                  T.C. Summary Opinion 2002-128



                     UNITED STATES TAX COURT



        MARTIN HIGBEE AND SUZANNE HIGBEE, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 12791-00S.               Filed October 4, 2002.


     James A. Mather, for petitioners.

     Anne W. Durning, for respondent.



     DEAN, Special Trial Judge:   This case was heard pursuant to

the provisions of section 7463 of the Internal Revenue Code in

effect at the time the petition was filed.   Unless otherwise

indicated, subsequent section references are to the Internal

Revenue Code in effect for the years at issue, and all Rule

references are to the Tax Court Rules of Practice and Procedure.

The decision to be entered is not reviewable by any other court,

and this opinion should not be cited as authority.
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     Respondent determined deficiencies in petitioners’ Federal

income taxes of $12,172 for 1997 and $16,016 for 1998 and

accuracy-related penalties of $2,434 for 1997 and $3,203 for 1998

under section 6662(a).    The issues for decision are:   (1) Whether

petitioners are entitled to deduct losses from an S corporation;

(2) if not, whether such losses are deductible as proprietorship

losses; and (3) whether petitioners are liable for the accuracy-

related penalties for 1997 and 1998.

     The stipulated facts and exhibits received into evidence are

incorporated herein by reference.    At the time the petition in

this case was filed, petitioners resided in Tucson, Arizona.

                             Background

     During the years at issue, petitioner Martin Higbee was

employed as a professor at the University of Arizona in Tucson.

Petitioner Suzanne Higbee worked as a ticket agent for U.S.

Airways.

     Petitioners acquired property in Tucson, Arizona, to be used

as a "bed and breakfast".    They began operating sometime in 1996.

The property was a four-bedroom house.    Petitioners resided in

the house during the years at issue.

     The records of the Arizona Corporation Commission reflect

the incorporation of Cactus Quail Enterprises, Inc. (corporation)

on October 20, 1995, for purposes of carrying on the

"HOTEL/MOTEL" business.    The named corporate officers were
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Suzanne Higbee, president, and Martin Higbee, secretary.    The

agent appointed for the corporation was Dan Preiser.   In 1995 Mr.

Preiser, petitioners' accountant, prepared Form SS-4, Application

for Employer Identification Number, and Form 2553, Election by a

Small Business Corporation (Under Section 1362 of the Internal

Revenue Code), for the corporation.    The forms were not filed in

1995 because the business had not yet begun in that year.    In

early 1996, Mr. Preiser instructed Mr. Higbee to file both Forms

SS-4 and 2553.

     Petitioners filed Federal income tax returns for 1997 and

1998, each with an attached Schedule E, Supplemental Income and

Loss (From rental real estate, royalties, partnerships, S

Corporations, estates, trusts, REMICs, etc.).   The Schedules E

indicate that each petitioner has a 50-percent ownership interest

in "CACTUS QUAIL ENT INC".   The corporation is listed as an S

corporation with the employer identification number (EIN) 86-

0819375.   Each petitioner deducted an S corporation loss for each

year.

     The corporation filed Forms 1120S, U.S. Income Tax Return

for an S Corporation, for calendar years 1997 and 1998, attaching

a Schedule K-1, Shareholder's Share of Income, Credits,

Deductions, Etc., for each of petitioners.   Mr. Preiser, the

designated corporate agent, signed as the preparer of the

returns.
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     In early January of 1997, 1998, and 1999, petitioner Martin

Higbee, as president of the corporation, signed successive

interest-bearing promissory notes payable on demand to Martin

Higbee, as an individual.   On November 24, 1999, Cactus Quail

Enterprises, Inc. filed with the Arizona secretary of state an

Application for Registration of Trade Name to register its name.

The Office of the secretary of state responded by advising the

corporation that it "is not in good standing".

     An employee of the Commissioner's Ogden Service Center

(Service Center), in a letter dated March 2, 2000, wrote the

corporation in care of petitioner Suzanne Higbee to advise that

"According to our records, you have not been accepted as an S-

Corporation."   The letter informs the corporation to file a Form

1120, U.S. Corporation Income Tax Return, in lieu of a Form

1120S, or to apply for "relief for a late S-Corporation

election".

     The Commissioner issued to petitioners a statutory notice of

deficiency dated September 15, 2000, for 1997 and 1998

disallowing the deductions for S corporation losses claimed on

their joint Federal income tax returns, making mechanical

adjustments to their itemized deductions, and asserting the

accuracy-related penalties under section 6662(a).

     Petitioners' accountant, Mr. Preiser, in a letter to the

Service Center dated December 7, 2000, refers to Forms 1040X,
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Amended U.S. Individual Income Tax Return, filed by petitioners

that are intended to cancel "the previously filed Schedule E's

and have substituted Schedule C's".    The amended returns were

received by the Service Center on December 11, 2000.    On page 2,

Part II of the returns, Explanation of Changes to Income,

Deductions, and Credits, petitioners state that the returns are

being "filed to remove the K-1 from Cactus Quail Enterprises,

Inc. per letters from the IRS disallowing the S-corporation

election."   The explanation further states that the State

corporation commission reports for the corporation were not filed

for 1997, 1998, and 1999, and that the "corporation was no longer

valid after 12/31/96."

                            Discussion

     Petitioners' argument on brief is that they did business as

a proprietorship for the years at issue but, if they were doing

business as a corporate entity, then such entity was an S

corporation under section 1361.

     Respondent's position is that petitioners failed to make an

election under section 1362.   Respondent further argues that

petitioners have not shown that they were doing business as a

proprietorship in 1997 and 1998, but that even if they were, they

have not shown that they actually incurred the expenses they now

claim are deductible on Schedules C, Profit or Loss From

Business, of their personal returns.
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     Taxpayers generally bear the burden of proving that the

Commissioner’s determination is incorrect.    Rule 142(a); Welch v.

Helvering, 290 U.S. 111 (1933).    Section 7491(a)(1) provides,

however, that the burden of proof shifts to the Commissioner if,

among other requirements, the taxpayer introduces “credible

evidence with respect to any factual issue relevant to

ascertaining” his liability for the tax deficiency at issue.      The

Court concludes that section 7491 has no effect on the resolution

of the section 1362 election issue and does not shift the burden

of proof to respondent because petitioners have failed to comply

with the requirements of section 7491(a)(2).

Election Under Section 1362

     Petitioners seem to have all but abandoned the original

position taken on their personal returns for 1997 and 1998.

Their argument that the corporation was an S corporation is now

merely a "backup" to their argument that they operated as a

proprietorship in 1997 and 1998.    The issue, nevertheless, will

be addressed.

     Petitioners have offered as evidence to show that they filed

a proper election, a copy of a Form 2553 signed by Suzanne Higbee

on July 10, 1995, and testimony of Martin Higbee that he mailed

the Form 2553 at the same time and in the same envelope as a Form

SS-4, sometime in 1996.   Although there was no evidence or

argument offered by the parties on the issue, the Court is left
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to assume that the use of an EIN by the corporation on Forms

1120S means that it actually was assigned an EIN by the Internal

Revenue Service.

     Treatment as an S corporation is contingent on election with

consent of the shareholders.   Sec. 1362; sec. 1.1362-6, Income

Tax Regs.   To be effective, Form 2553 must be filed with the

Service Center designated in the instructions applicable to Form

2553.    Sec. 1.1362-6(a)(2), Income Tax Regs.; see Combs v.

Commissioner, T.C. Memo. 1989-206, affd. without published

opinion 907 F.2d 151 (6th Cir. 1990).   Therefore, filing requires

delivery to the Service Center.    Barber v. Commissioner, T.C.

Memo. 1999-260; Leather v. Commissioner, T.C. Memo. 1991-534.

     Proof of mailing raises a rebuttable presumption of delivery

that will be sufficient in the absence of evidence of

nondelivery.   See Anderson v. United States, 966 F.2d 487 (9th

Cir. 1992); Estate of Wood v. Commissioner, 92 T.C. 793, 798-799

(1989), affd. 909 F.2d 1155 (8th Cir. 1990).   Here, respondent

produced evidence of nondelivery in the form of a Certification

of Lack of Record with respect to Form 2553 for Cactus Quail or

for EIN XX-XXXXXXX.   Petitioners, on the other hand, have

produced no direct evidence that they mailed the form.   They have

failed to describe any details of the actual deposit of the Form

2553 in the United States mail.   See Leather v. Comissioner,

supra.   In view of the evidence of nonreceipt offered by
                                - 8 -

respondent, even if petitioners had offered evidence that the

form was mailed, we would be left with the conclusion that the

document was lost in transit.   In such a case, it is the taxpayer

who bears the risk of nondelivery.      Walden v. Commissioner 90

T.C. 947, 951-952 (1988); Smith v. Commissioner, T.C. Memo. 1994-

270, affd. without published opinion 81 F.3d 170 (9th Cir. 1996).

     The Court holds that the preponderance of the evidence

supports respondent's determination that petitioners are not

entitled to deduct losses from an S corporation for 1997 and

1998.

Operation as a Proprietorship

     Petitioners' primary argument is that the deductions claimed

on their returns as losses from an S corporation on Schedules E

should really have been reported as business expenses on

Schedules C.   They argue that Cactus Quail was not a corporation

at all during the years at issue and that the bed and breakfast

expenses were therefore incurred by and are deductible by them

personally.

     The Court will assume, without deciding, that petitioners

did operate as a proprietorship during 1997 and 1998 and would be

entitled to deduct business expenses on Schedules C.     Deductions,

however, are a matter of legislative grace, and taxpayers bear

the burden of proving their entitlement to any deduction claimed.

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New
                               - 9 -

Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).     Since

section 7491(a) does not alter the taxpayer's burden of proof

where the taxpayer has not complied with all applicable

substantiation requirements, including those of section 274(d),

sec. 7491(a) does not apply here.      Higbee v. Commissioner, 116

T.C. 438, 442 (2001).   Taxpayers have the burden of proving that

they meet each of the conditions of section 7491(a), because the

conditions are necessary prerequisites to establishing that the

burden of proof is on the Secretary.     H. Conf. Rept. 105-599, at

239 (1998), 1998-3 C.B. 747, 993.

     Section 162(a) allows a taxpayer to deduct all ordinary and

necessary business expenses paid or incurred during the taxable

year in carrying on any trade or business.     To be "necessary" an

expense must be "appropriate and helpful" to the taxpayer's

business.   Welch v. Helvering, 290 U.S. 111, 113 (1933).    To be

"ordinary" the transaction which gives rise to the expense must

be of a common or frequent occurrence in the type of business

involved.   Deputy v. du Pont, 308 U.S. 488, 495 (1940).    No

deduction is allowed for personal, living, or family expenses.

Sec. 262(a).

     Generally, if a claimed business expense is deductible, but

the taxpayer is unable to substantiate it, the Court is permitted

to make as close an approximation as it can, bearing heavily

against the taxpayer whose inexactitude is of his or her own
                                - 10 -

making.    Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir.

1930).    The estimate, however, must have a reasonable evidentiary

basis.    Vanicek v. Commissioner, 85 T.C. 731, 743 (1985).   For

certain expenses, section 274 supersedes the Cohan doctrine.        See

sec. 1.274-5T(a), Temporary Income Tax Regs., 50 Fed. Reg. 46014

(Nov. 6, 1985).    It requires, for example, strict substantiation

of expenses with respect to any listed property as defined in

section 280F(d)(4).    Sec. 274(d).   Listed property includes any

passenger automobile or any other property used as a means of

transportation, and computers.    Sec. 280F(d)(4)(A)(i), (ii), (iv).

     Petitioners have offered no documentary or testimonial

evidence for any of the expenses claimed for the "bed and

breakfast" operation.    In order for the Court to estimate the

amount of an expense, we must have some basis upon which an

estimate may be made.    Vanicek v. Commissioner, supra.   The Court

is without any such basis here, and any allowance would amount to

unguided largess.     Williams v. United States, 245 F.2d 559, 560

(5th Cir. 1957).

     Accordingly, the Court sustains respondent’s determination

that there are deficiencies in petitioners' income taxes for the

years 1997 and 1998.

Accuracy-Related Penalties

     Respondent determined that petitioners are liable for the

section 6662(a) accuracy-related penalties for 1997 and 1998.
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Taxpayers are liable for an accuracy-related penalty in the

amount of 20 percent of the portion of an underpayment of tax

attributable to any substantial understatement of income tax.

Sec. 6662(a) and (b)(2).   A "substantial understatement" is an

understatement for the taxable year exceeding the greater of 10

percent of the proper tax or $5,000.    Sec. 6662(d)(1)(A).   No

penalty will be imposed with respect to any portion of any

underpayment if it is shown that there was a reasonable cause for

such portion and that the taxpayer acted in good faith with

respect to such portion.   Sec. 6664(c).   This determination is

based on all the facts and circumstances.    Sec. 1.6664-4(b)(1),

Income Tax Regs.

     Section 7491(c) imposes on respondent the burden of

producing evidence to show that the section 6662(a) penalty is

appropriate, but respondent need not produce evidence regarding

reasonable cause.   Higbee v. Commissioner, supra at 446-447.

The Court has sustained respondent's determination of the

deficiencies for both years.   Petitioners' understatements of tax

exceed the greater of 10 percent of the proper tax or $5,000 for

each year.   The Court finds that respondent has satisfied the

burden of production with respect to the accuracy-related

penalties under section 6662(a).   Petitioners presented no

evidence indicating reasonable cause for the understated income.
                             - 12 -

Accordingly, the imposition of the accuracy-related penalties is

sustained.

     The Court has considered all of the other arguments made by

petitioners, and, to the extent that the arguments have not been

specifically discussed above, they have been found to be without

merit.

     Reviewed and adopted as the report of the Small Tax Case

Division.

                                        Decision will be entered

                                   for respondent.
