                        T.C. Memo. 2008-287



                      UNITED STATES TAX COURT



     RUSSELL D. KINNEY AND HEATHER R. KINNEY, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 14816-06.              Filed December 22, 2008.



     Russell D. Kinney and Heather R. Kinney, pro sese.

     Ann L. Darnold, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     MARVEL, Judge:   Respondent determined deficiencies in

petitioners’ Federal income taxes of $4,162 and $5,984 for 2003

and 2004, respectively, as well as section 6662(a) accuracy-
                              - 2 -

related penalties of $832 and $1,197 for 2003 and 2004,

respectively.1

     After concessions2 the issues for decision are:

     (1) Whether during 2003 and 2004 petitioners’ direct

marketing activity constituted an activity not engaged in for

profit;

     (2) whether petitioners are entitled to deductions claimed

on their Schedules C, Profit or Loss From Business, for expenses

not related to the direct marketing activity for 2003 and 2004;

     (2) whether petitioners are entitled to deduct additional

home mortgage interest of $336 for 2003;

     (3) whether petitioners have substantiated unreimbursed

employee expenses in excess of expenses conceded by respondent

for 2003;

     (4) whether petitioners are liable for the section 6662(a)

accuracy-related penalties.




     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure. Monetary amounts are rounded to the nearest dollar.
     2
      Respondent concedes that petitioners substantiated the
union dues and welding license expenses claimed on Schedule A,
Itemized Deductions, for 2003 as unreimbursed employee expenses,
but the parties dispute the remaining unreimbursed employee
expenses. Respondent also concedes that petitioners are entitled
to a $309 home mortgage interest deduction for 2003, but the
parties dispute the remaining home mortgage deduction.
                               - 3 -

                         FINDINGS OF FACT

     The parties have stipulated some of the facts, which we

incorporate in our findings by this reference.     Petitioners

resided in Oklahoma when their petition was filed.     Petitioners

were married and filed joint Federal income tax returns for the

years at issue, but they were separated at the time of trial.

     During the years at issue petitioners received wage and

other income from several sources.     Heather R. Kinney (Mrs.

Kinney) was employed by Women’s Health Group, Inc., earning

$28,329 and $20,492 for 2003 and 2004, respectively.     Russell D.

Kinney (Mr. Kinney) was a member of a local union and was

employed as a welder by K & L Smith Mechanical, Inc. (K & L

Smith), earning $37,454 and $49,155 in 2003 and 2004,

respectively.   Petitioners also reported “gaming” income of

$7,300 and $38,780 for 2003 and 2004, respectively.

I.   Petitioners’ Direct Marketing and Prospective Welding
     Businesses

     A.   Direct Marketing Activity

     In 2001 petitioners became involved with Melaleuca, Inc.

(Melaleuca), a direct marketing company selling health, wellness,

and household products through individuals (distributors).

Melaleuca is structured as an upline-downline system in which

distributors earn commissions when they recruit new distributors

(downlines) and when their downlines recruit more distributors.

Distributors also receive commissions on purchases of products by
                                 - 4 -

their downlines.   Melaleuca’s distributors qualify for discounts

on Melaleuca products.   Petitioners were recruited as downlines

by another distributor (upline).    Before their involvement with

Melaleuca petitioners had no experience in running a business or

conducting direct marketing activities.

     Initially petitioners concentrated on recruiting downlines,

but because of the $300 initiation fee that prospective downlines

had to pay, petitioners were not able to attract anyone.     Mrs.

Kinney sold some products to neighbors, friends, and coworkers.

After petitioners realized they could not recruit downlines, they

considered quitting the Melaleuca activity but decided to

continue selling products because of their inventory.   In

addition, they remained hopeful that they would eventually sign

up downlines.   Petitioners had been told by their upline that if

their potential downlines ordered Melaleuca products at

petitioners’ volume, petitioners would recoup their startup costs

in approximately 1 year.   However, petitioners did not calculate

how many downlines they would have to recruit to make their

marketing activity profitable.    Both petitioners continued their

full-time jobs.

     Petitioners owned a mobile home3 in a trailer park, which

after they ceased using it as a residence, they converted for use



     3
      Mr. Kinney purchased the mobile home in 1986, and
petitioners used it as their primary residence until 2003.
                                  - 5 -

exclusively as an office for their Melaleuca activity, including

storing inventory.    Although they purchased a computer and

printer for their Melaleuca activity, petitioners did not have

Internet service at the mobile home, and they placed online

orders with Melaleuca on their computer at home.

      When petitioners became Melaleuca distributors, they

consulted Susan Boyer (Ms. Boyer) regarding business records they

had to maintain.    Although petitioners obtained computer software

from Ms. Boyer, they recorded all items on paper and retained

receipts.    Petitioners did not maintain a separate bank account

for the Melaleuca activity.    Petitioners never generated a profit

from the Melaleuca activity.      In 2003 and 2004 petitioners

reported gross sales of $412 and $595, respectively.

      B.    Preparations To Start Welding Business

      In the latter part of 2003 Mr. Kinney prepared to start a

welding business because he anticipated receiving orders for pipe

fabrication from an acquaintance.      In 2004 Mr. Kinney constructed

gates, built a pole building, and purchased a welding machine and

other supplies.    However, for

reasons beyond Mr. Kinney’s control, he did not actually begin to

operate a business.

II.   Petitioners’ Federal Income Tax Returns

      Petitioners timely filed their 2003 and 2004 Forms 1040,

U.S. Individual Income Tax Return (2003 and 2004 returns).       Ms.
                                - 6 -

Boyer prepared the returns.    Schedule C attached to the 2003

return (2003 Schedule C) described petitioners’ Melaleuca

activity as “Marketing”.   Besides the Melaleuca expenses, on the

2003 Schedule C petitioners also claimed mileage for vehicles and

expenses for one cellular phone that pertained to Mr. Kinney’s

employment at K & L Smith.

     Petitioners’ Schedule C attached to the 2004 return (2004

Schedule C) described petitioners’ business activity as

“Marketing Welding”.   Marketing referred to the Melaleuca

activity, and welding referred to Mr. Kinney’s prospective

welding business.   Gross income of $595 reported on the 2004

Schedule C represented petitioners’ gross sales of Melaleuca

products.   In addition to claiming deductions for the Melaleuca

activity and for the prospective welding business, on the 2004

Schedule C petitioners also claimed deductions for (1) mileage

for vehicles and expenses of one cellular phone that pertained to

Mr. Kinney’s employment at K & L Smith and (2) work clothes

expenses for both petitioners’ jobs.    The 2004 Schedule C did not

separately identify the expenses related to the Melaleuca

activity, the prospective welding business, and petitioners’

employment.

     Petitioners deducted the following Schedule C expenses on

their 2003 and 2004 returns:
                               - 7 -

         Sch. C expense category           2003            2004
     Car and truck                        $8,795          $9,217
     Commissions and fees                  1,542            -0-
     Depreciation                          5,591            -0-
     Legal and professional
     services                                418             649
     Office expense                          313            -0-
     Rent or lease
       Vehicles, machinery and
         equipment                          -0-              273
       Other business property             3,246           7,500
     Repairs and maintenance               1,225             676
     Supplies                                802           2,813
     Taxes and licenses                     -0-              107
     Travel                                  341            -0-
     Meals and entertainment                 646            -0-
     Other
       Toll                                 -0-               85
       Meetings                              108            -0-
       Phones                              2,911           1,180
       Work clothes                         -0-              484
       Tools                                -0-              400
         Total                            25,938          23,384


     On the 2003 return petitioners itemized their deductions,

attaching to the return Schedule A, Itemized Deductions (2003

Schedule A).   On the 2003 Schedule A petitioners reported home

mortgage interest of $9,587 and unreimbursed employee expenses of

$2,186.4   After applying the section 67(a) limitation,

petitioners deducted $1,158 of unreimbursed employee expenses.

Petitioners attached to their return a Form 2106-EZ, Unreimbursed




     4
      For 2004 petitioners reported unreimbursed employee
expenses totaling $2,234 but did not claim them because such
expenses did not exceed the 2-percent limitation under sec.
67(a).
                                - 8 -

Employee Business Expenses, but the form did not show how the

amount was calculated.

III. Notice of Deficiency

     In the notice of deficiency respondent disallowed all of

petitioners’ 2003 and 2004 Schedule C deductions on the following

grounds:    “no amount in excess of zero has been adequately

substantiated as to amount of deductibility.    In addition, it has

not been established that the requirements of Internal Revenue

Code Section 274 have been met.”    For 2003 respondent also

disallowed $1,803 of petitioners’ itemized deductions because of

lack of substantiation.5    This amount consisted of home mortgage

interest expense of $645 and unreimbursed employee expenses of

$1,158.    Respondent also determined that petitioners were liable

for accuracy-related penalties under section 6662(a) of $832 and

$1,197 for 2003 and 2004, respectively.

                              OPINION

     The Commissioner’s determinations are presumed correct, and

the taxpayer ordinarily bears the burden of proving that those

determinations are erroneous.    Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933).    Moreover, deductions are a matter of

legislative grace, and the taxpayer bears the burden of proving

that he is entitled to any deduction claimed.    INDOPCO, Inc. v.



     5
      Respondent also made computational adjustments to self-
employment tax and the sec. 24(a) child tax credit for 2004.
                               - 9 -

Commissioner, 503 U.S. 79, 84 (1992).   Petitioners do not contend

that section 7491(a) shifts the burden of proof to respondent,

and petitioners have not established that they satisfy the

section 7491(a)(2) requirements.

I.   Schedule C Deductions Related to the Melaleuca Activity

     A.    In General

     Respondent argues that petitioners may not deduct the

Schedule C expenses attributable to the Melaleuca activity

because the Melaleuca activity did not constitute a trade or

business and was not engaged in for profit.6    Section 162(a)

allows a taxpayer to deduct ordinary and necessary expenses of

carrying on the taxpayer’s trade or business.    To be engaged in a

trade or business with respect to which deductions are allowable

under section 162, “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).

     Section 183(a) restricts taxpayers from deducting losses for

an activity that is not engaged in for profit.    Section 183(c)

defines “activity not engaged in for profit” as “any activity


     6
      In the notice of deficiency respondent disallowed Schedule
C deductions for lack of substantiation. In the pretrial
memorandum and at trial respondent also contended that
petitioners’ Melaleuca activity did not constitute a trade or
business engaged in for profit within the meaning of secs. 162
and 183. Petitioners do not object on procedural grounds to
respondent’s argument under sec. 183.
                              - 10 -

other than one with respect to which deductions are allowable for

the taxable year under section 162 or under paragraph (1) or (2)

of section 212.”

     Absent a stipulation to the contrary, see sec. 7482(b)(2),

this case is appealable to the Court of Appeals for the Tenth

Circuit, see sec. 7482(b)(1), which has applied the dominant or

primary objective standard to test whether an alleged business

activity is conducted for profit, Hildebrand v. Commissioner, 28

F.3d 1024, 1027 (10th Cir. 1994), affg. Krause v. Commissioner,

99 T.C. 132 (1992); Cannon v. Commissioner, 949 F.2d 345, 350

(10th Cir. 1991), affg. T.C. Memo. 1990-148;7 Oswandel v.

Commissioner, T.C. Memo. 2007-183.     Under the standard applied by

the Court of Appeals for the Tenth Circuit, the dominant or

primary objective of petitioners’ Melaleuca activity must be to

earn a profit.   Whether an activity was engaged in for profit is

a factual determination to be resolved on the basis of all the

surrounding facts and circumstances.     Hildebrand v. Commissioner,

supra at 1027.

     Factors enumerated in regulations under section 183

generally are utilized in determining whether the requisite


     7
      In both Hildebrand v. Commissioner, 28 F.3d 1024, 1027
(10th Cir. 1994), affg. Krause v. Commissioner, 99 T.C. 132
(1992), and Cannon v. Commissioner, 949 F.2d 345, 350 (10th Cir.
1991), affg. T.C. Memo. 1990-148, the Court of Appeals for the
Tenth Circuit applied the dominant or primary objective test at
the partnership level in analyzing whether a partnership was
engaged in an activity for profit under sec. 183.
                               - 11 -

profit objectives are present under section 162.      See Cannon v.

Commissioner, supra at 348; Krause v. Commissioner, supra at 168.

Section 1.183-2(b), Income Tax Regs., sets forth a nonexclusive

list of factors to be considered in determining whether a

taxpayer has the requisite profit objective.      The factors are:

(1) The manner in which the taxpayer carries on the activity; (2)

the expertise of the taxpayer or his advisers; (3) the time and

effort expended by the taxpayer in carrying on the activity; (4)

the expectation that assets used in the activity may appreciate

in value; (5) the success of the taxpayer in carrying on other

similar or dissimilar activities; (6) the taxpayer’s history of

income or loss with respect to the activity; (7) the amount of

occasional profits, if any, which are earned; (8) the financial

status of the taxpayer; and (9) elements of personal pleasure or

recreation.    No single factor is determinative, and not all

factors are applicable in every case.      See Abramson v.

Commissioner, 86 T.C. 360, 371 (1986).

     B.   Applying the Factors

     We analyze the most pertinent of the factors listed in the

regulation to illustrate why we conclude that petitioners’

Melaleuca activity was not an activity engaged in for profit.

          1.    The Manner in Which Petitioners Conducted the
                Activity

     In deciding whether a taxpayer has conducted an activity in

a businesslike manner we consider:      (1) Whether complete and
                              - 12 -

accurate books and records were maintained; (2) whether the

activity was conducted in a manner substantially similar to other

activities of the same nature that were profitable; and (3)

whether changes in operating methods, adoption of new techniques,

or abandonment of unprofitable methods were done in a manner

consistent with an intent to improve profitability.   See Engdahl

v. Commissioner, 72 T.C. 659, 666-668 (1979); sec. 1.183-2(b)(1),

Income Tax Regs.

     When petitioners signed up as downlines, they consulted Ms.

Boyer regarding necessary recordkeeping and obtained from her a

computer program and a book for recording “everything”.   Mr.

Kinney testified that petitioners did not use the software but

instead contemporaneously recorded all items in the book8 and

retained receipts.   We are not convinced that petitioners’

recordkeeping represented anything other than an effort to

substantiate expenses claimed on their return.   For a taxpayer’s

books and records to indicate a profit motive, the taxpayer

should use the books and records “as analytic or diagnostic tools

in an effort to achieve profitability”, Nissley v. Commissioner,

T.C. Memo. 2000-178, for example, to enable a taxpayer to cut

expenses, increase profits, and evaluate the overall performance

of the operation, see Golanty v. Commissioner, 72 T.C. 411, 430



     8
      Petitioners did not give the book to the IRS during the
audit and did not introduce the book into evidence.
                              - 13 -

(1979), affd. without published opinion 647 F.2d 170 (9th Cir.

1981).   Petitioners could not meaningfully analyze profitability

and make informed decisions regarding their Melaleuca activity on

the basis of the collection of receipts and invoices they

retained.   Although they believed they would recoup their startup

costs if they could recruit some downline distributors, they did

not estimate what sales level they had to maintain to break even.

Although Mrs. Kinney prepared spreadsheets to assist the tax

return preparation process, petitioners did not use the

spreadsheets to analyze profitability of the business or to

identify cost-cutting measures.

     Petitioners failed to maintain certain records that

individuals pursuing a similar activity with a profit objective

are expected to maintain.   See Nissley v. Commissioner, supra.

In addition, the records petitioners did maintain were neither

complete nor accurate.   For example, for 2004 petitioners

reported $595 in gross sales but retained records reflecting only

$393 in gross sales.

     Petitioners also did not prove that they made changes to

their business activity in order to generate a profit.    For

example, petitioners offered no evidence that they considered

switching companies or that they consulted successful direct

marketers about how to improve sales and reduce expenses.

Despite their losses, petitioners continued to buy products
                                - 14 -

without increasing their sales volume or changing their method of

operation.    We conclude that petitioners did not conduct their

Melaleuca activity in a businesslike manner.

            2.   The Expertise of Petitioners or Their Advisers

     Preparation for an activity by an extensive study of its

accepted business, economic, and scientific practices, or

consultation with those who are experts therein, may indicate a

profit objective.     Engdahl v. Commissioner, supra at 668; sec.

1.183-2(b)(2), Income Tax Regs.    Efforts to gain experience and a

willingness to follow expert advice may indicate a profit motive.

See, e.g., Dworshak v. Commissioner, T.C. Memo. 2004-249.

     Before signing up as downlines, petitioners never engaged in

any direct marketing activity or any other type of sales

business.    Petitioners relied only on advice from another

Melaleuca distributor.    Under a direct marketing system like

Melaleuca an upline is an interested party rendering advice to

promote his own interest.    See Ogden v. Commissioner, T.C. Memo.

1999-397 (direct marketers “may be biased when discussing * * *

[their direct marketing activity] because they have a natural

desire to advance the organization and/or obtain income from a

downliner.”), affd. 244 F.3d 970 (5th Cir. 2001).     Petitioners

never sought advice from an independent party.     On balance we

conclude that petitioners did not have, and did not acquire from

others, a sufficient grounding in direct marketing.
                                   - 15 -

               3.   Petitioners’ Time and Effort Devoted to the
                    Activity

       The fact that a taxpayer devotes personal time and effort to

carry on an activity may indicate an intention to derive a

profit, particularly where there are no substantial personal or

recreational elements associated with the activity.       Sec. 1.183-

2(b)(3), Income Tax Regs.

       Mr. Kinney’s testimony about the amount of time petitioners

devoted to the Melaleuca activity was confusing and unclear.           Mr.

Kinney testified that Mrs. Kinney spent a couple of hours weekly

trying to sell Melaleuca products and that he spent approximately

1 hour daily filling out order sheets.       However, Mr. Kinney

testified he placed orders for merchandise once a month.          We

cannot reconcile Mr. Kinney’s testimony about the amount of time

he and his wife spent on the activity9 with the small amount of

sales reported, nor do we understand what he did for an hour a

day.       Consequently we disregard Mr. Kinney’s testimony on this

point.       See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

       Petitioners maintained full-time jobs during the years at

issue, and in 2004 Mr. Kinney also devoted time and effort to his

prospective welding business.       In addition, Mrs. Kinney started



       9
      Copies of customer receipts indicate that in 2003 and 2004
petitioners made less than two sales per month, and the average
sale was $21. We find it hard to believe that this sales volume
required Mr. Kinney to spend 1 hour daily filling out order
sheets.
                                - 16 -

gambling at some point and spent far more time gambling during

the years at issue than selling Melaleuca products or recruiting

downlines.   Petitioners’ other activities left little time for

the Melaleuca activity.

          4.     Petitioners’ History of Income or Loss From the
                 Activity

     A taxpayer’s history of income or loss with respect to an

activity may indicate the presence or absence of a profit

objective.     See Golanty v. Commissioner, supra at 426; sec.

1.183-2(b)(6), Income Tax Regs.    However, “a series of startup

losses or losses sustained because of unforeseen circumstances

beyond the control of the taxpayer may not indicate a lack of

profit motive.”     Kahla v. Commissioner, T.C. Memo. 2000-127

(citing Engdahl v. Commissioner, 72 T.C. at 669, and section

1.183-2(b)(6), Income Tax Regs.), affd. without published opinion

273 F.3d 1096 (5th Cir. 2001).

     Petitioners’ activity never generated a net profit.    Their

Melaleuca activity mostly provided them discounts on products for

personal use and deductions for personal expenses, such as

expenses related to their car, cellular phone, Internet service,

and mobile home.    Although the activity was in its early years,

petitioners recognized that they needed to build a downline

organization to maintain a profit, yet they did nothing to reduce

costs or terminate the activity when they were unsuccessful at

recruiting downline distributors.    We fail to see how petitioners
                                - 17 -

could recoup their cumulative losses under these circumstances.

We conclude petitioners’ substantial losses from the activity

indicate that the Melaleuca activity was not engaged in for

profit.

            5.   Elements of Personal Pleasure or Recreation

     The existence of personal pleasure or recreation relating to

the activity may indicate the absence of a profit objective.     See

sec. 1.183-2(b)(9), Income Tax Regs.     However, an activity is not

treated as an activity not engaged in for profit merely because

the activity may have recreational or pleasurable elements.     Id.

Petitioners’ Melaleuca activity was so intertwined with social

and recreational elements that it is difficult to discern what

part, if any, of the activity was business and what part was

pleasure.   For example, on a January 2003 trip to a cheerleading

convention10 petitioners invited their acquaintances to dinner

during which they talked about cheerleading and Melaleuca

products.   Petitioners treated the cost of the dinner as a

deductible expense.    During another personal trip to New Mexico,

Texas, and Las Vegas, Nevada, petitioners delivered products to

and discussed Melaleuca with spouses of persons whom Mr. Kinney

had met through his employment.    Petitioners deducted the cost of

meals and some lodging expenses.    We conclude that elements of



     10
      During the years at issue petitioners’ daughter was a
cheerleader.
                                - 18 -

personal pleasure and recreation indicate that petitioners did

not engage in the Melaleuca activity with a primary objective of

realizing a profit.

            6.   Conclusion

      The remaining factors either do not apply or do not favor

petitioners’ position.    After considering the factors listed in

section 1.183-2(b), Income Tax Regs., and the facts and

circumstances of this case, we conclude that petitioners did not

engage in the Melaleuca activity with the primary objective of

realizing a profit.    Accordingly, we hold that petitioners’

Melaleuca activity during the years in issue was not an activity

engaged in for profit within the meaning of sections 162 and 183.

II.   Deductibility of 2003 and 2004 Schedule C Expenses

      A.    2003 Schedule C Expenses

            1.    Expenses Related to the Melaleuca Activity

      Because we have concluded that petitioners did not engage in

the Melaleuca activity for profit, we now turn our analysis to

what deductions, if any, petitioners may claim under section

183(b)(1) and (2).    Section 183(b)(1) permits deductions which

are otherwise allowable without regard to whether the activity is

engaged in for profit, such as State and local taxes and

interest.    Section 183(b)(2) allows deductions that would be

allowable if the activity were engaged in for profit but only to
                               - 19 -

the extent of gross income received from the activity, reduced by

deductions under section 183(b)(1).

     For 2003 petitioners provided records showing they paid

Tulsa County tax of $50, an expense that appears to be deductible

under section 164(a) and allowable under section 183(b)(1).

Petitioners also paid rent for the lot for the mobile home

totaling $1,320.11   We are satisfied, on the basis of Mr.

Kinney’s testimony, that petitioners used the mobile home

exclusively for the Melaleuca activity.   We find that petitioners

may deduct the county tax in full and may deduct the lot rent

expenses up to $362, the excess of the $412 gross profit from the

Melaleuca activity over the county tax.   Given the section

183(b)(2) limitation, we do not need to address whether

petitioners substantiated other deductions related to the

Melaleuca activity on their 2003 Schedule C.

          2.   Expenses Related to Mr. Kinney’s Employment
               Erroneously Claimed on the 2003 Schedule C

     The 2003 Schedule C included mileage and cellular phone

expenses related to Mr. Kinney’s employment at K & L Smith.

Although those deductions should have been claimed on

petitioners’ 2003 Schedule A as miscellaneous itemized deductions

subject to the 2-percent adjusted gross income limitation under



     11
      The record does not establish under which category of the
2003 Schedule C petitioners claimed the lot rent expense and the
county tax.
                                - 20 -

section 67(a), we consider whether petitioners are entitled to

these deductions.

     A taxpayer may deduct unreimbursed employee expenses as an

ordinary and necessary business expense under section 162.      Lucas

v. Commissioner, 79 T.C. 1, 6 (1982).    An employee cannot deduct

such expenses to the extent that the employee is entitled to

reimbursement from his or her employer for expenditures related

to his or her status as an employee.     Id. at 7.   Along with other

miscellaneous itemized deductions, unreimbursed employee expenses

are subject to the 2-percent limitation of section 67(a).     We

accept as credible Mr. Kinney’s testimony that K & L Smith did

not reimburse him for mileage and cellular phone expenses.

                (a) Car and Truck Expenses

     Petitioners claimed $8,795 in car and truck expenses on the

2003 Schedule C, which included van and truck expenses for the

Melaleuca activity and truck expenses for Mr. Kinney’s

employment.   Passenger automobiles and any other property used as

a means of transportation are listed property, see sec.

280F(d)(4)(A)(i) and (ii), and these expenses are subject to the

provisions of section 274(d).    Section 274(d) requires taxpayers

to provide adequate records or sufficient other evidence

establishing the amount, time, place, and business purpose of the

expense to corroborate the taxpayer’s statements.     Mr. Kinney

claimed that he maintained a contemporaneous log, but he did not
                               - 21 -

introduce it into evidence.    To substantiate mileage expenses,

petitioners presented calendars that used an alphabetical code

for indicating business or personal use of their vehicles.

Although petitioners’ code system separates business and personal

mileage, it does not separate how many miles were driven for the

Melaleuca activity and for Mr. Kinney’s employment.    The

calendars have meager explanations about the purpose of a few

trips; only a few entries describe trip destinations.    We

conclude the calendars do not satisfy the strict substantiation

requirements of section 274(d), and we sustain respondent’s

determination disallowing car and truck expenses.

               (b) Cellular Phone Expenses

     On the 2003 Schedule C petitioners claimed cellular phone

expenses under the category “other expenses”.    Petitioners

introduced into evidence cellular phone bills that establish that

they subscribed to a family plan for two cellular phones, one for

Mr. Kinney and one for Mrs. Kinney.     Mr. Kinney did not use any

other cellular phone.   Cellular phones are listed property, see

sec. 280F(d)(4)(A)(v), and section 274(d) provides that no

deduction shall be allowed unless the taxpayer substantiates,

inter alia, the business use of the property.    Petitioners did

not offer a detailed breakdown of personal and business use of

Mr. Kinney’s cellular phone.    Petitioners failed to establish the

additional charges, if any, they incurred because of Mr. Kinney’s
                               - 22 -

employment.    Therefore, petitioners are not entitled to the

cellular phone expense deduction.

     B.   The 2004 Schedule C Expenses

          1.     Expenses Related to the Melaleuca Activity

     For 2004 petitioners did not claim any deductions that are

allowable under section 183(b)(1).      As discussed above, section

183(b)(2) permits petitioners to offset expenses against gross

income from the Melaleuca activity.     Petitioners substantiated

the following:    (1) $330 rent for the mobile home lot for January

through March 2004 and (2) $238 of utilities attributable to the

mobile home office.    These substantiated expenses total $568,

leaving a small discrepancy between income from the activity and

substantiated expenses.

     Petitioners claimed the following deductions related to the

Melaleuca activity.

                 (a) Car and truck expenses ($9,217)

     As discussed above, petitioners’ mileage records do not

satisfy the substantiation requirements of section 274(d).      In

addition, the records do not separate miles driven for the

Melaleuca activity and miles driven for Mr. Kinney’s employment.

Accordingly, none of the car and truck expenses may be deducted

as an expense of the Melaleuca activity.
                              - 23 -

               (b) Legal and Professional Services ($649)

     Petitioners offered no evidence to substantiate that they

paid for legal and professional services for 2004.

               (c) Supplies ($2,813)

     Petitioners did not substantiate what items they purchased

and deducted as supplies or their business purpose.

               (d) Tolls deducted as “Other expenses” ($85)

     Although tolls related to Mr. Kinney’s employment may

qualify as a deductible unreimbursed employee expense,

petitioners did not prove how to allocate the tolls expense

between driving for the Melaleuca activity and driving for Mr.

Kinney’s employment.   Accordingly, none of the tolls may be

deducted as an expense of the Melaleuca activity.

     On the basis of the foregoing, we conclude that petitioners

have not substantiated Melaleuca-related expenses in excess of

$568.

          2.   Unreimbursed Employee Expenses Erroneously Claimed
               on the 2004 Schedule C

     On the 2004 Schedule C petitioners claimed $484 of work

clothes expenses.   Mr. Kinney testified that for his employment

he wore heavy denim and khaki shirts, steel-toed boots, safety

glasses, and welding hats, and Mrs. Kinney wore scrubs to work.

Clothing is a deductible expense only if it is required for the

taxpayer’s employment, unsuitable for general wear, and not worn

for personal use.   See Hynes v. Commissioner, 74 T.C. 1266, 1290
                              - 24 -

(1980); Yeomans v. Commissioner, 30 T.C. 757, 767 (1958).     Such

costs are not deductible even if a taxpayer establishes that he

would not have purchased the items but for the employment.     Hynes

v. Commissioner, supra at 1290.

     The receipts introduced into evidence to substantiate Mr.

Kinney’s work clothes expenses contain unclear abbreviated

descriptions that do not allow us to determine what items were

purchased.   With respect to Mrs. Kinney’s work clothes,

petitioners have not established that Mrs. Kinney did not receive

any reimbursement for her work clothes.   The receipts presented

to substantiate Mrs. Kinney’s work clothes expenses describe the

items purchased as “Comfort Wash Elastic-waist Pants”, “Comfort

Wash Checked Fashion Warm-up” and “Knit Polo Shirt by Jerzees”.

Such descriptions are insufficient to establish that the clothes

purchased are not suitable for general wear.   Petitioners did not

argue any special circumstances that prevented the use of the

clothes outside of work.   Accordingly, we disallow a deduction

for work clothes for lack of substantiation.

     Besides the work clothes expenses, the 2004 Schedule C also

includes mileage and cellular phone expenses related to Mr.

Kinney’s employment at K & L Smith.    For the same reasons that we

disallowed these deductions for 2003, we disallow car and truck

and cellular phone deductions for 2004.
                                - 25 -

          3.      Expenses Related to the Prospective Welding
                  Business

     The record establishes that the following deductions claimed

on the 2004 Schedule C related to Mr. Kinney’s prospective

welding business:

                 Item on the 2004 Schedule C          Amount

           Rent or lease
             Vehicles, machinery and equipment          $273
             Other business property                   7,500
           Repairs and maintenance                       676
           Tools                                         400
             Total                                     8,849

     As discussed above, section 162 allows a taxpayer to deduct

ordinary and necessary expenses of carrying on the taxpayer’s

trade or business.    See sec. 162(a); sec. 1.183-2(a), Income Tax

Regs.   For the expense to be deductible under section 162,

however, the taxpayer’s business operations must actually have

commenced.     See Jackson v. Commissioner, 864 F.2d 1521, 1525-1526

(10th Cir. 1989), affg. 86 T.C. 492 (1986).       The taxpayer has not

“‘engaged in carrying on any trade or business’ within the

intendment of section 162(a) until such time as the business has

begun to function as a going concern and performed those

activities for which it was organized.”        Richmond Television

Corp. v. United States, 345 F.2d 901, 907 (4th Cir.), vacated and

remanded on other grounds 382 U.S. 68 (1965).       Mr. Kinney never

started operating the welding business; rather, he undertook

preparatory steps, such as constructing a building and locating a
                                - 26 -

key client.12   Accordingly, the prospective welding business

expenses are not deductible under section 162(a).

III. 2003 Itemized Deductions

     A.   Home Mortgage Interest Deduction

     Respondent disallowed the home mortgage interest deduction

of $336 for lack of substantiation.      Section 163(h)(2)(D) allows

a deduction for interest paid on a qualified residence.     Section

163(h)(4)(A)(i) further defines “qualified residence” as either

the taxpayer’s principal residence or another residence selected

by the taxpayer and used as a residence.     Taxpayers must be able

to substantiate the amount claimed.      See sec. 6001; sec. 1.6001-

1(a), Income Tax Regs.

     Petitioners provided no documentation or other evidence to

substantiate that they are entitled to a home mortgage interest

deduction in excess of that allowed by respondent.     Accordingly,

we sustain respondent’s disallowance of the home mortgage

interest deduction in excess of the $309 allowed.




     12
      Petitioners did not argue that the prospective welding
business expenses are startup expenditures eligible for
amortization under sec. 195. Even if they had, sec. 195(b)(1)
requires a taxpayer to elect to treat startup expenditures as
deferred expenses that may be amortized over a period of not less
than 60 months, and the amortizaton period cannot begin any
earlier than the month in which the active trade or business
begins.
                               - 27 -

      B.   Unreimbursed Employee Expenses13

      In the notice of deficiency respondent disallowed $1,158 of

unreimbursed employee expenses.   Respondent concedes that

petitioners substantiated the union dues and other union

assessment amounts as well as welding licenses expenses but

maintains that the conceded amounts are projected to be less than

the 2-percent limitation of section 67(a).    Petitioner failed to

substantiate amounts in excess of those conceded by respondent.

Accordingly, we disallow a deduction for unreimbursed employee

expenses in excess of deductions conceded by respondent.

IV.   Other Matters

      The Court’s holding on the above adjustments, in turn,

determines to what extent petitioners are entitled to the child

tax credit for 2004 and whether petitioners are liable for self-

employment tax.    These adjustments will be addressed in a Rule

155 computation.

V.    Accuracy-Related Penalty Under Section 6662

      Respondent contends that petitioners are liable for the

accuracy-related penalty on the grounds of (1) negligence or

disregard of rules or regulations under section 6662(a) and

(b)(1) for 2003 and (2) negligence or disregard of rules or




      13
      We remind the parties that when making their Rule 155
calculations, miscellaneous itemized deductions must be adjusted
for the 2-percent limitation. See sec. 67(a).
                                - 28 -

regulations and substantial understatement of tax under section

6662(a) and (b)(1) and (2) for 2004.

     Section 6662(a) and (b)(1) authorizes the Commissioner to

impose a 20-percent penalty on the portion of an underpayment of

income tax attributable to negligence or disregard of rules or

regulations.    Negligence is defined as any failure to make a

reasonable attempt to comply with the provisions of the internal

revenue laws.    Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax

Regs.   Negligence is strongly indicated where a taxpayer fails to

make a reasonable attempt to ascertain the correctness of a

deduction, credit, or exclusion on a return which would seem to a

reasonable and prudent person to be “‘too good to be true’” under

the circumstances.    Sec. 1.6662-3(b)(1)(ii), Income Tax Regs.

     Section 6662(a) and (b)(2) also authorizes the Commissioner

to impose a 20-percent penalty if there is a substantial

understatement of income tax.    An understatement is substantial

if the amount of the understatement for the taxable year exceeds

the greater of 10 percent of the tax required to be shown on the

return or $5,000.    Sec. 6662(d)(1)(A).

     Respondent bears the initial burden of production with

respect to petitioner’s liability for the section 6662(a) penalty

and must produce sufficient evidence indicating that it is

appropriate to impose the penalty.       See sec. 7491(c).   Respondent

has satisfied his burden with proof that in 2004 the amount of
                                - 29 -

understatement exceeds the greater of $5,000 or 10 percent of the

tax required to be shown on the return.    Respondent also met his

burden of production with respect to negligence by establishing

that petitioners did not maintain required records or

substantiate deductions as required by the Code.

     Because respondent has met his burden of production,

petitioners must come forward with sufficient evidence to

persuade the Court that respondent’s determination is incorrect.

See Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001).

Petitioners did not do so.    Petitioners offered no credible

evidence to establish that they should not be liable for the

section 6662 penalty.    They failed to properly substantiate their

home mortgage interest deduction and work clothes expenses and

improperly claimed Schedule C deductions.

     The accuracy-related penalty is not imposed with respect to

any portion of the underpayment if the taxpayer can establish

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

6664(c)(1).   Petitioners bear the burden of producing evidence to

demonstrate reasonable cause under section 6664(c)(1).     We

determine reasonable cause and good faith on a case-by-case

basis, taking into account all pertinent facts and circumstances.

Sec. 1.6664-4(b)(1), Income Tax Regs.    The most important factor

is the extent of the taxpayer’s effort to assess his proper tax

liability.    Id.   The record does not establish that petitioners
                               - 30 -

had reasonable cause and acted in good faith.14   Therefore, we

sustain respondent’s determination to impose the 6662(a)

accuracy-related penalty for 2003 and 2004.

     We have considered all of the arguments raised by either

party, and to the extent not discussed, we find them to be

irrelevant or without merit.

     To reflect the foregoing,


                                     Decision will be entered under

                                 Rule 155.




     14
      A taxpayer’s reasonable reliance on the advice of an
independent professional adviser as to the tax treatment of an
item may demonstrate reasonable cause. Petitioners introduced no
evidence to support a finding that Ms. Boyer was a competent tax
professional. They also introduced no evidence that they
provided all information to Ms. Boyer or that they actually
relied in good faith on Ms. Boyer’s return preparation.
Neonatology Associates, P.A. v. Commissioner, 115 T.C. 43, 99
(2000), affd. 299 F.3d 221 (3d Cir. 2002).
