                            T.C. Memo. 2018-143



                      UNITED STATES TAX COURT



     ANDREW MITCHELL BERRY AND SARA BERRY, Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent

  RONALD GENE BERRY AND LINDA KATHRYN BERRY, Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 9707-15, 14090-15.             Filed September 4, 2018.



     Andrew Mitchell Berry and Sara Berry, pro se in docket No. 9707-15.

     Ronald Gene Berry and Linda Kathryn Berry, pro se in docket No.

14090-15.

     Steven Mitchell Roth and Kris H. An, for respondent.
                                         -2-

[*2]         MEMORANDUM FINDINGS OF FACT AND OPINION


       KERRIGAN, Judge: In these consolidated cases, respondent issued Ronald

and Linda Berry (Ronald and Linda) and Andrew and Sara Berry (Andrew and

Sara) (collectively, petitioners) notices of deficiency for tax year 2011.

Respondent determined a $122,963 deficiency and a $24,592 section 6662(a)

accuracy-related penalty for Ronald and Linda. Respondent determined a

$193,478 deficiency and a $38,695 section 6662(a) accuracy-related penalty for

Andrew and Sara.

       After concessions by both parties the issues for our consideration are:

(1) whether petitioners’ S corporation, Phoenix Construction and Remodeling, Inc.

(Phoenix), overreported its gross receipts by $60,000, (2) whether Phoenix has

additional cost of goods sold, (3) whether petitioners are entitled to flowthrough

deductions for additional car and truck expenses of Phoenix of $26,641,

(4) whether Andrew and Sara are entitled to a deduction of $16,789 for car and

truck expenses reported on Schedule C, Profit or Loss From Business, (5) whether

Andrew and Sara are entitled to a Schedule C deduction for business use of the
                                         -3-

[*3] home of $976, (6) and whether petitioners are liable for accuracy-related

penalties under section 6662(a).1

      Unless otherwise indicated, 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. We round all monetary amounts to the

nearest dollar.

                               FINDINGS OF FACT

      Some of the facts are stipulated and are so found. Petitioners resided in

California when they timely filed their petitions.

Phoenix

      In 2011 Ronald and Andrew owned and operated Phoenix, an S corporation.

Phoenix built and remodeled homes in San Luis Obispo County, California (San

Luis Obispo).

      Gary Luttrell was a fractional investor in construction homes in San Luis

Obispo. Mr. Luttrell held a partial interest in unfinished homes, and he would

often sell parts of the unfinished homes. On October 11, 2011, Mr. Luttrell died.

His death certificate listed his occupation as a psychiatric technician.

      1
      Respondent contends that petitioners are not entitled to deduct $249,370 of
Phoenix’s expenses for 2011. Petitioners contest only some of these disallowed
expenses.
                                       -4-

[*4] During 2011 Phoenix had one bank account with Bank of America and two

bank accounts with Wells Fargo Bank. It used QuickBooks software to keep track

of its records.

      On or about April 13, 2012, Phoenix filed a Form 1120S, U.S. Income Tax

Return for an S Corporation, for 2011. Both couples claimed 50% of Phoenix’s

flowthrough profits and losses on their respective Schedules E, Supplemental

Income and Loss, for 2011. H&R Block prepared Phoenix’s tax return as well as

petitioners’ respective Forms 1040, U.S. Individual Income Tax Return, for 2011.

Respondent examined Phoenix’s tax return for 2011, and petitioners’ notices of

deficiency included adjustments pursuant to the examination of Phoenix. On

January 28, 2015, the revenue agent’s acting supervisor executed a Civil Penalty

Approval Form which stated that accuracy-related penalties would be imposed on

Phoenix’s shareholders.

      After the notices of deficiency were issued, petitioners provided respondent

with additional information regarding Phoenix’s expenses. Following review

respondent allowed deductions of $1,144,138 and disallowed deductions of

$249,370.
                                       -5-

[*5] Ronald and Linda

      Ronald and Linda timely and jointly filed their Form 1040 for 2011. On

their Schedule E they reported income of $39,990. On January 28, 2015, the

revenue agent’s acting supervisor executed a Civil Penalty Approval Form

approving the penalty determined in the notice of deficiency issued on February

27, 2015.

Andrew and Sara

      Andrew and Sara timely and jointly filed their Form 1040 for 2011. During

2011 Andrew had a bank account with Bank of America. Andrew and Sara

reported car and truck expenses of $12,515 on their Schedule C and respondent

disallowed any deduction for these expenses. The Schedule C was for a business,

Sales Sales. They reported income of $39,990 on their Schedule E. On January

28, 2015, the revenue agent’s acting supervisor executed a Civil Penalty Approval

Form approving the penalty determined in the notice of deficiency issued on

February 27, 2015.

                                    OPINION

      Generally, the Commissioner’s determinations in a notice of deficiency are

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

determinations are erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111,
                                        -6-

[*6] 115 (1933). Under section 7491(a), in certain circumstances, the burden of

proof may shift from the taxpayer to the Commissioner. Petitioners have not

claimed or shown that they have met the specifications of section 7491(a) to shift

the burden of proof to respondent as to any relevant factual issue.

      Deductions are a matter of legislative grace, and a taxpayer must prove his

or her entitlement to a deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79,

84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

Generally, an S corporation shareholder determines his or her tax liability by

taking into account a pro rata share of the S corporation’s income, losses,

deductions, and credits. Sec. 1366(a)(1). Where a notice of deficiency includes

adjustments for S corporation items with other items unrelated to the S

corporation, we have jurisdiction to determine the correctness of all adjustments.

See Winter v. Commissioner, 135 T.C. 238 (2010).

      Section 162 permits taxpayers to deduct all ordinary and necessary business

expenses paid or incurred during the taxable year. A taxpayer claiming a

deduction on a Federal income tax return must demonstrate that the deduction is

allowable pursuant to a statutory provision and must further substantiate that the

expense to which the deduction relates has been paid or incurred. Sec. 6001;
                                        -7-

[*7] Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), aff’d per curiam, 540

F.2d 821 (5th Cir. 1976).

Gross Receipts

      Petitioners contend that $60,000 of Phoenix’s gross receipts in 2011 were

included mistakenly. They contend that cash deposits of $50,000 and $10,000,

made on August 5 and December 19, 2011, respectively, were a loan from Linda’s

father, James Cummings. Money received pursuant to a loan is not included in

gross income because there is an obligation to repay. See Commissioner v. Tufts,

461 U.S. 300, 307 (1983). A bona fide loan requires both parties to have an

actual, good-faith intent to establish a debtor-creditor relationship when the funds

are advanced. Fisher v. Commissioner, 54 T.C. 905, 909-910 (1970).

      Petitioners did not substantiate that there was a loan from Mr. Cummings.

The only evidence they produced was a purported promissory note for $48,000.

Petitioners did not sign the purported promissory note, and it was not dated. Mr.

Cummings did not testify, and there was no evidence of repayment. We conclude

there was no debtor-creditor relationship. Accordingly, we sustain respondent’s

determination that Phoenix’s gross receipts were not overreported.
                                         -8-

[*8] Cost of Goods Sold

        “Cost of goods sold” is an offset subtracted from gross receipts in

determining gross income, sec. 1.61-3(a), Income Tax Regs., and is not a

“deduction”, see Metra Chem Corp. v. Commissioner, 88 T.C. 654, 661 (1987).

Any amount claimed as cost of goods sold must be substantiated, and taxpayers

are required to maintain records sufficient for this purpose. Sec. 6001; Nunn v.

Commissioner, T.C. Memo. 2002-250, slip op. at 16; sec. 1.6001-1(a), Income Tax

Regs.

        Petitioners contend that Ronald purchased construction materials from Mr.

Luttrell and that Phoenix should be allowed $33,040 of cost of goods sold.

Petitioners produced purported invoices for these purchases. Some of these

purported invoices included dates and purported signatures of Mr. Luttrell. Others

had no date and no signature. One of the invoices that had Mr. Luttrell’s

purported signature was dated after his death. The purported invoices total

$25,450, which is less than $33,040. Petitioners did not substantiate that these

purchases were made from Mr. Luttrell.

        Petitioners also contend that Phoenix is entitled to an additional $8,375 of

cost of goods sold. They contend $6,000 was for the purchase of concrete made

by Victor Sanchez on behalf of petitioners and that their QuickBooks records
                                        -9-

[*9] show payments to Mr. Sanchez. They contend the remaining $2,375 was for

the purchase of building materials at Home Depot. Petitioners contend that there

was an error in their QuickBooks records and an amount labeled Sherwin

Williams should have been labeled Home Depot. They provided no additional

evidence regarding these materials. Petitioners did not substantiate adequately

these additional costs of goods sold. See, e.g., Olive v. Commissioner, 139 T.C.

19, 32-33 (2012) (finding that the general ledgers alone did not suffice to

substantiate the taxpayer’s cost of goods sold), aff’d, 792 F.3d 1146 (9th Cir.

2015).

      The Court may estimate the amount of a deductible expense if a taxpayer

establishes that an expense is deductible but is unable to substantiate the precise

amount. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930);

Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). This principle is often

referred to as the Cohan rule. See, e.g., Estate of Reinke v. Commissioner, 46

F.3d 760, 764 (8th Cir. 1995), aff’g T.C. Memo. 1993-197. This Court has

applied the Cohan rule or similar principles to estimate a taxpayer’s basis in

property and cost of goods sold. See Wheeler v. Commissioner, T.C. Memo.

2014-204, at *7. The taxpayer must provide a reasonable evidentiary basis for the
                                       - 10 -

[*10] estimate. Id. Evaluating petitioners’ testimony and the other evidence, we

conclude no adjustments should be made to cost of goods sold.

Phoenix’s Car and Truck Expenses

      Certain expenses specified in section 274(d) are subject to strict

substantiation rules. No deductions under section 162 shall be allowed for “listed

property”, as defined in section 280F(d)(4), “unless the taxpayer substantiates by

adequate records or by sufficient evidence corroborating the taxpayer’s own

statement”. Sec. 274(d)(4). Listed property includes passenger automobiles and

other property used for transportation. Sec. 280F(d)(4)(A)(i) and (ii).

      To meet the heightened substantiation requirements, a taxpayer must

substantiate the amount, time of use, and business purpose of the expense. Sec.

274(d); see also sec. 1.274-5T(b)(6), Temporary Income Tax Regs., 50 Fed. Reg.

46016 (Nov. 6, 1985). To substantiate by adequate records, the taxpayer must

provide an account book, a log, or a similar record, as well as documentary

evidence, which are together sufficient to establish each element of an

expenditure. Sec. 1.274-5T(c)(2)(i), Temporary Income Tax Regs., 50 Fed. Reg.

46017 (Nov. 6, 1985). Documentary evidence includes receipts, paid bills, or

similar evidence. Sec. 1.274-5(c)(2)(iii), Income Tax Regs. To substantiate by

sufficient evidence corroborating the taxpayer’s own statement, the taxpayer must
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[*11] establish each element by the taxpayer’s statement and by direct evidence,

such as documentary evidence. Sec. 1.274-5T(c)(3)(i), Temporary Income Tax

Regs., 50 Fed. Reg. 46020 (Nov. 6, 1985).

      Notably, section 274(d) overrides the Cohan rule. Boyd v. Commissioner,

122 T.C. 305, 320 (2004); sec. 1.274-5T(a), Temporary Income Tax Regs., 50 Fed.

Reg. 46014 (Nov. 6, 1985) (flush language) (noting that section 274 supersedes

the Cohan rule). Therefore, this Court is precluded from estimating any expenses

that are covered by section 274(d).

      Petitioners contend that Phoenix is entitled to a deduction of $26,641 for the

use of a passenger vehicle. They did not provide a log pertaining to the use of the

passenger vehicle or other evidence showing the business use of the vehicle.

Petitioners did not meet the requirements of section 274(d) and therefore are not

entitled to deduct car and truck expenses of $26,641.

Andrew’s Car and Truck Expenses

      Andrew contends that he and Sara are entitled to a deduction for car and

truck expenses of $12,525. In support of these expenses he provided his 2011

bank statement, on which he circled some of the entries and labeled them as “fuel”

or “truck”. He provided no evidence to show that these were business expenses or
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[*12] any evidence to meet the requirements of section 274(d). Accordingly,

respondent’s disallowance of deductions for these expenses is sustained.

Andrew’s Home Office Deduction

      Andrew contends that he and Sara are entitled to a deduction for previously

unclaimed expenses for a home office. No deduction is allowed with respect to a

home office unless “allocable to a portion of the dwelling unit which is

exclusively used on a regular basis” as the taxpayer’s principal place of business.

Sec. 280A(a), (c)(1). Andrew did not provide any evidence to show that a portion

of his residence was exclusively used for business or how he calculated that a

portion of his residence was used for business. See Sam Goldberger, Inc. v.

Commissioner, 88 T.C. 1532, 1557 (1987). Andrew and Sara are not entitled to a

deduction for the business use of their home.

Accuracy-Related Penalty

      Respondent determined that for 2011 petitioners are liable for accuracy-

related penalties pursuant to section 6662(a). Respondent contends that

petitioners are liable for the accuracy-related penalties on alternative grounds:

(1) the underpayments are attributable to negligence or disregard of rules or

regulations within the meaning of section 6662(b)(1) or (2) there were substantial

understatements of income tax within the meaning of section 6662(b)(2). Only
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[*13] one accuracy-related penalty may be applied with respect to any given

portion of an underpayment, even if that portion is subject to the penalty on more

than one of the grounds set out in section 6662(b). Sec. 1.6662-2(c), Income Tax

Regs.

        The Commissioner bears the burden of production with respect to an

individual taxpayer’s liability for penalties. Sec. 7491(c). Once the

Commissioner meets this burden, the taxpayer must come forward with persuasive

evidence that the Commissioner’s determination is incorrect. See Rule 142(a);

Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). Section 6751(b)(1)

provides that “[n]o penalty under this title shall be assessed unless the initial

determination of such assessment is personally approved (in writing) by the

immediate supervisor of the individual making such determination or such higher

level official as the Secretary may designate.” In Graev v. Commissioner, 149

T.C. __ (Dec. 20, 2017), supplementing and overruling in part 147 T.C. 460

(2016), we held that the Commissioner’s burden of production under section

7491(c) includes establishing compliance with the supervisory approval

requirement of section 6751(b).

        Respondent provided a Civil Penalty Approval Form meeting the

requirements of section 6751(b). Respondent has satisfied the burden of
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[*14] production with respect to the penalty in each notice of deficiency, and the

burden of proof remains with petitioners to show that the penalties are

inappropriate. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.

      Negligence includes any failure to make a reasonable attempt to comply

with the provisions of the internal revenue laws and is the failure to exercise due

care or the failure to do what a reasonable and prudent person would do under the

circumstances. Sec. 6662(c); Neely v. Commissioner, 85 T.C. 934 (1985); sec.

1.6662-3(b)(1), Income Tax Regs. Negligence also includes any failure by the

taxpayer to keep adequate books and records to substantiate items properly. Sec.

1.6662-3(b)(1), Income Tax Regs.

      Petitioners failed to keep adequate records to substantiate the expenses of

Phoenix. For example, they did not keep records that met the requirements of

section 274(d). Respondent sufficiently carried the burden of production with

respect to the section 6662(a) and (b)(1) penalties for negligence.

      The section 6662(a) penalty may not be imposed with respect to any portion

of an underpayment of tax for which it is shown that the taxpayer had reasonable

cause and acted in good faith. Sec. 6664(c)(1). Regulations promulgated under

section 6664(c) provide that the determination of reasonable cause and good faith

“is made on a case-by-case basis, taking into account all pertinent facts and
                                         - 15 -

[*15] circumstances.” Sec. 1.6664-4(b)(1), Income Tax Regs. Petitioners did not

show reasonable cause for failing to keep adequate books and records in order to

substantiate items properly. H&R Block prepared their tax returns. No evidence

was produced regarding the information given to the tax return preparer. We hold

that petitioners are liable for the section 6662(a) and (b)(1) penalties for

negligence.

      To reflect the foregoing,


                                                  Decisions will be entered

                                        under Rule 155.
