                               T.C. Memo. 2015-202



                         UNITED STATES TAX COURT



           JOSE ESPAILLAT AND MIRIAN LIZARDO, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 19095-12.                          Filed October 15, 2015.



      Marcy E. Golomb, for petitioners.

      Michael W. Lloyd, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      BUCH, Judge: Respondent issued notices of deficiency determining the

following deficiencies and penalties with respect to Mr. Espaillat and Ms.

Lizardo’s Federal income tax for the 2008 and 2009 taxable years:1


      1
       All section references are to the Internal Revenue Code as in effect for the
tax years in issue. All Rule references are to the Tax Court Rules of Practice and
                                                                       (continued...)
                                        -2-

                      [*2]                        Penalty
                      Year       Deficiency     sec. 6662(a)

                      2008        $56,254         $11,251
                      2009           4,164            833

Additionally, respondent allowed Mr. Espaillat and Ms. Lizardo a $3,000 capital

loss deduction for 2009. Most of the adjustments relate to a $359,000 loss

deduction claimed with respect to taxable year 2008 on a Schedule C, Profit or

Loss From Business, for Rocky Scrap Metal, Inc. (Rocky Scrap Metal), a scrap

metal business owned and operated by Mr. Espaillat’s brother, Leoncio Espaillat

(Leoncio). Among other adjustments, respondent disallowed that loss deduction

and determined accuracy-related penalties under section 6662(a) and (b)(1) and

(2).

       After concessions, the primary issues for decision are whether the $359,000

loss deduction should be disallowed for 2008 and whether Mr. Espaillat and Ms.

Lizardo are liable for accuracy-related penalties under section 6662(a) and (b)(1)

and (2). On the basis of the evidence presented at trial, we sustain respondent’s

disallowance of the loss deduction; however, Mr. Espaillat and Ms. Lizardo are



       1
      (...continued)
Procedure. All monetary amounts are rounded to the nearest dollar.
                                       -3-

[*3] not liable for accuracy-related penalties. At trial respondent moved to amend

the pleadings to conform to the evidence to disallow the $3,000 capital loss

deduction for 2009. We will grant respondent’s motion.

                              FINDINGS OF FACT

      Since 1998 Mr. Espaillat has owned a successful landscaping business aptly

named Dusty Landscaping, LLC, in Phoenix, Arizona, where he resides with his

wife, Ms. Lizardo.

      During the years in issue Mr. Espaillat was also involved with Rocky Scrap

Metal. Ms. Lizardo was a homemaker, but she also assisted with keeping records

and helping with Rocky Scrap Metal as needed.

      On each of their joint Federal income tax returns for 2008 and 2009, Mr.

Espaillat and Ms. Lizardo included a Schedule C for Dusty Landscaping and also a

second Schedule C. The Dusty Landscaping Schedule C for 2008 reflects a

successful landscaping and maintenance business that earned $209,355. The

second Schedule C for 2008 relates to a business named “Jose Espaillat”, which is

characterized as a “second hand metal dealer” and for which Mr. Espaillat and Ms.

Lizardo claimed a $359,000 loss deduction for 2008. The loss is reported as

“Other expenses” on line 27 of the Schedule C. All other lines on the “Jose

Espaillat” Schedule C are blank. This loss deduction more than offset the
                                        -4-

[*4] $209,355 in revenue from Dusty Landscaping. For 2009 Dusty Landscaping

earned $37,957 and the “Jose Espaillat” Schedule C business reported gross

receipts of $18,775 and zero expenses, resulting in a net profit of $18,775.

I.    Rocky Scrap Metal

      In 2006 Leoncio started Rocky Scrap Metal. The articles of incorporation

for Rocky Scrap Metal were filed with the secretary of state of Texas on

September 25, 2006. Rocky Scrap Metal is a C corporation in the metal recycling

or “scrap metal” industry. Rocky Scrap Metal filed Forms 1120, U.S. Corporation

Income Tax Return, for 2007, 2008, and 2009. Each return reports that “L.

Espaillat” owns 100% of the common corporate stock. No other shareholders are

listed. Mr. Espaillat has not asserted that he received any stock when Rocky Scrap

Metal was founded in 2006.

      Leoncio enlisted Mr. Espaillat to assist him in running the business and to

provide startup funds.

      From 2006 to 2013 Mr. Espaillat assisted Leoncio with Rocky Scrap Metal,

traveling to Texas regularly. Mr. Espaillat repaired property owned by Rocky

Scrap Metal and also assisted with financial management and overall operations.

Mr. Espaillat’s involvement with the business was based on an oral agreement. As

time progressed Mr. Espaillat became more involved in Rocky Scrap Metal,
                                        -5-

[*5] eventually traveling to Texas monthly and staying a week or more. In 2008

Mr. Espaillat purchased a home in Texas where he stayed during his frequent trips.

While in Texas, he ran Dusty Landscaping remotely with the help of his business

manager.

      Mr. Espaillat helped fund Rocky Scrap Metal. Because Leoncio needed

working capital and his bank was charging a high rate of interest, Mr. Espaillat

agreed to provide seed money. Mr. Espaillat provided the money to Leoncio but

did not charge interest; he simply asked to be paid back. He provided cash to fund

the business, and he also made direct purchases for Rocky Scrap Metal. During

2007 and 2008 Mr. Espaillat and Ms. Lizardo (and Dusty Landscaping)

contributed at least $285,000 to Leoncio and Rocky Scrap Metal. Mr. Espaillat’s

support of Rocky Scrap Metal also continued in 2009, during which he paid

Rocky Scrap Metal’s bankruptcy attorney.

      Because Mr. Espaillat could not always be in Texas, he enlisted his son,

Eduan, to work at Rocky Scrap Metal. Eduan worked at Rocky Scrap Metal from

August 2007 to July 2008 and again from fall 2011 to July 2012. Eduan assisted

with sorting through the scrap metal and preparing bids on behalf of Rocky Scrap

Metal. If a bid was successful, he was responsible for delivering the cash to the

seller. He also assisted with sales and finances because Leoncio did not have
                                         -6-

[*6] expertise in these areas. While working at Rocky Scrap Metal, Eduan

observed Leoncio’s business practices and questionable financial skills.

        Rocky Scrap Metal operated at least until 2013. In 2009 it filed for

bankruptcy protection. Rocky Scrap Metal issued Mr. Espaillat a Form 1099-

MISC, Miscellaneous Income, for 2010 reporting income of $72,000 and a Form

1099-MISC for 2011 reporting income of $58,000. In 2013 it was the subject of

litigation over its ownership.

II.     Bankruptcy

        The scrap metal market collapsed in 2008, and Rocky Scrap Metal’s

business suffered. Rocky Scrap Metal claimed a net operating loss deduction for

2008.

        Rocky Scrap Metal filed a petition for bankruptcy in 2009. Leoncio

retained bankruptcy counsel who was paid by Mr. Espaillat, and Leoncio signed

the bankruptcy petition on behalf of Rocky Scrap Metal as its president. Mr.

Espaillat was unfamiliar with bankruptcy, but he signed the bankruptcy plan at

Leoncio’s behest. That plan listed Mr. Espaillat as a creditor. An amended

Schedule F, Creditors Holding Unsecured Nonpriority Claims, filed on June 3,

2010, in the bankruptcy of Rocky Scrap Metal, listed Mr. Espaillat as having an

unsecured priority claim of $285,000 for “Money Loaned”.
                                        -7-

[*7] The bankruptcy plan provided that all unsecured general creditors would

receive 100% of the amounts owed to them. The creditors voted to approve the

plan on September 15, 2010; Mr. Espaillat voted in favor of the plan. On

September 16, 2010, the bankruptcy court confirmed the plan. The bankruptcy

court entered a final decree on March 10, 2011. Mr. Espaillat received a check for

$6,000 as a result of the bankruptcy plan.

III.   Mr. Espaillat’s Ownership of Rocky Scrap Metal

       On October 28, 2010, Mr. Espaillat entered into a stock purchase agreement

with Leoncio for ownership of Rocky Scrap Metal. The agreement provided that

Mr. Espaillat would receive 50% of the company in exchange for the $285,000 he

had previously extended plus $50,000 in cash. The agreement states: “Seller will

sell, transfer, and deliver to Buyer and Buyer will purchase, at the closing date,

* * * 50% of the outstanding issued stock of the Corporation.”

       In 2011 because of the management problems at Rocky Scrap Metal and

Mr. Espaillat’s need to work at Dusty Landscaping, Eduan and Ms. Lizardo moved

to Texas to work daily at Rocky Scrap Metal. Mr. Espaillat believed that he was a

co-owner of Rocky Scrap Metal, which is why his family moved to Texas to help

with the business operations.
                                        -8-

[*8] IV.       Rocky Scrap Metal Litigation

      Eventually the relationship between Mr. Espaillat and Leoncio deteriorated.

While this case has been pending, a lawsuit was also pending regarding control of

Rocky Scrap Metal.2 On June 13, 2013, a judge entered a temporary restraining

order barring Mr. Espaillat, Ms. Lizardo, and Eduan from managing or controlling

the business bank accounts, records, or the business operations of Rocky Scrap

Metal. Mr. Espaillat’s, Ms. Lizardo’s, and Eduan’s involvement in Rocky Scrap

Metal ended in June 2013.

V.    Tax Return and Audit

      Mr. Espaillat and Ms. Lizardo kept the business records for Dusty

Landscaping and their other financial affairs. For many years they employed

Timothy Golomb, a certified public accountant (C.P.A.) with over 30 years of

experience to prepare their returns. He prepared their jointly filed 2008 and 2009

tax returns.

      Before filing their returns, Mr. Espaillat and Ms. Lizardo filled out a

questionnaire that Mr. Golomb used, and they supplied complete and accurate

information for all of the relevant issues. Before preparing the returns, Mr.


      2
       Rocky Scrap Metal, Inc. v. Espaillat, No. 2013-25865 (Dist. Ct. Harris
Cty., Tex., 189th Jud. Dist.).
                                       -9-

[*9] Golomb discussed with Mr. Espaillat and Ms. Lizardo the transfers they made

to Rocky Scrap Metal and the other expenditures they made on its behalf. After

these discussions Mr. Golomb recommended that a Schedule C was “the best place

to put it.” They followed his advice and took this position when reporting their

expenses associated with Rocky Scrap Metal on their 2008 return.

      On May 7, 2012, the Internal Revenue Service (IRS) issued a notice of

deficiency to Mr. Espaillat and Ms. Lizardo concerning their 2008 and 2009

returns. The notice of deficiency made adjustments to the Schedules C filed with

those returns. In particular, it disallowed the claimed $359,000 “other expenses”

deduction on the 2008 return. Additionally for 2008, the IRS disallowed a

$16,070 deduction for repairs and maintenance, a $9,430 deduction for mortgage

interest, and $10,108 in itemized deductions. The IRS increased gross receipts

and sales by $13,537 and decreased costs of goods sold by $8,485. In sum, the

IRS made an adjustment of $369,907 for 2008 for a total corrected tax liability of

$37,181 (not including self-employment tax). Mr. Espaillat and Ms. Lizardo’s

2009 income tax return included a Schedule C for a scrap metal business with

$18,775 of gross receipts and zero expenses. For 2009 the IRS again disallowed

deductions for repairs and maintenance of $14,059 and mortgage interest of

$15,414. The IRS determined a $285,000 short-term loss for 2009 relating to the
                                        - 10 -

[*10] bankruptcy of Rocky Scrap Metal, of which $3,000 was allowed as a capital

loss deduction for 2009. Throughout the audit proceedings Mr. Espaillat and Ms.

Lizardo took the position that the funds were a loan to Leoncio.

      On July 30, 2012, while residing in Arizona, Mr. Espaillat and Ms. Lizardo

timely filed a petition with the Court. The petition states that “[t]he entire amount

of the deficiency and addition to tax is in dispute.” Mr. Espaillat and Ms. Lizardo

take particular issue with the disallowance of the $359,000 loss deduction for

2008. They assert that the loss is an ordinary and necessary business expense

related to a business called “Second Hand Metal” although at trial they took the

position that this amount should have been $285,000. The testimony and evidence

related mainly to the expenditures of and transfers to Rocky Scrap Metal; the only

allusion to any other scrap metal business was during the parties’ opening

statements and when they were specifically discussing how items were reported

for tax purposes.

      Respondent initially contended that Mr. Espaillat’s funds were capital

investments and thus the loss was a capital loss. At the conclusion of trial

respondent moved to amend the pleadings to conform to the evidence, seeking to

deny the $3,000 capital loss deduction that had been allowed in the notice of

deficiency for 2009.
                                        - 11 -

[*11] After trial Mr. Espaillat and Ms. Lizardo failed to address any of the other

Schedule C issues in their opening brief or their reply brief. Respondent detailed

these issues in his opening brief.

VI.   Motion To Conform the Pleadings to the Evidence

      At trial respondent moved to conform the pleadings to the evidence.

Specifically, respondent asserted that the allowance of a $3,000 capital loss

deduction in the notice of deficiency was unsupported by the evidence at trial and

was contrary to Mr. Espaillat and Ms. Lizardo’s trial position that their

contribution to a scrap metal business entitled them to a Schedule C loss

deduction.

      Respondent now argues that Rocky Scrap Metal is an ongoing C

corporation and that after 2009 Mr. Espaillat and Ms. Lizardo received things of

significant value (e.g., money evidenced by Forms 1099-MISC and stock

evidenced by the stock purchase agreement) from Rocky Scrap Metal. Moreover,

by filing tax returns after 2009 and by being involved in ongoing 2013 litigation

concerning who controlled it, Rocky Scrap Metal indicated that it was continuing

to operate. Thus, respondent argues that the evidence is inconsistent with his

treatment of Mr. Espaillat and Ms. Lizardo as creditors on the notice of deficiency
                                         - 12 -

[*12] and that it is also inconsistent with a determination that a bad debt deduction

is proper for 2009.

                                      OPINION

      The issues we must decide are whether Mr. Espaillat and Ms. Lizardo’s

claimed 2008 Schedule C loss deduction for the “Jose Espaillat” scrap metal

business should be adjusted and whether they are liable for accuracy-related

penalties under section 6662(a) and (b)(1) and (2). Additionally, we must decide

whether to grant respondent’s motion to amend the pleadings to conform to the

evidence regarding the $3,000 capital loss deduction for 2009. Other issues raised

in the notice of deficiency and not addressed in the stipulations or at trial are

deemed conceded.3




      3
        We deem Mr. Espaillat and Ms. Lizardo to have abandoned or conceded
adjustments made to their 2008 and 2009 Schedules C relating to Dusty
Landscaping, adjustments to their 2008 and 2009 self-employment tax,
adjustments to their 2008 and 2009 itemized deductions, and the adjustment to
their 2009 education credit because they did not raise these issues at trial or on
brief. See Nicklaus v. Commissioner, 117 T.C. 117, 120 n.4 (2001); Rybak v.
Commissioner, 91 T.C. 524, 566 n.19 (1988).
                                        - 13 -

[*13] I.       Burden of Proof

      Taxpayers generally bear the burden of proof when contesting the

determinations set forth in a notice of deficiency.4 If taxpayers introduce “credible

evidence with respect to any factual issue”, the burden of proof on that issue will

shift to the Commissioner if certain conditions are met.5 However, if the

Commissioner raises a new issue or seeks an increase in the deficiency, the

Commissioner bears the burden of proof as to the new issue or the increased

deficiency.6 Taxpayers bear the burden of proving the amounts of any claimed

deductions.7 Mr. Espaillat and Ms. Lizardo do not argue that the burden should

shift, and they have not met the requirements under section 7491(a) for shifting the

burden. Accordingly, the burden remains on them except for the issue of their

entitlement to the capital loss deduction for 2009, which respondent raised at trial.




      4
          See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
      5
          Sec. 7491(a)(1).
      6
          See Rule 142(a)(1).
      7
      INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); sec.
1.6001-1(a), Income Tax Regs.
                                         - 14 -

[*14] The Commissioner bears the burden of production with respect to any

penalty or addition to tax.8 Taxpayers then bear the burden of proving any

defenses.9

II.   Procedural Issue

      Generally, we deem issues raised and tried by the consent of the parties to

have been raised in the pleadings.10 In appropriate circumstances, an issue that

was not expressly pleaded but was tried by express or implied consent of the

parties may be treated as if raised in the pleadings.11 Whether a motion to conform

the pleadings should be allowed, however, is within the discretion of the Court.12

If the opposing party is unfairly surprised or prejudiced, then the motion should be

denied.13




      8
          Sec. 7491(c).
      9
          See Higbee v. Commissioner, 116 T.C. 438, 447 (2001).
      10
           Rule 41(b).
      11
        Rule 41(b)(1); LeFever v. Commissioner, 103 T.C. 525, 538-539 (1994),
aff’d, 100 F.3d 778 (10th Cir. 1996).
      12
           Commissioner v. Estate of Long, 304 F.2d 136, 144 (9th Cir. 1962).
      13
         Estate of Horvath v. Commissioner, 59 T.C. 551, 555 (1973); see also
Krist v. Commissioner, T.C. Memo. 2001-140; McGee v. Commissioner, T.C.
Memo. 2000-308.
                                        - 15 -

[*15] After a review of the entire record, we find that the factual issues giving rise

to respondent’s motion were raised during trial with the parties’ consent. The

evidence on which respondent bases his motion was admitted at trial by way of the

stipulation of facts. We do not find that granting respondent’s motion would

unfairly surprise or prejudice Mr. Espaillat and Ms. Lizardo. Accordingly, we will

grant respondent’s motion to conform the pleadings to the evidence and to assert

an increased deficiency.

III.   Business Expense or Loss Deduction

       Mr. Espaillat and Ms. Lizardo offer a muddled series of arguments that they

are entitled to deduct a loss from a scrap metal business. At times they seem to

argue that Mr. Espaillat made neither a loan nor an investment, but the record is

clear that he did not operate his own scrap metal business; he provided funds to

Leoncio and Rocky Scrap Metal. To the extent they argue that Mr. Espaillat

invested in Rocky Scrap Metal, they failed to prove that the investment became

worthless at any time during the years in issue. And at times they seem to argue

that Mr. Espaillat lent money to Leoncio and to Rocky Scrap Metal, but they failed

to establish worthlessness of any such loans. They argue that Mr. Espaillat and

Leoncio were in a de facto partnership, but the record is clear that Rocky Scrap
                                        - 16 -

[*16] Metal was an operating C corporation. In short, none of these muddled

theories are supported by either the law or the facts.

      A.       Business Expense Deduction

      Deductions are a matter of “legislative grace”, and “a taxpayer seeking a

deduction must be able to point to an applicable statute and show that he comes

within its terms.”14 As a general rule, section 162(a) authorizes a deduction for

“all the ordinary and necessary expenses paid or incurred during the taxable year

in carrying on any trade or business”. An expense is ordinary for purposes of this

section if it is normal or customary within a particular trade, business, or

industry.15 An expense is necessary if it is appropriate and helpful for the

development of the business.16 Implicit in the foregoing definitions is the concept

that a taxpayer must in fact be “carrying on” a trade or business for expenditures to

be deductible under section 162.

      Mr. Espaillat and Ms. Lizardo claimed a deduction of $359,000 as “other

expenses” on their 2008 return. Although they introduced business



      14
           See Rule 142(a); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440
(1934).
      15
           Deputy v. du Pont, 308 U.S. 488, 495 (1940).
      16
           Commissioner v. Heininger, 320 U.S. 467, 471 (1943).
                                         - 17 -

[*17] records into evidence, none of the evidence supports deductions for an

independent “Jose Espaillat” scrap metal business.

      There was no such business. The evidence solely related to the operations

of, funds provided to, and family dynamics concerning Rocky Scrap Metal, and as

a result Mr. Espaillat and Ms. Lizardo failed to meet their burden of proving

entitlement to deductions for expenses from a separate scrap metal business. The

record establishes that the only scrap metal business was that of Rocky Scrap

Metal. And it is well established that officers, employees, or shareholders may not

deduct the payment of corporate expenses on their individual returns.17 “Such

payments constitute either capital contributions or loans to the corporation and are

deductible, if at all, only by the corporation.”18

      B.     Individual Loss Deduction

      In their briefs Mr. Espaillat and Ms. Lizardo argue they are entitled to an

ordinary loss deduction under section 165. Section 165(a) permits a deduction for

uncompensated losses during a given tax year. As relevant to the present case,



      17
       Craft v. Commissioner, T.C. Memo. 2005-197 (citing Deputy v. du Pont,
308 U.S. at 494, Noland v. Commissioner, 269 F.2d 108 (4th Cir. 1959), aff’g T.C.
Memo. 1958-60, and Rink v. Commissioner, 51 T.C. 746, 751 (1969)).
      18
        Gantner v. Commissioner, 91 T.C. 713, 725 (1988) (citing Deputy v. du
Pont, 308 U.S. at 494, and Rink v. Commissioner, 51 T.C. at 751).
                                           - 18 -

[*18] section 165(c) limits the deduction for an individual taxpayer to losses either

incurred in a trade or business or resulting from a transaction entered into for

profit.

          The evidence supports three plausible theories as to why Mr. Espaillat and

Ms. Lizardo might be entitled to a loss deduction. The first theory is that they are

entitled to a loss deduction from a Schedule C scrap metal business. Mr. Espaillat

and Ms. Lizardo argue that they are engaged in an independent trade or business

because of their involvement with Rocky Scrap Metal. However, as already

discussed, a taxpayer that devotes time and energy to the affairs of a corporation is

not engaged in his or her own trade or business but instead is furthering the

business of the corporation.19 Such a taxpayer is not permitted to deduct losses

attributable to a corporation on his or her Schedule C because they belong to the

corporation.20 Accordingly, Mr. Espaillat and Ms. Lizardo are not permitted a loss

deduction under section 165(c)(1).




          19
               Whipple v. Commissioner, 373 U.S. 193, 202 (1963).
          20
      Moline Props., Inc. v. Commissioner, 319 U.S. 436, 439 (1943); Charfoos
v. Commissioner, T.C. Memo. 1991-292.
                                        - 19 -

[*19] This leads us to the remaining theories: a worthless securities deduction for

a loss on their investment in Rocky Scrap Metal or a bad debt deduction for losses

on the loans to Rocky Scrap Metal. We take those in turn.

      C.       Worthless Securities

      Mr. Espaillat and Ms. Lizardo testified that they received an interest in

Rocky Scrap Metal for the transfers to Leoncio and Rocky Scrap Metal. If this

were the case, Mr. Espaillat and Ms. Lizardo would be entitled to a worthless

securities deduction under section 165(g) upon showing that their securities

became worthless. To show worthlessness, a taxpayer must demonstrate a “fixed

and identifiable event” demonstrating worthlessness.21 A deduction for a loss

from worthless securities is allowed only for the year that the loss is sustained.22

      Mr. Espaillat and Ms. Lizardo failed to demonstrate worthlessness for either

2008 or 2009. Mr. Espaillat testified to the scrap metal industry’s crashing in

2008, decreasing the value of Rocky Scrap Metal. However, we have previously

held that a mere decline in the value of stock does not indicate worthlessness when




      21
     Dittman v. Commissioner, 23 T.C. 789, 798 (1955); Dewey v.
Commissioner, T.C. Memo. 1993-645.
      22
           Austin Co. v. Commissioner, 71 T.C. 955, 969 (1979).
                                       - 20 -

[*20] the stock still has recognizable value.23 Therefore, without more, the stock

did not become worthless in 2008.

      It also did not become worthless in 2009. Rocky Scrap Metal filed for

bankruptcy in 2009; however, it continued to operate. The continuation of a

business after a taxpayer claims a worthless securities deduction indicates that the

deduction was premature.24 After 2009 Mr. Espaillat received stock and

nonemployee compensation from Rocky Scrap Metal; those facts indicate

continuing operations. Moreover, continuing operations are further indicated by a

lawsuit over Rocky Scrap Metal’s control that was commenced in 2013. Thus, if

the funds Mr. Espaillat provided to Rocky Scrap Metal were contributions relating

to an ownership interest, that interest did not become worthless in 2009 because

Rocky Scrap Metal continued to operate at least into 2013.

      Mr. Espaillat and Ms. Lizardo are not entitled to a worthless securities loss

deduction under section 165(g)(1) for 2008 or 2009.




      23
      Goran v. Commissioner, T.C. Memo. 1995-100; sec. 1.165-4(a), Income
Tax Regs.
      24
           Goran v. Commissioner, T.C. Memo. 1995-100.
                                        - 21 -

[*21] D.       Bad Debt Deduction

      The other plausible theory is that Mr. Espaillat and Ms. Lizardo are entitled

to a bad debt deduction under section 166. Much of the evidence supports the

notion that Mr. Espaillat’s transfers to Rocky Scrap Metal or Leoncio were loans.

Nonetheless, even a bona fide loan to Rocky Scrap Metal would not entitle Mr.

Espaillat and Ms. Lizardo to a deduction.

      Section 166 allows taxpayers to deduct any debt that becomes worthless

within the taxable year.25 To be entitled to a deduction, the taxpayer must show a

bona fide debt based on a debtor-creditor relationship.26

      Business debts and nonbusiness debts are treated differently under section

166.27 Nonbusiness debts are defined as debts other than “(A) a debt created or

acquired (as the case may be) in connection with a trade or business of the

taxpayer; or (B) a debt the loss from the worthlessness of which is incurred in the

taxpayer’s trade or business.”28 Whether a debt is a business or nonbusiness debt




      25
           Sec. 166(a)(1).
      26
           Sec. 1.166-1(c), Income Tax Regs.
      27
           Cooper v. Commissioner, 143 T.C. 194, 216 (2014).
      28
           Sec. 166(d)(2).
                                           - 22 -

[*22] is a question of fact,29 and for a business debt taxpayers “must show that the

bad debt loss is ‘proximately related’ to the conduct of trade or business, or that

the debt was created in the course of trade or business.”30 Taxpayers must treat

nonbusiness bad debts as losses from the sale or exchange of a short-term capital

asset and can deduct the debt only for the year that the debt becomes wholly

worthless.31 However, business bad debts give rise to ordinary deductions that can

be offset against ordinary income.32 Under section 1212(b), a noncorporate

taxpayer is required to offset capital losses against capital gains for a particular

taxable year. If aggregate capital losses exceed aggregate capital gains for a

taxable year, up to $3,000 of the excess may be deducted against ordinary

income.33




        29
       Rollins v. Commissioner, 276 F.2d 368, 371 (4th Cir. 1960), aff’g 32 T.C.
604 (1959); sec. 1.166-5(b)(2), Income Tax Regs.
        30
             Litwin v. United States, 983 F.2d 997, 999 (10th Cir. 1993).
        31
             Secs. 166(d)(1)(B), 1211(b), 1212(b); sec. 1.166-5(a)(2), Income Tax
Regs.
        32
             Sec. 166(a).
        33
             Sec. 1211(b).
                                        - 23 -

[*23] As an initial matter, Mr. Espaillat and Ms. Lizardo do not argue and the

record does not support that they are in the business of lending. Accordingly, we

must focus on the rules for nonbusiness bad debts.

      In order to deduct a nonbusiness bad debt, a taxpayer must show that the

loan became wholly worthless.34 Section 166 allows only wholly worthless

nonbusiness debts to be deducted, and in order for a debt to be wholly worthless

its “last vestige of value” must be gone.35 Taxpayers “must show sufficient

objective facts from which worthlessness could be concluded; mere belief of

worthlessness is not sufficient.”36 If a debtor files a bankruptcy petition, the

bankruptcy can be an indication that at least part of an unsecured debt is

worthless; however, “[i]n bankruptcy cases a debt may become worthless before

settlement in some instances; and in others, only when a settlement in bankruptcy

has been reached.”37




      34
        Dustin v. Commissioner, 53 T.C. 491, 501 (1969), aff’d, 467 F.2d 47 (9th
Cir. 1972); sec. 1.166-5(a)(2), Income Tax Regs.
      35
        Bodzy v. Commissioner, 321 F.2d 331, 335 (5th Cir. 1963), aff’g in part,
rev’g in part T.C. Memo. 1962-40.
      36
           Fincher v. Commissioner, 105 T.C. 126, 138 (1995).
      37
           Sec. 1.166-2(c), Income Tax Regs.
                                       - 24 -

[*24] The Court’s determination of worthlessness is based on a facts and

circumstances test, and the taxpayer must show “identifiable events that form the

basis of reasonable grounds for abandoning any hope of recovery.”38 The

taxpayer’s determination that the debt became wholly worthless “must be made in

the exercise of sound business judgment, based upon as complete information as is

reasonably obtainable.”39 A taxpayer’s subjective opinion of worthlessness,

standing alone, is not enough.40

      Mr. Espaillat and Ms. Lizardo initially took the position that the $285,000

contribution to Rocky Scrap Metal constituted a loan to Leoncio although they

treated Leoncio and Rocky Scrap Metal as interchangeable. Mr. Espaillat and Ms.

Lizardo presented documentation of Rocky Scrap Metal’s 2009 bankruptcy filing

to show worthlessness. In making the determination to allow a deduction for

2009, respondent assumed that Rocky Scrap Metal was defunct and that the

purported loan was worthless as a result of the 2009 bankruptcy. Accordingly,



      38
       Aston v. Commissioner, 109 T.C. 400, 415 (1997); see also Fincher v.
Commissioner, 105 T.C. at 137-138; Dallmeyer v. Commissioner, 14 T.C. 1282,
1291-1292 (1950).
      39
           Andrew v. Commissioner, 54 T.C. 239, 248 (1970).
      40
         Fox v. Commissioner, 50 T.C. 813, 822 (1968) (“Mere belief that a debt is
bad is insufficient to support a deduction for worthlessness[.]”).
                                       - 25 -

[*25] respondent credited Mr. Espaillat and Ms. Lizardo with a $3,000 capital loss

deduction for 2009 on the theory that it was bad debt. But the record indicates that

Rocky Scrap Metal was an operating business after the 2009 bankruptcy--Mr.

Espaillat and Ms. Lizardo received income from Rocky Scrap Metal in 2010 and

2011. Furthermore, a lawsuit over its control commenced in 2013.

      Regardless of whether the funds constituted a loan, the debt was not

worthless in 2009 because Rocky Scrap Metal continued to be an operating entity.

Accordingly, a bad debt deduction is not allowed because the loan did not become

worthless at that time.

      E.     De Facto Partnership

      Mr. Espaillat and Ms. Lizardo argue that the deductions were allowable

because Rocky Scrap Metal was not a corporation but instead was a de facto

partnership. This argument is without merit; the record is clear that Rocky Scrap

Metal was a corporation. Rocky Scrap Metal conducted a legitimate, even if not

always profitable, scrap metal business with a physical location in Texas. Rocky

Scrap Metal was incorporated in 2006 with the secretary of state of Texas and

filed Forms 1120 for 2007, 2008, and 2009.

      Under Moline Props., Inc., we do not disregard a corporation for Federal tax

purposes if it served an intended business function or purpose or engaged in
                                        - 26 -

[*26] business.41 The degree of corporate business purpose or the quantum of

business activity required for recognition of the separate existence of a corporation

is rather minimal.42 Rocky Scrap Metal easily overcomes this hurdle. We will not

disregard its form.

IV.   Penalties

      Section 6662(a) and (b)(1) and (2) imposes a 20% accuracy-related penalty

on any portion of an underpayment of tax required to be shown on a return if the

underpayment is due to, among other reasons, negligence, disregard of rules or

regulations, or any substantial understatement of income tax. An understatement

of income tax is “substantial” if the understatement exceeds the greater of 10% of

the tax required to be shown on the return or $5,000.43 Respondent asserts these

penalties in the alternative.




      41
           Moline Props., Inc. v. Commissioner, 319 U.S. at 438-439.
      42
       Hosp. Corp. of Am. v. Commissioner, 81 T.C. 520, 579-580 (1983);
Strong v. Commissioner, 66 T.C. 12, 24 (1976), aff’d without published opinion,
553 F.2d 94 (2d Cir. 1977); Nat Harrison Assocs., Inc. v. Commissioner, 42 T.C.
601, 618 (1964).
      43
           Sec. 6662(d).
                                        - 27 -

[*27] These penalties do not apply to any portion of an underpayment for which a

taxpayer establishes that he had reasonable cause and acted in good faith.44 The

Court must consider all facts and circumstances in determining whether the

taxpayer acted with reasonable cause and in good faith.45 To establish good-faith

reliance on an adviser, the taxpayer must prove that (i) the taxpayer gave the return

preparer complete and accurate information, (ii) an incorrect return was the

preparer’s fault, and (iii) the taxpayer believed in good faith that he was relying on

a competent return preparer’s advice as to the tax treatment.46

      Mr. Espaillat and Ms. Lizardo run a landscaping business in Arizona.

Although the landscaping business is successful, Mr. Espaillat’s expertise is in

running a labor-intensive company. He is familiar with running a business and

keeping records but has limited knowledge of the tax code. In sum, Mr. Espaillat

is an experienced small business owner but not a sophisticated taxpayer.




      44
           Sec. 6664(c)(1).
      45
      Higbee v. Commissioner, 116 T.C. at 448; sec. 1.6664-4(b)(1), Income
Tax Regs.
      46
       Estate of Goldman v. Commissioner, 112 T.C. 317, 324 (1999) (citing
Metra Chem Corp. v. Commissioner, 88 T.C. 654, 662 (1987)), aff’d without
published opinion sub nom. Schutter v. Commissioner, 242 F.3d 390 (10th Cir.
2000).
                                        - 28 -

[*28] For the years in issue Mr. Espaillat and Ms. Lizardo enlisted Mr. Golomb,

their C.P.A. of over a decade, to prepare their returns. Mr. Golomb had Mr.

Espaillat and Ms. Lizardo each fill out a questionnaire before preparing their

return for each year. He testified that Mr. Espaillat and Ms. Lizardo provided all

the requisite information and were otherwise thorough in completing the

questionnaires. Mr. Golomb credibly testified that he held a conversation

discussing the facts of the situation with Mr. Espaillat and Ms. Lizardo about the

different places to report their loss on the returns and that he thought a Schedule C

was “the best place to put it.”

      While the facts at hand do not lend themselves to such a position, Mr.

Espaillat and Ms. Lizardo relied on Mr. Golomb in good faith. Mr. Espaillat and

Ms. Lizardo have retained Mr. Golomb for at least 10 years without incident. Mr.

Golomb is a C.P.A. with over 30 years of experience. Moreover, because Mr.

Espaillat and Ms. Lizardo had always used a Schedule C in relation to Dusty

Landscaping, they had every reason to believe that a Schedule C was the

appropriate place to report their financial dealings with Rocky Scrap Metal. While

Mr. Espaillat and Ms. Lizardo’s trust in Mr. Golomb was misplaced, they believed

in good faith that he was accurately and correctly preparing their returns.
                                        - 29 -

[*29] In sum, Mr. Espaillat and Ms. Lizardo provided sufficient evidence and

testimony that they acted with reasonable cause and in good faith within the

meaning of section 6664(c) in relying on their C.P.A. with respect to the

disallowed deductions. Accordingly, they are not liable for accuracy-related

penalties for 2008 and 2009.

V.    Conclusion

      Mr. Espaillat and Ms. Lizardo have failed to meet their burden of proving

that they are entitled to all or part of their claimed loss deductions for 2008 or

2009. We do not need to reach the question of whether the funds Mr. Espaillat

provided to Leoncio or Rocky Scrap Metal were loans or contributions to capital

because each of these alternatives would result in the disallowance of the claimed

Schedule C loss deductions for the years before us. Respondent’s motion to

conform the pleadings to the evidence for 2009 will be granted, and the capital

loss deduction for 2009 will be disallowed. Mr. Espaillat and Ms. Lizardo are not

liable for accuracy-related penalties for 2008 and 2009.

      To reflect the foregoing,


                                                 An appropriate order and decision

                                        will be entered under Rule 155.
