                              T.C. Memo. 2015-167



                        UNITED STATES TAX COURT



             JIJUN CHEN AND XIUJING GU, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 4954-14.                         Filed August 24, 2015.


      Jijun Chen and Xiujing Gu, pro sese.

      David A. Indek, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      RUWE, Judge: Respondent determined deficiencies in petitioners’ Federal

income tax and accuracy-related penalties as follows:

                                             Accuracy-related Penalty
              Year        Deficiency                Sec. 6662

              2010          $3,231                       $646
              2011           6,159                      1,232
              2012          10,115                      2,023
                                         -2-

[*2] The issues for decision are: (1) whether petitioners are entitled to deduct

certain business expenses claimed on Schedules C, Profit or Loss From Business,

for the taxable years 2010, 2011, and 2012 (years in issue); (2) whether a State

income tax refund of $5,827 petitioners received in 2012 constitutes taxable

income for that year; and (3) whether petitioners are liable for accuracy-related

penalties under section 6662(a) for the years in issue.

      Unless otherwise indicated, all section references are to the Internal

Revenue Code (Code) in effect for the years in issue, and all Rule references are to

the Tax Court Rules of Practice and Procedure.

                                FINDINGS OF FACT

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

facts and the attached exhibits are incorporated herein by this reference.

      At the time the petition was filed, petitioners resided in Maryland.

      On July 24, 2009, petitioners formed Allonger, LLC (Allonger), a private

biotechnology company. Allonger’s principal office is in Wilmington, Delaware.1

Petitioner Jijun Chen2 is Allonger’s sole shareholder and is listed as the resident



      1
          Allonger also has a location in Quingdao, China.
      2
          Mr. Chen has a medical degree and a Ph.D., both of which he obtained in
China.
                                         -3-

[*3] agent for Allonger on the limited liability company registration. Between

July 24, 2009, and December 31, 2012, petitioners did not earn any money through

Allonger or acquire any clients or contracts for Allonger.

      Petitioners have two children, A.Y.C. and E.Y.C.,3 both of whom were born

in 2001. The Forms W-2, Wage and Tax Statement, submitted to the Internal

Revenue Service (IRS) show that Allonger paid A.Y.C. and E.Y.C. wages in tax

year 2012 totaling $9,960.4 Allonger did not pay other wages or compensation to

any other individuals for the years in issue. As discussed infra, petitioners claim

various Schedule C deductions for the years in issue associated with Allonger.

      For tax years 2010 and 2011 petitioners claimed refunds of $10,769 and

$14,615, respectively. On Schedule A, Itemized Deductions, of their 2011 Federal

income tax return, petitioners claimed a $6,206 deduction for Maryland State

income tax paid. In 2012 petitioners received a $5,827 Maryland State income tax

refund. Petitioners did not report the 2011 refund on their 2012 Federal income

tax return.




      3
      It is the Court’s policy to refer to minor children only by their initials. See
Rule 27(a)(3).
      4
      Petitioners did not issue Forms W-2 or Forms 1099-MISC, Miscellaneous
Income, from Allonger to their children for the 2010 or 2011 tax year.
                                         -4-

[*4] Petitioners timely filed a joint Federal income tax return for each of the

years in issue.5 Mr. Chen listed his occupation as programmer, and Xiujing Gu

listed her occupation as professional. Respondent issued to petitioners a notice of

deficiency for the years in issue. Petitioners timely filed a petition disputing the

determinations in the notice of deficiency.

                                      OPINION

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

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

determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111,

115 (1933). Petitioners do not contend, and the evidence does not establish, that

the burden of proof shifts to respondent under section 7491(a) as to any issue of

fact.

A. Petitioners’ Claimed Deductions

        Deductions are a matter of legislative grace, and the taxpayer bears the

burden of proving entitlement to any deduction claimed. Rule 142(a); INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering,

292 U.S. 435, 440 (1934). Section 6001 requires the taxpayer to maintain records

        5
       The record includes copies of petitioners’ 2010 and 2011 Forms 1040, U.S.
Individual Income Tax Return, and a transcript of petitioners’ 2012 tax return.
Attached to petitioners’ posttrial brief is a copy of their 2012 Form 1040.
                                         -5-

[*5] sufficient to establish the amount of each deduction claimed. See also sec.

1.6001-1(a), Income Tax Regs.

      Section 162(a) allows as a deduction “all the ordinary and necessary

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

business”. See Boyd v. Commissioner, 122 T.C. 305, 313 (2004). 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 is necessary if it is

appropriate and helpful for the development of the business. Commissioner v.

Heininger, 320 U.S. 467, 471-472 (1943); Deputy v. du Pont, 308 U.S. 488, 495

(1940). In contrast, section 262(a) disallows deductions for personal, living, or

family expenses.

      If the taxpayer establishes that an expense is deductible but is unable to

substantiate the precise amount, we may estimate the amount, bearing heavily

against the taxpayer whose inexactitude is of his or her own making. See Cohan

v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). The taxpayer must present

sufficient evidence for the Court to form an estimate because without such a basis,

any allowance would amount to unguided largesse. Williams v. United States, 245

F.2d 559, 560-561 (5th Cir. 1957); Vanicek v. Commissioner, 85 T.C. 731, 742-

743 (1985).
                                         -6-

[*6] However, section 274 overrides the Cohan rule with regard to certain

expenses. See Sanford v. Commissioner, 50 T.C. 823, 828 (1968), aff’d per

curiam, 412 F.2d 201 (2d Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax

Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985). Under section 274(d), the taxpayer

must meet stricter substantiation requirements to be allowed a deduction under

section 162. 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) an expense for gifts; or (4) the use of “listed property” as defined

in section 280F(d)(4), including any passenger automobiles. 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; (2) the time and place of the expense; and (3) the business purpose of the

expense. Sec. 274(d); see Oswandel v. Commissioner, T.C. Memo. 2007-183,

2007 Tax Ct. Memo LEXIS 185, at *7. Even if such an expense would otherwise

be deductible, section 274 may still preclude a deduction if the taxpayer does not

present sufficient substantiation. Sec. 1.274-5T(a), Temporary Income Tax Regs.,

supra.
                                        -7-

[*7] Petitioners reported zero gross receipts for Allonger for each of the years in

issue. Petitioners claimed deductions for Schedule C business expenses pertaining

to Allonger of $30,739 for 2010, $44,182 for 2011, and $43,730 for 2012, all of

which are in issue. These Schedule C expenses are as follows:

               Expense                     2010         2011          2012

     Advertising                           ---           $202          $222
     Car and truck                      $11,850        19,010        10,544
                                                                       1
     Contract labor                        ---             350           250
     Depreciation                         2,505         2,774         4,705
     Employee benefit programs            3,446         4,844         5,178
     Insurance                               546          614            626
     Legal and professional                  571           ---          ---
     Office expense                       2,144          3,711        1,939
     Repairs and maintenance                 920         1,323           919
     Supplies                                999         1,773           951
     Taxes and licenses                     ---             725         550
     Travel                               1,594          2,779        2,410
     Meals and entertainment              1,839          2,269        1,941
     Utilities                            2,317          3,768        3,432
     Wages                                  ---             ---       9,960
     Other expenses                       2,008               40         103
      Total                              30,739         44,182       43,730
        1
         Attached to petitioners’ posttrial brief is a copy of their 2012
    Schedule C, showing a $250 contract labor expense claimed for this
    year. The notice of deficiency indicates that this amount was claimed
    for 2010.

      Although not specifically argued by petitioners, it appears that certain

expenses claimed on their Schedules C for the years in issue are car and truck
                                         -8-

[*8] mileage expenses and home office expenses. For clarity we will address

petitioners’ claimed expenses in three categories: car and truck expenses, home

office expenses, and other expenses.

      1. Car and Truck Expenses

      Petitioners claimed car and truck expenses for each of the years in issue, and

these expenses are subject to the heightened substantiation requirements of section

274(d). See secs. 274(d)(4), 280F(d)(4)(A)(i). As applicable to vehicle expenses,

section 274(d) requires the taxpayer to substantiate by adequate records or by

sufficient evidence corroborating the taxpayer’s own statement: (1) the mileage;

(2) the time and place of the use; and (3) the business purpose of the use. See

Solomon v. Commissioner, T.C. Memo. 2011-91, 2011 Tax Ct. Memo LEXIS 90,

at *8. Substantiation by adequate records requires the taxpayer to maintain an

account book, a diary, a log, a statement of expense, trip sheets, or a similar record

prepared contemporaneously with the use or expenditure and documentary

evidence (e.g., receipts or bills) of certain expenditures. See sec. 1.274-

5(c)(2)(iii), Income Tax Regs.; sec. 1.274-5T(c)(2), Temporary Income Tax Regs.,

50 Fed. Reg. 46017 (Nov. 6, 1985). A log that is kept on a weekly basis is

considered contemporaneous for this purpose. See sec. 1.274-5T(c)(2)(ii)(A),

Temporary Income Tax Regs., 50 Fed. Reg. 46017-46018 (Nov. 6, 1985). The
                                        -9-

[*9] level of detail required for substantiating by adequate records the business use

of listed property depends on the facts and circumstances of such use. See id.

subdiv. (ii)(C), 50 Fed. Reg. 46018-46019.

      We find that petitioners have failed to prove that they are entitled to deduct

any car and truck expenses for the years in issue as required under section 274(d).

Petitioners did not provide any records to establish the mileage driven, the time

and place of vehicle use, or the business purpose of the use. Accordingly, we

sustain respondent’s disallowance of petitioners’ claimed car and truck expense

deductions for the years in issue.

      2. Home Office Expenses

      Although petitioners did not specifically deduct expenses for the business

use of their home, many of the claimed Schedule C expenses are considered home

office expenses and thus are subject to the requirements of section 280A. For

example, petitioners submitted into evidence seven Howard County, Maryland,

water and sewer bills pertaining to their residential address in Columbia,

Maryland.

      Section 280A(a) provides as a general rule that no deduction otherwise

allowable to an individual “shall be allowed with respect to the use of a dwelling

unit which is used by the taxpayer during the taxable year as a residence.” The
                                       - 10 -

[*10] term “dwelling unit” is defined as “a house, apartment, condominium,

mobile home, boat, or similar property, and all structures or other property

appurtenant to such dwelling unit.” Sec. 280A(f)(1)(A). However, section

280A(c) contains an exception to the general disallowance of subsection (a). In

pertinent part, section 280A(c)(1) provides:

            SEC. 280A(c). Exceptions for Certain Business or Rental Use;
      Limitation on Deductions for Such Use.--

                   (1) Certain business use.--Subsection (a) shall not apply
             to any item to the extent such item is allocable to a portion of
             the dwelling unit which is exclusively used on a regular basis--

                         (A) as the principal place of business for any trade
                   or business of the taxpayer,

                          (B) as a place of business which is used by
                   patients, clients, or customers in meeting or dealing with
                   the taxpayer in the normal course of his trade or
                   business, or

                         (C) in the case of a separate structure which is not
                   attached to the dwelling unit, in connection with the
                   taxpayer’s trade or business.

For an expense related to a dwelling unit to fit within this exception, some portion

of the dwelling unit must be used regularly and exclusively for the taxpayer’s trade

or business. See Scully v. Commissioner, T.C. Memo. 2013-229, at *21.
                                        - 11 -

[*11] Petitioners contend that, for the years in issue, they used their entire

personal residence to operate Allonger. The only evidence petitioners provided to

support this contention was Mr. Chen’s unpersuasive testimony. Furthermore, the

Maryland Department of Assessments and Taxation lists Allonger’s principal

office in Wilmington, Delaware. We find that petitioners have failed to

demonstrate or prove that any portion of their dwelling was regularly and

exclusively used for business purposes for the years in issue. Accordingly, we

sustain respondent’s disallowance of deductions for the home office expenses for

the years in issue.

      3. Other Expenses

      To substantiate the remaining Schedule C expenses claimed for the years in

issue, petitioners offered into evidence a self-created spreadsheet of expenses.

The spreadsheet contains category titles, dates, names of vendors/items, and

amounts. The vast majority of these items, from what we can perceive, are for the

tax year 2010, and a few are for tax year 2011. There is no indication of

expenditures for tax year 2012. Petitioners’ spreadsheet lists vendors such as

Macy’s, JCPenney, Toys R Us, Hair Cuttery, The Sandal Factory, Mikes Music of

Maryland, and Olenka School of Music.
                                       - 12 -

[*12] Petitioners have failed to substantiate that any of the expenses on their

spreadsheet were incurred by Allonger in carrying on its trade or business. At trial

Mr. Chen acknowledged that many of the expenses claimed by petitioners as

business expense deductions were indeed personal in nature and were for the

benefit of petitioners’ children. Among other things, Mr. Chen acknowledged

that: (1) for the years in issue the employee benefits program expenses consisted

entirely of sending his children to daycare; (2) for 2010 travel and entertainment

expenses were incurred educating his children; and (3) for 2011 a $757

depreciation expense was for depreciating his children’s musical instruments.

Petitioners did not explain how these expenses are ordinary and necessary in

carrying on the business operations of Allonger. These expenses are clearly

personal in nature and are expressly disallowed as a deduction by section 262(a).

Furthermore, to the extent that these expenses constitute entertainment,

amusement, or recreational expenses, petitioners have failed to meet the

heightened substantiation requirements of section 274(d).

      Petitioners also claimed a deduction for total wages of $9,960 that Allonger

paid to A.Y.C. and E.Y.C. during 2012. Mr. Chen testified that his children--who

were 11 years old in 2012--were paid for “doing some office cleaning * * * [and]

office organiz[ing]”. However, aside from the Forms W-2 submitted to the IRS,
                                       - 13 -

[*13] petitioners have produced no documentation to establish that the minor

children performed work for Allonger in 2012 or that Allonger actually paid this

expense. Therefore, we cannot conclude that petitioners’ minor children

performed work for Allonger or that Allonger paid wages of $9,960 to petitioners’

children in 2012.

      Petitioners have not sufficiently substantiated that they incurred any

ordinary and necessary business expenses relating to the business operations of

Allonger for the years in issue. Accordingly, we sustain respondent’s

disallowance of petitioners’ other expenses claimed on Schedules C for the years

in issue.

B. State Income Tax Refund

      Generally, if an amount deducted on a prior year’s tax return resulted in a

reduction of tax and a tax benefit to the taxpayer and is subsequently recovered,

that amount must be included in gross income for the year the recovery is

received. See sec. 111(a); Kadunc v. Commissioner, T.C. Memo. 1997-92, 1997

Tax Ct. Memo LEXIS 104, at *5-*6. Therefore, gross income includes a refund of

State income tax for the year received to the extent that the payment of such tax

was claimed as a deduction for a prior taxable year which resulted in a reduction
                                        - 14 -

[*14] of Federal income tax. See Kadunc v. Commissioner, 1997 Tax Ct. Memo

LEXIS 104, at *5-*6.

      On Schedule A of their 2011 Federal income tax return petitioners claimed a

$6,206 deduction for State and local income taxes paid. In 2012 petitioners

received a State income tax refund of $5,827 from the State of Maryland for

income tax paid during 2011. Petitioners did not report this amount as income on

their 2012 Federal income tax return. Petitioners did not provide any evidence to

dispute their receipt of the refund in 2012 or explain their failure to report such

amount as income on their 2012 income tax return. Accordingly, we sustain

respondent’s determination that the $5,827 State income tax refund is includable

in petitioners’ gross income for their 2012 tax year.

C. Accuracy-Related Penalties

      In the notice of deficiency respondent determined that petitioners are liable

for section 6662(a) accuracy-related penalties of $646, $1,232, and $2,023 for the

taxable years 2010, 2011, and 2012, respectively. Respondent contends that

petitioners’ underpayments of tax are attributable to either negligence or

substantial understatements of income tax. Section 6662(a) and (b)(1) and (2)

imposes an accuracy-related penalty of 20% on any portion of an underpayment

which is attributable to, among other things, negligence or intentional disregard of
                                        - 15 -

[*15] the rules or regulations or any substantial understatement of income tax. For

purposes of section 6662, the term “negligence” includes any failure to make a

reasonable attempt to comply with the provisions of the Code, and the term

“disregard” includes any careless, reckless, or intentional disregard for the rules or

regulations. Sec. 6662(c); see also Neely v. Commissioner, 85 T.C. 934, 947

(1985). Negligence also includes any failure to exercise ordinary and reasonable

care in the preparation of a tax return or any failure to keep adequate books and

records and to properly substantiate items. Sec. 1.6662-3(b)(1), Income Tax Regs.

On the other hand, a substantial understatement of income tax exists when the

taxpayer’s 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 Commissioner bears the burden of production concerning the

imposition of penalties and must provide sufficient evidence indicating that it is

appropriate to impose the penalty. See sec. 7491(c); Higbee v. Commissioner, 116

T.C. 438, 446 (2001). Once the Commissioner meets his “burden of production”,

the “burden of proof” remains with the taxpayer, including the burden of proving

that the penalty is improper due to reasonable cause under section 6664. Rule

142(a); Higbee v. Commissioner, 116 T.C. at 446-447.
                                        - 16 -

[*16] For the years in issue, we find that petitioners acted negligently by failing to

keep adequate books and records and by not exercising reasonable care given the

circumstances. Petitioners could not and did not substantiate the deductions that

respondent disallowed. That petitioners claimed Schedule C deductions that were

personal in nature and not supported by their documentation exhibits that, at the

very least, they were careless in complying with their income tax obligations.

      Section 6664(c)(1) provides that the penalty under section 6662(a) shall not

apply to any portion of an underpayment if it is shown that there was reasonable

cause for the taxpayer’s position and that the taxpayer acted in good faith with

respect to that portion. See Higbee v. Commissioner, 116 T.C. at 448. The

determination of whether the taxpayer acted with reasonable cause and in good

faith is made on a case-by-case basis, taking into account all the pertinent facts

and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs. Petitioners have the

burden of proving that the penalty is inappropriate because of reasonable cause

under section 6664. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-

447. Petitioners have failed to argue or prove that the penalties are inappropriate

because of reasonable cause. Accordingly, we hold that petitioners are liable for

the accuracy-related penalties under section 6662(a) for their underpayments of

tax for the years in issue.
                                       - 17 -

[*17] Petitioners are liable for accuracy-related penalties under section 6662(a).

On brief respondent states that portions of the above amounts are based on the

adjustment of refundable credits, and therefore the amounts will need to be

recalculated in a Rule 155 computation. See Rand v. Commissioner, 141 T.C. 376

(2013).

      In reaching our decision, we have considered all arguments made by the

parties, and to the extent not mentioned or addressed, they are irrelevant or

without merit.

      To reflect the foregoing,


                                                           Decision will be entered

                                                    under Rule 155.
