                               T.C. Memo. 2015-33


                         UNITED STATES TAX COURT



          LEONARDO VILLEGAS, Petitioner v. COMMISSIONER OF
                  INTERNAL REVENUE, Respondent

                    GRACE VILLEGAS, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 10600-12, 25070-13.               Filed February 26, 2015.



      Leonardo Villegas and Grace Villegas, pro sese.

      Carolyn A. Schenck and Katherine Holmes Ankeny, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      NEGA, Judge: By separate notices, respondent determined deficiencies in

petitioners’ individual 2007 income tax and additions to tax as follows:1


      1
      Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the year at issue. All Rule references are to the Tax
                                                                       (continued...)
                                         -2-

          [*2]                                     Additions to tax
                                         Sec.           Sec.           Sec.
                       Deficiency     6651(a)(1)     6651(a)(2)       6654(a)
 Leonardo Villegas1     $132,912       $29,905        $33,228         $6,049
   (Mr. Villegas)
Grace Villegas          134,008         30,152          33,502         6,099
  (Mrs. Villegas)

      1
        Respondent originally determined a deficiency in Mr. Villegas’ income tax
of $187,146 and additions to tax totaling $91,797 for 2007. Respondent’s sub-
sequently revised position, shown above, reflects Mr. Villegas’ 50% community
property share in certain income items. Respondent prepared a second substitute
for return (SFR) to account for these changes.

      After concessions, the issues for decision are: (1) whether petitioners are

entitled to exclude from gross income a portion of the gain realized from the sale

of their group home property in 2007; (2) whether petitioners are entitled to add

the cost of capital improvements to their basis in the group home property; (3)

whether petitioners are entitled to deduct expenses reported on Schedule C, Profit

or Loss from Business, of their 2007 tax returns for their group home business;

and (4) whether petitioners are liable for additions to tax for the 2007 tax year.2

      1
       (...continued)
Court Rules of Practice and Procedure. All monetary amounts are rounded to the
nearest dollar.
      2
        Petitioners’ self-employment tax is also at issue. Self-employment income
is subject to self-employment tax. Sec. 1401(a). A taxpayer’s self-employment
                                                                      (continued...)
                                         -3-

[*3]                           FINDINGS OF FACT

       Some of the facts have been deemed stipulated pursuant to Rule 91(f) by

reason of petitioners’ failure to respond to an order to show cause.3 The

stipulation of facts and the accompanying exhibits are incorporated herein by this

reference. Petitioners were married and resided in California, a community

property State, when their petitions were filed. Petitioners were both cash method

taxpayers for the year at issue. Their cases were consolidated for trial, briefing,

and decision.

       In 1994 petitioners purchased a four-bedroom house in Diamond Bar,

California (Diamond Bar), for $200,000. The house included a kitchen, two

bathrooms, a living room, a family room, a garage, and an outdoor area with a

patio and a pool. That same year they decided to develop the Diamond Bar house

as a group home for the developmentally disabled and started doing business as

the L. Marillac Group Home (Marillac). Petitioners used the Diamond Bar house


       2
        (...continued)
income generally is equal to the gross income derived from business less any
business expenses which the taxpayer substantiates. Sec. 1402(a) and (b); sec.
1.1402(a)-1(a)(1), Income Tax Regs. Respondent’s determinations with respect to
petitioners’ self-employment tax and deductions are computational adjustments
that will be resolved by our decisions on the primary issues.
       3
       Proposed stipulations of fact were deemed established by the Court’s April
28, 2014, order.
                                         -4-

[*4] to accommodate and care for Marillac’s six clients. The clients used three

bedrooms, with two clients per bedroom. Petitioners used the fourth bedroom as

their office.

       Marillac cared for its clients by attending to their personal hygiene,

providing meals, and organizing activities for them throughout the day. Marillac

was reimbursed for these services by the California Department of Health Care

Services (DHCS). In 2007 DHCS paid Marillac a total of $341,916 for its

services. That same year DHCS issued a Form 1099-MISC, Miscellaneous

Income, to Marillac to report its payments to petitioners in conjunction with these

services. Petitioners, as sole proprietors of Marillac, received this income.

       On late-submitted returns for the 2007 tax year, petitioners reported total

expenses of $239,258 for Marillac on their respective Schedules C. This total

included, among other items, wage expenses of $89,621, repair and maintenance

expenses of $6,604, tax and license expenses of $12,010, home office expenses of

$25,708, and “other expenses” of $84,095. These “other expenses” included

$2,548 in “Bank Service Charges” and the same $6,604 for “Facility

Maintenance” that petitioners reported under repair and maintenance expenses.

Petitioners also deducted $2,083 for depreciation. To substantiate these expenses,

petitioners produced to respondent 636 pages of records including invoices, bank
                                        -5-

[*5] records, a payroll register, and receipts. The records contained information

pertaining to total taxable wages paid by Marillac to its employees, license fees

incurred by Marillac, and evidence that Marillac’s business bank accounts were

used at times for petitioners’ personal foreign travel. The records also contained a

summary spreadsheet of operating expenses by category for January through

November 2007. These categories, however, did not correspond to the categories

of expenses listed on petitioners’ 2007 tax returns, and petitioners did not explain

how this spreadsheet correlated with the expenses reported on their returns. The

other records produced to respondent did not contain useful information for

determining the amounts of petitioners’ remaining reported expenses.

      In order to deduct home office expenses, petitioners claimed the Diamond

Bar house was their personal residence. Mrs. Villegas’ slept at the Diamond Bar

house from time to time, but petitioners did not live at the Diamond Bar house and

in fact lived at a house on Mulvane Street in La Puente, California (Mulvane),

with their three children, one nephew, and Mr. Villegas’ parents. Petitioners’

checks, bank records, payroll records, tax preparation documents, and children’s

school records indicated that they used the Mulvane address. Marillac’s former

bookkeeper also traveled to Mulvane to work on Marillac’s cost reports for DHCS
                                       -6-

[*6] with Mrs. Villegas. Another former employee went to Mulvane for social

gatherings with petitioners.

      After receiving petitioners’ documentation, respondent reviewed this

integrated data retrieval system (IDRS) and compared it with the payroll register

and bank statements petitioners produced to reconcile the expenses they reported

on their tax returns. Through this analysis respondent determined that petitioners

could deduct only $57,392 in wage expenses and $5,605 in tax and license

expenses.

      Petitioners claim they made numerous home improvements during the more-

than-10-year period they owned the Diamond Bar house to operate Marillac’s

group home. However, the only record of costs of improvements they submitted

was a two-page handwritten table listing various examples of improvements. On

the table, petitioners wrote amounts for costs next to improvements they thought

pertained to the Diamond Bar house with the respective years they incurred these

costs. No other evidence was provided to substantiate the amounts listed on this

document.

      In 2007 petitioners sold the Diamond Bar house for $600,000, and they

received a Form 1099-S, Proceeds From Real Estate Transactions, from Coast City

Escrow reporting the sale. In order to exclude from gross income a portion of the
                                         -7-

[*7] gain from the sale under section 121, petitioners claimed the house was their

principal residence. Petitioners each excluded more than $250,000 of gain from

the sale on their separate returns for 2007.

      In August of 2007 petitioners sold the Marillac group home business to their

former bookkeeper for $180,000. In 2008 petitioners received a Form 1099-

MISC, from the buyer reporting the sale of Marillac from the prior year.

      Petitioners did not timely file returns for 2006 and 2007. The IRS prepared

substitutes for returns (SFRs) for 2007 based on information returns that it

received. In its calculations the IRS allowed a standard deduction for a single filer

and one exemption for each of petitioners’ returns. The IRS used the SFRs to

prepare petitioners’ notices of deficiency. After respondent mailed the notices of

deficiency, petitioners submitted returns for 2006 and 2007 and timely sought

redetermination in this Court.

                                      OPINION

I.    Petitioners’ Tax Liabilities

      The Commissioner’s determinations in a notice of deficiency are generally

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

determinations erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
                                         -8-

[*8] (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’ Principal Residence

        Section 121 excludes from gross income gain from the sale of a principal

residence. Generally, the property being sold must be a principal residence for an

aggregate of at least two years during the five-year period preceding the date of

the sale. A principal residence is “the primary dwelling or house that a taxpayer

occupied as his principal residence.” Gates v. Commissioner, 135 T.C. 1, 10

(2010). If taxpayers own two residences, they can satisfy the section 121

requirements with regard to only one. See sec. 1.121-1(b)(2), Income Tax Regs.

Petitioners did not live or reside at the Diamond Bar house at any time while

operating the Marillac group home at this site. First, none of Marillac’s employees

saw petitioners live at this address, and two former employees testified at trial that

petitioners lived on Mulvane. Second, none of the school records for petitioners’

children indicate that petitioners lived at the Diamond Bar address but instead

show that petitioners lived at Mulvane. Third, Mrs. Villegas’ sister told an IRS

agent that petitioners lived at Mulvane. Finally, we are not persuaded by Mrs.

Villegas’ claim that she stayed overnight at the Diamond Bar house because the
                                         -9-

[*9] room that Mrs. Villegas claimed to use as her bedroom was known to

Marillac employees as an office. Moreover, Mrs. Villegas’ credibility is

diminished by her testimony at trial and her conduct during a hearing with the

Court.

         We conclude that under section 121 petitioners’ Diamond Bar house was

not petitioners’ principal residence for two of the five years preceding its sale. We

accordingly sustain respondent’s determination that the section 121 exclusion does

not apply.

         B.    Adjusted Basis in the Diamond Bar property

         Generally, a taxpayer must recognize gain from the sale or exchange of

property. Sec. 1001(c); see also sec. 1.61-6(a), Income Tax Regs. (providing,

generally, that gain realized on the sale of property is included in gross income).

Section 1001(a) defines gain from the sale of property as the excess of the amount

realized on the sale of property over the adjusted basis of the property sold or

exchanged. Section 1011(a) provides that a taxpayer’s adjusted basis for

determining the gain from the sale or other disposition of property shall be its cost,

adjusted to the extent permitted by section 1016. See sec. 1016(a)(1); sec. 1.1016-

2(a), Income Tax Regs. (providing that the cost basis is increased by additional
                                         - 10 -

[*10] costs properly chargeable to capital account, including the cost of

improvements and betterments made to the property).

      Petitioners purchased the Diamond Bar house in 1994 for $200,000, and this

is their cost basis in the property. Petitioners argue that they are entitled to an

increased basis in the property because of costs incurred for various improve-

ments. The only evidence petitioners offer to substantiate their costs for improve-

ments is their two-page table that generally lists various home improvements. The

table contains handwritten amounts next to those improvements pertaining to the

Diamond Bar property with the year each improvement was made. No other

documentation was submitted to substantiate costs of petitioners’ improvements or

to verify the amounts listed on the handwritten table. We hold that petitioners

have failed to establish that any of the handwritten amounts on their table were in

fact paid in connection with the Diamond Bar property. We accordingly find that

petitioners’ basis in the Diamond Bar property is their cost basis of $200,000.

      C.     Schedule C Expenses

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

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

business.” A necessary expense is one that is “appropriate and helpful” to the

taxpayer’s business; ordinary expenses are those that are common or frequent in
                                       - 11 -

[*11] the type of business in which the taxpayer is engaged. Deputy v. du Pont,

308 U.S. 488, 495 (1940); Welch v. Helvering, 290 U.S. at 113. Personal, living,

and family expenses are generally not deductible. Sec. 262.

      Petitioners provided no credible evidence of any business expenses paid or

incurred during 2007 in excess of the amounts respondent conceded and allowed.

In an attempt to substantiate their expenses, petitioners submitted a disorganized

assortment of invoices, receipts, and bank records to respondent. Some of these

documents relate to personal expenses, such as foreign travel, instead of business

expenses, and many of the documents do not appear to correspond to the

categories of expenses listed on the table petitioners submitted as a summary of

their expenses. Petitioners admit that one category of expenses, “Repairs and

Maintenance”, was counted twice on their return. At trial petitioners failed to

clarify how the documents they produced related to their reported expenses or

establish that these expenses were in fact incurred. Petitioners ignored our

specific instructions to link their evidence to respondent’s adjustments. We need

not (and will not) undertake the task of sorting through the voluminous evidence

petitioners have provided in an attempt to see what is, and what is not, adequate

substantiation of the items on their returns. See Hale v. Commissioner, T.C.

Memo. 2010-229; Patterson v. Commissioner, T.C. Memo. 1979-362. Because
                                        - 12 -

[*12] petitioners failed to link the invoices, receipts, and bank records that they

produced with the amounts of expenses they reported, we hold that petitioners are

not entitled to any deduction for business expenses for the 2007 tax year beyond

the amounts respondent conceded and allowed.4

II.   Additions to Tax

      Respondent bears the burden of production for the additions to tax. See sec.

7491(c). Once respondent meets the burden of production, petitioners bear the

burden of proof, including the burden of proving reasonable cause for their late

payment or late filing. See Rule 142(a); Higbee v. Commissioner, 116 T.C. 438,

446-447 (2001).

      A.     Failure To Timely File a Tax Return

      Section 6651(a)(1) provides for an addition to tax when a taxpayer fails to

file a return timely, unless the taxpayer proves that the failure was due to

reasonable cause and not due to willful neglect. Late filing of a return is due to

reasonable cause “[i]f the taxpayer exercised ordinary business care and prudence

and was nevertheless unable to file the return within the prescribed time.” Sec.


      4
       Petitioners also claimed $25,709 in home office expense deductions. As
we stated earlier, petitioners did not use the Diamond Bar property as their
principal residence. See sec. 280A. Therefore, we conclude that no home office
deduction is allowable.
                                        - 13 -

[*13] 301.6651-1(c)(1), Proced. & Admin. Regs. For each month or fraction

thereof for which such failure continues, section 6651(a)(1) adds 5% of the tax

required to be shown on such return, up to a maximum addition of 25%.

       It was deemed stipulated that petitioners did not file timely returns for 2007,

but petitioners advance two explanations for their failure to file timely: (1) they

thought they owed no tax at the time and (2) they were confused as to when to

report income from the sale of Marillac because the buyer did not issue them a

Form 1099-MISC for the sale of the business until after the time to file had passed.

Further, Mr. Brown, petitioners’ accountant, whom they relied on in 2012 to

prepare and file their 2007 returns, claimed he needed additional time to gather

information about the cost basis of petitioners’ Diamond Bar property and the

expenses related to Marillac.

       First, petitioners’ belief that returns for 2007, if prepared, would show no

payments due provides no justification for neglecting to prepare and file those

returns because petitioners’ gross income for 2007 far exceeded the threshold for

nonfilers. A taxpayer’s mistaken belief that he or she need not file a return is not

reasonable cause. See Henningsen v. Commissioner, 26 T.C. 528, 536 (1956),

aff’d, 243 F.2d 954 (4th Cir. 1957); Ruggeri v. Commissioner, T.C. Memo. 2008-

300.
                                         - 14 -

[*14] Second, petitioners’ assertion that the buyer’s late issuance of a Form 1099-

MISC pertaining to the sale of Marillac was somehow responsible for their failure

to timely file 2007 returns is both unconvincing and misguided. Although

petitioners did not receive a Form 1099-MISC from the buyer until 2008, the sale

of the business took place in 2007 and petitioners received money from the sale in

2007. As cash method taxpayers, petitioners had a responsibility to report this

income for 2007--the year they received it. Furthermore, in 2008 petitioners

received a Form 1099-MISC for income received from DHCS in 2007 and a Form

1099-S for the sale of the Diamond Bar property in 2007 and still neglected to

submit tax returns for 2007 before respondent prepared SFRs. Finally, petitioners’

reliance on Mr. Brown does not justify their failure to timely file. See, e.g., United

States v. Boyle, 469 U.S. 241, 252 (1985).

        We hold that petitioners lacked reasonable cause for failing to file their

returns timely and accordingly sustain the section 6651(a)(1) additions to tax for

2007.

        B.    Failure To Timely Pay Tax

        Section 6651(a)(2) provides for an addition to tax when a taxpayer fails to

timely pay the tax shown on a return, unless the taxpayer proves that the failure

was due to reasonable cause and not due to willful neglect. Reasonable cause for
                                        - 15 -

[*15] purposes of section 6651(a)(2) depends upon whether the taxpayer, notwith-

standing the exercise of ordinary business care and prudence, was in fact unable to

pay or would suffer undue hardship if payment were made. See Ruggeri v.

Commissioner, T.C. Memo. 2008-300.

      A substitute for return prepared by the IRS pursuant to section 6020(b) is

treated as the “return” filed by the taxpayer for purposes of section 6651(a)(2).

See sec. 6651(g). For each month or fraction thereof for which a failure to pay

continues, section 6651(a)(2) adds 0.5% of the amount shown as tax on the return

but not paid, up to a maximum addition of 25%.

      It was deemed stipulated that petitioners did not file their 2007 returns

timely. Respondent prepared SFRs for 2007 that met the requirements of section

6020(b), and petitioners did not pay the amounts shown as due. See sec. 6651(g);

Cabirac v. Commissioner, 120 T.C. 163, 170-173 (2003). Petitioners assert that

their failure to pay was due to reasonable cause, and the excuses they offer for late

payment are the same excuses they offered for late filing. Petitioners offered no

evidence to show that they were unable to timely pay their tax liabilities or would

suffer undue hardship if they did. We accordingly sustain respondent’s

determinations with respect to the section 6651(a)(2) additions to tax for 2007.
                                         - 16 -

[*16] C.     Failure To Pay Estimated Tax

      Respondent also determined that petitioners are liable for additions to tax

for failure to pay estimated tax under section 6654. Section 6654 imposes an

addition to tax on an individual who underpays his estimated tax.5 The addition to

tax is calculated with reference to four required installment payments of the

taxpayer’s estimated tax liability. Sec. 6654(c) and (d). In general, each required

installment of estimated tax is equal to 25% of the “required annual payment”.

Sec. 6654(d). A taxpayer has an obligation to pay estimated tax only if he has a

“required annual payment”. Wheeler v. Commissioner, 127 T.C. 200, 212 (2006),

aff’d, 521 F.3d 1289 (10th Cir. 2008); see also Mendes v. Commissioner, 121 T.C.

308, 324 (2003). The “required annual payment” is equal to the lesser of (1) 90%

of the tax shown on the taxpayer’s return for that year (or, if no return is filed,

90% of his or her tax for such year) or (2) 100% of the tax shown on the

taxpayer’s return for the immediately preceding taxable year. Sec. 6654(d)(1)(A)

and (B). Returns submitted after the IRS has issued a notice of deficiency for a


      5
       Unless a statutory exception applies, the sec. 6654(a) addition to tax is
mandatory. See sec. 6654(a), (e); Recklitis v. Commissioner, 91 T.C. 874, 913
(1988). Sec. 6654 does not contain a general exception for reasonable cause or
absence of willful neglect. See Grosshandler v. Commissioner, 75 T.C. 1, 21
(1980). Petitioners do not contend that any of the statutory exceptions under sec.
6654(e) is applicable.
                                         - 17 -

[*17] particular year are not considered filed returns for purposes of section

6654(d)(1)(B)(i) and (ii). See Mendes v. Commissioner, 121 T.C. at 324-325;

Wolfgram v. Commissioner, T.C. Memo. 2010-69; Lenihan v. Commissioner, T.C.

Memo. 2006-259.

      It was deemed stipulated that petitioners did not timely file Federal income

tax returns for 2006 and 2007. Although petitioners eventually submitted returns

for the 2006 and 2007 tax years, we disregard these returns for the purposes of

section 6654 because they were submitted after respondent mailed a notice of

deficiency for the 2007 tax year to each petitioner. Mendes v. Commissioner, 121

T.C. at 324-325. Respondent produced sufficient evidence to demonstrate that

petitioners had required annual payments for 2007 equal to 90% of their tax for

the year, that petitioners did not make any estimated tax payments for 2007, and

that petitioners are liable for their respective section 6654 additions to tax for

2007. Accordingly, we hold that petitioners are liable for the section 6654(a)

additions to tax for 2007. See sec. 6654(e)(1).
                                      - 18 -

[*18] We have considered all the other arguments made by the parties, and to the

extent not discussed above, find those arguments to be irrelevant, moot, or without

merit.

         To reflect the foregoing,



                                               Decisions will be entered

                                      under Rule 155.
