                         T.C. Memo. 2011-17



                       UNITED STATES TAX COURT



         DANIEL D. AND DOROTHY HULTQUIST, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 12125-08.               Filed January 24, 2011.



     Maris Baltins, for petitioners.

     Catherine L. Campbell and Lisa M. Oshiro, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     VASQUEZ, Judge:    Respondent determined a $14,961 deficiency

in petitioners’ 2002 Federal income tax and a $3,740 addition to

tax under section 6651(a)(1).1




     1
        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.
                               - 2 -

     The issues for decision are whether petitioners are:   (1)

Entitled to reduce their gross receipts reported on Schedule C,

Profit or Loss From Business, by cost of goods sold of $32,4502

or, alternatively, deduct the amount as a bad debt under section

166(a); and (2) liable for a $3,740 addition to tax under section

6651(a)(1) for failure to timely file their 2002 Federal income

tax return.3

                          FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulations of facts and the attached exhibits are

incorporated herein by this reference.   Petitioners resided in

Washington State when their petition was filed.

     Daniel Hultquist (petitioner) is a college graduate who

worked for a Christian mission organization in remote parts of

the world for 12 years.   Upon returning to the United States in


     2
        Petitioners reported cost of goods sold of $45,144 on
their 2002 Schedule C. Respondent determined that petitioners
were entitled to cost of goods sold of only $7,000. Although
respondent disallowed $38,144 of petitioners’ reported cost of
goods sold, petitioners introduced evidence only as to why they
are entitled to cost of goods sold of $32,450. Because
petitioners did not introduce evidence as to the remaining
disallowed amount, $5,694, we treat petitioners as conceding this
amount.
     3
        We decline to address the merits of petitioners’
alternative argument that they are entitled to a deduction for
research or experimental expenditures under sec. 174(a)(1)
because it was raised for the first time on brief. See Rule
34(b)(4); Messer v. Commissioner, 52 T.C. 440, 455 (1969), affd.
438 F.2d 774 (3d Cir. 1971); Solaas v. Commissioner, T.C. Memo.
1998-25 n.2.
                                - 3 -

or around 1991 petitioner established Hultquist Construction, a

home construction business that he continues to operate.4

     In early 1999 petitioner met Franklin Duncan (Mr. Duncan),

who rented a house petitioner owned.      Mr. Duncan showed

petitioner a prototype of a tool that he had designed to make it

easier to remove fishhooks and flies (i.e., artificial flies used

as bait in fly-fishing) from fish.      Mr. Duncan was extremely

confident about the commercial prospects for this device, which

he would eventually patent as the “Duncan DeHook’r” (DeHook’r).

He told petitioner that he hoped to make a “million bucks within

one to two years” but that he lacked the necessary capital to

bring the product to market.    He then asked petitioner to help

him get the business started.

     Later in the year petitioner and Mr. Duncan informally

agreed to go into business together.      Mr. Duncan agreed to focus

on the design and production of the DeHook’r in exchange for

petitioner’s commitment to finance the project on an “as needed”

basis.   According to petitioner this meant that instead of giving

Mr. Duncan a lump sum of capital he agreed to pay any expenses

incurred.5


     4
        Petitioner operates Hultquist Construction as a sole
proprietorship and reports its income and expenses on a Schedule
C.
     5
        Mr. Duncan later showed petitioner a knot tying tool for
hooks, flies, jigs, and lures that he patented as the “Duncan
                                                   (continued...)
                               - 4 -

     During the initial phase of the business petitioner and Mr.

Duncan never discussed how they would share the profits.     Instead

they focused on finalizing the product’s design and determining

whether there was significant demand for the DeHook’r.

     By the end of 1999 Mr. Duncan and petitioner had finalized

the design of the DeHook’r and hired a local manufacturer to

produce 500 of them.   They promoted the DeHook’r at various trade

shows and received overwhelmingly positive feedback.   The

following year they decided to move forward with large-scale

production of the DeHook’r.

     On January 21, 2000, in anticipation of moving forward with

the production and marketing of the DeHook’r and the TailKnott’r,

petitioner formed Maiden Ventures, L.L.C. (Maiden Ventures),6 a

single-member limited liability company through which the

DeHook’r and the TailKnott’r would be sold.   Petitioner continued

to pay expenses as they were incurred, and he gave Mr. Duncan

money upon request to use “for the benefit of the company”.7


     5
      (...continued)
TailKnott’r” (TailKnott’r). Petitioner financed the development
and production of the TailKnott’r as well as the DeHook’r.
     6
        Maiden Ventures is a disregarded entity for Federal
income tax purposes. See sec. 301.7701-3(b), Proced. & Admin.
Regs. Consequently, petitioners reported all of Maiden Ventures’
income and expenses on Schedules C and included Maiden Ventures’
profits or losses on their Federal income tax returns.
     7
        Petitioner’s testimony was not clear in this regard. He
did not explain why he gave Mr. Duncan funds directly (e.g.,
                                                   (continued...)
                                - 5 -

Petitioner hired an attorney to draft a licensing agreement that

would grant him the exclusive rights to sell, market, and

manufacture the DeHook’r.    However, petitioner produced only an

unsigned version of the agreement, and it is unclear whether it

was ever executed.

     Petitioner soon became troubled by inefficiencies in the

production process that, in his opinion, prevented Mr. Duncan and

him from earning a profit.   Since petitioner was the only one

infusing capital into the business, he felt that Mr. Duncan

lacked sufficient motivation to address the manufacturing issues.

In an effort to motivate Mr. Duncan and “t[ie] him in

financially”, petitioner claims that he and Mr. Duncan agreed to

treat all subsequent payments to Mr. Duncan as loans.

     From February 9, 2000, through July 12, 2001, petitioner

issued 28 checks to Mr. Duncan totaling $32,450.8    Petitioner

wrote the following descriptions on the checks:     (1) “Personal

loan” (13 checks); (2) “Loan” (6 checks); (3) “Loan from MV” (1



     7
      (...continued)
whether these were out-of-pocket expense reimbursements), nor is
it clear from the documents he introduced at trial. He
characterized these payments as “something that [Mr. Duncan]
requested and it was something that I gave him. How he used [the
funds] I’m assuming was for obviously the benefit of the company.
* * * It wasn’t just going towards his personal [expenses] * * *
whatever I gave him was for the business”.
     8
        Petitioner made out some of the checks to Mr. Duncan’s
wife as a matter of convenience when Mr. Duncan was unable to
cash or deposit the checks.
                                 - 6 -

check); and (4) “Loan to Duncan” (1 check).    Seven checks

contained no description.    It is unclear from the record what Mr.

Duncan did with these funds, but petitioner assumed that they

were used in some way to further the business.

     Petitioner did not prepare any loan documents, promissory

notes, or other agreements evidencing the loans.    There were no

repayment schedules, maturity dates, or interest rates.

Petitioner hoped Mr. Duncan would repay the $32,450 from his

share of future profits.

     Petitioner never earned enough money to turn a profit.    He

eventually stopped funding the project in late 2003 or early

2004, and Mr. Duncan decided to take his patents elsewhere.    Mr.

Duncan continues to market and sell the DeHook’r and the

Tailknott’r for a different company.

     Petitioner never attempted to recover any of the $32,450 he

gave to Mr. Duncan.    He explained that “getting funds from [Mr.

Duncan] would be like getting water in the desert because I knew

of his financial situation”.

     Petitioners filed their 2002 Federal income tax return late,

on June 10, 2004.9    They included with their return a Schedule C

that reported Maiden Ventures’ 2002 gross receipts as $43,800 and

cost of goods sold as $45,144.    In calculating Maiden Ventures’


     9
        Petitioners were granted an extension of time to file
their 2002 Federal income tax return and had until Oct. 15, 2003,
to timely file.
                               - 7 -

cost of goods sold petitioners reported opening and closing

inventories of zero and purchases made during the year of

$45,144.   Petitioners, on the advice of their accountant,

included the $32,450 that petitioner gave to Mr. Duncan in 2000

and 2001 as purchases made during the 2002 tax year.10

Respondent disallowed all but $7,000 of the cost of goods sold on

the grounds that petitioners failed to establish that they made

purchases during the year in excess of that amount.

                              OPINION

     Respondent’s determinations in the statutory notice of

deficiency are presumed to be correct, and petitioners bear the

burden of proving that respondent erred in his determinations.11

See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

I. Cost of Goods Sold

     A manufacturing or merchandising business calculates its

gross income by subtracting cost of goods sold from gross


     10
        Petitioner used Quickbooks to keep track of the
business’ finances. For the period ending Dec. 31, 2002, his
trial balance showed inventory of $35,067.79 and cost of goods
sold of $8,370.24. Petitioner included the $32,450 he gave to
Mr. Duncan in 2000 and 2001 in inventory.

     Petitioner showed the trial balance to his accountant,
Wesley L. Delaney (Mr. Delaney), who advised petitioner to
include the inventory total in cost of goods sold. Mr. Delaney
advised petitioner to do this because “[Maiden Ventures is] a
cash basis taxpayer, and a cash basis taxpayer is not going to
have inventory”.
     11
        Petitioners have neither claimed nor shown that they
satisfied the requirements of sec. 7491(a) to shift the burden of
proof to respondent.
                                - 8 -

receipts.    Sec. 1.61-3(a), Income Tax Regs.    Cost of goods sold

includes the cost of items acquired for resale and the costs of

producing items for resale.    Sec. 1.162-1(a), Income Tax Regs.

Though cost of goods sold is technically an adjustment to gross

income and not a deduction, substantiation of the amounts claimed

as cost of goods sold is required.      See Rodriguez v.

Commissioner, T.C. Memo. 2009-22.       Where taxpayers do not have

adequate records but the record indicates that they clearly

incurred an offset to gross income, we may estimate the offset on

the basis of the evidence.    Cohan v. Commissioner, 39 F.2d 540,

543-544 (2d Cir. 1930); Jackson v. Commissioner, T.C. Memo. 2008-

70.

      Petitioners argue that they are entitled to include the

amounts given to Mr. Duncan in 2000 and 2001 in their cost of

goods sold for 2002 because the payments were made in

anticipation of developing and marketing the DeHook’r and the

TailKnott’r and the related costs were incurred in 2002.

Respondent counters that petitioners are not entitled to include

any of the $32,450 in their 2002 cost of goods sold because

petitioners are cash basis taxpayers and therefore deduct

expenses in the year in which they are paid.      Respondent further

argues that petitioners have not shown that Mr. Duncan used any

of the payments to pay expenses that allow for a corresponding

deduction.
                               - 9 -

     Petitioners have introduced no evidence as to how Mr. Duncan

used the $32,450.   In fact, petitioner testified that he is not

sure how Mr. Duncan used the $32,450 although he assumes Mr.

Duncan used it to further Maiden Ventures’ business.     Petitioner

did not obtain an accounting from Mr. Duncan of how he used the

$32,450, and petitioners failed to introduce receipts or invoices

showing that any of the $32,450 went towards the manufacturing of

the DeHook’r or the TailKnott’r.12     Petitioners also failed to

call Mr. Duncan to testify as to how he spent the $32,450.     The

burden is on petitioners to show that the amount claimed as cost

of goods sold is accurate.   Petitioner’s assumption that Mr.

Duncan used the money to further Maiden Ventures’ business is

insufficient to substantiate the $32,450 as cost of goods sold.

     Additionally, we are unable to estimate an amount of cost of

goods sold under the Cohan rule.     For the Cohan rule to apply, a

basis must exist on which we can make an approximation.     Vanicek

v. Commissioner, 85 T.C. 731, 742-743 (1985).     Petitioners have

introduced no evidence that provides us with such a basis, e.g.,

the cost of manufacturing the DeHook’rs and the TailKnott’rs and

the number manufactured in 2002.




     12
        We also note that petitioner wrote “loan” on most of the
checks he issued to Mr. Duncan, including “personal loan” on 13
of the checks, and believe this to be contradictory to the
proposition that petitioner may treat the money as a cost of
goods sold.
                                - 10 -

      Accordingly, we shall sustain respondent’s downward

adjustment to the cost of goods sold.

II.   Section 166 Business Bad Debt Deduction

      Alternatively, petitioners argue that the payments to Mr.

Duncan were loans and that they are entitled to a bad debt

deduction under section 166(a).

      Section 166(a) provides as a general rule that a deduction

shall be allowed for any debt which becomes worthless within the

taxable year.   Only a “bona fide” debt can be deducted, however.

Sec. 1.166-1(c), Income Tax Regs.    A bona fide debt arises when a

debtor-creditor relationship is formed as a result of an

unconditional, valid, and enforceable obligation to pay a fixed

or determinable sum of money.     Boatner v. Commissioner, T.C.

Memo. 1997-379, affd. without published opinion 164 F.3d 629 (9th

Cir. 1998); sec. 1.166-1(c), Income Tax Regs.     The objective

indicia of a bona fide debt include a note or other evidence of

indebtedness and an interest charge.     See Clark v. Commissioner,

18 T.C. 780, 783 (1952), affd. 205 F.2d 353 (2d Cir. 1953).       Also

considered are the existence of security or collateral, the

demand for repayment, records that may reflect the transaction as

a loan, and the borrower’s solvency at the time of the loan.      See

Schenk v. Commissioner, T.C. Memo. 1996-113.

      Petitioners have not established the existence of a bona

fide debt.   Petitioner and Mr. Duncan never agreed to a repayment
                               - 11 -

schedule setting forth how often payments were to be made, nor

did they specify a maturity date for the loans.    Petitioner never

made any demands for repayment despite the fact that he was aware

that Mr. Duncan continued to sell the patented fishing

accessories with another company.

       We also believe that any repayment was conditional on the

future success of the business.    Petitioner stated that “we were

hoping that [Mr. Duncan] could be paying me back each year off of

the income that we were generating”.    We interpret petitioner’s

statement to mean that he expected to be repaid only if the

business became profitable, which undermines the unconditional

obligation requirement specified in the regulations.    See sec.

1.166-1(c), Income Tax Regs.    Moreover, at the time he advanced

the funds to Mr. Duncan, petitioner was aware that Mr. Duncan was

unemployed and had no source of income aside from any potential

profits earned from their business venture.

       Accordingly, we find that petitioners have not established

that they are entitled to a bad debt deduction under section

166(a), and respondent’s determination is sustained.

III.    Section 6651(a)(1) Addition to Tax

       Section 6651(a)(1) imposes an addition to tax for failure to

file a return on the date prescribed (determined with regard to

any extension of time for filing), unless the taxpayer can

establish that such failure is due to reasonable cause and not
                              - 12 -

willful neglect.   Respondent bears the burden of production with

regard to the addition to tax under section 6651(a)(1).   See sec.

7491(c).

     Petitioners’ 2002 tax return was due on October 15, 2003.

They filed their return on June 10, 2004.   Petitioners have

presented no evidence indicating that their failure to timely

file was due to reasonable cause or that respondent’s

determination is otherwise incorrect.   Accordingly, petitioners

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

     In reaching our holdings herein, we have considered all

arguments made by the parties, and to the extent not mentioned

above, we find them to be irrelevant or without merit.

     To reflect the foregoing,


                                         Decision will be entered

                                    for respondent.
