                         T.C. Memo. 2009-118



                       UNITED STATES TAX COURT



                  KHAIRY E. AREF, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 11164-06.               Filed May 27, 2009.



     Khairy E. Aref, pro se.

     John D. Faucher, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     VASQUEZ, Judge:    Respondent determined a $41,920 deficiency

in and a $8,384 section 6662(a)1 penalty on petitioner’s 2002




     1
        All section references are to the Internal Revenue Code
in effect for the year in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
                               - 2 -

Federal income taxes.   After a concession,2 the issues for

decision are:   (1) Whether petitioner substantiated deductions

claimed on his Schedule C, Profit or Loss From Business; (2)

whether petitioner had unreported income; (3) whether petitioner

is entitled to claim head-of-household filing status; and (4)

whether petitioner is liable for the section 6662(a) penalty.

                         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 he filed the

petition, petitioner resided in Egypt.

     During 2002 petitioner worked for the California Department

of Corrections.   He was the agency coordinator.   Petitioner

developed and coordinated new programs for the State of

California Department of Corrections--which had 155,000

employees, 165,000 inmates, and a $6.7 billion budget.    His

supervisor was a cabinet secretary, and his second level

supervisor was the Governor of California.

     Petitioner is a licensed hazardous material specialist and a

certified instructor in hazardous materials.   He also is a

registered professional engineer and an environmental specialist.



     2
        Respondent concedes that petitioner paid $30,000 in
deductible alimony during 2002.
                               - 3 -

     Additionally, during 2002 petitioner operated an

international consulting and training business that provided

training and technical services on handling hazardous materials

and toxic substances (Mr. Aref’s business).   The training and

technical services were provided to private entity firefighters,

military personnel, and peace officers and for the operation of

correctional facilities, custody of inmates and prisoners,

handling and management of toxic substances, and emergency

response for spills and medical waste, as the case may be.

     Mr. Aref’s business had over 400 videotapes available for

training purposes, covering topics such as correctional

facilities construction and administration, peace officers’

training, environmental impact statements and reports,

corrections officers training, fire protection and safety, and

health and safety plans.   Petitioner oversaw the production

(including writing the narratives) and reproduction of the

videotapes.   Petitioner met with clients in the United States,

including the Prime Minister and the Deputy Prime Minister of

Egypt.

     Mr. Aref’s business operated in and had offices and business

equipment in Egypt.   Mr. Aref’s business had equipment in Egypt

that included two leased cars, Toyota Land Cruisers.    The cars

were used to get to training sessions and for pickups and
                                - 4 -

deliveries related to Mr. Aref’s business.    Mr. Aref’s business

also had an accountant in Egypt.

     Petitioner leased office space in Egypt.    The offices were

located at 17 Atbara Street and also at 64 Talmaneal Street in

Mohandeseen, Giza, Egypt.    At 17 Atbara Street a sign outside the

building had the name of Mr. Aref’s business on it.

     During the year in issue Mr. Aref’s business was marketed

and operated in Egypt by Ahmed Fadel.    Petitioner had a written

contract with Mr. Fadel.    The contract provided that petitioner

would establish training and technical services and that Mr.

Fadel would market them in Egypt.    Mr. Fadel was responsible for

providing logistical support to petitioner necessary to provide

the training.

     For 2002 petitioner deducted the following amounts as

business expenses:   Depreciation $1,119; interest $8,699; rent or

lease of vehicles, machinery, and equipment $9,808; rent or lease

of other business property $9,755; wages $23,000; and other

expenses $6,309 (accounting $3,600 and telephone $2,709) for a

total of $58,690.

     Mr. Fadel sent petitioner monthly invoices for the expenses

of Mr. Aref’s business.    These invoices were delivered to

petitioner.   Petitioner paid the invoices and had the payment

delivered directly to Mr. Fadel.    The amounts on the invoices tie

into the amounts claimed on petitioner’s Schedule C.
                                 - 5 -

      During 2002 petitioner received two separate loans3 of

$60,000 (a total of $120,000).    One loan was from Jose Fawzia,

and the second loan was from the Gawish Medical Center.4

                                OPINION

I.   Substantiation of Schedule C Deductions

      Generally, deductions are a matter of legislative grace;

taxpayers have the burden of showing that they are entitled to

any deduction claimed.    Rule 142(a); New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934).      Taxpayers are required to

maintain records that are sufficient to enable the Commissioner

to determine their correct tax liability.      See sec. 6001; sec.

1.6001-1(a), Income Tax Regs.

      Taxpayers are allowed a deduction for ordinary and necessary

expenses paid or incurred in carrying on a trade or business.

Sec. 162(a).   Whether an expenditure is ordinary and necessary is

generally a question of fact.     Commissioner v. Heininger, 320

U.S. 467, 475 (1943).    Generally, for an expenditure to be an

ordinary and necessary business expense, the taxpayer must show a

bona fide business purpose for the expenditure; there must be a

proximate relationship between the expenditure and the business



      3
        The characterization of the amounts as loans is not in
dispute.
      4
        The testimony was somewhat unclear on whether this loan
was from the Gawish Medical Center or from Dr. Hassan Gawish.
Either way, it was a separate loan for $60,000.
                                 - 6 -

of the taxpayer.     Challenge Manufacturing Co. v. Commissioner, 37

T.C. 650 (1962); Henry v. Commissioner, 36 T.C. 879 (1961).

        To be “necessary” within the meaning of section 162, an

expense needs to be “appropriate and helpful” to the taxpayer’s

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

requirement that an expense be “ordinary” connotes that “the

transaction which gives rise to it must be of common or frequent

occurrence in the type of business involved.”     Deputy v. du Pont,

308 U.S. 488, 495 (1940) (citing Welch v. Helvering, supra at

114).

     When taxpayers establish that they have incurred deductible

expenses but are unable to substantiate the exact amounts, we can

estimate the deductible amount in some circumstances, but only if

the taxpayers present 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 upon taxpayers whose inexactitude is of their own

making.     See Cohan v. Commissioner, supra at 544.   There must be

sufficient evidence in the record, however, to permit us to

conclude that a deductible expense was paid or incurred.

Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957).

     In addition to satisfying the criteria for deductibility

under section 162, certain categories of expenses must also
                                - 7 -

satisfy the strict substantiation requirements of section 274(d)

in order for a deduction to be allowed.   The expenses to which

section 274(d) applies include, among other things, those for

listed property, e.g., automobile expenses.    Secs. 274(d)(4),

280F(d)(4)(A)(i) and (ii).    We may not use the Cohan doctrine to

estimate expenses covered by section 274(d).    See Sanford v.

Commissioner, 50 T.C. 823, 827 (1968), affd. 412 F.2d 201 (2d

Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax Regs., 50 Fed.

Reg. 46014 (Nov. 6, 1985).    To substantiate a deduction

attributable to listed property, a taxpayer must maintain

adequate records or present corroborative evidence to show the

following:    (1) The amount of the expense; (2) the time and place

of use of the listed property; and (3) the business purpose of

the use.    Sec. 1.274-5T(b)(6), Temporary Income Tax Regs., 50

Fed. Reg. 46016 (Nov. 6, 1985).

     Our resolution of the substantiation issue turns on the

applicable law and our determination of the credibility of the

evidence presented.

     A.    Depreciation

     There is allowed as a depreciation deduction a reasonable

allowance for the exhaustion, wear and tear (including

obsolescence) of property used in a trade or business.      Sec.

167(a).    The basis on which exhaustion, wear and tear, and
                                 - 8 -

obsolescence are to be allowed in respect of any property is the

adjusted basis as provided in section 1011.    Sec. 167(c).

     The record does not establish what office furniture and/or

equipment was depreciated, what amount was paid for it, when it

was put in service, or who owned it.     Accordingly, petitioner has

not substantiated the deduction for depreciation.

     B.   Interest

     Petitioner testified that he gave his records regarding

interest to his accountant, the accountant arrived at the figure

on the return, and he trusted his accountant.    There is

insufficient credible evidence to establish a rational basis for

making an estimate of the deductible amount of interest

petitioner paid during 2002.   See Cohan v. Commissioner, supra at

543-544; Vanicek v. Commissioner, supra at 742-743.     Accordingly,

we shall not allow petitioner a deduction for interest.

     C.   Rent or Lease of Vehicles, Machinery, and Equipment

     Petitioner testified that he paid $818 per month to Mr.

Fadel to lease the two cars.   This amount is corroborated by

invoices petitioner submitted.

     Automobile expenses must also satisfy the strict

substantiation requirements of section 274(d) in order for a

deduction to be allowed because an automobile is listed property.

Secs. 274(d)(4), 280F(d)(4)(A)(i) and (ii).
                                - 9 -

     Petitioner did not keep a diary, log, trip sheet, or similar

record regarding the use of the cars, nor did he establish the

time and place of use of the cars (other than that the vehicles

were used in Egypt).   See secs. 274(d)(4), 280F(d)(4)(A)(i) and

(ii); sec. 1.274-5T(c)(2), Temporary Income Tax Regs., 50 Fed.

Reg. 46017 (Nov. 6, 1985).    Petitioner has failed to substantiate

the claimed automobile expenses in accordance with sections 162

and 274 and the regulations thereunder.   Accordingly, we sustain

respondent’s determination on this issue.

     D.   Rent or Lease of Other Business Property

     This expense was for the lease of office space in Egypt.

Office expenses may be “‘ordinary and necessary expenses paid or

incurred during the taxable year in carrying on any trade or

business’”.   Schnell v. Commissioner, T.C. Memo. 2006-147

(quoting section 162(a)).

     We find the invoices, corroborated by petitioner’s testimony

and the written contract with Mr. Fadel, to be credible evidence

of the amount that petitioner paid in 2002 for rent or lease of

office space used in Mr. Aref’s business.   All of the invoices

bear a “paid” stamp from Mr. Fadel acknowledging that petitioner

paid the invoice.   Accordingly, we conclude that petitioner has

substantiated this expense.
                                - 10 -

     E.   Wages

     This expense was for salary and wages for the people in

Egypt who provided or administered training and technical

services, for office staff, and for the drivers of the two cars.

Wages may be ordinary and necessary business expenses which

generally are deductible under section 162(a).    Brown v.

Commissioner, T.C. Memo. 1992-40.

     We find the invoices, corroborated by petitioner’s

testimony, to be credible evidence of the amount of the wage

expense of Mr. Aref’s business that petitioner paid in 2002.      All

of the invoices bear a paid stamp from Mr. Fadel acknowledging

that petitioner paid the invoice.    Accordingly, we conclude that

petitioner has substantiated this expense.

     F.   Accountant

     The accountant did the accounting, invoicing, and list of

purchases and sales for Mr. Aref’s business.   Accounting fees may

be ordinary and necessary business expenses which generally are

deductible under section 162(a).    Smith v. Commissioner, T.C.

Memo. 1994-640.

     We find the invoices, corroborated by petitioner’s testimony

and the written contract with Mr. Fadel, to be credible evidence

of the amount of the accountant expense of Mr. Aref’s business

that petitioner paid in 2002.    All of the invoices bear a “paid”

stamp from Mr. Fadel acknowledging that petitioner paid the
                                - 11 -

invoice.    Accordingly, we conclude that petitioner has

substantiated this expense.

     G.    Telephone

     Telephone expenses may be deductible under section 162(a) if

the expenses incurred are ordinary and necessary in carrying on a

trade or business.     Weeldreyer v. Commissioner, T.C. Memo.

2003-324 (citing Vanicek v. Commissioner, 85 T.C. at 742,

Sengpiehl v. Commissioner, T.C. Memo. 1998-23, and Green v.

Commissioner, T.C. Memo. 1989-599).

     Petitioner testified that he did not know the cost of a

basic telephone line in Egypt.    According to the invoices,

petitioner paid $315 per month for telephone service.

     When a taxpayer establishes that he 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 at 543-544; Vanicek

v. Commissioner, 85 T.C. at 742-743.     In estimating the amounts

allowable, we bear heavily upon the taxpayer whose inexactitude

is of his own making.    See Cohan v. Commissioner, supra at 544.

Upon the basis of the evidence presented, pursuant to Cohan, we

estimate that petitioner paid $150 per month for telephone

expenses and allow him a deduction of $1,800 for 2002.
                              - 12 -

II.   Unreported Income

      Respondent determined that petitioner had $84,581 in

unreported gross income.   At trial respondent conceded $6,000 of

this amount.5

      Every individual liable for tax is required to maintain

books and records sufficient to establish the amount of his or

her gross income.   Sec. 6001; DiLeo v. Commissioner, 96 T.C. 858,

867 (1991), affd. 959 F.2d 16 (2d Cir. 1992).   Where a taxpayer

fails to maintain or produce adequate books and records, the

Commissioner is authorized to compute the taxpayer’s taxable

income by any method that clearly reflects income.   Sec. 446(b);

Holland v. United States, 348 U.S. 121 (1954); Webb v.

Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1968), affg. T.C.

Memo. 1966-81.   The reconstruction of income need only be

reasonable in the light of all surrounding facts and

circumstances. Giddio v. Commissioner, 54 T.C. 1530, 1533 (1970).

The Commissioner is given latitude in determining which method of




      5
        At the May 15, 2007, recall of this case before Judge
Cohen, respondent conceded the unreported income issue on the
record. (At that time respondent had also conceded the issue in
his pretrial memorandum.) Apparently, respondent revoked or
withdrew this concession before the trial in the case (although
when asked in the case at bar whether the unreported income issue
was still at issue, respondent’s counsel initially answered
“No”). Petitioner did not object to the trial of the unreported
income issue or assert that the unreported income was no longer
at issue.
                                    - 13 -

reconstruction to apply when a taxpayer fails to maintain

records.       Petzoldt v. Commissioner, 92 T.C. 661, 693 (1989).

       Respondent used the source and application of funds method

(also known as the cash expenditures in excess of reported income

method) to reconstruct petitioner’s income.         Respondent failed to

include in his calculation the $120,000 in loans petitioner

received during 2002.6         When these loans are included in the

source and application of funds calculation, petitioner does not

have any unreported income for 2002 (the $120,000 of loans that

were not included as income exceeds the $78,581 ($84,581 minus

the $6,000 respondent conceded) determined to be unreported

income).       Accordingly, we find for petitioner on this issue.

III.       Head of Household

       An individual qualifies as a head of household if the

individual is not married at the close of the taxable year and

maintains as his home a household that constitutes for more than

one-half of the taxable year the principal place of abode of an

individual who qualifies as the taxpayer’s dependent within the

meaning of section 151.         Sec. 2(b)(1)(A).

       Respondent did not raise the issue of head-of-household

filing status in the notice of deficiency.         Respondent raised it




       6
        See supra note 3. Respondent disputed that petitioner
received the loans. We found as a fact that petitioner received
the $120,000 in loans.
                              - 14 -

as a new matter at trial.   Accordingly, respondent bears the

burden of proof on this issue.   See Rule 142(a).

      Petitioner was not married at the close of the taxable year.

Respondent has not established that petitioner did not maintain

as his home a household that constituted for more than one-half

of the taxable year the principal place of abode of an individual

who qualified as petitioner’s dependent within the meaning of

section 151.   Petitioner claimed two dependents on his 2002 tax

return.   Furthermore respondent’s reconstruction of petitioner’s

income using the source and application of funds method was based

on petitioner’s having a family of three.    Respondent has not

established the total cost of maintaining the household in 2002

or that petitioner did not provide over half of the cost.

Accordingly, respondent has failed to prove that petitioner is

not entitled to head-of-household status.

IV.   Section 6662(a)

      Section 7491(c) provides that the Commissioner will bear the

burden of production with respect to the liability of any

individual for additions to tax and penalties.    “The

Commissioner’s burden of production under section 7491(c) is to

produce evidence that it is appropriate to impose the relevant

penalty, addition to tax, or additional amount”.     Swain v.

Commissioner, 118 T.C. 358, 363 (2002); see also Higbee v.

Commissioner, 116 T.C. 438, 446 (2001).     However, the
                                - 15 -

Commissioner does not have the obligation to introduce evidence

regarding reasonable cause or substantial authority.       Higbee v.

Commissioner, supra at 446-447.

     Respondent determined that petitioner is liable for the

section 6662(a) penalty for 2002.    Pursuant to section 6662(a)

and (b)(1) and (2), a taxpayer may be liable for a penalty of 20

percent on the portion of an underpayment of tax due to

negligence or disregard of rules or regulations or a substantial

understatement of income tax.    “Negligence” includes any failure

by the taxpayer to keep adequate books and records or to

substantiate items properly.    Sec. 1.6662-3(b)(1), Income Tax

Regs.   An “understatement” is the difference between the amount

of tax required to be shown on the return and the amount of tax

actually shown on the return.    Sec. 6662(d)(2)(A).   A

“substantial understatement” exists if the understatement exceeds

the greater of (1) 10 percent of the tax required to be shown on

the return for a taxable year, or (2) $5,000.    See sec.

6662(d)(1)(A).   Respondent met his burden of production as there

was a substantial understatement.

     The accuracy-related penalty is not imposed with respect to

any portion of the underpayment as to which the taxpayer acted

with reasonable cause and in good faith.    Sec. 6664(c)(1).    The

decision as to whether the taxpayer acted with reasonable cause
                              - 16 -

and in good faith depends upon all the pertinent facts and

circumstances.   Sec. 1.6664-4(b)(1), Income Tax Regs.

     Petitioner maintained business records to substantiate his

expenses.   In total the invoices hardly deviated from the

expenses claimed by more than a few dollars (with the exception

of the telephone costs which were off by approximately $100).   We

conclude that petitioner acted with reasonable cause and in good

faith with respect to the substantiation of his business

expenses.

     To reflect the foregoing,


                                         Decision will be entered

                                    under Rule 155.
