                          T.C. Summary Opinion 2012-70



                         UNITED STATES TAX COURT



      JAVIER PADILLA AND MARIA ANGELES PADILLA, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 3557-10S.                         Filed July 17, 2012.



      Randal M. Reves, for petitioners.

      Emily J. Giometti and Robert D. Kaiser, for respondent.



                               SUMMARY OPINION



      PANUTHOS, Chief Special Trial Judge: This case was heard pursuant to the

provisions of section 7463 of the Internal Revenue Code in effect when the petition

was filed. 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
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case. Unless otherwise indicated, subsequent section references are to the Internal

Revenue Code in effect during the years at issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.

      Respondent determined a deficiency in petitioners’ 2006 Federal income tax

of $15,558 and an accuracy-related penalty of $3,112. Respondent also determined

a deficiency in petitioner Javier Padilla’s 2007 Federal income tax of $30,480, a

section 6651(a)(1) addition to tax of $1,438.65 for failure to timely file a return, and

an accuracy-related penalty of $6,069. After concessions,1 the issues for decision

are: (1) whether petitioners are entitled to business expense deductions for certain

labor costs in excess of amounts respondent allowed (2) whether petitioner Javier

Padilla is liable for the section 6651(a)(1) failure to file addition to tax for 2007, and

(3) whether petitioners are liable for the section 6662(a) accuracy-related penalties

for 2006 and 2007.

                                      Background

      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. Petitioners

resided in Ohio at the time the petition was filed.


      1
       At trial petitioners conceded all adjustments other than labor costs variously
described as “contract labor”, “spot labor”, “child labor”, and “cost of goods sold”.
                                         -3-

      Javier Padilla (petitioner) operated a business as a drywall contractor.

Petitioner entered into contracts with other businesses to install drywall and hired

laborers as independent contractors to perform the work. Petitioner paid the

independent contractors either by check or in cash. When petitioner paid the

independent contractors in cash, he often retained receipts.

      Petitioners filed a 2006 Form 1040, U.S. Individual Income Tax Return, with

a filing status of married filing jointly. Petitioner filed a 2007 Form 1040 with a

filing status of head of household. Both of these returns were selected for

examination.

      Petitioners claimed a business expense deduction of $227,131 for contract

labor on the 2006 return. During the examination petitioner provided completed but

unfiled Forms 1099-MISC, Miscellaneous Income, reflecting payments of $238,361

for contract labor. In the notice of deficiency for 2006 respondent allowed

$208,361 on the basis of the Forms 1099-MISC and related substantiation but

disallowed a $30,000 claimed deduction representing a purported payment to Jose

Mendoza.

      On the 2007 return petitioner claimed a business expense deduction for “other

expenses” which included, inter alia, $9,890 for “child labor” and $2,252 for “spot

labor”. Respondent disallowed these amounts in full in the notice of deficiency for
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2007. Also for 2007, petitioner claimed a business expense deduction for cost of

goods sold of $193,730. This amount included $177,280 for the cost of labor and

$16,450 for materials and supplies. During the examination, petitioner provided

completed but unfiled Forms 1099-MISC reflecting payments of $190,280 for

contract labor. In the notice of deficiency for 2007 respondent allowed a deduction

for cost of goods sold of $150,550.2 After the notice of deficiency was issued,

petitioner submitted a Form 1040X, Amended U.S. Individual Income Tax Return,

for 2007 claiming $6,890 for “child labor”, $950 for “spot labor”, $189,325 for the

cost of labor, and $19,291 for materials and supplies. Petitioner also provided

revised Forms 1099-MISC reflecting payments of $194,325.

      The amounts claimed on the return, amounts allowed in the notice of

deficiency for 2007, and the amounts claimed on the Form 1040X submitted after

the notice of deficiency are as follows:




      2
        Although not delineated in the notice of deficiency for 2007, the stipulated
exhibits reflect that respondent allowed $134,100 for contract labor and the entire
claimed materials expense of $16,450 for a total of $150,550. The contract labor
amount appears to be based on the amounts reflected in the Forms 1099-MISC
provided during examination to the extent they were supported by substantiation
that respondent accepted.
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                                           2007

                                                       Allowed
                                                    (per Notice of             Amended
                                Return                Deficiency)               Return


 Child Labor                     $9,890                   0                       $6,890

 Spot Labor                       2,252                   0                         950

     Labor            177,280             134,100                    189,325

    Materials &
     Supplies          16,450              16,450                     19,291
 Cost of Goods Sold             193,730                 $150,550                 208,616



       At trial petitioner submitted copies of checks reflecting payment of $6,890 to

his children for work performed and $950 for “spot labor”. Petitioner did not

provide any explanation as to the “spot labor”. Petitioner submitted copies of

checks and receipts indicating payment of amounts in excess of the amounts

reflected on the Forms 1099-MISC for some of the independent contractors.3 In

addition, petitioner submitted copies of checks reflecting payments to independent

contractors not previously included on the Forms 1099-MISC.4 Petitioner also

provided copies of checks and testimony regarding the $2,031.25 claimed for


       3
        The additional amounts total $29,385.09. This amount includes $844.29 in
checks and $28,540.80 in receipts. This amount does not include any undated
receipts proffered for years other than the years in issue.
       4
       These checks reflect payment of $4,800 to G. Parsly and payment of
$4,379.92 to A. Tovar.
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materials. The record does not reflect whether this amount is included in the

amount respondent previously allowed.

                                     Discussion

      In general, the Commissioner’s determination set forth in a notice of

deficiency is presumed correct, and the taxpayer bears the burden of showing that

the determination is in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933). Deductions are a matter of legislative grace. Deputy v. du Pont, 308 U.S.

488, 493 (1940); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). A

taxpayer bears the burden of proving entitlement to any deduction claimed. Rule

142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Welch v.

Helvering, 290 U.S. at 115; Wilson v. Commissioner, T.C. Memo. 2001-139.

      Pursuant to section 7491(a), the burden of proof as to factual matters shifts to

the Commissioner under certain circumstances. Petitioners have neither alleged that

section 7491(a) applies nor established their compliance with the substantiation and

recordkeeping requirements. See sec. 7491(a)(2)(A) and (B). Petitioners therefore

bear the burden of proof. See Rule 142(a).

Labor Costs

      A taxpayer must substantiate amounts claimed as deductions by maintaining

the records necessary to establish he or she is entitled to the deductions. Sec. 6001.
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Section 162(a) provides a deduction for certain business-related expenses. In order

to qualify for the deduction under section 162(a), “an item must (1) be ‘paid or

incurred during the taxable year,’ (2) be for ‘carrying on any trade or business,’ (3)

be an ‘expense,’ (4) be a ‘necessary’ expense, and (5) be an ‘ordinary’ expense.”

Commissioner v. Lincoln Sav. & Loan Ass’n, 403 U.S. 345, 352 (1971); Deputy v.

du Pont, 308 U.S. at 495 (to qualify as “ordinary”, the expense must relate to a

transaction “of common or frequent occurrence in the type of business involved”).

Whether an expense is ordinary is affected by time, place, and circumstance. Welch

v. Helvering, 290 U.S. at 113-114.

      If a taxpayer establishes that he or she paid or incurred a deductible business

expense but does not establish the amount of the expense, we may approximate the

amount of the allowable deduction, bearing heavily against the taxpayer whose

inexactitude is of his or her own making. Cohan v. Commissioner, 39 F.2d 540,

543-544 (2d Cir. 1930). In order for the Cohan rule to apply, there must be

sufficient evidence in the record to provide a basis for the estimate. Vanicek v.

Commissioner, 85 T.C. 731, 743 (1985).

      We conclude that the cost of labor is an ordinary and necessary expense for

petitioner to carry on his drywall installation business. We therefore allow business

expense deductions for labor to the extent they are substantiated.
                                        -8-

      The only issue petitioner raised at trial regarding 2006 was the disallowance

of a deduction relating to a $30,000 payment to Jose Mendoza for labor. Mr.

Mendoza was called as a witness at trial and testified regarding his work for

petitioner. The Court found his testimony, coupled with a dated receipt and a Form

1099-MISC provided during examination, sufficient to substantiate the payment for

2006. We therefore allow this amount as a business expense deduction for 2006.

      Petitioner disputes the disallowance of business expense deductions for “child

labor” and “spot labor” claimed for 2007. Sometimes petitioner’s children worked

for him after school and during summers. Petitioner paid his children for their work

and characterized those payments on his return as “child labor.” At trial petitioner

provided copies of checks that reflect payments to his children for labor of $6,898,

and we therefore allow this amount as a business expense deduction. As indicated,

petitioner did not explain the claimed “spot labor” deduction. As a result, we are

unable to ascertain whether it is an ordinary and necessary expense, and we

therefore disallow the business expense deduction for “spot labor”.

      Petitioner claims he is entitled to a business expense deduction for the cost of

labor in excess of the amount allowed for 2007 in the notice of deficiency. As
                                          -9-

indicated, respondent allowed petitioner a business expense deduction of $134,100

for the cost of labor. In addition to the amounts respondent allowed, petitioner has

substantiated, by check or receipt, additional payments for labor in 2007 of

$29,385.09. Thus, the total labor expense (reflected as cost of goods sold) allowed

for 2007 is $163,485.09.

      Petitioner also submitted receipts which were undated or were for years not in

issue. We do not accept these as substantiation for payments during the years in

issue. One of the undated receipts relates to a purported $30,000 payment to Jose

Mendoza for 2007. We do not allow a business expense deduction for a purported

$30,000 payment to Mr. Mendoza for 2007 which was neither substantiated during

examination nor evidenced by a check or dated receipt.

      Petitioner provided copies of checks reflecting payment for materials.

Petitioner has not satisfied the Court that he had additional costs for materials in

excess of the amount respondent allowed. Respondent’s determination with respect

to the business expense deduction for materials and supplies is therefore sustained.

Failure to File Addition to Tax

      Section 6651(a)(1) imposes an addition to tax of 5% per month of the amount

of tax required to be shown on the return, not to exceed 25%, for failure to timely
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file a return. The addition to tax under section 6651(a)(1) is imposed unless the

taxpayer establishes that the failure to timely file was due to reasonable cause and

not willful neglect. Section 7491(c) provides that the Commissioner has the burden

of production in any Court proceeding with respect to liability for an addition to tax.

The record reflects that petitioner did not file his 2007 Federal income tax return

until May 8, 2008. Petitioner gave no testimony regarding this issue. The record

does not establish that petitioner’s failure to timely file his 2007 Federal income tax

return was due to reasonable cause and not willful neglect. Therefore, petitioner is

liable for the section 6651(a)(1) addition to tax.5

Accuracy-Related Penalty

      Taxpayers may be liable for a 20% penalty on the portion of an underpayment

of tax attributable to negligence, disregard of rules or regulations, or a substantial

understatement of income tax. Sec. 6662(a) and (b)(1) and (2). The term

“negligence” in section 6662(b)(1) includes any failure to make a reasonable

attempt to comply with the Code, and the term “disregard” includes any careless,

reckless, or intentional disregard. Sec. 6662(c). Negligence has also been defined


      5
        Since we have allowed some deductions respondent disallowed, the amount
of tax required to be shown on petitioner’s 2007 Federal income tax return will be
less than the amount determined in the notice of deficiency. We leave the
recalculation to the parties’ Rule 155 computations.
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as the failure to exercise due care or the failure to do what a reasonable and

ordinarily prudent person would do under the circumstances. See Allen v.

Commissioner, 92 T.C. 1, 12 (1989), aff’d, 925 F.2d 348, 353 (9th Cir. 1991);

Neely v. Commissioner, 85 T.C. 934, 947 (1985). Negligence also 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.

      The section 6662(a) accuracy-related penalty does not apply where the

taxpayer shows that he acted in good faith and with reasonable cause. Sec.

6664(c)(1). The determination of whether a taxpayer acted in good faith and with

reasonable cause depends on the facts and circumstances of each case and includes

the knowledge and experience of the taxpayer and the reliance on the advice of a

professional, such as an accountant. Sec. 1.6664-4(b)(1), Income Tax Regs. Most

important in this determination is the extent of the taxpayer’s effort to determine the

proper tax liability. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99

(2000), aff’d, 299 F.3d 221 (3d. Cir. 2002).

      The Commissioner has the burden of production under section 7491(c) with

respect to the accuracy-related penalty under section 6662. To satisfy that burden,

the Commissioner must produce sufficient evidence showing that it is appropriate to

impose the penalty. Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
                                        - 12 -

Respondent determined the accuracy-related penalty for each year was due to

negligence. Respondent has satisfied his burden by producing evidence that

petitioner failed to maintain adequate books and records. Accordingly, because

respondent has met his burden of production, petitioner must come forward with

persuasive evidence that the accuracy-related penalty should not be imposed with

respect to the underpayment because he acted with reasonable cause and in good

faith. See sec. 6664(c)(1); Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446.

      Petitioners offered no argument or other evidence to show that there was

reasonable cause for the deductions claimed and that they acted in good faith with

respect to the underpayments. Respondent’s determination of the accuracy-related

penalties under section 6662(a) for 2006 and 2007 will be sustained.6

                                     Conclusion

      Petitioners are entitled to an additional business expense deduction for 2006

for the $30,000 payment to Mr. Mendoza. Petitioners are also liable for the section

6662(a) accuracy-related penalty for 2006. Petitioner is entitled to additional

business expense deductions for 2007 for payments to his children of $6,898 and for


      6
       As indicated, since we have allowed additional business expense deductions,
the amounts of tax required to be shown on petitioners’ 2006 and petitioner’s 2007
Federal income tax returns will be reduced from the amounts determined in the
notice of deficiency.
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payments to independent contractors of $29,385.09. Petitioner is also liable for the

section 6651(a)(1) addition to tax and the section 6662(a) accuracy-related penalty

for 2007.

      To reflect the foregoing,


                                                      Decision will be entered

                                                under Rule 155.
