                        T.C. Memo. 2007-320



                      UNITED STATES TAX COURT



         ROBERT L. AND BRENDA J. TARTER, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 20688-05.             Filed October 25, 2007.



     Eric Johnson, for petitioners.

     Christian A. Speck, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:   Petitioners petitioned the Court to

redetermine respondent’s determination of a 2001 income tax

deficiency of $457,491, a section 6662(a)1 accuracy-related



     1
      Rule references are to the Tax Court Rules of Practice and
Procedure. Unless otherwise noted, section references are to the
applicable versions of the Internal Revenue Code (Code).
                                - 2 -

penalty of $91,498.20, and a section 6651(a)(1) addition to tax

of $22,693.10 for failure to file timely.    With regard to the

income tax deficiency, we decide whether petitioners’ claimed

trade or business expense deductions are allowable.    We hold they

are not.    We also decide whether petitioners are liable for the

accuracy-related penalty.    We hold that they are.   Petitioners do

not dispute that their income tax return was filed untimely and

do not assert that a reasonable basis existed for their late

filing.    We sustain the addition to tax without further comment.

                          FINDINGS OF FACT

     The parties have filed with the Court stipulated facts and

exhibits.    The stipulated facts are found accordingly.

Petitioners are husband and wife, and they jointly filed a 2001

Form 1040, U.S. Individual Income Tax Return.    They resided in

Lincoln, California, when their petition was filed with the

Court.

A.   Petitioner’s Business History

     Robert Tarter (petitioner) went into business for himself in

approximately 1991, beginning B & B Construction (B&B).    B&B was

engaged in the business of preparing and pouring concrete

foundations and flatwork for residential projects.

     B&B operated as a sole proprietorship at its inception and

was still operating as a sole proprietorship at the beginning of

2001.    On December 15, 2000, petitioner formed BBT Enterprises,
                                - 3 -

Limited (BBT), a limited partnership.   The partners of BBT were

petitioner and B & B Complex Trust, with petitioner having a

1-percent interest and B & B Complex Trust having a 99-percent

interest.   By at least June 2001, B&B began to operate as BBT.

No Form 1065, U.S. Return of Partnership Income, was filed for

BBT for 2001.    No Form 1041, U.S. Income Tax Return for Estates

and Trusts, was filed for the B & B Complex Trust for 2001.

Petitioner reported all claimed income and deductions of the

concrete business for 2001 as those of a sole proprietorship on

their Schedule C, Profit or Loss From Business.

     A checking account for BBT, d.b.a. B&B, was opened on

May 17, 2001 (BBT account).   At that time, a checking account

existed in the name of B&B and petitioners (B&B account).

Sometime after August or September 2001, operating expenses for

the concrete construction business were paid out of the BBT

account.    After September 2001, funds represented by checks from

the BBT account were not funds that came from the B&B account.

B.   Additional Entities

     On September 15, 2000, petitioner set up the entity V & E

Leasing, Ltd., a California limited partnership (V&E Leasing).

The partners of V&E Leasing were petitioner and Granite Bay

Complex Trust.   Upon formation of V&E Leasing, petitioner held a

1-percent interest, and Granite Bay Complex Estate Trust held a

99-percent interest.   The depreciable vehicles and smaller
                                - 4 -

equipment assets that petitioner used for the concrete

construction business were transferred to V&E Leasing during

2001.   No Form 1065 was filed for V&E Leasing for 2001.

     Also on September 15, 2000, petitioner set up the entity

B & B Concrete Pumping, Ltd., a California limited partnership

(B&B Concrete Pumping).    The partners of B&B Concrete Pumping

were petitioner and Granite Bay Complex Trust.    Upon formation of

B&B Concrete Pumping, petitioner held a 1-percent interest and

Granite Bay Complex Estate Trust held a 99-percent interest in

B&B Concrete Pumping.   The bigger, more expensive concrete pumps

that petitioner used for the concrete construction business were

transferred to B&B Concrete Pumping during 2001.    No Form 1065

was filed for B&B Concrete Pumping for 2001.

C.   Payments to Workers

     Beginning in October 2000, petitioner began to use a payroll

system under which B&B’s approximately 100 to 200 employees were

leased to an employee leasing company, Labor Force Partners, Ltd.

(payroll company).   Through this leasing arrangement, the payroll

company became the primary legal employer of record.

     The individuals who originally presented and promoted

the payroll system to petitioner were David Clancy and Ray

Vallejo.   In September 2000, petitioner arranged for an

all-employee meeting for B&B workers.    At that meeting, Clancy

and Vallejo told the employees about the new payroll system.
                                - 5 -

Petitioner did not recall ever telling the employees they were

“fired”.

     The payroll company did not make any of the decisions

regarding the employees, for example who would be hired or fired

and how much they would be paid, or otherwise supervise the

day-to-day activities of the workers.    After the fall of 2000,

petitioner continued to make all the hiring and firing decisions

with respect to employees of the concrete business.    Similarly,

after the fall of 2000, petitioner or supervisors of B&B

continued to give the day-to-day instructions to employees of the

concrete business.    In general, employees were the same

individuals, performed the same type of work, were supervised the

same way, and were paid the same amounts both before and after

petitioner began paying the employees through the payroll

company.

     The payroll company set up two payroll accounts with

Paychex, a large processing company.    Pursuant to this new

payroll system, instead of receiving one paycheck, each employee

received two.   The first paycheck covered the minimum wage that

State law required.   The balance due an employee, called a

“dividend” payment, was paid in a second check from an account

under the name of Labor Force Partners Trust.    Petitioner did not

pay employment taxes or workers compensation on the portion of

the wages greater than the minimum wage.
                               - 6 -

     Shortly after the new payroll system began, petitioners’

return preparer, Shannon Perez (Perez), assumed bookkeeping for

the concrete business.   Perez also prepared petitioners’ 2001

Form 1040.   That Form 1040 was prepared in haste in order for

petitioners to satisfy a requirement to close on a new home.

Neither petitioners nor Perez thought the 2001 return was

accurate when prepared and filed, and they anticipated its

amendment.   On the Form 1040, petitioners reported approximately

$15 million in receipts and slightly more in expenses, resulting

in a net Schedule C loss of approximately $157,000.

     Perez kept track of the expenses of the concrete business by

categorizing and entering those expenses into a computer

Quickbooks data file using bank statements, check stubs, and

canceled checks that petitioner provided.   To prepare

petitioners’ return, Perez ran reports from the Quickbooks

database.

D.   Disallowed Deductions

     Petitioners’ 2001 Form 1040 was selected for audit, and

respondent, in the notice of deficiency mailed to petitioners on

August 29, 2005, determined that petitioner failed to

substantiate five categories of expenses on Schedule C:
                                - 7 -

     (1)    Employee benefits               $97,212
     (2)    Payroll taxes                   578,441
     (3)    Outside services                104,592
     (4)    Rent/lease
             Vehicles/machinery/equipment   187,004
     (5)    Depreciation and
             sec. 179 expense               407,075

These disallowed amounts are the amounts that petitioner claimed

in the referenced categories on his Schedule C.

E.   Substantiation

     Perez, no later than September 11, 2006, acknowledged errors

in every category of expense claimed on petitioner’s Schedule C

with the possible exception of depreciation.    Neither Perez nor

petitioners kept books and records of expenses of the concrete

business for 2001 that reflected the deduction amounts claimed in

the categories listed on petitioner’s 2001 Schedule C.

F.   Financial Statements

     Perez prepared financial statements that she knew were

inconsistent with petitioners’ 2001 tax return, which she had

prepared.   The financial statements made petitioner’s business

look more profitable than it appeared on his Schedule C.   The

2001 profit and loss statement purporting to show petitioners’

2001 net income from the concrete business was intended to be

used to obtain a license in Nevada and showed $999,648 more in

net income than the net income reflected on petitioner’s

Schedule C.
                                - 8 -

G.   Discovery

     Before trial, on July 7, 2006, respondent served

interrogatories on petitioners, asking them to list every item

claimed as an expense deduction on the 2001 Schedule C.   Perez

prepared petitioners’ responses to those interrogatories.    For

every item except depreciation that respondent disallowed in the

notice of deficiency, petitioners’ interrogatory responses

reflected deduction amounts greater than the amounts reported on

the Schedule C.

H.   The Seizures

     On November 30, 2005, agents of respondent’s Criminal

Investigation Division (CID) executed simultaneous search

warrants at petitioner’s business and at the payroll company.

From November 30, 2005, through the trial in this case, CID has

retained originals or copies of all electronic or paper records

seized pursuant to the search warrants.   At the time of the

seizures, CID created an inventory of the seized paper documents.

The seized paper records consist of approximately 85 boxes of

materials seized from B&B Construction and 40 boxes of materials

seized from the payroll company.

                               OPINION

     The burden of proof is on petitioners to show that

respondent’s determinations set forth in the notice of deficiency

are incorrect.    See Rule 142(a)(1); See Welch v. Helvering, 290
                                - 9 -

U.S. 111, 115 (1933).   Deductions are strictly a matter of

legislative grace, and petitioners must show that their claimed

deductions are allowed by the Code.     Petitioners must also keep

sufficient records to substantiate any deduction that would

otherwise be allowed by the Code.   See sec. 6001; New Colonial

Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).     In order to meet

their burden of proof, petitioners must introduce sufficient

evidence to:   (1) Make a prima facie case establishing that

respondent committed the errors alleged in the petition and (2)

overcome the evidence submitted by (or otherwise favorable to)

respondent.    See Lyon v. Commissioner, 1 B.T.A. 378, 379 (1925).

For the burden to shift to respondent, petitioners must comply

with the substantiation and record-keeping requirements of the

Code.   See sec. 7491(a)(2)(A) and (B).   We conclude that the

burden of proof has not shifted to respondent with respect to any

of the issues affecting petitioners’ tax liability because we

find that petitioners failed to comply with substantiation

requirements of the Code.

A.   Employee Benefits and Payroll Taxes

     Respondent’s notice of deficiency disallowed the amounts

petitioner claimed on his Schedule C for employee benefits and

payroll taxes, $97,212 and $578,441, respectively.    Respondent

determined that the expenses were disallowed because petitioners

did not provide information to support the deductions and did not
                               - 10 -

establish that the expenses were ordinary and necessary.

Respondent argues on brief that petitioners have never

established that these costs were not claimed on the 2001

Schedule C as labor costs under cost of goods sold.

     In support of their benefits and payroll tax deductions,

petitioners detailed amounts paid to Kaiser for medical insurance

invoices and amounts paid to the payroll company for disability

insurance.   From the evidence presented, it appears that payments

were made for medical and disability benefits; however, these

proofs of payment in no way address nor negate respondent’s

argument that those items may already be included in petitioner’s

Schedule C as labor costs under cost of goods sold.    We sustain

respondent’s determination on this issue.

B.   Outside Services

     Respondent’s notice of deficiency disallowed the amount

petitioner claimed on his Schedule C for “Outside services”,

$104,592.    Respondent claims that petitioners did not provide

information to support the deductions and that petitioners did

not establish that the expenses were ordinary and necessary.      In

support of their outside services deduction, petitioners explain

on brief that the amount represents legal and engineering fees.

     Perez tried to substantiate the expenses for “outside

services” with a list that included several payments to

“Operating Engineers”.    Perez claimed Operating Engineers
                                - 11 -

belonged in that category because they provided engineering

services or certifications as shown in their invoices; however,

Operating Engineers was the union for the concrete pump truck

operators.   In the check registers, the payments to Operating

Engineers were categorized as “Subcontractors”.     According to the

interrogatory responses, items categorized as “Subcontractors”

were part of the cost of goods sold.

     Although we find it likely that the payments claimed by

petitioners were in fact made for legal and engineering costs,

those fees may already be included in petitioner’s Schedule C as

a part of cost of goods sold.     Also, to the extent that those

fees were for services performed for BBT and not B&B, they are

not deductible by petitioners.2    Petitioners provide no

information on those components that make up the cost of goods

sold amount claimed on the Schedule C, nor do they distinguish

fees paid by B&B from those paid by BBT.     In the light of this

absence of evidence, the credible evidence in the record does not

permit us to find that the outside services deduction is

supportable as an independent Schedule C deduction.




     2
      For example, a fee for legal services, dated June 1, 2001,
is directed to “BBT Enterprises dba B & B Construction”,
indicating that BBT had already set itself forth as a business
entity by that date.
                               - 12 -

C.   Rent/Lease Vehicles/Machinery/Equipment

     Respondent’s notice of deficiency disallowed the amount

petitioner claimed on his Schedule C for renting or leasing of

vehicles, machinery, and equipment, $187,004.   The notice of

deficiency stated that this cost was disallowed because

petitioners did not provide information to support the deductions

and did not establish that the expenses were ordinary and

necessary.   Petitioners support this deduction with a stipulation

listing checks and a record of check stubs.

     We note that the checks paid from the beginning of the year

through July 21, 2001, were paid out of the B&B account while the

checks paid after that date were paid out of the BBT account.

All checks dated from July 31, 2001, through the end of 2001 were

issued from the BBT account.   BBT did not file a Form 1065 for

2001, nor did B&B Complex Trust, the 99-percent partner of BBT,

file a Form 1041 for 2001.   Petitioner cannot claim a deduction

on his Schedule C for the rent/lease of vehicles, machinery, and

equipment if those expenses were in fact incurred by BBT.   In the

light of all the evidence, we hold that the deductions on

Schedule C are limited to only those expenses stipulated by the

parties to have been paid out of the B&B account.

D.   Depreciation

     Respondent’s notice of deficiency disallowed the amount

claimed on Schedule C for depreciation, $407,075.   The notice
                              - 13 -

stated that the depreciation was disallowed because petitioners

did not provide information to support the deductions and did not

establish that the expense was ordinary and necessary.    In

support of the depreciation expense, petitioners offer a one-page

depreciation schedule that includes the bases of certain stated

assets, the method of depreciation, and the 2001 deprecation

claimed.

     Section 167(a) allows a deduction for a reasonable allowance

for the exhaustion, wear and tear, and obsolescence of property

used in a trade or business or held for the production of income.

The basis on which a depreciation deduction is allowable with

respect to any property under section 167(a) is the adjusted

basis of the property, determined under section 1011 for the

purpose of determining gain on the sale or other disposition of

the property.   See sec. 167(c).

     Petitioners’ depreciation schedule lacks an essential piece

of information, the owner of the assets.   For 2001, possible

asset owners include petitioners, BBT, V&E Leasing, B&B Concrete

Pumping, or perhaps one of the partners of one of these

partnerships, and it is certainly possible, if not likely, that

ownership of the itemized assets changed throughout 2001.

Although we are satisfied that a concrete business would have

depreciable assets, we cannot find evidence in the record by

which we can determine the amount of the depreciation expense for
                                - 14 -

petitioner’s Schedule C; therefore, we sustain respondent’s

determination with respect to depreciation.3

E.   Accuracy-Related Penalty

     Respondent determined that petitioners are liable for an

accuracy-related penalty under section 6662(a).    Section 6662(a)

imposes an accuracy-related penalty equal to 20 percent of the

portion of an underpayment that is attributable to, among other

things, negligence.   Petitioners will avoid this penalty if the

record shows that they were not negligent; i.e., they made a

reasonable attempt to comply with the provisions of the Code and

they were not careless, reckless, or in intentional disregard of

rules or regulations.   See sec. 6662(c); Keeler v. Commissioner,

243 F.3d 1212, 1221 (10th Cir. 2001), affg. Leema Enters., Inc.

v. Commissioner, T.C. Memo. 1999-18.     Negligence connotes a lack

of due care or failure to do what a reasonable and prudent person

would do under the circumstances.    See Allen v. Commissioner, 92

T.C. 1 (1989), affd. 925 F.2d 348 (9th Cir. 1991).    An


     3
      As noted above, on Nov. 30, 2005, CID agents executed
simultaneous search warrants at petitioner’s business and the
payroll company, and respondent has remained in possession of
those materials through the date of trial. The record does not
provide support that this circumstance impaired petitioners’
preparations for and offering of evidence at trial. In fact,
after this case was set for trial, respondent moved for
continuance, but petitioners opposed that motion; and the request
for continuance was denied. Further, Perez testified that the
information she had used to prepare petitioner’s Schedule C came
from the Quickbooks accounting system that she used and that she
had been able to restore that information from Quickbooks files
backups that had not been seized.
                                - 15 -

accuracy-related penalty is not applicable to any portion of an

underpayment to the extent that a taxpayer has reasonable cause

for that portion and acts in good faith with respect thereto.

See sec. 6664(c)(1).

     Respondent bears the burden of production with respect to

the accuracy-related penalty.    Sec. 7491(c).   To meet this burden

of production, respondent must produce sufficient evidence that

it is appropriate to impose an accuracy-related penalty.    Once

respondent has produced sufficient evidence, the burden of proof

is upon petitioners.   See Higbee v. Commissioner, 116 T.C. 438,

449 (2001).   Petitioners may carry their burden by proving that

with respect to their underpayment there existed reasonable cause

and they acted in good faith.    Sec. 6664(c)(1).

     Respondent has satisfied the burden of production in that

the record establishes that petitioners failed to substantiate

their claimed deductions.   Section 6001 imposes on petitioners a

duty to maintain books and records sufficient to support items

reported on their returns, and petitioners’ breach of that duty

is contrary to what a prudent and responsible taxpayer would have

done under the circumstances.    See sec. 1.6662-3(b)(1), Income

Tax Regs.   Further, petitioners have failed to persuade us that

their failure to maintain the requisite substantiation was

excused by reasonable cause and good faith; therefore, we sustain
                             - 16 -

respondent’s determination that petitioners are liable for the

accuracy-related penalty under section 6662(a).

     We have considered all arguments by petitioners for holdings

contrary to those which we reach herein.    To the extent not

discussed, we conclude that those arguments are irrelevant or

without merit.



                                           Decision will be entered

                                   under Rule 155.
