                        T.C. Memo. 2011-179



                      UNITED STATES TAX COURT



         ROBERT AND EILEEN LOPEZ ORTEGA, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 10106-09.              Filed July 28, 2011.



     Robert and Eileen Lopez Ortega, pro sese.

     Nathan C. Johnston, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GOEKE, Judge:   Respondent determined a deficiency in

petitioners’ Federal income tax of $15,379 and an accuracy-
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related penalty under section 6662(a)1 and (b)(1) of $3,076 for

tax year 2006. The issues2 for decision are:

     (1)     Whether petitioners are entitled to deduct as ordinary

business expenses $46,758 for legal fees and other items reported

on Schedule C, Profit or Loss From Business, for 2006; we hold

they are not; and

     (2)     whether petitioners are liable for the accuracy-related

penalty under section 6662(a) and (b)(1); we hold they are.

                           FINDINGS OF FACT

     Petitioners resided in California at the time their petition

was filed.

     Mr. Ortega owned real estate in Mexico.     The properties in

question cover 4,500 acres, including 6 miles of beachfront.      Mr.

Ortega has held these properties since 1973.     Respondent has

disallowed deductions related to these properties.

         The expense deductions at issue were claimed on two

Schedules C.     One showed expenses of $22,758 and listed Mr.

Ortega’s principal business as “real estate develope” (sic).      The

other reported expenses of $24,000 and listed the business as

“The Rancho Loreto Bay”.


     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedures.
     2
      Other issues are computational and will be resolved
according to the outcome of issue 1.
                                 - 3 -

     Petitioners also reported real estate activities on two

Schedules E, Supplemental Income and Loss, as part of their

2006 return.     The relationship of the activities reflected on the

Schedules E and the expenses in dispute is not clear in the

record.     Respondent makes no adjustment to the Schedule E items.

        Mr. Ortega divided his Mexican real estate holdings into

three distinct units.

     1.      Los Cocos

     Los Cocos was intended to be a recreational vehicle (RV)

park.     This property is adjacent to the only marina in the area.

     2.      Rancho Notri

     During 2006, Mr. Ortega testified, he was developing Rancho

Notri as a planned community.    He intended to develop and sell

homes and condominiums from this property.    He also planned to

develop a marina and other businesses to benefit from the seaside

location of this property.    In 2006 the land was zoned

agricultural for Mexican tax purposes.    Nevertheless, Rancho

Notri was not an operational ranch and had no agricultural

function.

     In 2006 Mr. Ortega undertook a number of improvements for

the area including clearing the land, inserting ground markers,

and showing lot delineation.    However, no lots had been sold

through 2010.
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       3.   Miramar

       The Miramar property comprises beachfront lots subdivided

into smaller parcels.     Mr. Ortega intended that the lots would be

sold as building sites.     He expected the lots would be sold in

phases, but no sales occurred in 2006.

       Petitioners timely filed their 2006 Form 1040, U.S.

Individual Income Tax Return.     As stated, the return included two

Schedules E.     The first, for two properties in the United States

and Los Cocos RV park (Los Cocos), showed $35,623 in expenses.

The second, for the Rancho Loreto Bay (also known as Rancho

Notri) property, showed $86,120 in expenses.       None of these

amounts were reported on line 17 of petitioners’ Form 1040

because of the passive activity loss limitations under section

469.

       On the Schedule C with the stated business of developing

real estate, petitioners claimed and respondent disallowed the

following deductions:     Car and truck expenses--$2,649;

depreciation-- $97; supplies--$346; travel--$8,549; meals and

entertainment--$625;     taxes and licenses--$4,600; laundry and

cleaning--$2,800; and telephone--$3,092.     On the other Schedule

C, petitioners claimed a deduction for legal fees of $24,000, and

at trial Mr. Ortega identified what were characterized as Web

site expenses of $270 which were not reflected on the 2006

return.     These two items are also in dispute.    Mr. Ortega
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testified that the legal expenses related to a cash settlement

paid to squatters on certain parcels of the Mexican property to

allow clear legal title to be established.

      Respondent sent petitioners a notice of deficiency for 2006,

and petitioners timely filed a petition with this Court.

                               OPINION

I.    Burden of Proof

      The taxpayer bears the burden of proving by a preponderance

of the evidence that the Commissioner’s determinations are

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

(1933).    However, under section 7491(a), if the taxpayer produces

credible evidence with respect to any factual issue relevant to

ascertaining the taxpayer’s liability for tax and meets other

requirements, the burden of proof shifts from the taxpayer to the

Commissioner as to that factual issue.   We find that petitioners

have failed to produce sufficient evidence to cause the burden to

shift to respondent.    Accordingly, the burden of proof remains on

petitioners.

II.   Expense Deductions

      Deductions are a matter of legislative grace, and taxpayers

must maintain adequate records to substantiate the amounts of

their income and entitlement to any deductions or credits

claimed.   Rule 142(a)(1); INDOPCO, Inc. v. Commissioner, 503 U.S.
                               - 6 -

79, 94 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435,

440 (1934).

      Section 162(a) authorizes a deduction for “all the ordinary

and necessary business expenses paid or incurred during the

taxable year in carrying on any trade or business”.    Whether an

expense is ordinary is determined by time, place, and

circumstance.

      Certain expenses may not be estimated because of the strict

substantiation requirements of section 274(d).   This “strict

substantiation” rule overrides the general rule of Cohan that we

may estimate deductions where evidence is inadequate.    Cohan v.

Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930) (estimation of

deductions, bearing heavily against taxpayer whose inexactitude

is of his or her own making); Sanford v. Commissioner, 50 T.C.

823, 827 (1968) (strict-substantiation provision takes precedence

over Cohan rule), affd. 412 F.2d 201 (2d Cir. 1969).    The

heightened substantiation requirements of section 274(d) apply

to:   (1) Any traveling expense, including meals and lodging away

from home; (2) any item with respect to an activity in the nature

of entertainment, amusement, or recreation; (3) any expense for

gifts; or (4) the use of “listed property”, as defined in section

280F(d)(4), including any passenger automobiles.

      In the present case, section 274(d) applies to the disputed

automobile, travel, and meals expenses.   Petitioners must
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substantiate these expenses by contemporaneous records showing:

(1) The amount of each expense; (2) the time and place of the

travel; and (3) the business purpose of the expense.

      As to the $24,000 in legal expenses, the cost of defending

or perfecting title to property constitutes a capital expenditure

and no current deduction shall be allowed for it.   Estate of

Franco v. Commissioner, T.C. Memo. 1980-340; Cowden v.

Commissioner, T.C. Memo. 1965-278, affd. per curiam 365 F.2d 832

(1st Cir. 1966); sec. 1.263(a)-2(c), Income Tax Regs.

     Another issue in this case is whether the activities for

which Schedule C deductions have been claimed are distinct trades

or businesses from the activities petitioners reported on

Schedule E which were subject to the passive activity loss

limitations.

     Respondent argues that petitioners did not adequately

establish distinct trades or businesses and that petitioners also

failed to substantiate the disputed deductions in any event.    We

will discuss the individual expense items, but we also find no

trade or business operated in 2006 separate from the activities

reported in the two Schedules E.

     A.   Travel Expenses

     Petitioners claimed a deduction for travel expenses of

$8,549 for tax year 2006.   To substantiate their claimed

expenses, Mr. Ortega created an air travel log and provided
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copies of ticket stubs and credit card statements.    However, the

air travel log was not created contemporaneously but rather was a

reconstruction near the time of trial.    Petitioners could not

connect the receipts and other documentation with the flights and

amounts stated on the air travel log.    Some of the ticket stubs

listed passengers other than petitioners, and the credit card

statements did not indicate the destination of the air travel or

the names of the passengers who purchased the tickets.      In sum,

given the inadequacy of the evidence produced, petitioners have

failed to substantiate the travel expenses.    Respondent’s

determination is sustained.

     B.   Meals and Entertainment Expenses

     Petitioners claimed a deduction of $625 for meals and

entertainment expenses.    To substantiate the meals and

entertainment, petitioners provided receipts.    However, the

receipts failed to indicate the business purpose of the meals or

the meals’ relationship to a trade or business.    Petitioners have

failed to adequately substantiate these expenses.    Respondent’s

determination is sustained.

     C.   Car and Truck Expenses

     Petitioners claimed a deduction of $2,649 for car and truck

expenses in 2006.   To substantiate these expenses, petitioners

created a mileage log.    The mileage log was not created

contemporaneously, but rather at or near the time of trial.     The
                                  - 9 -

mileage log fails to specify how any of the stated business trips

relate to any of petitioners’ properties or to a trade or

business.     Respondent’s determination is sustained.

     D.     Supplies Expenses

     Petitioners claimed a deduction of $346 for supplies.

Petitioners provided four receipts.       However, the receipts lacked

adequate notation of a business purpose.      In addition,

petitioners failed to provide a business purpose for the

purchases of the supplies.      Respondent’s determination is

sustained.

     E.     Taxes and Licenses Expenses

     Petitioners claimed a deduction of $4,600 for taxes and

licenses.     To substantiate these expenses, petitioners provided

seven receipts from the Mexican Government which had been stamped

paid.     Mr. Ortega testified that one receipt was for Rancho

Notre, three were for Los Cocos, and the remaining receipts were

for a property called Malicon, which was the office headquarters.

However, some of these receipts were in the names of Mr. Ortega’s

two brothers.     Petitioner testified that although some of these

receipts did not show his name, he paid the taxes and thus was

entitled to the deductions.      Mr. Ortega testified that the

receipts showed different owners because of a municipal law which

provided that “no one can hold or own property more than 1,800

square meters.     So in order to keep the property intact I asked
                              - 10 -

my brothers if I could put 1,800 square meters in their

respective names to work around this local ordinance”.

     While we find that petitioners have provided adequate

documentation in the receipts for taxes and licenses expenses,

they have failed to establish that the reported expenses were not

more properly associated with the activities reported on

Schedules E of their income tax return.   Accordingly, we find

these expenses are not deductible as Schedule C expenses.

     F.   Cleaning and Laundry Expenses

     Petitioners claimed a deduction of $2,800 on their Schedule

C for laundry and cleaning expenses.   Mr. Ortega stated that

although these expenses were listed on their Schedule C as

laundry and cleaning expenses, it was a “misposting”.    The

expenses were described by Mr. Ortega as “cleaning experiences”,

which consisted of clearing the grounds of any fallen trees or

debris after storms.   Mr. Ortega stated that most of the cleaning

expense was related to Los Cocos.

     Petitioners provided receipts which showed the location,

date, hours worked, and work done by “trabajadores” or laborers.

Mr. Ortega testified that these receipts provided the information

that he would need in order for the laborers to get paid.      The

laborers would sign and Mr. Ortega would then give a conversion

from pesos to dollars and pay them.
                               - 11 -

     The Court finds that petitioners’ receipts provide

documentation of the deduction for the cleaning and laundry

expenses but as a Schedule E expense, which does not create a

current deduction for 2006 because of the passive loss rules.

Accordingly, respondent’s adjustment is sustained.

     G.    Telephone and Web Site Expenses

     Petitioners claimed a deduction of $8,092 on their Schedule

C for telephone expenses.    Mr. Ortega also testified at trial

that Web site expenses of $270 were an unresolved business

expense.    Petitioners provided copies of Verizon Wireless bills

to substantiate their claimed expenses.      Mr. Ortega testified

that he has a combination of services on his cell phone, which he

stated is primarily an international cell phone.      Petitioners’

Verizon Wireless bills did not indicate whether the cell phone

was used exclusively for business purposes, and thus we conclude

that petitioners have failed to substantiate that these expenses

were associated with a trade or business.      Similarly, the Web

site expense was not properly substantiated as a Schedule C

expense.    Accordingly, we sustain respondent’s determination.

     H.    Depreciation

     Petitioners claimed a deduction of $97 for depreciation on

their Schedule C.    However, petitioners have not provided any

evidence to explain or substantiate this deduction.      Therefore,
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petitioners are not entitled to this deduction, and we sustain

respondent’s determination.

       I.    Legal Fees

       Petitioners claimed a deduction for a $24,000 legal

settlement expense on their Schedule C.       The amount is the result

of a legal action taken by petitioners to force “squatters” or

“parachuters” off their properties.        Because of rising attorney’s

fees, petitioners felt that it would be easier to pay the

squatters to vacate their properties.       Petitioners are claiming

the legal expense as a theft loss, seeking to establish that

there was an illegal act.

       Petitioners provided documentation of an agreement whereby

each individual was paid $12,500 to vacate petitioners’

properties.

       Respondent argues that these expenses are not based upon a

currently active trade or business and are not current

deductions.       Respondent argues in the alternative that

petitioners may be entitled to capitalize these expenses.       We

agree with respondent’s analysis that these expenses are capital

and do not relate to an active trade or business in 2006.

III.        Accuracy-Related Penalty

       Respondent determined that petitioners are liable for an

accuracy-related penalty under section 6662(a) and (b).       Section
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6662(a) and (b)(1) and (2) imposes a 20-percent penalty on an

underpayment of tax required to be shown on a return if the

underpayment is attributable to a taxpayer’s negligence or

disregard of rules or regulations or substantial understatement

of income tax.   Section 6662(d)(1)(A) defines a substantial

understatement of income tax as a tax understatement that exceeds

the greater of 10 percent of the tax required to be shown on the

tax return or $5,000.

     Section 6662(c) defines negligence as including any failure

to make a reasonable attempt to comply with the provisions of the

internal revenue laws.   Negligence has also been defined as the

failure to exercise due care or the failure to do what a

reasonable and prudent person would do under the circumstances.

Neely v. Commissioner, 85 T.C. 934, 947 (1985).   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.

     Courts deciding a taxpayer’s liability for a negligence

penalty generally look both to whether the underlying investment

was legitimate and to whether the taxpayer exercised due care in

the position taken on the return.   Sacks v. Commissioner, 82 F.3d

918, 920 (9th Cir. 1996), affg. T.C. Memo. 1994-217.   When an

investment has such obviously suspect tax claims as to put a

reasonable taxpayer under a duty of inquiry, a good faith
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investigation of the underlying viability, financial structure,

and economics of the investment is required.   Roberson v.

Commissioner, T.C. Memo. 1996-335, affd. without published

opinion 142 F.3d 435 (6th Cir. 1998).

     Section 6664(c)(1) provides an exception to the accuracy-

related penalty if it is shown that the taxpayer had reasonable

cause and acted in good faith.   Sec. 1.6664-4(b)(1), Income Tax

Regs.   The decision as to whether the taxpayer acted with

reasonable cause and good faith depends upon all the pertinent

facts and circumstances.    Higbee v. Commissioner, 116 T.C. 438,

448 (2001); see sec. 1.6664-4(b)(1), Income Tax Regs.

     Relevant factors include the taxpayer’s efforts to assess

his proper tax liability, including the reasonableness and good

faith of reliance on the advice of a professional such as an

accountant.   Sec. 1.6664-4(b)(1), Income Tax Regs.   Reliance on

the advice of a professional tax adviser can be a defense to the

negligence penalty but does not necessarily demonstrate

reasonable cause and good faith.    United States v. Boyle, 469

U.S. 241, 250-251 (1985).

     Respondent has carried the threshold burden of production

under section 7491(c), and petitioners bear the burden of proving

reasonable cause.

     Respondent argues that petitioners were negligent in failing

to maintain adequate records and to substantiate their items
                               - 15 -

properly.   Respondent argues that petitioners should have know

that the claimed Schedule C expenses were not associated with

active trades or businesses.

     Petitioners managed the accounting and bookkeeping for the

foreign properties carelessly during 2006.    They failed to keep

records contemporaneous with the expenses, and they claimed

expenses for businesses which were in the development stage and

not yet operational.   We find petitioners’ underpayment negligent

and lacking in good faith or reasonable cause.

     Accordingly, the Court finds that petitioners have failed to

carry their burden, and we sustain respondent’s determination of

the accuracy-related penalty under section 6662(a) and (b)(1) for

tax year 2006.

     To reflect the foregoing,


                                      Decision will be entered

                                 for respondent.
