                  T.C. Summary Opinion 2007-54



                       UNITED STATES TAX COURT



                 WAYNE B. BAILEY, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 13014-05S.              Filed April 3, 2007.



     Wayne B. Bailey, pro se.

     Aimee R. Lobo-Berg, for respondent.


     VASQUEZ, Judge:    This case was heard pursuant to the

provisions of section 7463 of the Internal Revenue Code in effect

when the petition was filed.1   Pursuant to section 7463(b), the

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




     1
        Unless otherwise indicated, section references are to the
Internal Revenue Code, and Rule references are to the Tax Court
Rules of Practice and Procedure.
                               - 2 -

this opinion shall not be treated as precedent for any other

case.

     Respondent determined a $20,627 deficiency in petitioner’s

2001 Federal income tax, as well as a penalty of $4,125.40 under

section 6662(a).   Respondent also determined a $16,293 deficiency

in petitioner’s 2002 Federal income tax, as well as a penalty of

$3,258.60 under section 6662(a).    The issues for decision are:

(1) Whether the expenditures petitioner deducted on Schedule C,

Profit or Loss From Business, for 2001 and 2002 are subject to

the deductibility limitations of section 195; (2) whether

petitioner has substantiated those deductions; and (3) whether

petitioner is liable under section 6662(a) for accuracy-related

penalties for 2001 and 2002.

                            Background

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

The stipulation of facts and the attached exhibits are

incorporated herein by reference.    At the time the petition was

filed, petitioner resided in Corvallis, Oregon.

     During 2001 and 2002, petitioner was employed as the vice

president of strategy and business development by The Martin-

Brower Company, LLC.   At the same time, petitioner and his wife

attempted to develop a business concept he called “Tasha’s
                                 - 3 -

Cafe”.2    The concept involved a retail food and drink

establishment that served coffee and related items during the

day, and wine and related items at night.    Petitioner and his

wife attempted to take a “two-pronged” approach to generating

income from the Tasha’s Cafe concept.    The first “prong” was to

open a retail location in which petitioner and his wife could

operate an actual wine and coffee bar.    The second “prong” was to

sell the concept to entrepreneurs as a franchise.

     Petitioner outfitted the basement of his home in the style

of the proposed coffee and wine bar to determine the appearance

and operation of Tasha’s Cafe and to model the concept for

potential investors, local businesspeople, and franchisees.     In

his basement, petitioner installed restaurant-level food service

equipment, coffee- and wine-related artwork, and two different

types of flooring for testing purposes.    Petitioner brought

between 200 and 250 people to his basement model to promote the

retail coffee and wine bar aspect of his business.    Petitioner

brought approximately 30 potential franchise customers to his

basement to demonstrate the franchise possibilities of Tasha’s

Cafe.     While petitioner demonstrated the Tasha’s Cafe concept, he

served coffee, wine, and food.    Petitioner was never paid for the



     2
        For 2001, petitioner filed Form 1040, U.S. Individual
Income Tax Return, with a filing status of single. For 2002,
petitioner filed Form 1040, with a filing status of head of
household.
                                - 4 -

coffee, wine, or food he served in his basement, but he did

occasionally receive tips.

     In pursuit of the retail aspect of the Tasha’s Cafe concept,

petitioner identified and attempted to obtain retail space in

which to operate a Tasha’s Cafe in Lombard, Illinois.   Petitioner

obtained interior design schematics for the location, negotiated

business loans for capital to install equipment and furniture at

the Lombard location, negotiated the rental contract for the

location, and developed advertising strategies for the store.

However, it became evident to petitioner that opening a retail

location was much more costly than he had previously estimated,

and he abandoned the retail aspect of the business in January

2003 without having opened a cafe or sold any inventory.

     Petitioner also pursued the franchise aspect of Tasha’s

Cafe.   In addition to demonstrating the Tasha’s Cafe concept in

his basement, petitioner occasionally rented space at hotels near

Chicago O’Hare Airport in which he would conduct similar

demonstrations of the concept to potential franchisees flying in

from beyond the Chicago area.   Petitioner estimated that he held

“a couple of dozen” such presentations at airport hotels between

2001 and 2003.   Petitioner continued to market the Tasha’s Cafe

franchise concept until May of 2003, when he concluded that he

could no longer fund the development of the franchise concept.

Petitioner never sold a Tasha’s Cafe franchise.
                               - 5 -

     At several stages in petitioner’s career as a businessman

and consultant, petitioner was exposed to the food and drink

franchise industry and worked with some of the largest franchise

operators in the world, including McDonald’s Corporation.

Petitioner also earned a master’s degree in business

administration with a concentration in marketing and finance from

the University of Chicago in 1989.

     On his Form 1040 for 2001, petitioner reported wages of

$217,771.   Petitioner attached a Schedule C to his Form 1040 for

2001.   On his Schedule C for 2001, petitioner claimed business

deductions of $55,348, zero gross receipts or sales, and other

income of $161.   On the Schedule C for 2001, petitioner reported

the business name as “Tasha’s” and the principal business or

profession as “Retail”.

     On his Form 1040 for 2002, petitioner reported wages of

$188,468.   Petitioner attached a Schedule C to his 2002 income

tax return, reporting $48,001 of business deductions, zero gross

receipts or sales, and other income of $43.   On the Schedule C

for 2002, petitioner reported the business name as “Tasha’s” and

the principal business or profession as “Wine Distribution/

Retail”.

     On June 8, 2005, respondent sent petitioner the above-

mentioned notice of deficiency.   Respondent attached to the

notice of deficiency copies of Form 4549A, Income Tax Examination
                               - 6 -

Changes, and Form 886-A, Explanation of Adjustments.     The Form

4549A reveals that the deficiency arises from respondent’s

disallowance of petitioner’s claimed business deductions for 2001

and 2002, associated reductions in itemized deductions and

exemptions for 2001 and 2002, and respondent’s imposition of

section 6662(a) penalties for 2001 and 2002.3

      The only meaningful explanation for respondent’s

disallowance of petitioner’s claimed business deductions appears

on the Form 886-A and reads as follows:

      We disallowed the Schedule C expense amounts shown on
      your returns because we did not receive an answer to
      our request for supporting information. To be allowed
      a deduction, expense, exemption, credit, or other tax
      benefit, you must establish that you have met all
      requirements of the law. Since you did not do so, we
      have adjusted your deductions shown below to the
      amounts verified. Accordingly, we have increased your
      income $55,348 for tax year 2001 and $48,001 for the
      tax year 2002.

                            Discussion

I.   Burden of Proof

      At trial and on the brief, respondent argued that petitioner

was precluded from claiming the Schedule C deductions on his 2001

and 2002 income tax returns because the deductions related to

start-up expenditures within the meaning of section 195, and



      3
        Because respondent determined that petitioner was not
entitled to the deductions on his Schedules C for 2001 and 2002,
respondent also determined that petitioner’s 2001 and 2002 income
included the interest reported on the Schedules C of $161 and $43
for 2001 and 2002, respectively.
                               - 7 -

because petitioner failed to substantiate the Schedule C

deductions.

     In general, the Commissioner’s determinations set forth in a

notice of deficiency are presumed correct, and the taxpayer bears

the burden of showing that the determinations are erroneous.4

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

However, when the Commissioner relies on a basis or theory at

trial which was not stated or described in the notice of

deficiency, and the new basis or theory requires the presentation

of different evidence, the Commissioner has raised “new matter”,

and the burden of proof falls on him with respect to that new

matter.   Rule 142(a); Shea v. Commissioner, 112 T.C. 183, 197

(1999); Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507

(1989).   In determining whether the Commissioner has given a

taxpayer sufficient notice of his basis for determining a

deficiency, we examine a notice of deficiency in conjunction with

documents provided to a taxpayer or his or her representative

during the examination of a taxpayer’s income tax return.    Bitker

v. Commissioner, T.C. Memo. 2003-209.

     A.   Section 195

     Amounts paid or incurred in connection with creating an



     4
        Petitioner has neither claimed nor shown that he
satisfied the requirements of sec. 7491(a) to shift the burden of
proof to respondent with regard to any factual issue.
Accordingly, petitioner bears the burden of proof. Rule 142(a).
                                  - 8 -

active trade or business are start-up expenditures.    Sec. 195(c).

Section 195(a) generally precludes taxpayers from deducting

start-up expenditures.    However, for the years at issue, section

195(b) generally allowed taxpayers to elect to amortize start-up

expenditures over a period not less than 60 months, beginning (at

the earliest) in the year in which the active trade or business

commences.5   If the start-up expenditures relate to an endeavor

that never rises to the status of an active trade or business, a

taxpayer may not amortize the start-up expenditures.    See Bernard

v. Commissioner, T.C. Memo. 1998-20.

     In the matter before us, respondent’s notice of deficiency

makes no mention of section 195, the language of section 195, or

the principles upon which section 195 rests.    The record does not

establish that respondent raised section 195 during the

examination of petitioner’s income tax returns or otherwise

notified petitioner that section 195 was relevant to his

determination.    Respondent’s section 195 argument is therefore

new matter, and respondent bears the burden of proof with respect

to section 195.    Rule 142(a).




     5
        In 2004, Congress amended sec. 195(b) to allow electing
taxpayers to deduct start-up expenditures over a period of 180
months beginning with the month in which the active trade or
business begins. American Jobs Creation Act of 2004, Pub. L.
108-357, sec. 902(a)(1), 118 Stat. 1651. Sec. 195 applies as so
amended to amounts paid or incurred after Oct. 22, 2004.
                                 - 9 -

     B.   Substantiation

     Taxpayers must maintain records sufficient to enable the

Commissioner to determine their correct tax liability.    Sec.

6001; Higbee v. Commissioner, 116 T.C. 438, 440 (2001); sec.

1.6001-1(a), Income Tax Regs.     Taxpayers must “keep such

permanent books of account or records * * * as are sufficient to

establish the amount of gross income, deductions, credits, or

other matters required to be shown by such person in any return

of such tax or information.”     Sec. 1.6001-1(a), Income Tax Regs.

     The notice of deficiency in this matter, combined with

information on the attached Form 4549A and Form 886-A, adequately

reveals that respondent disallowed petitioner’s Schedule C

deductions because of petitioner’s failure to substantiate those

deductions.   As discussed supra, the Form 886-A states that

respondent disallowed the Schedule C expense amounts shown on

petitioner’s 2001 and 2002 returns because petitioner failed to

provide respondent with “supporting information”.    The Form 886-A

also states that petitioner “must establish that [his claimed

deductions have] met all requirements of the law.”    This

substantially corresponds both with the language of section 6001

and the regulations issued thereunder, and the principles

underlying section 6001.     Petitioner therefore bears the burden

of proof with respect to substantiating his claimed business

deductions.   Rule 142(a).
                                - 10 -

II.   Section 195

      As noted supra, taxpayers may neither deduct nor amortize

section 195 start-up expenditures if the activities to which the

expenditures relate fail to become an “active trade or business”.

Congress, through section 195(c)(2)(A), authorized the Secretary

to issue regulations to guide the determination of when an active

trade or business begins.    No such regulations have yet been

issued.

      In determining when an activity becomes an “active trade or

business” for the purpose of section 195(a), this Court has

sought guidance from cases interpreting the “engaged in a trade

or business” requirement for deduction under section 162.     See,

e.g., Weaver v. Commissioner, T.C. Memo. 2004-108.     For the

purpose of section 162, the U.S. Supreme Court has held that the

question of whether a taxpayer is “engaged in a trade or

business” requires examination of the facts in each particular

case.     Commissioner v. Groetzinger, 480 U.S. 23, 36 (1987).   To

be engaged in a trade or business, a taxpayer must:     (1)

Undertake an activity intending to make a profit; (2) be

regularly and actively involved in the activity; and (3) actually

have commenced business operations.      McManus v. Commissioner,

T.C. Memo. 1987-457, affd. without published opinion 865 F.2d 255

(4th Cir. 1988).    A taxpayer is not engaged in a trade or

business “until such time as the business has begun to function
                               - 11 -

as a going concern and performed those activities for which it

was organized.”    Richmond Television Corp. v. United States, 345

F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other

grounds 382 U.S. 68 (1965).    An enterprise need not have

generated sales or other revenue to have begun to carry on a

business.   Jackson v. Commissioner, 864 F.2d 1521, 1526 (10th

Cir. 1989), affg. 86 T.C. 492 (1986); Cabintaxi Corp. v.

Commissioner, 63 F.3d 614, 620 (7th Cir. 1995), affg. in part,

revg. in part, and remanding T.C. Memo. 1994-316.    However, mere

research into or investigation of a potential business is

insufficient to demonstrate that a taxpayer is engaged in a trade

or business.    Dean v. Commissioner, 56 T.C. 895, 902 (1971).

     In the matter before us, petitioner was not actively engaged

in the trade or business of the retail aspect of the Tasha’s Cafe

concept.    Petitioner never obtained the necessary licenses,

materials, or inventory for the retail business, established a

retail location, or held out any goods for sale.

     However, the record before us establishes that petitioner

was actively engaged in the trade or business of selling

franchises of the Tasha’s Cafe concept.    Petitioner developed

detailed plans for the operation and appearance of a Tasha’s Cafe

location.   Based on his analysis of the model in his basement,

petitioner determined the materials and design elements to be

used for outfitting a Tasha’s Cafe location.    Most importantly,
                               - 12 -

petitioner actually operated the franchise aspect of the Tasha’s

Cafe concept by holding numerous presentations to potential

franchisees in which he offered to sell Tasha’s Cafe franchises.

Petitioner therefore was actively engaged in the trade or

business of franchising the Tasha’s Cafe concept, and his

expenditures for 2001 and 2002 are not subject to the limitations

of section 195.

III.   Substantiation

       On petitioner’s Schedule C for 2001, he claimed $10,693 of

deductible car and truck expenses, $929 of deductible meals and

entertainment expenses, and $43,726 of other deductible expenses.

On petitioner’s Schedule C for 2002, he claimed $1,140 of

deductible car and truck expenses, $6,265 of deductible travel

expenses, $1,131 of deductible meals and entertainment expenses,

and $39,465 of other deductible expenses.

       Deductions are a matter of legislative grace, and taxpayers

generally bear the burden of proving that they are entitled to

any deductions 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).    As noted supra, taxpayers

must maintain sufficient records to enable the Commissioner to

determine their correct tax liability.    Sec. 6001.

       Section 162 generally allows a deduction for ordinary and

necessary expenses paid or incurred during the taxable year in
                               - 13 -

carrying on a trade or business.    Such expenses must be directly

connected with or pertain to the taxpayer’s trade or business.

Sec. 1.162-1(a), Income Tax Regs.    Generally, no deduction is

allowed for personal, living, or family expenses, nor is

deduction proper for expenditures that are properly categorized

as capital expenditures.    See secs. 262 and 263.   The

determination of whether an expenditure satisfies the

requirements of section 162 is a question of fact.     Commissioner

v. Heininger, 320 U.S. 467, 475 (1943).

     When a taxpayer establishes that he or she has incurred

deductible expenses but is unable to substantiate the exact

amounts, we can estimate the deductible amount, but only if the

taxpayer presents sufficient evidence to establish a rational

basis for making the estimate.    See Cohan v. Commissioner, 39

F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner, 85

T.C. 731, 742-743 (1985).    In estimating the amount allowable, we

bear heavily against the taxpayer where the inexactitude of the

record is of his or her own making.     See Cohan v. Commissioner,

supra at 544.

     However, deductions relating to travel, meals and

entertainment, gifts, or use of listed property (including

passenger automobiles) are subject to strict rules of

substantiation that supersede the doctrine in Cohan v.
                               - 14 -

Commissioner, supra at 544.    See sec. 274(d); sec. 1.274-

5T(c)(2), Temporary Income Tax Regs., 50 Fed. Reg. 46017 (Nov. 6,

1985).   The term “listed property” includes passenger

automobiles.   Sec. 280F(d)(4)(A)(i).   For deductions to which

section 274 applies, taxpayers must substantiate certain elements

of the deductible activity or use through either adequate records

or sufficient evidence corroborating the taxpayer’s own

statement.   Sec. 274(d).   If a taxpayer cannot satisfy the

substantiation burden imposed by section 274(d) with respect to a

deduction to which it applies, he fails to carry his burden of

establishing that he is entitled to deduct that expense,

regardless of any equities involved.    Sec. 274(d); Nicely v.

Commissioner, T.C. Memo. 2006-172; sec. 1.274-5T(a), Temporary

Income Tax Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985).     Generally,

taxpayers must substantiate each required element of an

expenditure or use.   Sec. 1.274-5T(b)(1), Temporary Income Tax

Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985).    At a minimum, a

taxpayer must substantiate:    (1) The amount of the expense, (2)

the time and place the expense was incurred, (3) the business

purpose of the expense, and (4) the business relationship to the

taxpayer of other persons benefited by the expense, if any.      Sec.

274(d); Shea v. Commissioner, 112 T.C. 183, 187 (1999).

     To substantiate the business deductions he claimed on his

2001 and 2002 income tax returns, petitioner presented a
                               - 15 -

disorganized set of invoices, receipts, canceled checks, and

other documents from 2001 and 2002.     At trial, petitioner offered

almost no testimony explaining the transactions underlying the

deductions on his 2001 and 2002 income tax returns.    In his

testimony, petitioner also admitted that he had mistakenly

presented several documents, receipts, and canceled checks that

relate to purely personal expenditures.

       Petitioner has failed to carry his burden of proof with

regard to the deductions subject to the limitations of section

274.    Petitioner has not presented adequate records which

substantiate the required elements for those expenditures subject

to section 274.    Nor has petitioner provided sufficient evidence

to corroborate his statements regarding his deductible

expenditures in 2001 and 2002.    We therefore uphold respondent’s

determination that petitioner has not adequately substantiated

his claimed deductions for expenditures relating to travel, meals

and entertainment, or business use of cars or trucks for 2001 and

2002.

       As to petitioner’s business deductions not subject to the

limitations of section 274, petitioner also has failed to

adequately substantiate nearly all of the business deductions

claimed on his Schedules C for 2001 and 2002.    Petitioner has

presented almost no evidence that links the expenditures

reflected in the receipts, invoices, and checks to his business
                                - 16 -

operations.   Petitioner’s records appear to reflect some business

expenditures, but in most instances we cannot determine whether

the expenditures bear any relationship to the franchise “prong”

of Tasha’s Cafe.    Nor has petitioner presented sufficient

evidence for the Court to estimate the amount of any of his

business expenditures.

      From the record before us, petitioner has presented some

canceled checks and paid invoices that show deductible

expenditures for legal fees, marketing expenses, and charitable

donations related to his Tasha’s Cafe franchising operations.

Those expenditures amount to $2,195 in legal fees and marketing

expenses for 2001, and $550 in charitable donations for 2002.

      Except as noted above, petitioner has not produced

sufficient evidence to persuade us that respondent’s

determinations are in error.    Consequently, with the exceptions

noted above, we sustain respondent’s deficiency determination.

IV.   Penalties

      A.   Section 6662(a) Penalty

      As noted supra, respondent determined section 6662(a)

penalties of $4,125.40 and $3,258.60 for 2001 and 2002,

respectively.     Respondent determined that petitioner’s 2001 and

2002 underpayments of tax were attributable to negligence or

disregard of rules and regulations, or alternatively that the
                               - 17 -

2001 and 2002 underpayments are attributable to substantial

understatements of income tax.

     Pursuant to section 6662(a), a taxpayer may be liable for a

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

(1) attributable to a substantial understatement of tax, or (2)

due to negligence or disregard of rules or regulations.   Sec.

6662(b).   The term “understatement” means the excess of the

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

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

(within the meaning of section 6211(b)(2)).   Sec. 6662(d)(2)(A).

Generally, an understatement is a “substantial understatement”

when the understatement exceeds the greater of $5,000 or 10

percent of the amount of tax required to be shown on the return.

Sec. 6662(d)(1)(A).   The term “negligence” in section 6662(b)(1)

includes any failure to make a reasonable attempt to comply with

the Internal Revenue Code and any failure to keep adequate books

and records or to substantiate items properly.   Sec. 6662(c);

sec. 1.6662-3(b)(1), Income Tax Regs.    Negligence has also been

defined as the failure to exercise due care or the failure to do

what a reasonable person would do under the circumstances.     See

Allen v. Commissioner, 92 T.C. 1, 12 (1989), affd. 925 F.2d 348,

353 (9th Cir. 1991); Neely v. Commissioner, 85 T.C. 934, 947

(1985).    The term “disregard” includes any careless, reckless, or

intentional disregard.   Sec. 6662(c).
                               - 18 -

     B.   Burden of Proof

     The Commissioner has the burden of production with respect

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

burden, the Commissioner must produce sufficient evidence

indicating that it is appropriate to impose the penalty.       See

Higbee v. Commissioner, 116 T.C. 438, 446 (2001).      Once the

Commissioner meets this burden of production, the taxpayer must

come forward with persuasive evidence that the Commissioner’s

determination is incorrect.   Rule 142(a); see Higbee v.

Commissioner, supra.   The taxpayer may meet this burden by

proving that he or she acted with reasonable cause and in good

faith.    See sec. 6664(c)(1); see also Higbee v. Commissioner,

supra; sec. 1.6664-4(b)(1), Income Tax Regs.

     C.   Analysis

     In the matter before us, respondent has met his burden of

production under section 7491(c).    The record shows that both

petitioner’s 2001 and 2002 income tax returns contain

understatements of tax greater than $5,000.    See sec.

6662(d)(1)(A)(ii).   Accordingly, petitioner bears the burden of

proving that the accuracy-related penalties should not be imposed

with respect to any portion of the understatements for which he

acted with reasonable cause and in good faith.      See sec.

6664(c)(1); Higbee v. Commissioner, supra at 446.
                              - 19 -

     Petitioner has failed to meet his burden of persuasion with

respect to the accuracy-related penalties.   Petitioner claimed

substantial deductions for which he apparently maintained no

records.   At trial, petitioner admitted that some of the

deductions on his Schedules C for 2001 and 2002 may have

represented personal expenditures, including the costs of a

family trip to Mexico and payments for insurance premiums on his

personal automobiles.   As noted supra, petitioner likely incurred

several business expenditures during 2001 and 2002.   However,

petitioner has not produced any evidence establishing that he

acted with reasonable cause and in good faith with respect to any

portion of the understatements of tax on his 2001 and 2002 income

tax returns.   Therefore, to the extent that we uphold

respondent’s determination of deficiencies for 2001 and 2002, we

conclude that petitioner is liable for the section 6662(a)

penalties.

     To reflect the foregoing,


                                         Decision will be entered

                                    under Rule 155.
