                         T.C. Summary Opinion 2018-38



                         UNITED STATES TAX COURT



            JOHN A. GARCIA AND JAMIE GARCIA, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 498-17S.                           Filed August 7, 2018.



      Solis Cooperson, for petitioners.

      Sheri A. Wight, for respondent.



                              SUMMARY OPINION


      THORNTON, 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


      1
      Unless otherwise indicated all section references are to the Internal
Revenue Code in effect for the year at issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure. Monetary amounts are rounded to the
                                                                       (continued...)
                                            -2-

Pursuant to section 7463(b), the decision to be entered is not reviewable by any

other court, and this opinion shall not be treated as precedent for any other case.

      Respondent determined a $27,017 deficiency and a $5,403 accuracy-related

penalty with respect to petitioners’ 2012 Federal income tax. The issues for

decision are: (1) whether legal and professional fees paid in 2012 are properly

deductible as ordinary and necessary business expenses of petitioners’ wholly

owned S corporation and (2) whether petitioners are liable for the accuracy-related

penalty pursuant to section 6662(a).2

                                        Background

      The parties have stipulated some facts, which we incorporate by this

reference. When they petitioned the Court, petitioners resided in California.

Shareholder Litigation

      In 2005 petitioners purchased 498,900 shares of stock in Randgold &

Exploration Co., Ltd. (R&E), a South African exploration and gold mining

investment company. At all relevant times petitioners have been the registered

owners of the R&E shares.



      1
       (...continued)
nearest dollar.
      2
          The parties filed a stipulation of settled issues resolving all other issues.
                                           -3-

        At some point R&E shareholders discovered that Investec Bank, Ltd.

(Investec), an international specialist bank, had engaged in a fraudulent scheme

involving R&E stock, which ultimately devalued R&E shares. Sometime before

2012 a consortium of minority shareholders (consortium) instituted litigation in a

South African court against R&E and Investec for corporate fraud (litigation).3

The purpose of the litigation was to secure judgment in favor of the R&E minority

shareholders and recover their investments.

        In return for a promised percentage of any ultimate recovery, petitioners

agreed to finance a portion of the consortium’s legal and related expenses. During

2012 their commitment totaled at least 500,000 rand.4 During 2012 the

consortium made “capital calls”, whereby it invoiced petitioners and other

consortium members for their agreed-upon contributions to fund the litigation. In

response to these capital calls, on February 1, 2012, petitioners wired $39,609

from their personal brokerage account with Fidelity Investments (Fidelity account)


        3
        A group of shareholders that included Mr. Garcia commenced the R&E
litigation as early as 2005, and a second group was formed shortly thereafter to
represent a broader group of shareholders. On March 28, 2011, “the applicants”
(ostensibly including petitioners) instituted legal proceedings in a South African
court, seeking an order to require Investec to purchase the applicants’ R&E shares
for a certain price.
        4
            In subsequent years petitioners’ commitment increased to at least 850,000
rand.
                                        -4-

to Anglorand Securities, Ltd. (Anglorand), another plaintiff in the litigation. At

the then-current exchange rate, this payment satisfied 300,000 of their total

500,000 rand commitment to the consortium. The remaining 200,000 rand of the

commitment was satisfied by two subsequent, roughly equal payments of U.S.

dollars, viz, on June 13, 2012, petitioners wired $12,321 from their Fidelity

account to Anglorand, and on December 20, 2012, JGx5 Enterprises (JGx5),

petitioners’ wholly owned subchapter S corporation, wired $12,250 from its

corporate bank account to Anglorand.

      At some unspecified time Mr. Garcia entered into a written agreement with

Mankadan Investments (identified in the record as one of the “workers” in the

consortium) to provide professional services to the consortium in return for an

extra percentage of any recovery.

Creation of Subchapter S Corporation, JGx5

      On February 9, 2012, JGx5 was incorporated in the State of California with

Mr. Garcia as the sole shareholder. During 2012 JGx5 owned four rental

properties described as single-family residences. During 2012 three of these

properties were rented and the fourth was in the process of being rehabbed or

refurbished. The four rental properties were in southern California. During 2012
                                        -5-

JGx5 managed these properties but did not otherwise engage in property

management services to third parties.

       On February 28, 2012, petitioners signed two documents, each captioned

“SPECIAL MINUTES OF JGX5 ENTERPRISES”.5 One of these documents

states in part:

       A) money transfers into JGx5 Enterprises from John & Jamie Garcia
       will be deemed loans to the Corporation[,] B) costs incurred by John
       & Jamie Garcia associated with the assignment of assets or otherwise
       transferred to JGx5 Enterprises shall be treated as a loan to JGx5
       Enterprises whereas such costs shall not be in excess of such costs
       incurred up until the time of the transfer, C) money transfers out of
       JGx5 Enterprises to John & Jamie Garcia will be deemed repayment
       of loans or in the event such loans have been repaid such money
       transfers out of JGx5 enterprises will be considered a [sic] income
       distribution or otherwise * * *.

This document states that any loans are noninterest bearing and are for a term of

the “greater of 20 years or Perpetual Term”.

       The other document, captioned “Special Minutes”, states that petitioners

“assign their litigation rights for any investment made by John and Jamie Garcia to

JGX5 Enterprises.” It also states that “the business of JGX5 is to make

investments, including the funding of litigation costs * * * [i]n exchange for * * *


       5
      Although the parties have stipulated that Mr. Garcia was the sole
shareholder of JGx5 during 2012, Mrs. Garcia signed each of these documents as
“Shareholder”.
                                         -6-

a[n] ownership interest in the litigation recovery, if any.” The document further

states that “this memo is to provide further clarity that Randgold & Exploration

litigation funding is being done through JGX5 Enterprises and that JGX5

Enterprises will earn a fair return on its investment for funding such litigation.”

The document states: “RESOLVED, that JGX5 accepts litigation and the costs

thereof in return for a reasonable assignment of shares necessary to cover the costs

of litigation and provide for a reasonable recovery.”

        None of the R&E stock was ever actually assigned to JGx5 and, as

previously stated, petitioners remained the registered owners of the R&E stock at

all relevant times. JGx5 never submitted an application to intervene in the R&E

litigation, and none of the legal documents relating to the R&E litigation refers to

JGx5.

Tax Returns

        On its 2012 Form 1120S, U.S. Income Tax Return for an S Corporation,

JGx5 listed its business activity code as 531110, which corresponds to “Lessors of

Residential Buildings & Dwellings (including equity REITs)”. On the 2012 Form

1120S JGx5 claimed a deduction for legal and professional fees of $76,630 and

reported an ordinary business loss of $133,952.
                                        -7-

      On their 2012 Form 1040, U.S. Individual Income Tax Return, petitioners

reported wages of $429,222 earned by Mr. Garcia from his employment as a

financial analyst for ADP Totalsource and claimed a $138,067 loss on Schedule E,

Supplemental Income and Loss. The Schedule E loss included the $133,952

ordinary business loss reported by JGx5. Petitioners’ 2012 Form 1040 reported

total tax of $100,661.

      By notice of deficiency respondent disallowed $72,780 of the legal and

professional fees deduction claimed by JGx5.6 Respondent also determined that

petitioners were liable for the section 6662(a) accuracy-related penalty.

                                     Discussion

I. Deductibility of Legal Expenses

      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

(1933). Deductions are allowed as a matter of legislative grace, and the taxpayer

bears the burden of proving entitlement to any claimed deduction. Rule 142(a);




      6
       Respondent determined in the notice of deficiency that petitioners were
allowed to deduct $64,180 of these expenses as a miscellaneous itemized
deduction.
                                        -8-

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co.

v. Helvering, 292 U.S. 435, 440 (1934).

      The primary issue is whether petitioners are entitled to a pass-through

deduction for certain legal and professional fees that JGx5 claimed on its

corporate income tax return.7 Petitioners claim that $64,180 of these fees is

deductible under section 162(a) as ordinary and necessary business expenses of

JGx5.8 Respondent contends that these fees are not deductible under section

162(a) but concedes, as determined in the notice of deficiency, that they are

properly deductible by petitioners under section 212, as nonbusiness income-

producing expenses. The distinction matters inasmuch as a deduction under




      7
        An eligible small business corporation that elects S corporation status is
generally exempt from corporate income tax. See sec. 1363(a). Instead, the S
corporation’s shareholders must report pro rata shares of the S corporation’s
taxable income, losses, deductions, and credits. Sec. 1366(a)(1)(A); sec. 1.1366-
1(a), Income Tax Regs. An S corporation item generally retains its character for
the shareholder. Sec. 1366(b). An S corporation’s taxable income is generally
computed in the same manner as an individual’s. Sec. 1363(b).
      8
      Petitioners have raised no argument and adduced no evidence to support
any deduction for $8,600 of the total $72,780 of legal and professional fees that
respondent disallowed in the notice of deficiency. We deem petitioners to have
waived or conceded any issue as to $8,600 of the disallowed deduction.
                                        -9-

section 212 may be less beneficial to petitioners than a deduction under section

162(a).9

      Section 162(a) allows a deduction for “all the ordinary and necessary

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

business”. Petitioners have not shown that either the first payment of $39,609, on

February 1, 2012, or the second payment of $12,321, on June 13, 2012,

represented expenses “paid or incurred” by JGx5 so as to support a deduction

under section 162(a).10 Petitioners wired both of these payments to Anglorand

from their personal account, in partial satisfaction of their personal commitment to

contribute at least 500,000 rand of the consortium’s legal expenses.

      We assign little significance to the “Special Minutes” that petitioners signed

in 2012, purportedly assigning the litigation and costs to JGx5. Transfers between

a corporation and its sole shareholders are subject to heightened scrutiny, and the


      9
       As miscellaneous itemized deductions, sec. 212 deductions, unlike sec.
162(a) deductions, are generally deductible only to the extent they exceed 2% of
an individual’s adjusted gross income, see sec. 67, and may also be limited by
application of the alternative minimum tax, see sec. 56(b).
      10
       The taxable year for which business expenses may be deducted depends
upon whether the taxpayer uses the cash basis or accrual basis method of
accounting. See sec. 7701(a)(25) (“The terms ‘paid or incurred’ and ‘paid or
accrued’ shall be construed according to the method of accounting upon the basis
of which taxable income is computed[.]”). The record does not reflect whether
JGx5 was a cash basis or accrual basis taxpayer.
                                        - 10 -

labels attached to such transfers mean little if not supported by other objective

evidence. E.g., Boatner v. Commissioner, T.C. Memo. 1997-379, aff’d without

published opinion, 164 F.3d 629 (9th Cir. 1998). The record contains no objective

evidence to suggest that this paperwork altered in any way petitioners’ relationship

to the consortium or their personal obligation to the consortium for the legal

expenses in question. Indeed, all the evidence shows that the consortium

continued to invoice petitioners, and not JGx5, for payment of petitioners’

commitment even after the year at issue. JGx5 never submitted an application to

intervene in the R&E litigation, and none of the legal documents relating to the

R&E litigation refers to JGx5.

      We are similarly unimpressed by petitioners’ assertion that their February 1

and June 13, 2012, payments to Anglorand represented “loans” to JGx5 pursuant

to the “Special Minutes”. Neither payment could fairly be characterized as a

“transfer into” JGx5 under the terms of the “Special Minutes”, and there is no

objective evidence of a bona fide expectation of repayment. In any event, the

February 1, 2012, payment was made nine days before JGx5 was even

incorporated.

      Unlike the other two payments, the $12,250 payment on December 20,

2012, was in fact made by JGx5. Respondent has not argued that this payment
                                       - 11 -

was not “paid or incurred” by JGx5 within the meaning of section 162(a). As

explained below, however, this payment is also nondeductible by JGx5 because

petitioners have failed to show that it was an ordinary and necessary business

expense of JGx5.11

      For the reasons just discussed, the legal and professional fees at issue were

the expenses of petitioners rather than of JGx5. A taxpayer generally may not

deduct the payment of another person’s expense. See Deputy v. du Pont, 308 U.S.

488, 494-495 (1940); Betson v. Commissioner, 802 F.2d 365, 368 (9th Cir. 1986),

aff’g in part, rev’g in part, T.C. Memo. 1984-264; Hood v. Commissioner, 115

T.C. 172, 179-181 (2000); J. Gordon Turnbull, Inc. v. Commissioner, 41 T.C. 358,

378 (1963) (“Legal fees paid on behalf of, and for services rendered to, another are

generally not deductible as ordinary and necessary business expenses of the

payer.”), aff’d, 373 F.2d 87 (5th Cir. 1967). An exception to this general rule may

apply if a taxpayer pays someone else’s expenses to protect or promote his own

separate trade or business. See, e.g., Gould v. Commissioner, 64 T.C. 132, 134-

135 (1975); Lohrke v. Commissioner, 48 T.C. 679 (1967). This exception

      11
         Respondent has not raised, and accordingly we do not consider, any issue
as to whether this amount should be considered a constructive dividend from JGx5
to petitioners. Cf. Hood v. Commissioner, 115 T.C. 172, 179-182 (2000) (holding
that legal fees a corporation paid for the primary benefit of its sole shareholder
constituted nondeductible constructive dividends).
                                        - 12 -

typically applies only where the taxpayer pays the obligations of another person or

entity in financial difficulty and where the obligor’s inability to meet his

obligations threatens the taxpayer’s own business with direct and proximate

adverse consequences. Hood v. Commissioner, 115 T.C. at 180-181; see also

Square D Co. v. Commissioner, 121 T.C. 168, 200 (2003).

      “[T]he showing a corporation must make to deduct the expenses of its

shareholder is a strong one.” Hood v. Commissioner, 115 T.C. at 181. The test is

sometimes expressed as having two prongs: (1) the taxpayer’s primary motive for

paying the expenses must be to protect or promote the taxpayer’s business and (2)

the expenditures must constitute ordinary and necessary business expenses for the

furtherance or promotion of the taxpayer’s business. Lohrke v. Commissioner, 48

T.C. at 688; see also Capital Video Corp. v. Commissioner, 311 F.3d 458, 464 (1st

Cir. 2002), aff’g T.C. Memo. 2002-40; Menard, Inc. v. Commissioner, T.C.

Memo. 2004-207, rev’d on other grounds, 560 F.3d 620 (7th Cir. 2009).

      Petitioners do not meet either prong of this test. As to the first prong,

petitioners have not shown that the expenses in question were incurred primarily

for the benefit of JGx5 and that any benefit to petitioners was only incidental. See

Capital Video Corp. v. Commissioner, 311 F.3d at 464. The benefits to petitioners

are obvious: The costs were incurred to recover their investments in R&E. And
                                        - 13 -

as they acknowledge on brief, treating the payments as business deductions of

JGx5 rather than as section 212 expenses of petitioners would result in more

favorable tax treatment for petitioners. The business justification for JGx5 to pay

these expenses is not at all obvious. There is no suggestion, for instance, that any

payment of the expenses by JGx5 would have been motivated by any genuine

consideration to avoid adverse business consequences as might result if petitioners

were unable to meet their financial obligations. The record does not suggest that

petitioners were experiencing any financial difficulty in 2012. To the contrary, in

2012 Mr. Garcia reported over $400,000 of wage income.

      As to the second prong, petitioners have not shown that the legal expenses

in question represent ordinary and necessary business expenses in the furtherance

of the business of JGx5. The proper focus of our inquiry as applied to legal

expenses is on the origin of the subject of the litigation and not on the

consequences to the taxpayer. Capital Video Corp. v. Commissioner, 311 F.3d at

464 (citing United States v. Gilmore, 372 U.S. 39, 48 (1963)). The origin of the

claim was Investec’s alleged fraudulent activity that devalued the R&E shares that

petitioners held as minority shareholders. Petitioners--not JGx5--joined the

shareholder litigation group against Investec. As noted, the litigation and

petitioners’ obligation to fund the litigation arose before JGx5 was ever created.
                                          - 14 -

At all relevant times, the R&E shares were registered in petitioners’ names. As

Mr. Garcia testified, the purpose of the litigation was to secure judgment in favor

of the R&E shareholders and recover their investments.

        Petitioners contend that in the “Special Minutes” they assigned all their

R&E litigation rights to JGx5 and that the prospect of an ultimate payout to JGx5

from the R&E litigation constitutes a legitimate business activity of JGx5 as to

which the legal expenses should be deemed an ordinary and necessary business

expense. As noted, we assign little significance to these “Special Minutes”,

unsupported as they are by any objective evidence. In any event, contrary to the

teaching of Gilmore, petitioners’ argument focuses improperly on the potential

consequences of the R&E shareholders’ lawsuit--a potential payout in which JGx5

would allegedly share--rather than upon the origin and character of the underlying

claim. Moreover, the absence of any reliable documentation, such as a contract,

defining the role of JGx5 in the litigation or guaranteeing it a share of any future

recovery further supports the conclusion that petitioners engaged in the R&E

litigation in their personal capacities as investors in R&E and not on behalf of

JGx5.

        In the light of these considerations we assign little credence to petitioners’

assertions that JGx5 engaged in “litigation funding” as a business and that
                                        - 15 -

petitioners lent money to JGx5 to fund the litigation. In the first instance, for an

activity to constitute a trade or business, “the taxpayer must be involved in the

activity with continuity and regularity and * * * the taxpayer’s primary purpose for

engaging in the activity must be for income or profit.” Commissioner v.

Groetzinger, 480 U.S. 23, 35 (1987). During 2012 the R&E litigation was JGx5’s

only claimed “litigation funding” activity. We are not convinced that during 2012

JGx5 was involved in any “litigation funding” activity with the continuity and

regularity necessary for that activity to constitute a trade or business. Similarly,

even if, as petitioners allege, Mr. Garcia, through JGx5, provided advisory

services to the R&E litigation, the record does not show that JGx5 provided

advisory services with the continuity and regularity necessary for that activity to

constitute a trade or business.

      Petitioners have failed to show that any of the disputed legal and

professional fees were paid or incurred by JGx5 as ordinary and necessary

expenses in carrying on its trade or business. Accordingly, we sustain

respondent’s determination that these items are not deductible by JGx5 under

section 162.
                                       - 16 -

II. Accuracy-Related Penalty

      Respondent determined that petitioners are liable for a 20% accuracy-

related penalty pursuant to section 6662(a) and (b)(2) for an underpayment

attributable to a substantial understatement of income tax.

      Under section 7491(c) respondent bears the burden of production with

respect to this penalty. To meet this burden, respondent must produce evidence

establishing that it is appropriate to impose this penalty. Once respondent has met

his burden of production, the burden of proof is upon the taxpayer to show that he

is not liable for the penalty. See Higbee v. Commissioner, 116 T.C. 438, 449

(2001).12

      Section 6662(a) and (b)(2) imposes the accuracy-related penalty on any

portion of a tax underpayment that is attributable to any substantial understatement

of income tax, defined in section 6662(d)(1)(A) as an understatement that exceeds

the greater of 10% of the tax required to be shown on the return or $5,000. The

total tax reported on petitioners’ 2012 tax return was $100,661; the understatement

of income tax determined in the notice of deficiency is $27,017. Therefore, the

      12
       The parties have stipulated the existence of a signed supervisory approval
form which satisfies any burden of production that respondent has under sec.
6751(b)(1) with respect to the sec. 6662(a) accuracy-related penalty. See Graev v.
Commissioner, 149 T.C. __, __ (slip op. at 13-14) (Dec. 20, 2017), supplementing
and overruling in part 147 T.C. 460 (2016).
                                        - 17 -

amount of tax required to be shown on petitioners’ 2012 tax return was $127,678.

Petitioners’ understatement of tax of $27,017 exceeds $12,768, which is 10% of

the tax required to be shown on their 2012 tax return. Thus, petitioners’

understatement of income tax is substantial for purposes of the section 6662(a)

and (b)(2) accuracy-related penalty. The Court concludes that respondent has met

his burden of production for the accuracy-related penalty for a substantial

understatement of income tax for 2012.

      The accuracy-related penalty does not apply with respect to any portion of

an underpayment if the taxpayer acted with reasonable cause and in good faith

with regard to that portion. Sec. 6664(c)(1). Reasonable cause requires that the

taxpayer exercised ordinary business care and prudence as to the disputed item.

United States v. Boyle, 469 U.S. 241, 246 (1985). The term “good faith” has no

precise definition but means, among other things, (1) an honest belief and (2) the

intent to perform all lawful obligations. Sampson v. Commissioner, T.C. Memo.

2013-212, at *18. The determination of whether a taxpayer acted with reasonable

cause and in good faith is made on a case-by-case basis, taking into account all

facts and circumstances. Higbee v. Commissioner, 116 T.C. at 448; sec. 1.6664-

4(b)(1), Income Tax Regs. Generally, the most important factor is the extent of

the taxpayer’s effort to assess the taxpayer’s proper tax liability. Sec. 1.6664-
                                        - 18 -

4(b)(1), Income Tax Regs. Other circumstances that may indicate reasonable

cause and good faith include an honest misunderstanding of fact or law that is

reasonable in the light of all of the facts and circumstances, including the

experience, knowledge, and education of the taxpayer. Higbee v. Commissioner,

116 T.C. at 449; Sampson v. Commissioner, at *18; sec. 1.6664-4(b)(1), Income

Tax Regs.

      Petitioners made no attempts at trial or on brief to establish reasonable

cause and good faith. Accordingly, we sustain respondent’s determination that

petitioners are liable for the section 6662(a) penalty for an underpayment

attributable to a substantial understatement of their 2012 Federal income tax.

      The Court has considered all of petitioners’ arguments, contentions, and

statements. To the extent not discussed herein, the Court concludes that they are

moot, meritless, or irrelevant.

      To reflect the foregoing,


                                                       Decision will be entered

                                                 for respondent.
