                             T.C. Memo. 2018-127



                        UNITED STATES TAX COURT



   MARTHA G. SMITH AND GEORGE S. LAKNER, ET AL.,1 Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent


      Docket Nos. 8847-12, 25714-12               Filed August 13, 2018.
                 12293-14.



      Edward J. Leyden, for petitioners.

      Rachel L. Rollins and Jeffrey E. Gold, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      LAUBER, Judge: With respect to petitioners’ Federal income tax for

2007-2011, the Internal Revenue Service (IRS or respondent) determined



      1
       Cases of the following petitioners are consolidated herewith: Martha G.
Smith and George S. Lakner, docket No. 25714-12; and George S. Lakner and
Martha G. Smith, docket No. 12293-14.
                                          -2-

[*2] deficiencies in tax, additions to tax under section 6651(a)(1), and penalties

under sections 6662(a) and 6663(a),2 as follows:

                                    Addition to tax           Penalties
                Year   Deficiency   sec. 6651(a)(1)   Sec. 6662(a) Sec. 6663(a)

                2007    $27,339          $5,621          $5,468         -0-
                2008    106,999          25,472            -0-        $80,249
                2009     16,148           2,836           3,230         -0-
                2010    313,914          15,448            -0-        235,210
                2011    163,468          17,762            -0-        122,601

      After various concessions (discussed below), the issues for decision are

whether petitioners for various years: (1) received unreported income; (2) are

entitled to deductions claimed on Schedules A, Itemized Deductions, in amounts

greater than respondent has allowed; (3) are entitled to deductions claimed on

Schedules C, Profit or Loss From Business, in amounts greater than respondent

has allowed; (4) are entitled to losses claimed on Schedules E, Supplemental

Income and Loss; (5) are entitled to deductions for net operating losses (NOLs);

(6) are liable for late-filing additions to tax under section 6651(a)(1); and (7) are




      2
        All statutory references are to the Internal Revenue Code (Code) in effect
for the years at issue, and all Rule references are to the Tax Court Rules of Prac-
tice and Procedure. We round all monetary amounts to the nearest dollar.
                                        -3-

[*3] liable for accuracy-related penalties.3 With minor exceptions, we will sustain

respondent’s determinations.

                               FINDINGS OF FACT

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

fact and the attached exhibits are incorporated by this reference. Petitioners, who

are husband and wife, resided in Washington, D.C., when they filed their petitions.

A.     Background

       Petitioner George S. Lakner is a distinguished doctor and psychiatrist. He

has held teaching positions at Columbia University, Harvard University, and

George Washington University. Before he began teaching, he had a long career in

the U.S. Army, during which he was stationed at various military installations in

the United States and overseas. He has worked with the National Guard, the Vet-

erans Administration (VA), and the National Institutes of Health, all in his capa-

city as a psychiatrist.

       Dr. Lakner joined the Army in 1976 and rose through the ranks to become a

colonel. From 1999 to 2001 he was employed by the VA Medical Center in Loma

Linda, California. During that employment he raised concerns with his superiors

       3
       In the notice of deficiency for 2008, 2010, and 2011, the IRS asserted, as
alternatives to the fraud penalties, accuracy-related penalties under section
6662(a).
                                         -4-

[*4] that veterans with mental health problems were receiving inadequate care. In

November 2001 the VA terminated his employment.

      In January 2002 Dr. Lakner filed a Complaint of Employment Discrimina-

tion with the Equal Employment Opportunity Commission (EEOC), and the fol-

lowing month he filed an amended EEOC complaint. In both complaints he al-

leged that he had been the victim of discrimination on the basis of religion, nation-

al origin, age, and/or disability. In the alternative he alleged that he had been fired

as a reprisal for protected activity in which he had engaged. The record is unclear

as to the status of his complaint between 2002 and 2010.

      After leaving the VA, Dr. Lakner was deployed to Bosnia, where he was

severely injured by a roadside bomb in 2003. While recovering from his wounds

he was deployed to Kosovo. He alleges that in Kosovo he was confined for sever-

al months in military installations because the Army believed that the VA’s termi-

nation of his employment rendered his continued military service unlawful.

      After returning to the United States Dr. Lakner went on inactive status in

2006 and retired from the Army in 2008. Around that time he started a medical

consulting practice that he operated during the years at issue. The record is un-

clear as to the exact nature of his consulting practice.
                                        -5-

[*5] In January 2010 the EEOC held a hearing on Dr. Lakner’s complaints. Dur-

ing this hearing his attorney represented that the sole issue for adjudication was

whether Dr. Lakner’s employment had been unlawfully terminated by the VA. Dr.

Lakner testified that he had filed his complaint because he believed the VA had

discriminated against him for being Jewish. The hearing transcript contains no

reference to any physical sickness or injury suffered by Dr. Lakner.

      In January 2010 Dr. Lakner reached a settlement with the VA. Under this

settlement he received a lump-sum payment of $328,000, representing pecuniary

and nonpecuniary damages; $172,000 for attorneys’ fees; and $178,552 for ac-

crued annual leave. The VA reported the latter amount to him on a Form W-2,

Wage and Tax Statement.

      Petitioner Martha G. Smith was a licensed property manager during 2007-

2011. She was employed by Realtor Cathie Gill, Inc., where she supervised the

firm’s property management services. She also worked as an independent proper-

ty manager. During some or all of these years petitioners owned, jointly or indi-

vidually, as many as six rental properties: four in Washington, D.C., one in Cali-

fornia, and one in Connecticut. Ms. Smith managed these rental properties.
                                           -6-

[*6] B.      Petitioners’ Tax Returns

      Petitioners jointly filed a delinquent Form 1040, U.S. Individual Income

Tax Return, for each year at issue. They included in each return a Schedule C. On

each Schedule C they reported income and expenses for Dr. Lakner’s medical

consulting business and Ms. Smith’s rental real estate activity, without identifying

which items related to which business.

      1.     2007 Return

      For 2007 petitioners reported negative adjusted gross income (AGI) of

$67,106. On their Schedule C they reported gross receipts of $58,400 and total

expenses of $130,213, for a net loss of $71,813. The reported expenses were as

follows:

                           Item                    Amount

                   Commissions/fees                 $2,247
                   Insurance (other than health)     9,001
                   Legal/professional services      31,369
                   Office supplies                     862
                   Travel                            2,389
                   Meals/entertainment               1,035
                   Utilities                         4,441
                   Other                            78,869
                    Total                          130,213

      For 2007 petitioners claimed on Schedule A the following deductions:

medical expenses of $4,023, State and local taxes of $22,731, and home mortgage

interest of $31,011. They also claimed an NOL deduction of $85,258.
                                           -7-

[*7] 2.     2008 Return

      For 2008 petitioners reported negative AGI of $136,685. On their Sched-

ule C they reported gross receipts of $77,200 and total expenses of $191,350, for a

net loss of $114,150. The reported expenses were as follows:

                           Item                    Amount

                   Commissions/fees                 $4,162
                   Insurance (other than health)     9,900
                   Legal/professional services      43,362
                   Office supplies                   1,247
                   Travel                            2,257
                   Meals/entertainment                 864
                   Utilities                         4,762
                   Other                           124,796
                    Total                          191,350

      For 2008 petitioners claimed on Schedule A the following deductions:

medical expenses of $5,720, State and local taxes of $34,210, and home mortgage

interest of $58,246. They also claimed an NOL deduction of $99,383.

      3.    2009 Return

      For 2009 petitioners reported negative AGI of $193,471. On their Sched-

ule C they reported gross receipts of $66,617 and total expenses of $176,121, for a

net loss of $109,504. The reported expenses were as follows:

                          Item                     Amount

                   Commissions/fees                 $2,911
                   Insurance (other than health)    12,026
                   Legal/professional services      40,561
                                           -8-

[*8]               Office supplies                   1,440
                   Travel                            1,999
                   Meals/entertainment                 845
                   Utilities                         4,021
                   Other                           112,318
                    Total                          176,121

       For 2009 petitioners claimed on Schedule A the following deductions:

medical expenses of $5,703, State and local taxes of $27,136, and home mortgage

interest of $35,181. They also claimed an NOL deduction of $162,030.

       4.    2010 Return

       For 2010 petitioners reported negative AGI of $226,693. On their Sched-

ule C they reported gross receipts of $83,350 and total expenses of $166,544, for a

net loss of $83,194. The reported expenses were as follows:

                           Item                    Amount

                   Insurance (other than health)    $7,902
                   Legal/professional services         637
                   Office supplies                   2,640
                   Travel                            1,324
                   Meals/entertainment                 597
                   Utilities                         3,753
                   Other                           149,691
                    Total                          166,544

       For 2010 petitioners claimed on Schedule A the following deductions:

medical expenses of $4,187, State and local taxes of $23,504, home mortgage in-

terest of $39,144, and unreimbursed employee expenses of $700. They also

claimed an NOL deduction of $219,855.
                                           -9-

[*9] 5.      2011 Return

      For 2011 petitioners reported negative AGI of $81,344. On their Schedule

C they reported gross receipts of $20,748 and total expenses of $103,554, for a net

loss of $82,806. The reported expenses were as follows:

                           Item                    Amount

                   Commissions/fees                 $1,900
                   Insurance (other than health)     1,763
                   Office supplies                   4,101
                   Meals/entertainment               1,593
                   Other                            94,197
                    Total                          103,554

      For 2011 petitioners claimed on Schedule A the following deductions:

medical expenses of $4,397, State and local taxes of $37,803, and home mortgage

interest of $8,514. They claimed an NOL deduction of $250,773 and reported on

Schedule E a real estate net loss of $25,000.

      6.     IRS Examination

      The IRS selected petitioners’ 2007-2011 returns for examination. On the

basis of a bank deposits analysis the IRS determined that petitioners had omitted

rental income from all of their rental properties for 2008 and 2010; had omitted

gross receipts from Dr. Lakner’s medical consulting business for 2008 and 2010;

and had omitted a taxable settlement payment from the VA for 2010. The IRS did
                                         - 10 -

[*10] not perform a bank deposits analysis for the other years but determined that

petitioners had omitted specific items of gross income for 2007, 2009, and 2011.

      The IRS disallowed for lack of substantiation some of the deductions

claimed on petitioners’ Schedules A and all of the deductions claimed on their

Schedules C. After making various computational adjustments that are not at

issue here,4 the IRS determined the deficiencies set forth supra p. 2. The IRS also

determined late-filing additions to tax for all five years; accuracy-related penalties

for 2007 and 2009; fraud penalties for 2008, 2010, and 2011; and accuracy-related

penalties as alternatives to the fraud penalties for the latter three years.

      The IRS issued petitioners three timely notices of deficiency--one for 2007,

one for 2009, and the third for 2008, 2010, and 2011--setting forth the deficien-

cies, additions to tax, and penalties noted above. Petitioners timely petitioned this

Court for redetermination. We consolidated the three cases for purposes of trial,

briefing, and opinion. The cases were partially tried in September 2013, and a

further trial was held in December 2016.




      4
       The IRS made computational adjustments to the taxable portions of peti-
tioners’ Social Security income for all years, itemized deductions for 2008-2011,
and personal exemptions for 2008. We leave these adjustments to the parties’
Rule 155 computations.
                                       - 11 -

[*11]                                OPINION

I.      Burden of Proof

        The IRS’ determinations in a notice of deficiency are generally presumed

correct, and taxpayers bear the burden of proving them erroneous. Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933). For the presumption of correctness

to attach to a deficiency determination of unreported income, the Commissioner

must generally establish a “minimal evidentiary showing” connecting the taxpayer

with the income-producing activity, see Blohm v. Commissioner, 994 F.2d 1542,

1548-1549 (11th Cir. 1993), aff’g T.C. Memo. 1991-636, or demonstrate that the

taxpayer actually received unreported income, see Edwards v. Commissioner, 680

F.2d 1268, 1270 (9th Cir. 1982). Once the Commissioner makes the required

threshold showing, the burden of proof shifts to the taxpayer to prove by a prepon-

derance of the evidence that the Commissioner’s determinations are arbitrary or

erroneous. Helvering v. Taylor, 293 U.S. 507, 515 (1935); Tokarski v. Commis-

sioner, 87 T.C. 74 (1986).

        To satisfy his burden of production regarding unreported income for 2008

and 2010, respondent introduced bank records obtained during the IRS audit.

These records establish that petitioners received unreported income from Dr. Lak-

ner’s medical consulting business and from Ms. Smith’s rental real estate activity.
                                        - 12 -

[*12] And they establish that Dr. Lakner in 2010 received from the VA a check for

$328,000. Respondent has therefore made whatever “minimal evidentiary show-

ing” he might be required to make. His determinations of unreported income are

thus entitled to the general presumption of correctness. See Powerstein v. Com-

missioner, T.C. Memo. 2011-271, 102 T.C.M. (CCH) 497, 506.

      Petitioners thus bear the burden of proving by a preponderance of the evi-

dence that respondent’s determinations of unreported income are arbitrary or er-

roneous. See Williams v. Commissioner, 999 F.2d 760, 763 (4th Cir. 1993) (citing

Helvering v. Taylor, 293 U.S. at 515), aff’g T.C. Memo. 1992-153; Tokarski, 87

T.C. at 77. Petitioners likewise bear the burden of proving their entitlement to

deductions allowed by the Code and of substantiating the amounts of claimed

deductions. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); sec.

1.6001-1(a), Income Tax Regs. Petitioners do not contend, and they could not

plausibly contend, that the burden of proof as to any issue of fact should shift to

respondent under section 7491(a).

II.   Unreported Income

      Section 61(a) defines gross income as “all income from whatever source

derived,” including income derived from business. Exclusions from gross income

are narrowly construed. Commissioner v. Schleier, 515 U.S. 323, 328 (1995);
                                       - 13 -

[*13] Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 429-430 (1955);

Helvering v. Clifford, 309 U.S. 331, 334 (1940). A taxpayer must maintain books

and records establishing the amount of his or her gross income. See sec. 6001.

      When a taxpayer does not keep accurate books and records, the IRS may de-

termine his or her income “under such method as, in the opinion of the Secretary,

does clearly reflect income.” Sec. 446(b); see Petzoldt v. Commissioner, 92 T.C.

661, 693 (1989). And where the taxpayer has unexplained bank deposits, the IRS

may employ the bank deposits method to estimate income. Estate of Hague v.

Commissioner, 132 F.2d 775 (2d Cir. 1943), aff’g 45 B.T.A. 104 (1941); Estate of

Mason v. Commissioner, 64 T.C. 651, 657 (1975), aff’d, 566 F.2d 2 (6th Cir.

1977). The IRS has great latitude in reconstructing a taxpayer’s income, and the

reconstruction “need only be reasonable in light of all surrounding facts and cir-

cumstances.” Petzoldt, 92 T.C. at 687.

      Bank deposits are prima facie evidence of income. The bank deposits meth-

od starts with the presumption that all money deposited into a taxpayer’s bank ac-

count during a given period constitutes taxable income. Price v. United States,

335 F.2d 671, 677 (5th Cir. 1964). This presumption is rebutted to the extent the

deposits are shown to include nontaxable amounts, and “the Government must

take into account any non-taxable source * * * of which it has knowledge.” Ibid.;
                                        - 14 -

[*14] DiLeo v. Commissioner, 96 T.C. 858, 868 (1991), aff’d, 959 F.2d 16 (2d

Cir. 1992).

      After the IRS reconstructs a taxpayer’s income and determines a deficiency,

the taxpayer bears the burden of proving that the IRS’ implementation of the bank

deposits method was unfair or inaccurate. See Clayton v. Commissioner, 102 T.C.

632, 645-646 (1994); DiLeo, 96 T.C. at 871-872. The taxpayer may do so by

showing (among other things) that certain deposits came from nontaxable sources.

See Clayton, 102 T.C. at 645. Nontaxable sources include funds attributable to

interaccount bank transfers and returned checks as well as “loans, gifts, inherit-

ances, or assets on hand at the beginning of the taxable period.” Burgo v. Com-

missioner, 69 T.C. 729, 743 n.14 (1978) (quoting Troncelliti v. Commissioner,

T.C. Memo. 1971-72).

      A.      Unreported Income for 2008 and 2010

      Finding that petitioners lacked adequate books and records for 2008 and

2010, the revenue agent (RA) employed the bank deposits method to reconstruct

their income for those years. After obtaining petitioners’ bank statements by is-

suing summonses to their banks, the RA used the statements (which are part of the

record) to prepare schedules listing all deposits. After eliminating nontaxable re-

ceipts of which he was aware, and further reducing the total bank deposits by the
                                        - 15 -

[*15] income petitioners reported on their returns, the RA prepared and provided

to petitioners schedules that determined unreported income. The RA determined

that this unreported income was attributable to Dr. Lakner’s medical consulting

business, Ms. Smith’s rental real estate activity, the VA settlement payment, and a

separate litigation settlement of an insurance claim.

      Petitioners do not challenge the RA’s use of the bank deposits method or his

determination that their consulting and rental income was taxable. Rather, they

contend that he misapplied the bank deposits method by: (1) failing to exclude the

VA settlement payment, (2) failing to exclude other allegedly nontaxable amounts,

and (3) mischaracterizing certain receipts as rental income.

             1.    VA Settlement Payment

      Petitioners assert that at least part of the VA settlement payment they re-

ceived in 2010 was nontaxable because it represented damages for the physical in-

jury Dr. Lakner sustained in Bosnia in 2003. Proceeds from litigation settlements

constitute gross income unless the taxpayer proves that the proceeds fall within a

specific statutory exclusion. Schleier, 515 U.S. at 328-337; Save v. Commission-

er, T.C. Memo. 2009-209, 98 T.C.M. (CCH) 218, 218. The exclusion from gross

income upon which petitioners rely appears in section 104(a)(2). It provides that

gross income does not include damages received “on account of personal physical
                                       - 16 -

[*16] injuries or physical sickness.” For this purpose, “emotional distress shall

not be treated as a physical injury or physical sickness.” Sec. 104(a) (penultimate

sentence).

      When damages are received under a settlement agreement, the nature of the

claim that was the actual basis for the settlement determines whether the damages

are excludable under section 104(a)(2). United States v. Burke, 504 U.S. 229, 237

(1992). “The nature of the claim” is typically determined by reference to the terms

of the agreement. See Knuckles v. Commissioner, 349 F.2d 610, 613 (10th Cir.

1965), aff’g T.C. Memo. 1964-33; Robinson v. Commissioner, 102 T.C. 116, 126

(1994), aff’d in part, rev’d in part, and remanded on another issue, 70 F.3d 34 (5th

Cir. 1995). If the settlement agreement does not explicitly state which claims the

payment was made to settle, “the intent of the payor * * * is critical.” Longoria v.

Commissioner, T.C. Memo. 2009-162, 98 T.C.M. (CCH) 11, 15; see George v.

Commissioner, T.C. Memo. 2016-156, 112 T.C.M. (CCH) 239, 240.

      The intent of the payor may be determined by considering all relevant facts,

including the amount paid, the circumstances leading to the settlement, and the al-

legations in the injured party’s complaint. Green v. Commissioner, 507 F.3d 857,

868 (5th Cir. 2007), aff’g T.C. Memo. 2005-250; Bent v. Commissioner, 87 T.C.

236, 245 (1986), aff’d, 835 F.2d 67 (3d Cir. 1987). “[T]he nature of underlying
                                        - 17 -

[*17] claims cannot be determined from a general release that is broad and

inclusive.” Ahmed v. Commissioner, T.C. Memo. 2011-295, 102 T.C.M. (CCH)

607, 608, aff’d, 498 F. App’x 919 (11th Cir. 2012).

      In his EEOC complaints Dr. Lakner alleged that the VA had terminated his

employment because of his Jewish ancestry and religion and as reprisal for his

advocacy on behalf of veterans with psychological illness. His original and

amended complaints were filed in 2002. They did not mention (nor could they

possibly have mentioned) the injury he sustained in 2003.

      The EEOC hearing was held in 2010. During that hearing Dr. Lakner’s at-

torney stated that the sole issue for adjudication was whether Dr. Lakner’s em-

ployment with the VA had been unlawfully terminated in 2001. Neither his com-

plaint nor the hearing transcript contains any reference to physical injury or physi-

cal sickness.

      The settlement agreement between Dr. Lakner and the VA states that it re-

solves all matters he had raised in his complaint. The VA agreed to pay $328,000

in pecuniary and nonpecuniary damages, make a lump-sum payment for accrued

annual leave, and pay Dr. Lakner’s attorney’s fees. There is no mention of any

physical injury he had suffered. In exchange for the VA’s payments, Dr. Lakner

agreed to “withdraw, in their entirety, all discrimination complaints.” Apart from
                                        - 18 -

[*18] Dr. Lakner’s testimony at trial, there is no evidence that the EEOC settle-

ment payment represented compensation for the injuries he sustained in Bosnia.

      Dr. Lakner contends that the injury he sustained in Bosnia was exacerbated

by his alleged confinement in Kosovo and that the VA settlement agreement had

“linkage” to those events. But in deciding whether a settlement payment is ex-

cludable under section 104(a)(2), the crucial question is whether the settlement

amount was actually paid to redress a physical injury. See Molina v. Commission-

er, T.C. Memo. 2013-226, 106 T.C.M. (CCH) 371, 373. Dr. Lakner alleged no

physical injury in his EEOC complaints, and the settlement agreement clearly

states that the VA settled the case in consideration of his agreement to withdraw

“all discrimination complaints” he had made. Giving primacy to the terms of the

settlement agreement and to “the intent of the payor,” Longoria, 98 T.C.M. (CCH)

at 15, we find that the VA intended to settle, and did settle, Dr. Lakner’s claims of

discrimination based on religion, national origin, and reprisal.5 We accordingly


      5
        Dr. Lakner also agreed to waive “his right to pursue future causes of action
against the Agency based on facts in existence as of the date of * * * this Agree-
ment.” We have found such general, prospective waivers inadequate to show that
a settlement payment was made for a physical injury. See Devine v. Commission-
er, T.C. Memo. 2017-111, 113 T.C.M. (CCH) 1496, 1499. In any event, even if
petitioners could show that some portion of the $328,000 settlement was attri-
butable to physical injury, they have offered no evidentiary basis for calculating
that portion and would thus fail to meet their burden of proof.
                                        - 19 -

[*19] hold that the $328,000 VA settlement payment was not received “on account

of personal physical injuries or physical sickness” and is therefore not excludable

from gross income under section 104(a)(2).

             2.      Other Income for 2008 and 2010

      During 2008 and 2010 petitioners maintained 10 to 12 personal bank ac-

counts into which they made deposits. When performing his bank deposits analy-

sis, the RA subtracted from petitioners’ total deposits for 2008 and 2010 non-

taxable transfers of $216,357 and $523,795, respectively. These calculations

yielded net taxable deposits of $305,327 and $885,684, respectively. From these

sums he subtracted the gross income petitioners had reported on their 2008 and

2010 tax returns, i.e., $179,405 and $186,420, respectively. This yielded net un-

reported income of $125,922 for 2008 and $699,264 for 2010. Using information

in the bank records, the RA allocated this unreported income into three categories

(the $328,000 VA settlement payment is included in the Schedule C total for

2010):

                  Item                            2008      2010

      Litigation settlement proceeds                -0-    $275,000
      Medical consulting (Schedule C)            $92,887    334,175
      Rental real estate (Schedule E)             33,035     90,089
       Total                                     125,922    699,264
                                        - 20 -

[*20] The litigation proceeds of $275,000 reflected an insurance settlement peti-

tioners received in 2010 following a casualty loss to one of their rental homes.

This loss was caused by a neighbor who did unauthorized work on his property,

resulting in a landslide that damaged the retaining wall on petitioners’ property.

Respondent conceded in his post-trial brief that these insurance proceeds were ex-

cludable from gross income and hence that the $275,000 was a nontaxable deposit.

Petitioners’ unreported income for 2010, including the VA settlement payment, is

thus reduced to $424,264.

      Petitioners have supplied no credible evidence that would justify eliminat-

ing any other bank deposits as nontaxable items. Petitioners have stipulated that

they did not receive any gifts or inheritances during these years. Contrary to their

contention, the RA correctly accounted for interaccount transfers of $158,443 for

2008 and $76,122 for 2010. Petitioners assert that a $719 check that Dr. Lakner

received from the VA in 2008 was excludable from gross income under section

104, but they provided no credible evidence that the VA made this payment on

account of disability, physical injury, or physical sickness.

      There is likewise no factual basis for petitioners’ assertion that the RA erred

in characterizing certain bank deposits as rental income. Each deposit that the RA

characterized as rent corresponded to a check that named one or both petitioners as
                                         - 21 -

[*21] payees and either (1) bore the notation “rent” on the memo line or (2) show-

ed an address matching the address of one of petitioners’ rental properties. Peti-

tioners assert that the RA double-counted certain deposits by treating them as rent,

but they have supplied no evidentiary support for that assertion.

        In sum, we find that petitioners have failed to carry their burden of showing

error in the RA’s bank deposits analysis for 2008 or 2010, apart from the errone-

ous inclusion of the $275,000 insurance settlement as conceded by respondent.

We accordingly find that petitioners had unreported income of $125,922 for 2008

and $424,264 for 2010, allocable between Schedule C and Schedule E as shown

on the table above. See supra p. 19.

        B.    Unreported Income for 2007, 2009, and 2011

        For 2007 petitioners concede that they failed to report taxable interest in-

come of $34,357. For 2011 respondent concedes that a $28,735 distribution peti-

tioners received from an IRA account was not includable in gross income. We

thus sustain respondent’s determination of unreported income for 2007, but not for

2011.

        For 2007 and 2009 petitioners contend that the RA erred in allocating in-

come between Schedule C and Schedule E. For both years petitioners lumped to-

gether, on a single Schedule C, the income and expenses connected with Dr. Lak-
                                        - 22 -

[*22] ner’s medical consulting business and the income and expenses connected

with Ms. Smith’s rental real estate activity. The latter amounts should have been

reported on Schedule E. Given the disarray in petitioners’ recordkeeping, untang-

ling the two streams of income and expenses was no easy task. Using information

in petitioners’ bank records, the RA determined that $58,400 of Schedule C gross

receipts for 2007 and $66,617 of Schedule C gross receipts for 2009 should be re-

characterized as rental income and transferred to Schedule E. Petitioners have not

shown that this determination was arbitrary or erroneous.

III.   Schedule A Deductions

       For 2008 petitioners claimed a deduction of $58,246 for home mortgage

interest expense. The IRS reduced the allowable deduction to $35,669, determin-

ing that petitioners had failed to substantiate the remainder. Petitioners introduced

no credible evidence to support a deduction larger than the IRS has allowed.

       For 2008, 2010, and 2011 petitioners deducted State and local taxes of

$34,210, $23,504, and $37,803, respectively. The IRS in the notice of deficiency

disallowed these deductions in their entirety. In his post-trial brief respondent

conceded that petitioners are entitled to State tax deductions of $4,197 for 2008,

$4,120 for 2010, and $32,390 for 2011. Petitioners introduced no credible evi-
                                        - 23 -

[*23] dence to substantiate deductions for State taxes in amounts larger than

respondent has conceded.6

IV.   Schedule C Deductions

      Deductions are a matter of legislative grace. The taxpayer bears the burden

of proving that reported business expenses were actually incurred and were “ordi-

nary and necessary.” Sec. 162(a); Rule 142(a); INDOPCO, Inc., 503 U.S. at 83.

The taxpayer also bears the burden of substantiating expenses underlying his

claimed deductions by keeping and producing records sufficient to enable the IRS

to determine his correct tax liability. Sec. 1.6001-1(a), (e), Income Tax Regs. The

failure to keep and present such records counts heavily against a taxpayer’s at-

tempted proof. Rogers v. Commissioner, T.C. Memo. 2014-141, 108 T.C.M.

(CCH) 39, 43. In certain circumstances the Court may approximate the amount of

an expense if the taxpayer proves that it was incurred but cannot substantiate the

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

the taxpayer must provide some basis for such an estimate. Vanicek v. Commis-

sioner, 85 T.C. 731, 742-743 (1985).


      6
      Petitioners contend that “there is a substantial possibility” that their disal-
lowed Schedule A expense deductions were attributable to their rental properties.
As noted in the text, they supplied no credible evidence to substantiate the
expenses, regardless of the schedule on which they might properly be reportable.
                                       - 24 -

[*24] Section 274(d) imposes strict substantiation requirements for deductions

claimed for expenses of traveling (including meals and lodging while away from

home), gifts, and entertainment. No such deduction is allowed unless the taxpayer

substantiates, by adequate records or by sufficient evidence corroborating his own

statements, the amount, time and place, and business purpose for each expendi-

ture. Sec. 274(d); sec. 1.274-5T(a), (b), and (c), Temporary Income Tax Regs., 50

Fed. Reg. 46014-46017 (Nov. 6, 1985). A court may not apply the Cohan rule to

approximate expenses covered by section 274(d). Sanford v. Commissioner, 50

T.C. 823, 827-828 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969).

      For 2007-2011 petitioners claimed deductions on Schedule C in the respec-

tive amounts of $130,213, $191,350, $176,121, $166,544, and $103,554. With

minor exceptions, the IRS disallowed these deductions for lack of substantiation

or because they constituted “personal, living, or family expenses.” See sec.

262(a). We sustain these determinations subject to certain concessions by re-

spondent as noted below.7




      7
        Petitioners lumped together on their Schedules C expenses allegedly in-
curred both in Dr. Lakner’s medical consulting business and in the rental real es-
tate activity. To the extent that petitioners have substantiated expenses properly
reportable on Schedule E rather than Schedule C, we have noted that in the text
below.
                                        - 25 -

[*25] A.     2007 and 2009

      To substantiate their expenses for 2007 and 2009, petitioners provided at

trial numerous receipts and invoices, order confirmation emails, canceled checks,

bank statements, and handwritten summaries. Because these documents were

highly disorganized, we instructed petitioners to attach to their post-trial briefs

spreadsheets linking each claimed deduction to specific substantiating documents

in the record. The spreadsheets petitioners supplied did not do this in a helpful or

plausible way. We will briefly address each category of expenses petitioners

claim to have paid:

      • Meals, Entertainment, and Business Gifts: Petitioners claimed deductions

for grocery shopping, airline and car rental expenses, dining out at numerous res-

taurants, and alleged business gifts in the form of wine, desserts, flowers, and gift

cards. These expenses are subject to the strict substantiation requirements of

section 274(d). See Sanford, 50 T.C. at 827; sec. 1.274-5T(a), Temporary Income

Tax Regs. Petitioners did not satisfy these requirements because they failed to

supply any credible evidence establishing the time, place, and/or business purpose

for these expenditures.

      • Professional Services: Petitioners claimed deductions for legal fees, ap-

praisal fees, and accounting fees. Such expenses are deductible on Schedule C
                                       - 26 -

[*26] only if incurred in connection with the taxpayer’s trade or business. Kenton

v. Commissioner, T.C. Memo. 2006-13; Test v. Commissioner, T.C. Memo. 2000-

362, aff’d, 49 F. App’x 96 (9th Cir. 2002). As purported substantiation petitioners

supplied canceled checks or invoices showing lawyers or other professionals as

payees. Petitioners have provided no evidence that would enable the Court to

determine whether the claimed payments had any connection with Dr. Lakner’s

consulting business or with Ms. Smith’s rental real estate activity. We therefore

sustain the disallowance of all deductions in this category.

      • Professional and Licensing Fees: To substantiate these expenses petition-

ers offered canceled checks made out to the D.C. Treasurer and various medical

associations. We sustain disallowance of all deductions in this category because

petitioners have failed to prove that the canceled checks corresponded to ordinary

and necessary expenses of Dr. Lakner’s consulting business.

      • Maintenance: Respondent has conceded that petitioners have substantia-

ted $100 of deductible maintenance expenses for 2007. The IRS properly disal-

lowed deductions for the other reported expenses in this category because they

were personal, were incurred outside the years at issue, or were not shown to have

any connection with Dr. Lakner’s consulting business or with petitioners’ rental

properties.
                                        - 27 -

[*27] • Miscellaneous Property-Related Expenses: Petitioners submitted a large

stack of canceled checks, receipts, and invoices showing payments to numerous

utility companies, service companies, insurance companies, and retail stores (such

as Macy’s, Home Depot, and Bed Bath and Beyond). Petitioners do not contend

that any of these expenses was properly deductible on Schedule C. Respondent

has conceded that petitioners are entitled to a Schedule E deduction of $532 for

improvements to a rental property in 2009. We did not find credible petitioners’

testimony that any of the other reported expenses related to their rental properties

as opposed to their personal residence. Petitioners have not carried their burden of

proving that these expenses were properly deductible. See sec. 262; Tokarski, 87

T.C. at 77.

      • Property Tax and Mortgage Interest: As purported substantiation for

Schedule C expenses in 2007 and 2009, petitioners’ spreadsheet listed real prop-

erty taxes and home mortgage interest that they had separately claimed as itemized

deductions on Schedule A. The IRS allowed all of the itemized deductions that

petitioners claimed for 2007 and 2009. Petitioners have failed to substantiate any

deductions for property taxes or interest beyond the amounts the IRS allowed as

itemized deductions.
                                        - 28 -

[*28] • IRA Contributions: As purported substantiation for their Schedule C ex-

penses, petitioners’ spreadsheets listed IRA contributions of $2,000 for 2007 and

2009. Petitioners separately claimed on line 32 of their Form 1040 for each year,

and the IRS allowed, an IRA contribution deduction of $2,000. Petitioners have

failed to prove that they are entitled to IRA deductions larger than those respond-

ent has allowed.

      • Charitable Contributions: As purported substantiation for their Schedule

C expenses, petitioners’ spreadsheet listed charitable contributions of $2,430 for

2007. Petitioners for 2007 separately claimed on Schedule A, and the IRS al-

lowed, a charitable contribution deduction of $2,100. Petitioners have failed to

prove that they are entitled to a charitable contribution deduction for 2007 in ex-

cess of the amount respondent allowed on Schedule A.

      • Other Expenses: On their spreadsheet for 2007 petitioners listed an ex-

pense of $159 for “professional training.” Respondent conceded that petitioners

substantiated $40 of this expense. We find that they have not substantiated the re-

mainder.
                                       - 29 -

[*29] B.     2008, 2010, and 2011

      For 2008, 2010, and 2011, the IRS disallowed most of petitioners’ claimed

Schedule C expense deductions, determining that they had substantiated only the

following:

                   Item                2008       2010      2011

             Travel                   $2,257     $1,324      -0-
             Meals/entertainment         864        957    $1,593
              Total                    3,121      2,281     1,593

      Petitioners have produced no invoices, bank statements, credit card state-

ments, or other credible documentation to substantiate the existence or amount of

any other Schedule C expenses. We reject their request that we estimate their

deductible expenses because they have provided no evidentiary basis on which we

could base such an estimate. See Norgaard v. Commissioner, 939 F.2d 874, 879

(9th Cir. 1991) (requiring the taxpayer to present credible evidence from which the

Court can make an estimate under the Cohan rule), aff’g in part, rev’g in part T.C.

Memo. 1989-390. We find that petitioners have not substantiated Schedule C

expenses for 2008, 2010, or 2011 in excess of the amounts respondent has

allowed.
                                        - 30 -

[*30] V.     Schedule E Loss

      On their Schedule E for 2011 petitioners reported income of $13,045 from

two rental properties and negative income of $38,045 from three rental properties,

producing an alleged rental real estate loss of $25,000. They reported the full

amount of that loss on line 17 of their Form 1040. In the notice of deficiency the

IRS disallowed any deduction for that loss, stating: “Your rental loss was disal-

lowed because * * * you are not a real estate professional and your modified ad-

justed gross income is over $150,000.”

      The Code allows an individual who actively participates in a rental real es-

tate activity to deduct against ordinary income up to $25,000 of losses from that

activity if AGI is less than $150,000. See sec. 469(i)(1), (2), and (3). Respondent

concedes that Ms. Smith actively participated in the rental real estate activity dur-

ing 2011. In light of the adjustments to income that we have sustained, however,

petitioners’ AGI for 2011 was substantially in excess of $150,000. Thus, assum-

ing arguendo that petitioners have substantiated their claimed real estate loss, they

cannot deduct any portion of it unless Ms. Smith during 2011 was a “real estate

professional,” i.e., a taxpayer engaged in a “real property business” within the

meaning of section 469(c)(7).
                                          - 31 -

[*31] Section 469(a) generally disallows a current deduction for a “passive activ-

ity loss” incurred by an individual. Section 469(c) defines “passive activity” to

include an activity involving a trade or business in which the taxpayer does not

“materially participate” and “any rental activity” regardless of whether the taxpay-

er materially participates. Sec. 469(c)(1), (2), (4). But section 469(c)(7) provides

that the rental real estate activity of a real estate professional is not per se passive.

See Kosonen v. Commissioner, T.C. Memo. 2000-107, 79 T.C.M. (CCH) 1765,

1767; sec. 1.469-9(b)(6), (c)(1), Income Tax Regs. If a real estate professional

materially participates in a rental real estate activity, that activity is treated as non-

passive, and the section 469(a) disallowance does not apply. See Shiekh v. Com-

missioner, T.C. Memo. 2010-126, 99 T.C.M. (CCH) 1526, 1528; Fowler v. Com-

missioner, T.C. Memo. 2002-223, 84 T.C.M. (CCH) 281, 284; sec. 1.469-9(e)(1),

Income Tax Regs.

      To qualify as a real estate professional, a taxpayer must (among other

things) “perform[] more than 750 hours of services during the taxable year in real

property trades or businesses in which * * * [she] materially participates.” Sec.

469(c)(7)(B)(ii). The taxpayer must satisfy the 750-hour requirement personally;

participation in the real estate activity by the taxpayer’s spouse is not attributed to

the taxpayer for this purpose. Oderio v. Commissioner, T.C. Memo. 2014-39, 107
                                        - 32 -

[*32] T.C.M. (CCH) 1214, 1215; sec. 1.469-9(c)(4), Income Tax Regs. Moreover,

“personal services performed as an employee shall not be treated as performed in

real property trades or businesses” unless “such employee is a 5-percent owner

* * * in the employer.” Sec. 469(c)(7)(D)(ii).

      During 2011 Ms. Smith was employed by Realtor Cathie Gill, Inc., where

she supervised the firm’s property management services. There is no evidence

that she held a 5% ownership interest (or any ownership interest) in that firm. Her

services rendered as an employee therefore do not count in determining whether

she met the 750-hour requirement.

      Petitioners have produced no documentary evidence of any kind to substan-

tiate the number of hours that Ms. Smith or Dr. Lakner devoted to their rental

properties. Ms. Smith did not testify at trial. Dr. Lakner testified that his wife

spent 500 to 600 hours annually, and that he spent another 1,000 to 1,200 hours

annually, managing those properties. There was no documentary support for these

assertions, which were at best “ballpark guesstimates,” and we did not find Dr.

Lakner’s testimony credible. See Moss v. Commissioner, 135 T.C. 365, 369

(2010); Tokarski, 87 T.C. at 77. Finding as we do that neither petitioner was a real
                                        - 33 -

[*33] estate professional during 2011, we sustain respondent’s disallowance of the

$25,000 Schedule E loss deduction petitioners claimed for that year.8

VI.   NOLs

      On line 21 of their 2007-2011 returns, captioned “Other Income,” petition-

ers claimed “net operating loss carryover[s]” in the following amounts:

                          Year           NOL

                          2007         $85,258
                          2008          99,383
                          2009         162,030
                          2010         219,855
                          2011         250,773

Respondent disallowed these NOL deductions entirely, and properly so.

      A taxpayer may generally deduct, as an NOL for a taxable year, an amount

equal to the sum of the NOL carryovers and carrybacks to that year. Sec. 172(a).

A taxpayer claiming an NOL deduction must file with his return “a concise state-

ment setting forth the amount of the * * * [NOL] deduction claimed and all mater-

ial and pertinent facts relative thereto, including a detailed schedule showing the

computation of the * * * [NOL] deduction.” Sec. 1.172-1(c), Income Tax Regs.


      8
       Petitioners did not claim any rental real estate losses on their returns for
2007-2010 and did not include a Schedule E in any of those returns. They have
not substantiated, for any of those years, rental real estate expenses in excess of
the Schedule E income that respondent has determined. Thus, they are not entitled
to any deductions for real estate losses for 2007, 2008, 2009, or 2010.
                                        - 34 -

[*34] Petitioners bear the burden of establishing both the existence of NOLs for

prior years and the NOL amounts that may properly be carried forward to the years

at issue. See Rule 142(a); Keith v. Commissioner, 115 T.C. 605, 621 (2000).

      The $85,258 NOL deduction petitioners claimed for 2007 allegedly repre-

sented the carryforward of losses petitioners had incurred in 2004-2006. Petition-

ers did not attach to their 2007 return the explanatory statement required by the

regulations. They offered no evidence that they had sustained bona fide losses

during 2004-2006, apart from submitting copies of the tax returns on which they

reported those losses. Merely claiming a loss does not substantiate it. See Coburn

v. Commissioner, T.C. Memo. 2014-113, 107 T.C.M. (CCH) 1551, 1558 (“A tax-

payer’s return is merely a statement of the taxpayer’s position and cannot be used

to substantiate a deduction.”); see also Gould v. Commissioner, 139 T.C. 418, 447

(2012), aff’d, 552 F. App’x 250 (4th Cir. 2014).

      The NOL carryforward deductions petitioners claimed for 2008-2011 re-

sulted from the $85,258 NOL carryforward from 2004-2006 (to which they were

not entitled) and the negative AGI they reported for 2007-2010 (in the aggregate

amount of $623,955). As a result of the adjustments we have sustained, requiring

inclusion of unreported income and disallowing petitioners’ claimed Schedule C

loss deductions, petitioners will have substantial positive AGI for each year at is-
                                        - 35 -

[*35] sue. Because they have no operating losses to carry forward, the IRS

properly disallowed all of their claimed NOL deductions.

VII. Additions to Tax

      Section 6651(a)(1) provides for an addition to tax of 5% of the tax required

to be shown on the return for each month or fraction thereof for which there is a

failure to file the return, not to exceed 25% in toto. The parties have stipulated

that petitioners’ 2007-2011 returns were filed late. Respondent has thus met his

burden of production under section 7491(c).

      A taxpayer who files his return late is liable for the section 6651(a)(1) addi-

tion to tax unless he shows that his failure was due to reasonable cause and not

due to willful neglect. United States v. Boyle, 469 U.S. 241, 245 (1985). Petition-

ers first assert that Dr. Lakner’s deployment overseas constitutes reasonable cause

for their failure to file timely. But Dr. Lakner returned to the United States from

overseas deployment in 2006. Petitioners have offered no cogent explanation why

his overseas military service during 2006 and prior years rendered them unable to

file timely returns for 2007-2011, the first of which was not due for filing until

April 2008.

      Alternatively, petitioners contend that “significant health problems” made it

impossible for them to file their returns on time. Petitioners introduced no cred-
                                         - 36 -

[*36] ible evidence to support this assertion. They insisted throughout the trial

that they actively engaged in a medical consulting business and a rental real estate

activity during the tax years at issue. Their returns for each year were prepared by

a certified public accountant (CPA) at “Physicians’ Tax Service.” If ill health did

not prevent petitioners from managing their commercial affairs, we find no basis

for concluding that ill health prevented them from furnishing information timely to

their return preparer. See Poppe v. Commissioner, T.C. Memo. 2015-205, 110

T.C.M. (CCH) 401, 406-407 (rejecting ill health defense where taxpayer as a se-

curities trader “engag[ed] in activities that required a high degree of concentration

and ability to analyze and organize information”); Hardin v. Commissioner, T.C.

Memo. 2012-162, 103 T.C.M. (CCH) 1861, 1862-1863 (rejecting ill health de-

fense where taxpayer was able to manage his business affairs, including managing

two rental properties, selling one of them, and being employed full time).

        In sum, we conclude that petitioners have failed to carry their burden of

proving that they had reasonable cause for failing to file their 2007-2011 returns

on time. We thus sustain the addition to tax under section 6651(a)(1) for each

year.
                                        - 37 -

[*37] VIII. Penalties

      In his post-trial brief respondent conceded that petitioners are not liable for

fraud penalties under section 6663, as the IRS had determined in the notice of de-

ficiency for 2008, 2010, and 2011. But respondent contends that petitioners are

liable for accuracy-related penalties under section 6662(a) for all five years. We

agree with that submission.

      The Code imposes a 20% penalty on the portion of any underpayment of tax

attributable to “[n]egligence or disregard of rules and regulations” or “[a]ny sub-

stantial understatement of income tax.” Sec. 6662(a) and (b)(1) and (2). Negli-

gence includes “any failure to make a reasonable attempt to comply” with the in-

ternal revenue laws. Sec. 6662(c). An understatement of income tax is “substan-

tial” if it exceeds the greater of $5,000 or 10% of the tax required to be shown on

the return. Sec. 6662(d)(1)(A).

      Under section 7491(c) respondent bears the burden of production with re-

spect to the liability of any individual for any penalty. See Higbee v. Commission-

er, 116 T.C. 438, 446 (2001). Respondent has satisfied his burden of production

as to negligence by showing that petitioners for each year failed to report all of

their taxable income and failed to maintain any meaningful books and records for

their business activities. See sec. 1.6662-3(b)(1), Income Tax Regs.
                                       - 38 -

[*38] In Graev v. Commissioner, 149 T.C. __ (Dec. 20, 2017), supplementing and

overruling in part 147 T.C. 460 (2016), we held that respondent’s burden of pro-

duction under section 7491(c) also includes establishing compliance with section

6751(b). That section requires that penalties be “personally approved (in writing)

by the immediate supervisor of the individual making such determination.” See

Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), aff’g in part, rev’g in

part T.C. Memo. 2015-42.

      For 2007 and 2009 the record includes copies of Civil Penalty Approval

Forms signed by the immediate supervisor of the revenue agent who examined

petitioners’ returns, approving imposition of section 6662(a) penalties against pe-

titioners for those years. For 2008, 2010, and 2011 the record includes copies of a

Civil Penalty Approval Form, signed by the immediate supervisor of the revenue

agent who examined petitioners’ returns, approving imposition of section 6663

fraud penalties and (in the alternative) section 6662(a) accuracy-related penalties

against petitioners for those years. We accordingly find that respondent has satis-

fied his burden of production to show compliance with section 6751(b).

      No penalty is imposed with respect to any portion of an underpayment if the

taxpayer acted with reasonable cause and in good faith with respect thereto. See

sec. 6664(c)(1). The taxpayer generally bears the burden of proving reasonable
                                        - 39 -

[*39] cause and good faith. Higbee, 116 T.C. at 446. Reasonable cause can be

shown by good-faith reliance on the advice of a qualified tax professional. Sec.

1.6664-4(b)(1), (c), Income Tax Regs. Whether the taxpayer actually relies on the

advice and whether such reliance is reasonable present questions of fact. Neona-

tology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98 (2000), aff’d, 299 F.3d 221

(3d Cir. 2002); sec. 1.6664-4(c)(1), Income Tax Regs. For reliance to be reason-

able, the taxpayer must (among other things) have provided “necessary and accu-

rate information to the adviser.” Neonatology Assocs., P.A., 115 T.C. at 99.

      Petitioners contend that they made a good-faith effort to determine their

Federal income tax liabilities correctly because they hired a CPA to prepare their

returns. Petitioners did not call the CPA to testify at trial. They offered no evi-

dence to show that he was a competent adviser or that they actually relied on him

in good faith.

      All of the adjustments we have sustained in this case involve unreported

income and unsubstantiated deductions. Assuming arguendo that petitioners’

CPA was competent, it is obvious that petitioners did not supply him with all

“necessary and accurate information” needed to prepare their 2007-2011 returns

properly. Ibid. We conclude the “reasonable cause” exception does not apply and

that all of the underpayments (as redetermined) are attributable to negligence. Al-
                                       - 40 -

[*40] ternatively, in the event the Rule 155 computations show that the various

understatements of income tax exceed the greater of $5,000 or 10% of the amounts

required to be shown on the respective returns, we conclude that those underpay-

ments are attributable to substantial understatements of income tax for which

reasonable cause has not been shown.

      To reflect the foregoing,


                                                Decisions will be entered under

                                       Rule 155.
