Respondent contends that he was entitled to compute Desert Academy’s

gross receipts using the bank deposits method because (1) Desert Academy’s

records were “unreliable, inaccurate, and incomplete”; (2) Desert Academy

accounted for its expenses on a cash basis; and (3) Desert Academy was ineligible

to use the deferral method provided for in Rev. Proc. 2004-34, supra, because the

advance payments were subject to a condition subsequent and were thus earned in

the year of receipt.9

      Mrs. Cvancara credibly testified that she intended from the beginning for

Desert Academy to use an accrual method of accounting because the school year

spans two calender years. Desert Academy did not check the box indicating

whether it was using an accrual or a cash method of accounting on its 2003 Form

1065, but it affirmatively stated on its 2004-06 Forms 1065 that the information

reported on those forms was calculated using an accrual method of accounting.



      9
        Petitioners did not introduce Desert Academy’s financial statements, and we
infer that it did not prepare applicable financial statements within the meaning of
Rev. Proc. 2004-34, sec. 4.06, 2004-1 C.B. 991, 992, for the years at issue.
                                       - 20 -

[*20] And although Mrs. Cvancara testified that she mistakenly included advance

payments received in 2005 for services to be rendered in 2006 on Desert

Academy’s 2005 Form 1065, she also included advance payments received in 2004

for services to be rendered in 2005 on Desert Academy’s 2005 Form 1065. She

also included advance payments received in 2005 for services to be rendered in

2006, and excluded advance payments received in 2006 for services to be rendered

in 2007, on Desert Academy’s 2006 Form 1065. Desert Academy’s records for

2005 and 2006, although imperfect, clearly indicate which payments were to be

deferred to the following year. Moreover, Revenue Agent Cox testified that she

probably would have used an accrual method in determining Desert Academy’s

gross receipts had petitioners provided her with Desert Academy’s records during

the examination and that an accrual method was a more appropriate method of

accounting for the advance payments at issue in this case. We find that Desert

Academy (1) elected to use an accrual method of accounting, (2) elected to use the

deferral method with respect to any advance payments it received, see Rev. Proc.

2004-34, supra, and (3) maintained its record of income, and calculated its income

for income tax purposes, using an accrual method of accounting.

      We accordingly reject respondent’s first contention that Desert Academy did

not use an accrual method because its records were “unreliable, inaccurate, and
                                       - 21 -

[*21] incomplete”. Although far from perfect, Desert Academy’s records were

sufficient to allow respondent to verify the amounts deferred. See Rev. Proc. 71-21,

sec. 4, 1971-2 C.B. at 550.10

      Respondent’s second contention is that Desert Academy was not using an

accrual method because, although it may have accounted for its income under an

accrual method, it accounted for its expenses under the cash method.11

Respondent, however, did not exercise his discretion under section 446(b), see

Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 532-533 (1979), to require

Desert Academy to change its method of accounting to the cash method. Rather,

respondent seems to be arguing that Desert Academy’s purported use of the cash

method to account for its expenses supports respondent’s theory that Desert

Academy never actually employed an accrual method of accounting. However, we

      10
        Moreover, contrary to respondent’s contention, Rev. Proc. 2004-34, supra,
contains no explicit requirement that a taxpayer electing the deferral method must
maintain adequate books and records to allow the Commissioner to verify the
amounts deferred.
      11
        The regulations specifically disallow accounting for income on the cash
method and expenses on an accrual method, see sec. 1.446-1(c)(1)(iv), Income Tax
Regs., and we have previously sustained the disallowance of such schemes, see
Grider v. Commissioner, T.C. Memo. 1999-417, 78 T.C.M. (CCH) 1209, 1211
(1999). The regulations, however, do not specifically disallow the use of an accrual
method to calculate income and the cash method to calculate expenses. See also
sec. 1.162-3, Income Tax Regs. (providing that the costs for certain incidental
materials or supplies can be deducted from gross income during the year they are
purchased).
                                         - 22 -

[*22] have already found that Desert Academy elected an accrual method of

accounting, elected to account for advance payments it received under the deferral

method, and calculated its income under an accrual method. Desert Academy’s

purported use of the cash method to calculate its expenses does not alter our

conclusions.

      Respondent’s final contention is that the advance payments were subject to a

condition subsequent, see Rev. Proc. 2004-34, sec. 5.02(3)(b), because parents that

prepaid their children’s tuition were entitled to a refund if they withdrew their

children from the school. Respondent’s contention is flawed, however, because it

appears to be based on a misreading of Rev. Proc. 2004-34, sec. 5.02(3)(b). The

revenue procedure does not make the existence of a condition subsequent

controlling. Rather, it provides that the determination of whether an amount is

earned in a subsequent year “must be made without regard to whether the taxpayer

may be required to refund the advance payment upon the occurrence of a condition

subsequent.” Id. Here, because Desert Academy is entitled to retain the advance

payments only if it provides the services that it agreed to provide, we determine that

Desert Academy earned the advance payments in the year that the services

were provided without regard to any condition subsequent. Accordingly, Desert

Academy was entitled to use the deferral method for those payments.
                                        - 23 -

[*23] In short, we conclude that Desert Academy properly accounted for advance

payments it received under the deferral method allowed under Rev. Proc. 2004-34,

supra.

         C.   Petitioners’ Payments to Desert Academy

         Respondent contends that payments of $10,468 and $6,200 made by

petitioners to Desert Academy during 2005 and 2006, respectively, represented

tuition for two of petitioners’ children.12 Petitioners contend that those payments

were capital contributions and not tuition.




         12
        Respondent belatedly contends on brief that petitioners have treated these
payments inconsistently because they claimed a tax credit of $109 for child and
dependent care expenses of $3,960 paid to Desert Academy in 2005. See secs.
1.44A-4(a)(4), 1.21-4(b) (2012), Income Tax Regs. Petitioners contend that they
erroneously reported that the funds were paid to Desert Academy and that they
should have provided on their return the name of a different school that petitioners’
eldest son attended in 2005.

       We note that petitioners did not claim child and dependent care credits on
their Forms 1040 for tax years 2003 and 2004 and 2006-08, even though at least one
of their children attended Desert Academy’s school during at least some of those
years. We further note that respondent raised this issue for the first time on brief,
and petitioners were not afforded an opportunity to produce additional evidence to
support their contention. Accordingly, to the extent that respondent is asserting that
petitioners cannot claim the amount they reported as a child and dependent care
expense on their 2005 Form 1040 as a capital contribution to Desert Academy, we
decline to consider the argument because doing so would prejudice petitioners. See
DiLeo v. Commissioner, 96 T.C. 858, 891-892 (1991), aff’d, 959 F.2d 16 (2d Cir.
1992).
                                         - 24 -

[*24] Generally, no gain or loss is recognized to a partnership or its partners upon

the contribution of property to a partnership in exchange for a partnership interest.

Sec. 721(a); sec. 1.721-1(a), Income Tax Regs. The contributing partner’s basis in

the partnership interest is the amount of money contributed plus the adjusted basis

of other contributed property, increased by the amount of any gain recognized by

the contributing partner. Sec. 722. Gain is also not recognized to a partner on the

distribution of property from a partnership to a partner, except to the extent that the

distribution exceeds the partner’s adjusted basis in the partnership. Sec. 731(a)(1).

However, where a distribution is not in liquidation of a partner’s interest in the

partnership, the partner’s basis in the partnership is reduced by the amount of money

distributed plus the adjusted basis of other property distributed. Sec. 733.

      In certain instances the Code treats transactions between a partnership and a

partner as transactions between the partnership and a third party. See sec. 707(a).

Section 1.707-1(a), Income Tax Regs., provides that

      [a] partner who engages in a transaction with a partnership other than
      in his capacity as a partner shall be treated as if he were not a member
      of the partnership with respect to such transaction. Such transactions
      include, for example, loans of money or property by the partnership to
      the partner or by the partner to the partnership, the sale of property by
      the partner to the partnership, the purchase of property by the partner
      from the partnership, and the rendering of services by the partnership
                                          - 25 -

       [*25] to the partner or by the partner to the partnership. * * *
       However, transfers of money or property by a partner to a partnership
       as contributions, or transfers of money or property by a partnership to a
       partner as distributions, are not transactions included within the
       provisions of this section. In all cases, the substance of the transaction
       will govern rather than its form. * * *

In short, transactions between a partnership and a partner are treated as transactions

between a partnership and a third party only where the substance of the transactions

is that of transactions between a partnership and a third party. See id.; see also sec.

1.707-3(b), Income Tax Regs. (providing factors indicating that a contribution of

property and a related distribution of money or property are, in substance, a

disguised sale of the contributed property).

       Petitioners were the only members of Desert Academy. Over the years,

petitioners made significant capital contributions to Desert Academy. Mrs.

Cvancara credibly testified that petitioners never intended for Desert Academy to

charge tuition for their children and that all of their payments to Desert Academy

were intended to be capital contributions. Desert Academy did not record

petitioners’ payments to it as tuition received. Additionally, the timing of

petitioners’ payments to Desert Academy indicates that the payments were not

tuition for petitioners’ children but, rather, capital contributions to cover shortfalls
                                        - 26 -

[*26] in Desert Academy’s operating accounts. Accordingly, we find that, in

substance, these payments were capital contributions and not tuition.

      Because petitioners’ payments to Desert Academy were capital contributions,

any amounts that Desert Academy paid on account of petitioners’ children should be

treated as distributions from Desert Academy to petitioners. Respondent, however,

does not contend that Desert Academy distributed money or property to petitioners

by not charging petitioners tuition. Rather, respondent contends that petitioners’

capital contributions to Desert Academy should be recast as tuition payments

because Desert Academy was required to charge petitioners tuition.

      To support this contention respondent cites cases in which we sustained

the disallowance of charitable contribution deductions on the grounds that the

payments in question were not charitable contributions under section 170 but

rather tuition payments. See DeJong v. Commissioner, 36 T.C. 896, 899-900

(1961), aff’d, 309 F.2d 373 (9th Cir. 1962); Oppewal v. Commissioner, T.C.

Memo. 1971-273, 30 T.C.M. (CCH) 1177, 1178 (1971), aff’d, 468 F.2d 1000 (1st

Cir. 1972); see also Sklar v. Commissioner, 125 T.C. 281, 291-292 (2005), aff’d,

549 F.3d 1252 (9th Cir. 2008). In DeJong v.Commissioner, 36 T.C. at 899, we

held that, as used in section 170, “the term ‘charitable contribution’ is synonymous
                                         - 27 -

[*27] with the word ‘gift’” and that “[i]f a payment proceeds primarily from the

incentive of anticipated benefit to the payor beyond the satisfaction which flows

from the performance of a generous act, it is not a gift”. Accordingly, in the cases

respondent cites, we found that the payments at issue were made with the

anticipation of receiving a substantial benefit in return and were thus not

charitable contributions. See id. at 899-900; Oppewal v. Commissioner, 30

T.C.M. (CCH) at 1178; see also Sklar v. Commissioner, 125 T.C. at 292.

      The reasoning of these cases, however, is inapplicable here for two reasons.

First, DeJong and Oppewal construed the term “charitable contribution” as it is

used in section 170. By contrast, the issue here is whether the nonrecognition

provisions of section 721 apply to petitioners’ payments to Desert Academy.

Section 170 and section 721 serve entirely different purposes, and our cases

applying the term “charitable contribution” in section 170 do not control our

interpretation of the term “contribution” as it is used in section 721. Second, and

more importantly, we have found that petitioners’ payments to Desert Academy

were, in substance, capital contributions and not tuition. That is, petitioners did

not make the payments at issue in anticipation of receiving a benefit from Desert

Academy. Rather, petitioners made the payments at issue because Desert

Academy required capital contributions to continue operating. By contrast, in the
                                        - 28 -

[*28] cases respondent cites, we found that the taxpayers made the payments at

issue only because they anticipated receiving a substantial benefit in return. See

DeJong v. Commissioner, 36 T.C. at 899-900; Oppewal v. Commissioner, 30

T.C.M. (CCH) at 1178.

       Accordingly, we conclude that petitioners’ payments to Desert Academy in

2005 and 2006 were capital contributions and not tuition.

III.   Self-Employment Income

       As we have concluded that Desert Academy properly accounted for advance

payments it received in 2005 and 2006 under the deferral method, see supra pp. 18-

23, and that amounts petitioners paid to Desert Academy constituted capital

contributions and not tuition, see supra pp. 23-28, Desert Academy had no net

income during 2005 or 2006. Accordingly, petitioners are not liable for self-

employment tax for 2005 or 2006. See secs. 1401(a), 1402(a).13

IV.    Cost of Goods Sold

       Respondent concedes that Desert Academy was entitled to cost of goods sold

of $30,548 for 2005. Petitioners contend that Desert Academy was entitled to cost

of goods sold of $47,266 for 2005.

       13
        We therefore need not decide whether Mr. Cvancara is a limited partner
under sec. 1402(a)(13). See Renkemeyer, Campbell & Weaver, LLP v.
Commissioner, 136 T.C. 137, 149-150 (2011).
                                          - 29 -

[*29] We note at the outset that it does not appear that Desert Academy maintained

inventories of merchandise that it sold to customers. The amount that Desert

Academy claimed as cost of goods sold in reality consists of expenses paid or

incurred in carrying on Desert Academy’s educational business. We analyze

petitioners’ claim for additional cost of goods sold accordingly.

      A.     In General

      Section 162(a) permits a taxpayer to deduct ordinary and necessary expenses

paid or incurred in carrying on a trade or business. See Commissioner v. Lincoln

Sav. & Loan Ass’n, 403 U.S. 345, 352 (1971). A trade or business expense is

ordinary for purposes of section 162 if it is normal or customary within a particular

trade, business, or industry, and it is necessary if it is appropriate and helpful for the

development of the business. Commissioner v. Heininger, 320 U.S. 467, 471

(1943). Section 262(a) disallows deductions for personal, living, or family

expenses. See also sec. 1.162-17(a), Income Tax Regs.

      Generally, a taxpayer must maintain adequate records to substantiate the

amounts of his or her income and entitlement to any deductions or credits claimed.

Sec. 6001; sec. 1.6001-1(a), Income Tax Regs. When a taxpayer establishes that

he or she paid or incurred a deductible expense but does not establish the amount

of the expense, we may estimate the amount allowable in some circumstances (the
                                        - 30 -

[*30] Cohan rule). See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir.

1930), aff’g in part, rev’g in part 11 B.T.A. 743 (1928). There must be sufficient

evidence in the record, however, 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. 731, 743 (1985). In estimating the amount allowable, we bear heavily upon

the taxpayer who failed to maintain required records and to substantiate deductions

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

      For certain kinds of business expenses, section 274(d) overrides the Cohan

rule. See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d per curiam, 412

F.2d 201 (2d Cir. 1969). Under section 274(d), a taxpayer must satisfy strict

substantiation requirements before a deduction is allowable. These strict

substantiation requirements apply to any traveling expense, including meals and

lodging away from home, any item with respect to an activity in the nature of

entertainment, or the use of listed property, as defined in section 280F(d)(4),

including passenger automobiles and, for the years at issue, cellular telephones.

      To deduct these expenses, the taxpayer must “substantiate[] by adequate

records or by sufficient evidence corroborating the taxpayer’s own statement”: (1)

the amount of the expense or other item; (2) the time and place of travel,
                                          - 31 -

[*31] entertainment, or use of the property; (3) the business purpose of the expense

or other item; and (4) the business relationship of the taxpayer to the persons

entertained or using the property. Sec. 274(d). To satisfy the requirements of

section 274(d), a taxpayer must maintain records and documentary evidence that in

combination are sufficient to establish each element of an expenditure or use. Sec.

1.274-5T(c)(1) and (2), Temporary Income Tax Regs., 50 Fed. Reg. 46016-46017

(Nov. 6, 1985). Although a contemporaneous log is not required, corroborative

evidence created at or near the time of the expenditure to support a taxpayer’s

reconstruction “of the elements * * * of the expenditure or use must have a high

degree of probative value to elevate such statement” to the level of credibility of a

contemporaneous record. Sec. 1.274-5T(c)(1), Temporary Income Tax Regs.,

supra.

         B.    Burden of Proof

         Generally, the taxpayer bears the burden of proving that he is entitled to any

claimed deduction. See Rule 142(a)(1); INDOPCO, Inc. v. Commissioner, 503

U.S. 79, 84 (1992). This includes the burden of substantiation. Sec. 6001;

Hradesky v. Commissioner, 65 T.C. 87, 89 (1975), aff’d per curiam, 540 F.2d 821

(5th Cir. 1976); sec. 1.6001-1(a), (e), Income Tax Regs. If, however, a taxpayer

produces credible evidence with respect to any factual issue relevant to
                                        - 32 -

[*32] ascertaining the taxpayer’s tax liability for any tax imposed by subtitle A or B

of the Code and satisfies the requirements of section 7491(a)(2), the burden of proof

on any such issue shifts to the Commissioner. Sec. 7491(a)(1). However, because

we decide the factual issues with respect to Desert Academy’s claimed cost of

goods sold on the preponderance of credible evidence and not on any failure to

carry the burden of proof, we need not decide whether petitioners satisfy the

requirements of section 7491(a)(1) and (2). See Estate of Jorgensen v.

Commissioner, 431 Fed. Appx. 544, 547 (9th Cir. 2011), aff’g T.C. Memo.

2009-66; Blodgett v. Commissioner, 394 F.3d 1030, 1039 (8th Cir. 2005), aff’g

T.C. Memo. 2003-212; Knudsen v. Commissioner, 131 T.C. at 188-189.

      C.     Disputed Items

      Initially, respondent disallowed Desert Academy’s 2005 cost of goods sold

in its entirety. Petitioners introduced into evidence a document purporting to be a

summary of Desert Academy’s cost of goods sold for 2005. Mrs. Cvancara

testified that this document was initially created during 2005 and the beginning of

2006 but that it had been amended several times since. Mrs. Cvancara further

testified that she retained the original summary document as well as the receipts

and bank statements that she used to create the summary document. We held the

record open after trial to allow petitioners to submit to respondent and, through a
                                        - 33 -

[*33] supplemental stipulation, to the Court, the original summary document and

any supporting documents. After trial, petitioners submitted an additional amended

summary document and various supporting receipts and bank statements but did not

submit the original summary document. After receiving the supporting receipts and

bank statements, respondent conceded that Desert Academy had cost of goods sold

of $30,548 for 2005. The amended summaries and the supporting documents were

included in a supplemental stipulation of facts filed on April 11, 2011, and the

attached documents were admitted into evidence without objection, but petitioners

have offered no specific testimony to explain the business purpose of the various

disputed items. Without testimony or other evidence as to the business purpose of

the disputed items, we cannot know whether many of the disputed items had a

business purpose. Moreover, we cannot assume that certain disputed items had a

business purpose because some of the receipts that petitioners introduced appear to

show that some of the expenses were for Mrs. Cvancara’s personal expenses.

Accordingly, as petitioners bear the burden of proof, we can allow only those items

the business purpose of which is apparent.

      The parties refer to the disputed items by the number assigned to each item

in the summary document petitioners introduced, and for the convenience of the

parties, we will refer to them accordingly. The disputed items fall into three
                                         - 34 -

[*34] general categories: (1) items respondent disallowed because petitioners failed

to satisfy the section 274(d) substantiation requirements with respect to those items;

(2) items respondent disallowed because they lacked a business purpose; and (3)

items respondent disallowed because petitioners were unable to produce legible,

detailed receipts to substantiate the claimed expenses.14

             1.     Items Inadequately Substantiated Under Section 274(d)

      Respondent disallowed several items that relate to expenses for meals,

entertainment, cellular telephones, and the use of a passenger automobile. To

deduct these expenses, petitioners are required to satisfy the strict substantiation

requirements of section 274(d).

      Items 8, 9, 111, 226, 235, 239, 245, and 315 are charges totaling $259

incurred at various restaurants and eateries. Petitioners failed to produce credible

evidence with respect to the persons entertained or the business purpose of these

items. Accordingly, we sustain respondent’s disallowance of these items.

      Items 22, 52, 115, 153, 171, 204, 223, 246, 292, 337, 379, and 406 are

charges totaling $850 for cellular telephone services and accessories. Petitioners



      14
        Additionally, Desert Academy’s records show item 16 as an expense of
$2.81, but the receipt provided by petitioners shows $2.19. We accordingly sustain
respondent’s adjustment to item 16.
                                        - 35 -

[*35] failed to produce credible evidence with respect to the business purpose of

these items. Accordingly, we sustain respondent’s disallowance of these items.

      Items 26, 104, 112, 227, 261, 262, 278, 340, 352, 357, and 408 are charges

totaling $415 incurred at various gas stations. Petitioners failed to produce credible

evidence with respect to the business purpose of these items. Accordingly, we

sustain respondent’s disallowance of these items.

             2.     Items Lacking a Business Purpose

      Respondent disallowed several items, or parts thereof, that he deemed

personal, or otherwise not business, expenses. Petitioners contend that the

disallowed expenses were business expenses and should have been allowed.

      After reviewing these disputed items, we find that some of the items had a

business purpose and some were personal expenses. We are unable to determine

whether the rest of the items had a valid business purpose. Because petitioners bear

the burden of proof, we cannot allow those items, or parts thereof, the business

purpose of which is not apparent. See Rule 142(a)(1). Accordingly, in the table

that follows, we set out with respect to each of these items (1) the amount

petitioners claimed, (2) the amount respondent allowed, (3) the amount we allow
                                       - 36 -

[*36] as a valid business expense, and (4) the amount of the disallowed expenses

that we determine to be personal expenses.15


              Amount claimed         Amount           Allowed as
               by petitioners      allowed by          business         Personal
   Item                            respondent          expenses         expenses

                                                        1
    11             $13.78             $8.97               $13.78              -0-
                                                            2             3
    17              50.67              -0-                    2.49          $4.24
    18              64.38              -0-                    -0-             -0-
    25              48.14             32.54                 32.54             -0-
                                                          4
    62              97.28              -0-                  97.28             -0-
    81               7.61              -0-                    -0-             -0-
                                                        5
    91             178.38            151.83               170.19              -0-
                                                          6                 7
    94              40.38             31.89                 33.64             6.68
                                                                            8
    123             31.22             17.64                 17.64             2.78
                                                                          9
    125             43.28              9.96                   9.96          14.65
                                                                           10
    128             42.28             27.34                 27.34             2.99
                                                         11                12
    155             15.26             12.48                 13.27             1.99
                                                                           13
    169             85.36             75.00                 75.00             6.37
                                                                           14
    190             17.25              -0-                    -0-             2.11
                                                         15
    191             13.70              -0-                  13.70             -0-
                                                         16
    210             33.66             23.69                 33.66             -0-
    216              9.72              -0-                    -0-             -0-
                                                                           17
    232             15.65             12.20                 12.20             3.67
    241             93.70             50.81                 50.81             -0-
                                                                         18
    243             93.73             49.53                 49.53           22.32
                                                           19
    247              2.48              -0-                    1.49            -0-

      15
        We specifically find that some of the disallowed expenses were personal
expenses because, as discussed infra pp. 47-49, we find that petitioners are liable
for an accuracy-related penalty for an underpayment of tax attributable to negligence
or disregard of rules and regulations, see sec. 6662(a), (b)(1), with respect to
amounts we determine to be personal expenses but not with respect to the other
disallowed expenses that we do not allow in this part.
                                       - 37 -

 [*37]

                                                         20               21
    253              9.27              2.97                  3.21             6.06
                                                        22                23
    260            171.29             82.51                88.22              0.44
                                                                         24
    268             90.20             63.82                63.82            14.64
                                                                           25
    277             23.51             15.47                15.47              1.04
                                                          26
    284              5.98              -0-                   5.98             -0-
    285             28.82              -0-                   -0-              -0-
    301             37.63             31.47                31.47              -0-
    317             18.98              -0-                   -0-              -0-
                                                          27               28
    319             10.15              5.48                  9.15             1.00
                                                                         29
    322            153.04             97.86                97.86            10.25
    324             31.78             29.00                29.00              -0-
                                                        30                 31
    325             63.86             29.16                31.52              1.26
                                                        32
    328             32.43             25.10                27.87              -0-
                                                                           33
    333             36.64             21.13                21.13              2.00
                                                        34
    338             49.29             40.85                44.16              -0-
                                                        35
    341             24.99             11.00                13.67              -0-
                                                        36                 37
    351             61.78             43.79                45.17              2.16
                                                        38
    356             31.38              -0-                 27.50              -0-
                                                                           39
    361             36.72             29.02                29.02              3.14
                                                        40                 41
    364A            49.98             41.90                46.52              3.74
    365             51.60              -0-                   -0-              -0-
    377             23.69             15.76                15.76              -0-
                                                          42
    380              7.77              -0-                   7.77             -0-
    407             18.38              -0-                   -0-              -0-
    409             10.81              -0-                   -0-              -0-
     Total       2,077.88          1,090.17           1,308.79           113.53

      1
         Respondent did not include the markup of this receipt, and we see no reason
not to allow the full amount.
       2
         We allow the milk. Respondent’s notes on several receipts indicate that
Desert Academy served snacks and drinks to its students. Accordingly, we allow
expenses that serve this business purpose. All adjustments in this table reflect tax
shown on the receipt.
       3
         We find that the children’s medicine is a personal expense.
       4
         We allow the router as a business expense.
                                         - 38 -

[*38] 5We allow the training pants as a business expense.
       6
         We allow the pop tarts. See supra table note 2.
       7
         We find that the drinks are personal.
       8
         We find that the coffee and water are personal.
       9
         We find that the candy, drinks, and medicine are personal.
       10
          We find that the coffee is personal.
       11
          We allow the tax on the allowed items.
       12
          We find that the coffee is personal.
       13
          We find that the nursing pads are personal.
       14
          We find that the coffee is personal.
       15
          We allow the résumé paper as a business expense, and respondent
disallowed the remaining items only because the cost of the résumé paper was
illegible. Accordingly, we allow this item in full.
       16
          We allow the plants as a business expense.
       17
          We find that the coffee is personal.
       18
          We find that the infant formula and cookies are personal.
       19
          We allow the milk. See supra table note 2.
       20
          We allow the tax on the allowed item.
       21
          We find that the coffee and the coffee cake are personal.
       22
          We allow the tax on the allowed items.
       23
          We find that the chocolate is personal.
       24
          We find that the backpack and the soda are personal.
       25
          We find that the infant bottle is personal.
       26
          We allow the fruit snacks, see supra table note 2, and the other items are not
claimed.
       27
          We allow the plates as a business expense.
       28
          We find that the mocha drink is personal.
       29
          We find that the shampoo is personal.
       30
          We allow the tax on the allowed items.
       31
          We find that the gum and chocolate are personal.
       32
          We allow the popcorn. See supra table note 2.
       33
          We find that the Mars Snickers bar is personal.
       34
          We allow the tax on the allowed items.
       35
          We allow the oatmeal. See supra table note 2.
       36
          We allow the milk. See supra table note 2.
       37
          We find that the Sunday paper is personal.
                                        - 39 -

[*39] 38We allow the Incredibles DVD as a business expense. We also allow the
juice and the popcorn. See supra table note 2.
       39
          We find that the coffee is personal.
       40
          We allow the milk and the juice. See supra table note 2.
       41
          We find that the medicine is personal.
       42
          We allow the plastic cutlery, the cups, and the whipped cream. See supra
 table note 2.

             3.     Items Lacking Legible Receipts

      Respondent disallowed several items for which there were no receipts or the

receipts were illegible.16 Petitioners failed to provide documentation showing that

items 49, 55, 138, 146, 186, and 349, which are expenses totaling $688, were paid

by Desert Academy, and we accordingly sustain respondent’s disallowance of these

items.17 Petitioners, however, have shown that Desert Academy paid the rest of

these disputed items.

      Items 36, 93, 158, 209, 212, and 266 are expenses totaling $3,215.

Respondent disallowed item 36 because petitioners provided only an invoice from

Xerox. But the bank statement for January shows that the claimed amount was


      16
        These are items 2, 5, 6, 12, 20, 23, 24, 27, 28, 32, 36, 39, 40, 45, 48, 49,
51, 55, 56, 57, 58, 63, 66, 67, 68, 69, 73, 74, 82, 84, 89, 92, 93, 95, 98, 103, 105,
118, 138, 140, 141, 146, 158, 179, 181, 182, 186, 192, 196, 203, 208, 209, 212,
219, 220, 230, 231, 240, 254, 257, 266, 269, 270, 281, 291, 297, 321, 330, 335,
349, 358, 360, 367, 372, 378, 396, 399, 401, 402, 405, 410, and 411.
      17
       Although petitioners did not identify item 84, a corresponding charge, dated
March 3, is noted on Desert Academy’s bank statement.
                                          - 40 -

[*40] paid. Item 93 is a check to Great American for fundraising activities. Item

158 is a check for golf lessons for some of Desert Academy’s students. Item 209 is

a receipt for postage. Item 212 is a check to AZ Images for advertising services.

Respondent disallowed item 212 because no receipt or invoice was provided; but

the invoice for item 176, which respondent allowed, shows that Desert Academy

entered into a three-month contract with AZ Images for a one-quarter-page ad, and

item 212 appears to be the payment for the third month of that contract. Item 266 is

a check for legal fees paid to Boates & Crump. Respondent disallowed item 266

because no documentation was provided, but the bank statement for September

shows that a check in the amount claimed was paid on September 21, 2005, and

respondent allowed other related legal expenses. Accordingly, we allow these

items.

         Items 68, 69, 269, and 270 are payments totaling $6,128. Petitioners contend

that these items represent payments on Desert Academy’s credit cards. Petitioners

have not introduced the credit card statements into evidence, and we cannot

determine whether these payments are for expenses properly deducted in prior

years. Accordingly, we sustain respondent’s disallowance of these items.

         The rest of these items are expenses totaling $4,175. With respect to these

items petitioners have shown that Desert Academy paid the amounts claimed.
                                         - 41 -

[*41] Petitioners, however, have not produced legible, itemized receipts for these

items. Because we have sustained some of respondent’s determinations with

respect to the items that petitioners have substantiated with legible, itemized

receipts, we cannot allow these items in full. We will, however, apply the Cohan

rule because we are convinced that a significant percentage of these expenses were

deductible business expenses, see Rodriguez v. Commissioner, T.C. Memo.

2009-22, 97 T.C.M. (CCH) 1090, 1096 (2009) (applying the Cohan rule where the

taxpayer pervasively intermingled business and personal expenses) (citing Feingold

v. Commissioner, T.C. Memo. 1956-214), and respondent has not asserted that any

of these items are subject to the strict substantiation requirements of section 274(d).

We estimate that 50% of these items were business expenses. Accordingly, we

allow Desert Academy to deduct 50% of these items.

V.    Petitioners’ Bases in Desert Academy

      Generally, a partner may deduct the partner’s distributive share of losses of a

partnership in which the partner is a member. Sec. 702(a). However, a partner’s

distributive share of a partnership’s loss is allowed only to the extent of the

partner’s adjusted basis in the partnership. Sec. 704(d); sec. 1.704-1(d)(1), Income

Tax Regs. Any additional loss is allowed as a deduction “at the end of the

partnership year in which such excess is repaid to the partnership.” Sec. 704(d).
                                        - 42 -

[*42] Respondent made no determinations in the notice of deficiency with respect

to whether petitioners had sufficient bases in Desert Academy to deduct Desert

Academy’s losses for 2005 and 2006. Accordingly, respondent concedes that he

bears the burden of proving that petitioners lacked sufficient bases in Desert

Academy to deduct those losses. See Rule 142(a)(1).

      Respondent contends that petitioners each had a basis of zero in Desert

Academy during 2005 and 2006. Petitioners contend that they had sufficient bases

in Desert Academy to deduct the claimed losses. Specifically, petitioners contend

that they made net contributions to Desert Academy of $104,205, $45,150, $25,107,

and $8,097 for 2003, 2004, 2005, and 2006, respectively.

      Respondent contends that petitioners introduced evidence showing only that

they made capital contributions to Desert Academy of $72,980 and $8,136 during

2003 and 2005, respectively. Respondent contends that petitioners presented no

evidence to support their position that they made any capital contributions to Desert

Academy during 2004 and 2006. Respondent further contends that petitioners had

bases of zero in Desert Academy at the end of 2005 and 2006 because petitioners

had already claimed losses from Desert Academy of $64,413 and $50,135 for 2003

and 2004, respectively.
                                         - 43 -

[*43] Respondent’s contentions miss the mark. Respondent bears the burden of

proving that petitioners lacked sufficient bases to deduct Desert Academy’s losses

for 2005 and 2006. Respondent has produced no evidence supporting his

adjustments to petitioners’ claimed net capital contributions for 2003 and 2005.18

Respondent has produced no evidence supporting his contention that petitioners

made no capital contributions in 2004 and 2006. Additionally, we have concluded

that petitioners’ payments to Desert Academy in 2005 and 2006 were capital

contributions and not tuition. See supra pp. 23-28. Accordingly, we find that

respondent has not met his burden of showing that petitioners had insufficient bases

in Desert Academy at the end of 2005 and 2006 to deduct Desert Academy’s

claimed losses.

VI.   Accuracy-Related Penalty Under Section 6662(a)

      Section 6662(a) and (b)(1) and (2) authorizes the Commissioner to impose a

20% penalty on an underpayment of tax that is attributable to, among other things,

(1) negligence or disregard of rules or regulations or (2) any substantial

understatement of income tax. Only one section 6662 accuracy-related penalty


      18
        Respondent determined that $404 and $1,049 of petitioners’ claimed capital
contributions for 2003 and 2005, respectively, were personal expenses. Even if we
were to agree with these adjustments, petitioners would still have more than
sufficient bases in Desert Academy to deduct the claimed losses for 2005 and 2006.
                                         - 44 -

[*44] may be imposed with respect to any given portion of an underpayment. New

Phoenix Sunrise Corp. v. Commissioner, 132 T.C. 161, 187 (2009), aff’d, 408 Fed.

Appx. 908 (6th Cir. 2010); sec. 1.6662-2(c), Income Tax Regs.

      The term “negligence” includes any failure to make a reasonable attempt to

comply with the provisions of the internal revenue laws, and the term “disregard”

includes any careless, reckless, or intentional disregard. Sec. 6662(c); sec. 1.6662-

3(b)(1) and (2), Income Tax Regs. “‘Negligence’ also includes any failure by the

taxpayer to keep adequate books and records or to substantiate items properly.”

Sec. 1.6662-3(b)(1), Income Tax Regs. Disregard of rules or regulations “is

‘careless’ if the taxpayer does not exercise reasonable diligence to determine

the correctness of a return position” and “is ‘reckless’ if the taxpayer makes little or

no effort to determine whether a rule or regulation exists, under circumstances

which demonstrate a substantial deviation from the standard of conduct that a

reasonable person would observe.” Sec. 1.6662-3(b)(2), Income Tax Regs.; see

also Neely v. Commissioner, 85 T.C. 934, 947 (1985). An understatement means

the excess of the amount of the tax required to be shown on the return over the

amount of the tax imposed which is shown on the return, reduced by any rebate.

Sec. 6662(d)(2)(A). An understatement is substantial in the case of an individual
                                        - 45 -

[*45] 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 accuracy-related penalty does not apply with respect to any portion of the

underpayment for which the taxpayer shows that there was reasonable cause and

that the taxpayer acted in good faith. Sec. 6664(c)(1). The decision as to whether a

taxpayer acted with reasonable cause and in good faith is made on a case-by-case

basis, taking into account all of the pertinent facts and circumstances. See sec.

1.6664-4(b)(1), Income Tax Regs. “Circumstances that may indicate reasonable

cause and good faith include an honest misunderstanding of fact or law that is

reasonable in light of all of the facts and circumstances, including the experience,

knowledge, and education of the taxpayer.” Id.

      The Commissioner bears the burden of production with respect to the

taxpayer’s liability for the section 6662(a) penalty and must produce sufficient

evidence indicating that it is appropriate to impose the penalty. See sec. 7491(c);

Higbee v. Commissioner, 116 T.C. at 446-447. Once the Commissioner meets his

burden of production, the taxpayer must come forward with persuasive evidence

that the Commissioner’s determination is incorrect or that the taxpayer had
                                         - 46 -

[*46] reasonable cause or substantial authority for the position. See Higbee v.

Commissioner, 116 T.C. at 446-447.

      Respondent contends that petitioners are liable for the section 6662(a)

accuracy-related penalty for 2005 and 2006 because the underpayments of tax were

attributable to either (1) negligence or disregard of rules or regulations or (2) a

substantial understatement of income tax. In particular, respondent contends that

the record shows that petitioners failed to keep adequate books and records, failed

to cooperate with respondent, and regularly mixed personal and business expenses.

Additionally, respondent observes that petitioners are well-educated, intelligent

individuals and Mr. Cvancara is employed as a special agent with the Internal

Revenue Service. Accordingly, respondent contends that petitioners’ conduct falls

far below the standard of reasonable care.

      Petitioners contend that Desert Academy’s records were generally accurate

and sufficient and that Mr. Cvancara’s employment with respondent should not be

held against petitioners because respondent prohibited Mr. Cvancara from

participating in Desert Academy’s finances and tax return preparation.
                                         - 47 -

[*47] A.     Negligence or Disregard of Rules and Regulations

             1.     Gross Receipts

      Mrs. Cvancara failed to record significant amounts of Desert Academy’s

receipts for 2005 and 2006. We find that Mrs. Cvancara was negligent in failing to

accurately maintain Desert Academy’s records with respect to the receipts omitted

from Desert Academy’s records. See sec. 1.6662-3(b)(1), Income Tax Regs.

Accordingly, to the extent that petitioners underpaid their Federal income taxes for

2006 on account of Mrs. Cvancara’s failure to accurately maintain Desert

Academy’s records of its receipts, we conclude that respondent has met his burden

of producing evidence showing that petitioners’ underpayment of tax was

attributable to negligence or disregard of rules and regulations and that petitioners

have not satisfied their burden of showing that Mrs. Cvancara was not negligent or

that she acted with reasonable cause and in good faith.19




      19
        As we have concluded that Desert Academy properly accounted for
advance payments it received in 2005 and 2006 under the deferral method, see
supra pp. 18-23, and that petitioners’ payments to Desert Academy in 2005 and
2006 were capital contributions and not tuition, see supra pp. 23-28, Desert
Academy overstated its gross receipts for 2005. Accordingly, no part of the
underpayment of tax for 2005 will be attributable to petitioners’ failure to accurately
record Desert Academy’s receipts.
                                             - 48 -

[*48]            2.     Cost of Goods Sold

        For 2005 Mrs. Cvancara (1) did not satisfy the strict substantiation

requirements of section 274(d) with respect to the items subject to those

requirements, see sec. 1.6662-3(b)(1),20 (2) erroneously claimed personal expenses

as Desert Academy’s business expenses,21 and (3) erroneously deducted Desert

Academy’s credit card payments.22 Petitioners have not introduced credible

evidence showing that Mrs. Cvancara acted with reasonable cause or in good faith

in claiming these deductions. Accordingly, we conclude that, with respect to these

items, respondent has met his burden of producing evidence showing that

petitioners’ underpayment of tax was attributable to Mrs. Cvancara’s negligence

or disregard of rules and regulations and that petitioners have not satisfied their

burden of showing that Mrs. Cvancara was not negligent or that she acted with

reasonable cause and in good faith.

        However, with respect to the rest of the items, where we have sustained, in

whole or in part, respondent’s determinations, a different conclusion obtains. We

sustained respondent’s determinations with respect to these items because the


        20
             These are the items discussed supra part IV.C.1.
        21
             These are the items we found to be personal expenses supra part IV.C.2.
        22
             These are items 68, 69, 269, and 270, discussed supra part IV.C.3.
                                         - 49 -

[*49] business purpose of the expenses in question was not obvious from the

substantiation offered, and petitioners did not fill that gap with any testimony.

Respondent, however, bears the burden of production with respect to penalties. See

sec. 7491(c). Respondent has not introduced evidence showing that any of these

items were not business expenses. Mrs. Cvancara maintained a running log of

Desert Academy’s expenses and retained the supporting bank statements and many

of the receipts. We find that Desert Academy’s expense records complied with the

Code’s recordkeeping requirements, see sec. 1.6662-3(b)(1), Income Tax Regs.,

and respondent has not asserted that any of these items were subject to the strict

substantiation requirements of section 274(d), see id. Accordingly, with respect to

the rest of respondent’s determinations, we conclude that respondent has not met his

burden of producing evidence that the underpayment of tax was attributable to

negligence or disregard of rules or regulations.23

      B.     Substantial Understatement

      Alternatively, to the extent that the Rule 155 computations show that the

understatement of tax for 2005 or 2006 exceeds the greater of 10% of the tax

      23
        We note that, to the extent that we find that petitioners are liable for the sec.
6662(a) accuracy-related penalty for an underpayment of tax attributable to
negligence or disregard of rules or regulations, Mr. Cvancara did not contribute to
such negligence or disregard of rules or regulations because respondent prohibited
him from participating in Desert Academy’s finances and tax return preparation.
                                        - 50 -

[*50] required to be shown on the return or $5,000, see sec. 6662(d)(1)(A),

petitioners are liable for a section 6662(a) penalty for an underpayment of tax

attributable to a substantial understatement of income tax.

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

discussed above, conclude those arguments are irrelevant, moot, or without merit.

      To reflect the foregoing,


                                                       An appropriate order will be

                                                 issued, and decision will be entered

                                                 under Rule 155.
