                             T.C. Memo. 2013-211



                        UNITED STATES TAX COURT



                PAUL GRAFFIA, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos.    4066-11, 15659-09,         Filed September 9, 2013.
                    15865-09, 4044-11,
                     4054-11.



             Ps organized PCSC, an S corporation, in which P-M and P-D
      had ownership interests. Ps, PCSC, and a friendly third party
      executed and exchanged (and later canceled) reciprocal promissory
      notes. P-M and P-D deducted substantial flow-through losses from
      PCSC’s activities. R disallowed Ps’ flow-through deductions. In
      addition, R disallowed NOL deductions and other deductions not
      related to PCSC, determined that P-D and P-A had unreported
      income, and determined that Ps are liable for accuracy-related
      penalties.



      1
       Cases of the following petitioners are consolidated herewith: Marilynne
Graffia, docket Nos. 15659-09 and 4044-11; and David M. and Amy L. Graffia,
docket Nos. 15865-09 and 4054-11.
                                                         -2-

[*2]           Held: P-M and P-D are not entitled to deduct PCSC’s losses
        because (1) Ps did not substantiate those losses, (2) P-M and P-D did
        not have sufficient basis in PCSC’s stock to support deductions,
        since P-M’s and P-D’s alleged basis in PCSC’s stock resulted from a
        series of paper transactions that largely canceled out one another and
        did not reflect economic outlays, and (3) P-D did not materially
        participate in PCSC.

              Held, further, Ps did not substantiate their entitlement to any
        other deductions; P-D and P-A failed to report capital gain income;
        and Ps are all liable for accuracy-related penalties.


        Paul W. Graffia, for himself.

        Marilynne Graffia, for herself.

        David M. and Amy L. Graffia, for themselves.

        Mariann S. Carbone and Justin D. Scheid, for respondent.


                                                  CONTENTS


FINDINGS OF FACT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

        I.       Petitioners. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
        II.      Tenant Improvement Program. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
        III.     PCSC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
        IV.      PCSC’s attempts to exploit the Tenant Improvement Program. . . . . . 9
        V.       Royalty agreements.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
        VI.      Paul’s promissory note to Thomas Olson.. . . . . . . . . . . . . . . . . . . . . 12
        VII.     The million-dollar notes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
        VIII.    PCSC’s facilitation agreement with Olson Contractors.. . . . . . . . . . 15
        IX.      PCSC’s expenses and returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
                                                          -3-

[*3]              A.        Royalty fee payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

                            1.       Marilynne Graffia’s royalty fee contributions. . . . . . . . 17
                            2.       Setoff of the Paul Graffia note. . . . . . . . . . . . . . . . . . . . 18
                            3.       Assignment agreement. . . . . . . . . . . . . . . . . . . . . . . . . . 20

                  B.        Credit card payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

         X.       Petitioners’ tax returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
         XI.      Notices of deficiency and petitions. . . . . . . . . . . . . . . . . . . . . . . . . . 23

OPINION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

         I.       Evidentiary principles. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

                  A.        Burden of proof. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
                  B.        Lack of records. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
                  C.        Lack of testimony by David and Marilynne.. . . . . . . . . . . . . . 27

                            1.       Lack of counsel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
                            2.       Expectation of the Commissioner’s
                                     calling the witnesses.. . . . . . . . . . . . . . . . . . . . . . . . . . . 30

         II.      Disregarding fictitious arrangements. . . . . . . . . . . . . . . . . . . . . . . . . 33
         III.     Royalty fee income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

                  A.        Actual receipt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
                  B.        Constructive receipt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

         IV.      Pass-through of PCSC losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

                  A.        PCSC’s trade or business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
                  B.        Deductions underlying PCSC’s losses. . . . . . . . . . . . . . . . . . . 45

                            1.       PCSC’s royalty expenses. . . . . . . . . . . . . . . . . . . . . . . . 46
                            2.       Credit card expenditures. . . . . . . . . . . . . . . . . . . . . . . . 48
                                                    -4-

[*4]           C.      Shareholders’ material participation. . . . . . . . . . . . . . . . . . . . 49
               D.      Shareholders’ basis.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

       V.      NOL carryover deductions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         53
       VI.     Paul’s Schedule C expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         55
       VII.    Unreported income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    56
       VIII.   Accuracy-related penalties. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       57

               A.      Substantial understatement.. . . . . . . . . . . . . . . . . . . . . . . . . . . 58
               B.      Negligence. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
               C.      Defenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59


               MEMORANDUM FINDINGS OF FACT AND OPINION


       GUSTAFSON, Judge: The Internal Revenue Service (IRS) determined

deficiencies in petitioners’ Federal income tax and penalties as follows:

        Petitioners                Year            Deficiency                  Sec. 6662 Penalty

       David and                   2005            $64,384                          $12,876.80
       Amy Graffia                 2006             70,680                           14,136.00
                                   2007             44,193                            8,838.60

       Marilynne Graffia           2005               1,079                                215.80
                                   2006               2,514                                502.80
                                   2007               3,948                                789.60

       Paul Graffia                2005              10,807                             2,161.40
                                   2006              12,041                             2,408.20
                                   2007              13,823                             2,764.60
                                          -5-

[*5] Pursuant to section 6213(a),2 David and Amy Graffia, Marilynne Graffia, and

Paul Graffia have petitioned the Court for redetermination of those deficiencies.

For the years in issue Marilynne and David had complete ownership of Preferred

Capital Service Corp. (“PCSC”), an S corporation to which several of the issues in

these cases relate. Central to this case is a circular and essentially fictitious

arrangement of obligations--involving PCSC, petitioners, and a business

acquaintance of theirs--that largely canceled each other out. The specific issues

for decision are:3

      1. whether Marilynne or Paul actually or constructively received royalty

income from PCSC. We hold that they did not;

      2. whether Paul’s gross income for 2005 or 2006 includes any amount

associated with PCSC’s alleged cancellation of Paul’s promissory note for

$385,000. We hold that it does not;

      3. whether Marilynne and David and Amy are entitled to deduct for 2005,




      2
       Unless otherwise indicated, all citations of sections refer to the Internal
Revenue Code (26 U.S.C.) in effect for the tax years in issue, and all citations of
Rules refer to the Tax Court Rules of Practice and Procedure.
      3
        There are other computational adjustments set forth in the notices of
deficiency issued to Paul and to David and Amy. Resolution of those adjustments
will follow automatically from the Court’s determinations with regard to the issues
resolved in this opinion.
                                         -6-

[*6] 2006, or 2007 any amount of deductions attributable to PCSC. We hold that

they are not, because they failed to substantiate any deductions for PCSC, they

failed to show that they had any basis in PCSC, and David and Amy did not

materially participate in PCSC during the years in issue;

       4. whether Marilynne or Paul established that either of them was entitled to

net operating loss (“NOL”) carryover deductions for taxable year 2005, 2006, or

2007. We hold that neither has;

       5. whether Paul is entitled to any of the deductions and offsets that he

claimed on his Schedule C, “Profit or Loss From Business”, for taxable year 2005.

We hold that he is not;

       6. whether David and Amy failed to report $4,492 of taxable income

associated with the sale of stocks or bonds for tax year 2007. We hold that they

did; and

       7. whether petitioners are liable for the accuracy-related penalties

determined against them. We hold that they are.

                                 FINDINGS OF FACT

       Trial of these cases was held in Chicago, Illinois. Some of the facts in these

cases were stipulated and are so found. At the time they filed their petitions,

petitioners lived in Illinois.
                                           -7-

[*7] I.         Petitioners

          Paul and Marilynne Graffia are married, and for the years in issue they filed

separate Federal income tax returns. David Graffia is Paul and Marilynne’s son.

For the years in issue David and his wife Amy filed joint Federal income tax

returns.

          Paul prepared his and Marilynne’s tax returns for the years in issue.

Although Paul has extensive experience in accounting, he is not registered or

licensed as a certified public accountant in any jurisdiction. H&R Block prepared

David and Amy’s 2005, 2006, and 2007 joint returns.

II.       Tenant Improvement Program

          Paul Graffia created the Tenant Improvement Program in 2001 and

developed and modified it in the succeeding years. The purpose of the Tenant

Improvement Program was to provide commercial property owners an innovative

way to finance tenant improvements with capital acquired by the program

promoter in exchange for program fees and an interest in the leasehold. (The

details of the program are not significant to this case.)

          The record contains extensive documentation of market research and legal

advice Paul used to develop the Tenant Improvement Program. He hired lawyers

to assure the validity of his concept and to help him prepare the documents
                                        -8-

[*8] necessary to effectuate it. Petitioners persuaded us that they had a subjective

intention to use the program to generate a profit; but there is insufficient evidence

to show whether the program had substantial commercial value.

III.   PCSC

       PCSC is an Illinois corporation created by Marilynne and David, which is

engaged in the business of real estate construction and improvement financing.

For the years in issue PCSC was a subchapter S corporation on the accrual

method. Petitioners put on no evidence--expert or otherwise--to prove the value of

PCSC at any time.

       From PCSC’s organization in 2001 until December 31, 2006, Marilynne and

David were the sole shareholders of PCSC, with Marilynne owning 55.7% and

David owning 44.3%. In 2007 David acquired 100% ownership of PCSC. Paul

held himself out as a representative of PCSC (for example, as PCSC’s “New

Business Development Manager”), and he also prepared the Federal income tax

returns for PCSC. In 2010 Thomas Olson (who is discussed in more detail below)

acquired all of David’s interest in PCSC.

       In all three years in issue, David was employed at other companies.

Employing the burden-of-proof principles discussed below, we find that David did
                                         -9-

[*9] not expend as much as 100 hours per year working for PCSC in any of the

years in issue or in preceding years.4

IV.   PCSC’s attempts to exploit the Tenant Improvement Program

      During the years in issue, PCSC did not have a bank account, any cash

receipts or cash disbursements, or any documented book value, and did not invoice

any customers for services rendered or for any other purpose. However, the record

shows numerous targeted marketing efforts by Paul, on behalf of PCSC, that

attempted to generate interest in the Tenant Improvement Program. Although

these marketing efforts did not lead to the completion of any tenant improvement

projects during the years in issue, Paul’s work for PCSC in the years in issue laid

the ground work for at least one tenant improvement project that did later come to

fruition (i.e., the Market Square Project in Zion, Illinois) and for others that had

the potential to do so, through the use of the Tenant Improvement Program or

some other PCSC-guided financing arrangement. The initial stages of the Market

      4
        David did not testify at trial. The only evidence offered to show the
quantum of his activity was a purported log and supporting documents that relate
to the pre-suit years 2002-04. However, there is no evidence as to the preparation
or authorship of that log, nor can we assume that the backup documents actually
reflect work done by David (as opposed to work done by Paul in his name). Trial
witnesses other than Paul showed little awareness of the involvement of David in
PCSC-related work, and the testimony about David’s involvement with Market
Square did not specify the years involved and concerned a transaction that
culminated well after the years in issue.
                                        - 10 -

[*10] Square Project began in 2004, and PCSC became involved with the project

financing in 2008.

      We therefore find that Paul Graffia was engaged, under the auspices of

PCSC, in a bona fide business venture, entered into for profit.5 However, as we

now show, various of PCSC’s purported contracts lacked that same bona fide

character.

V.    Royalty agreements

      Paul and Marilynne Graffia executed three successive agreements providing

for royalties: The first had an effective date of January 1, 2002; the second had an

effective date of January 1, 2005; and the third also had an effective date of

January 1, 2005 (but was actually not executed before 2008). Each of those

agreements purported to give PCSC rights to use the Tenant Improvement

Program in exchange for royalty payments to Paul and Marilynne. Petitioners

claim that the third agreement, which was executed no earlier than 2008 and was

entitled “Tenant Improvement Program Franchise Agreement” (and which we

refer to as “the Franchise Agreement”), was the one that was effective for the years


      5
       The Commissioner did not contend, in the alternative, that if PCSC was a
for-profit activity, any expenditures it made were “start-up expenditures” that are
not immediately deductible, pursuant to section 195(a). We therefore do not
address this issue.
                                         - 11 -

[*11] in issue.6 The Franchise Agreement provides that Paul and Marilynne were

due to receive royalty payments as follows:

                                  2005             2006        2007

      Marilynne Graffia          $250,000         $275,000      ---
      Paul Graffia                135,000          250,000   $125,000

          Total                   385,000          525,000    125,000

      As we set out below, PCSC did not actually pay these royalties in cash but

by deemed capital contributions (in Marilynne’s case) and by purported

forgiveness of fictitious debt (in Paul’s case). Marilynne had no material

involvement in developing the program, and there was therefore no business

reason for her to be entitled to royalties. Petitioners offered no evidence--expert

or otherwise--to show the value of the program or the amount of royalties that it

would have warranted in an arm’s-length transaction; and we find, as to both

Marilynne and Paul, that the royalty agreements were fictitious, that royalties were

never expected or intended to be paid, and that instead the royalties were intended

      6
       Since the Franchise Agreement was not created before 2008, it was not
actually in effect during the years in issue. Petitioners claim that the Franchise
Agreement replaced the two predecessor royalty agreements and that it more
completely and accurately reflects the actual agreement between the parties that
was in effect January 1, 2005. We do not find that any of the three was a bona fide
agreement, and petitioners did not persuade us that they were executed as alleged;
but we find that the Franchise Agreement did comport with petitioners’ desired tax
outcomes.
                                       - 12 -

[*12] as window dressing to add an appearance of reality to the overall

arrangement and, in Marilynne’s case, to establish her apparent basis in PCSC, as

we discuss below.

VI.   Paul’s promissory note to Thomas Olson

      Thomas Olson is the president and sole shareholder of Olson General

Contractors, Inc., a general construction company that we refer to here as “Olson

Contractors.” Mr. Olson also owns Thomas Holdings, Inc. (“THI”). Paul has

known Mr. Olson for over 30 years and has worked with him on several joint

business ventures.

      Petitioners contend that in their prior dealings Mr. Olson lent or advanced

money to Paul; but probative evidence of such loans or advances is lacking,7 and

      7
        The alleged prior loans and advances underlying Paul’s note are
unsubstantiated. In reaching $383,404 as the total amount supposedly due on the
note, the calculation sheet appended to the note adds: $40,000 for “legal fees paid
to Siegan Barbarkoff and Skadin Arps [sic] et al. as of January 1996”; $70,000 for
“monies directly advanced to Paul through 1996”; $8,601 for “public storage
payments”; $155,803 in interest calculated at 10% annually; and $109,000 for
“[a]dditional advances to Paul and/or Marilynne in the form of taxable income not
subject to interest charges from the 1st of February 1996 through the date hereof”.
Apart from public storage receipts, there is no documentary evidence to support
the underlying advances to Paul listed on the calculation sheet. Even the evidence
substantiating the public storage payments is problematic because it states that Mr.
Olson, and not Paul, was the lessee on the storage rental agreement, so that if
Mr. Olson paid these amounts he was evidently paying his own obligation, not
lending or advancing anything to Paul. Paul describes the “advances” of $70,000
                                                                      (continued...)
                                       - 13 -

[*13] we do not so find. Apparently in late 2004, Paul signed an undated

promissory note (which we refer to as “the Paul Graffia note”) and an

accompanying document entitled “Calculation of Monies Due Thomas A. Olson”

(“calculation sheet”). The promissory note, which contains no due date, payment

schedule, or demand date, states that “the undersigned maker [Paul Graffia]

Promises to Pay to the order of Thomas A. Olson * * * the sum reflected on the

attached calculation sheet of monies due”. The calculation sheet is dated

December 31, 2004, and lists amounts totaling $383,400. Paul did not make any

principal or interest payments on the Paul Graffia note before it was canceled, and

we find that neither Paul nor Mr. Olson intended or expected that Paul would pay

the note.

      Shortly after Paul executed the note to Mr. Olson in late 2004, David

Graffia acquired the note from Mr. Olson in exchange for David’s own $385,000

note (payable to “the bearer hereof”); and David then contributed the Paul Graffia

note to PCSC as a purported capital contribution. In early 2005, PCSC then


      7
       (...continued)
and $109,000 as arising from situations in which Mr. Olson would make business
investments and Paul would work on the investment and receive wages or
“advances” from Olson’s investment but agreed to pay Olson back when the
ventures turned a profit (which they never did). There is no evidence documenting
the payment or the purpose of the legal fees.
                                       - 14 -

[*14] canceled the Paul Graffia note, purportedly to set off royalty payments that

were ostensibly due to Paul for the “Tenant Improvement Program”. Petitioners

contend that David’s $385,000 note was repaid in full; however, apart from a

promissory note stamped “PAID IN FULL” there is no credible evidence that

David actually repaid Mr. Olsen $385,000.8 We find that neither David nor

Mr. Olson expected that David would pay his note; and as a result, we find that

neither David nor PCSC had any basis in the Paul Graffia note.

VII. The million-dollar notes

      David executed a note dated January 3, 2005, ostensibly promising to pay to

Mr. Olson $1 million plus interest no later than December 31, 2010; and

Mr. Olson executed a note with the same date on behalf of THI, ostensibly

promising to pay to David $1 million plus interest no later than January 3, 2008.

The notes were executed in purported fulfillment of an agreement entitled

“Promissory Note Credit Terms of Agreement”, pursuant to which THI would lend


      8
        Our record does reflect a check from David and Amy to Mr. Olsen in the
amount of $83,411.36 dated March 1, 2010. The check’s memo line states
“Interest”. While it is possible to infer that this check may have reflected an
interest payment on David’s note to Mr. Olson, neither David nor Mr. Olson
testified about this check. Given the importance of the issue and the absence of
other proof to support a finding of genuine indebtedness, we find the lack of
testimony about the check to weigh heavily against its having any probative value
with regard to the genuineness of David’s purported $385,000 debt.
                                       - 15 -

[*15] $1 million to PCSC (through David), PCSC would cause the money “to be

made payable to” THI, David would contribute Mr. Olson’s note to PCSC as a

capital contribution to PCSC, and David’s shares of PCSC would be delivered and

pledged to Mr. Olson as collateral for the supposed loan. No money ever changed

hands as a result of the purported loans. Petitioners assert that David repaid

$615,000 on his $1 million note, which they contend was thereafter canceled and a

new note was issued for the remaining unpaid balance in the amount of $385,000.

But again, petitioners offer no proof of the $615,000 partial payment except for a

note stamped “PARTIALLY PAID/ BALANCE VIA RENEWAL”.

      We are not persuaded that either David or Mr. Olson expected or intended

to honor these notes and find instead that they were window dressing to increase

David’s apparent basis in PCSC, as we discuss below.

VIII. PCSC’s facilitation agreement with Olson Contractors

      In December 2005, PCSC executed a “Facilitation Agreement” with Olson

Contractors. In the Facilitation Agreement, PCSC agreed to give Olson

Contractors the exclusive right to perform tenant improvement construction work

for PCSC within the “Chicagoland franchise territory”. In exchange for this

exclusive construction right, the Facilitation Agreement purportedly obliged Olson

Contractors (1) to give PCSC “most favored client-best pricing status” for the
                                       - 16 -

[*16] construction work that was to be done and (2) to pay PCSC a commission

totaling $1,600,000 payable out of Olson Contractors’ profits from the work

generated by PCSC. In addition Olson Contractors agreed to pay PCSC a

$155,000 guaranteed minimum payment in 2005, which would be deductible from

the $1,600,000 commission.

      Petitioners put on no evidence--expert or otherwise--to show that the rights

purportedly granted to Olson Contractors were worth $1.6 million or any other

amount. As we explain below, the minimum payment was purportedly satisfied by

a payment to Paul Graffia (which we find did not actually occur in a year in issue)

and the remainder was never paid. We find that Paul (through PCSC) and

Mr. Olson (through Olson Contractors) did hope to do projects that would

generate profit and that they intended to share those profits to some degree, but the

specific terms of the Facilitation Agreement were not intended by the parties to be

binding.

IX.   PCSC’s expenses and returns

      IRS account transcripts for PCSC show that PCSC reported net losses of

$447,693 for 2005, $491,323 for 2006, and $137,378 for 2007. These reported

losses correspond to the PCSC flow-through loss deductions that were claimed by

PCSC’s owners--i.e., Marilynne (who claimed losses of $249,363 for 2005 and
                                       - 17 -

[*17] $273,667 for 2006) and by David and Amy (who claimed losses of $198,330

for 2005, $217,656 for 2006, and $137,378 for 2007)--on Schedules E attached to

their respective returns. PCSC’s Forms 1120, U.S. Corporation Income Tax

Returns, are not in evidence, and we cannot tell what income, if any, or deductions

made up PCSC’s claimed net losses. Apart from evidence of PCSC’s royalty fees

and credit card expenses (which we discuss below), we find no evidence to

support any actual or constructive PCSC expenditures that might be deductible.

      A.     Royalty fee payments

      Petitioners point to the Franchise Agreement and their tax returns as

evidence that PCSC incurred deductible royalty payments in the years in issue.

However, there is no indication that PCSC actually made cash royalty payments to

Paul or Marilynne in any of the years in issue. Instead, the following occurred:

             1.    Marilynne Graffia’s royalty fee contributions

      In 2005 Marilynne entered into an agreement with PCSC and David entitled

“Agreement to Provide Capital”. The Agreement to Provide Capital states in

relevant part:

      Capital contribution of Stockholder [Marilynne]: Stockholder hereby
      agrees to transfer, assign and contribute to the company [PCSC] the
      first one million dollars ($1,000,000.00) in royalty fee payments made
      pursuant to the * * * franchise agreement, upon their payment and
                                        - 18 -

[*18] receipt by Stockholder, as paid in capital contribution for the
      account of Stockholder.

      In 2005 when her $250,000 royalty payment was due, PCSC did not actually

make payments to Marilynne. Instead, Marilynne reported on her 2005 Federal

income tax return royalty fee income of $250,000 (almost entirely offset by

PCSC’s flow-through losses that she claimed, as we noted above) and PCSC

credited an additional $250,000 to her capital account. PCSC’s corporate minutes

reflect Marilynne’s capital contribution and that PCSC’s corresponding royalty fee

obligation was discharged. The same events transpired in 2006 with Marilynne’s

royalty fee of $275,000. We find that her purported receipt of royalties from

PCSC and her contribution of them to PCSC were fictitious means of inflating her

apparent basis in PCSC to enable her to claim losses.

             2.    Setoff of the Paul Graffia note

      As for the amounts that PCSC purportedly owed Paul for royalty payments,

Paul granted to PCSC (in a document entitled “Loan/Note Settlement Agreement”)

the right to set off his debt under the Paul Graffia note (which PCSC had acquired

from Mr. Olson) against that royalty obligation.9 This settlement agreement


      9
        There was a provision in the Franchise Agreement that prohibited PCSC
from setting off royalty payments with other obligations; but at trial Paul testified
that he waived that provision.
                                       - 19 -

[*19] provides that $135,000 would be set off in 2005 and $250,000 in 2006--the

total amounts of royalties supposedly due.

      Paul did report those royalty amounts on Schedule E, “Supplemental

Income and Loss”, of his income tax returns. However, the royalty income was

fictitious, and we conclude he reported it as window dressing. If PCSC claimed

corresponding deductions for its supposed royalty payments to Paul, then just as

they were fictitious income to Paul they were fictitious expenditures of PCSC; and

any pass-through losses from PCSC that arose from those royalty deductions are

unsubstantiated.

      On his 2005 Schedule C, Paul reported income and claimed deductions (in

much greater amounts) associated with the purported cancellation of the Paul

Graffia note. That is, he reported $133,404 of “Gross receipts”, i.e., arising from

the purported cancellation of the Paul Graffia note, and then he deducted the

following supposedly related items: $109,000 of “Returns and allowances”,10

$155,000 of “Interest - Other”, $40,000 of “Legal and professional services”, and

$8,601 of “Rent/Lease - Other Business Property”. Paul contends (without any

      10
        Paul contends that $109,000 due on the Paul Graffia note represented
alleged advances to Paul that he included in income in the years that they were
received, and therefore, he contends, they should be deductible on his 2005 return.
Even if the note were genuine (we hold it was not), Paul has offered no proof that
he had included $109,000 in income for prior years.
                                       - 20 -

[*20] documentary corroboration) that in pre-suit years he used borrowed money

to pay for the deduction items, but that he did not claim deductions for them in

prior years, because deductions for the items were “suspended” until his purported

debt was paid. We find that these expenses deducted on Paul’s 2005 return were

not paid in 2005 (and we do not reach the question whether they were paid in any

pre-suit year).

             3.    Assignment agreement

      Petitioners also claim that PCSC paid and that Paul received royalty

payments pursuant to an agreement entered into December 2005 entitled

“Assignment of Contract Payments”. This agreement provided, among other

things, that PCSC would assign to Paul its rights to commission payments due

from Olson Contractors, which included a $155,000 guaranteed minimum

payment and that amounts paid to Paul would be deemed royalty fee payments.

Accordingly, Olson Contractors or Mr. Olson, himself, was supposedly to pay

$155,000 directly to Paul to satisfy royalty fees that PCSC supposedly owed him.

We find that no such payment took place in any of the years in issue; and we

cannot tell whether PCSC reported the $155,000 amount in its income--a

necessary step before it could claim its assignment as a deduction. Although both

Paul and Mr. Olson testified that this payment occurred, neither indicated that the
                                        - 21 -

[*21] alleged payment was made during any of the years in issue; and we can find

no documentary evidence to support an actual payment of $155,000 by Olson or

receipt by Paul of that amount. None of Paul’s returns for the years in issue (i.e.,

2005, 2006, or 2007) appear to include this alleged $155,000 payment in income.

We find that PCSC made no such payment.

      Petitioners claim a second assignment by PCSC to Paul occurred in 2006.

In July 2006 PCSC and THI entered into a “Purchase and Sale Agreement” by

which PCSC purportedly sold to THI PCSC’s franchise business, which entailed

PCSC’s interests and obligations (including alleged royalty fee obligations) in the

Franchise Agreement and Facilitation Agreement. Paul claims that pursuant to the

Purchase and Sale Agreement and the Assignment Agreement he received

$250,000 in royalty fees. Even though Paul did report $250,000 as “Royalties

received” on Schedule E of his 2006 return, we find no credible evidence to

support Paul’s actual receipt of this $250,000 in 2005, 2006, or 2007. Again, we

cannot tell whether PCSC included in its reported income the supposed $250,000

payment from THI; and we find that it made no such payment to Paul.

      B.     Credit card payments

      Petitioners claim that David made capital contributions to PCSC in the

amounts of $43,179.85 in 2005, $31,201.60 in 2006, and $56,891 in 2007, in the
                                       - 22 -

[*22] form of credit card payments that David supposedly made on behalf of

PCSC in payment of its expenses. Petitioners did substantiate that David incurred

credit card charges in the amount claimed for 2005; but there is no evidence

documenting any 2006 or 2007 credit card purchases or payments. Moreover,

especially in the absence of any testimony by David, it is unclear which, if any, of

these credit card expenditures actually reflect expenses of PCSC and which, if any,

were actually claimed on PCSC’s returns as deductible business expenses. We do

not find any deductible business expenses of PCSC among David’s credit card

charges.

X.    Petitioners’ tax returns

      For the years in issue, Paul and Marilynne filed separate Federal income tax

returns on Forms 1040, “U.S. Individual Income Tax Return”. Paul prepared his

and Marilynne’s tax returns for the years in issue. On the Schedules E attached to

their respective 2005 and 2006 Forms 1040, Paul and Marilynne each reported as

royalty income amounts consistent with the terms of the Franchise Agreement, set

out above. On his 2007 return Paul reported $159,366 of royalty income, and

petitioners have not accounted for the $34,366 discrepancy between the $125,000

allegedly due under the contract and the income Paul reported. (As we have held

above, Paul and Marilynne received none of these amounts.)
                                       - 23 -

[*23] On his tax returns, Paul claimed NOL carryover deductions of $13,850 for

2005, $315,208 for 2006, and $231,804 for 2007. Marilynne also claimed NOL

deductions of $10,280 for 2005, $20,163 for 2006, and $28,900 for 2007. Paul

and Marilynne each attached, to their separate tax returns, individual schedules

calculating their respective NOL carryovers for 2005, 2006, and 2007, which show

that the claimed losses originated in 2000 and 2003. However, their returns for

2000 and 2003 are not in our record; and, more important, there is no evidence

before us to substantiate Paul’s or Marilynne’s prior-year losses that would have

given rise to NOL deductions for either of them.

      For the years in issue David and his wife Amy filed joint Federal income tax

returns. H&R Block prepared David and Amy’s 2005, 2006, and 2007 joint

returns. On their return for 2007, they reported $4,265 of capital gain on line 13.

XI.   Notices of deficiency and petitions

      On November 22, 2010, the IRS issued a notice of deficiency to Paul for his

2005, 2006, and 2007 tax years. In that notice the IRS determined that Paul did

not have any royalty income for any of the years in issue, that Paul did not have

gross receipts of $133,404 arising from the cancellation of the Paul Graffia note,

which he reported on his 2005 Schedule C, and that he was not entitled to any

offsets or deductions that he claimed on his 2005 Schedule C. The IRS also
                                        - 24 -

[*24] determined that Paul was not entitled to any of the NOL deductions that he

claimed and that he is liable for section 6662(a) accuracy-related penalties for

2005, 2006, and 2007.

      The IRS issued to Marilynne two notices of deficiency, one on April 1,

2009, for her 2005 tax year, and a second on November 23, 2010, for her 2006 and

2007 tax years. In those notices the IRS determined that Marilynne did not have

royalty income of $250,000 for 2005 and $274,562 for 2006, and that she was not

entitled to claim deductions for any PCSC flow-through losses. The IRS also

determined that for 2005, 2006, and 2007 Marilynne was not entitled to claim any

NOL deductions and is liable for section 6662(a) accuracy-related penalties.

      The IRS issued to David and Amy notices of deficiency dated April 1, 2009,

for tax year 2005 and dated November 18, 2010, for tax years 2006 and 2007, in

which the IRS determined that David and Amy were not entitled to deduct any

PCSC flow-through losses. In addition, the IRS determined that David and Amy

received a total of $8,757 in capital gains (i.e., not only the $4,265 they reported)

and thus failed to report $4,492 in capital gain income from the sale of stock in
                                       - 25 -

[*25] 2007.11 The IRS determined that David and Amy are liable for section

6662(a) accuracy-related penalties for 2005, 2006, and 2007.

      Petitioners each timely filed petitions seeking redetermination of the

deficiencies determined in their respective notices of deficiency. These cases have

been consolidated for purposes of trial.

                                     OPINION

I.    Evidentiary principles

      A.     Burden of proof

      Generally, the Commissioner’s determinations set forth in a notice of

deficiency are presumed correct, and the taxpayer bears the burden of proving the

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

115 (1933). Moreover, deductions are a matter of legislative grace, and the

taxpayer bears the burden of proving that he is entitled to any deduction claimed.

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).




      11
         The notice of deficiency states: “It is determined that your net capital
gains are $8,757.00 for taxable year 2007, as computed in schedule attached,
rather than $4,265.00 as reported on your income tax return for 2007.” The
schedule attached to the notice of deficiency reflected an entry of $4,265 (the same
amount reported on line 13 of David and Amy’s tax return) as long-term capital
gain and an additional entry of $4,492 as short-term capital gain.
                                        - 26 -

[*26] B.     Lack of records

      Section 6001 requires that–

             Every person liable for any tax imposed by this title, or for the
      collection thereof, shall keep such records, render such statements,
      make such returns, and comply with such rules and regulations as the
      Secretary may from time to time prescribe. * * * [Emphasis added.]

Taxpayers are thus required to keep sufficient records to substantiate their gross

income, deductions, credits, and other tax attributes. See also 26 C.F.R.

sec. 1.6001-1(a), Income Tax Regs. Taxpayers are required to retain their books

and records as long as they may become material:

             (e) Retention of records.--The books or records required by
      this section shall be kept at all times available for inspection by
      authorized internal revenue officers or employees, and shall be
      retained so long as the contents thereof may become material in the
      administration of any internal revenue law. [Emphasis added.]

26 C.F.R. sec. 1.6001-1(e). For many of the disputed points in these cases,

petitioners lack records entirely. The excuse that Paul offers for this gap is that

(he says) their records were among articles wrongfully discarded by a storage

facility. However, Paul did not testify about the nature of the records nor how

they came to be in the storage facility; and in a suit brought by Marilynne (not

Paul or David) and Mr. Olson against the storage facility, an appraisal of the

missing items was obtained, but the records do not appear among the listed items.
                                        - 27 -

[*27] Moreover, petitioners allege that Mr. Olson had custody of the stored items

because they served as collateral for Paul’s alleged debts to Mr. Olson; but it is

hard to see why business records would have been included among items over

which petitioners ceded custody to Mr. Olson. We are not persuaded that the

missing records were lost by the storage facility, nor that they were ever in that

facility, nor that they ever existed.

      In addition to a lack of PCSC’s own accounting records (apart from a few

bank statements and records for public storage payments), petitioners did not offer

accounting records from Mr. Olson or any of his businesses that would have

corroborated petitioners’ contentions about their and PCSC’s business dealings

with Mr. Olson, if those contentions were correct.

      C.     Lack of testimony by David and Marilynne

      For much of their case, petitioners rely solely on Paul’s testimony; and, in

particular, David and Marilynne--who were present in court throughout the trial--

did not testify, even though deductions, losses, and transactions particular to them

are at issue here. In evaluating the taxpayer’s evidence, we keep in mind “[t]he

rule * * * that the failure of a party to introduce evidence within his possession

and which, if true, would be favorable to him, gives rise to the presumption that if

produced it would be unfavorable.” See Wichita Terminal Elevator Co. v.
                                        - 28 -

[*28] Commissioner, 6 T.C. 1158, 1165 (1946), aff’d, 162 F.2d 513 (10th Cir.

1947).12 The Commissioner aptly observes in his post-trial briefs that this

principle counts against petitioners in several of the matters in dispute.

Petitioners respond as follows:

      Petitioners were without the assistance of counsel. David and
      Marilynne were not called to testify by Petitioners because Petitioners
      fully expected Respondent to call them to testify whereupon
      Petitioners could redirect and/or cross examine saving the Court’s
      time. Not having David and Marilynne testify is the result of




      12
         This negative presumption may not arise “where the evidence is equally
available to both parties”; and for this purpose testimonial evidence may be
considered “available” to the Commissioner where he could subpoena the witness
to testify at trial. See Jordan v. Commissioner, 134 T.C. 1, 10 (2010) (citing Kean
v. Commissioner, 469 F.2d 1183, 1187 (9th Cir. 1972)). However, “The
determination of the question of equal availability depends upon all the facts and
circumstances bearing upon the witness’s relation to the parties and not merely
upon his physical presence at trial or accessability for service of a subpoena. The
potential witness must be equally available both legally and practically. * * *
[Where the taxpayers] had superior knowledge of the testimony that might be
expected from * * * [a witness, he] * * * was not as available to the Commissioner
as he was to” the taxpayers. Kean v. Commissioner, 469 F.2d at 1188. The un-
called witnesses in these cases were petitioners themselves (who are relatives of
the other petitioner), so that petitioners obviously had superior knowledge of the
testimony that they could be expected to give (especially since this Court’s Rules
deliberately restrict the Commissioner’s ability to depose a petitioner; see
Rule 74(c)). Moreover, whereas the un-called witness in Jordan v. Commissioner,
134 T.C. at 10, “potentially could corroborate” other testimony, the witnesses not
called at the trial of these cases could have given unique testimony about their
own supposed transactions. The negative presumption of Wichita Terminal is
appropriate here.
                                        - 29 -

[*29] ineffective legal representation resulting from Petitioners not
      able to avail themselves of legal counsel.

In so saying, petitioners make two distinct points:

             1.    Lack of counsel

      Petitioners implicitly renew their objection to the Court’s refusal to allow

them a continuance in these cases to enable them to hire counsel. However, the

cases had previously been continued three times; and petitioners did have counsel

who previously withdrew from the case (and who had replaced prior counsel who

had also withdrawn). We concluded that petitioners had been given sufficient

opportunity to hire counsel and that a further continuance was not likely to result

in their actually being represented by counsel at any trial scheduled anytime in the

near future. As we stated in our order of January 24, 2012:

      While a self-represented petitioner would often prefer to be
      represented by counsel, more than half of this Court’s petitioners
      represent themselves at trial. This Court is therefore experienced
      with the difficulties that such self-represented petitioners face and is
      accustomed to helping them acclimate themselves to the courtroom
      and its procedures. Moreover, we note that Mr. Graffia is the
      principal spokesman for the petitioners, * * * and that his filings
      show him to be a literate, organized, and articulate person. The
      absence of counsel is not a compelling reason to delay this
      case--especially where two attorneys have withdrawn because of
      disagreements between counsel and clients. We see no reason to
      assume that a third attorney would fare any differently. Moreover,
      since Mr. Graffia emphasizes his declining health, we infer that a
                                        - 30 -

[*30] later trial may be more problematic for Mr. Graffia, not less,
      and we are therefore all the more disinclined to delay the trial
      in this case.

Petitioners’ lack of counsel does not alter the burden of proof in these cases nor

the appropriateness of drawing negative inferences from the silence of two of the

petitioners.

               2.   Expectation of the Commissioner’s calling the witnesses

      If it is true that “Petitioners fully expected Respondent to call them to

testify”, then that expectation unaccountably survived the Court’s warning to the

contrary. At the conclusion of the first day of trial, the following exchange

occurred:

      THE COURT: * * * [W]e must finish this on Thursday morning.

            Petitioners, we’ll finish the testimony of Mr. Paul Graffia and
      then will Petitioners be calling themselves as witnesses. Mr. David
      Graffia, will you be testifying?

      MR. D. GRAFFIA: I’m not sure at this point.

      THE COURT: All right. Marilynne Graffia, will you be testifying?

      MRS. M. GRAFFIA: I’m not sure either.

      MR. P. GRAFFIA: We’re not sure.
                                       - 31 -

[*31] THE COURT: All right. Of course, the chance exists that if
      you do not call yourselves as witnesses that Respondent has
      the p[re]rogative of doing that.

      MR. P. GRAFFIA: Sure.

When trial resumed and Paul concluded his testimony, petitioners stated they had

no other witnesses to call. They explained that, instead, they would be content to

cross-examine David and Marilynne after the Commissioner called them as

witnesses. The Court warned them as follows:

      THE COURT: All right. Let me explain a couple of risks that you
      face.

      MR. P. GRAFFIA: Okay. Thank you, sir.

      THE COURT: If you decide we won’t call them and you say
      Petitioner rests, that means that you have put on your case and you’re
      done. You face the risk that at that point Respondent says,
      Respondent rests. And then if there was information you needed to
      get on through these other witnesses, you didn’t put it on. That’s one
      risk that you face.
             [Emphasis added.]

The Court then addressed “Another risk”--i.e., that petitioners’ cross-examination

of witnesses could not exceed the scope of the Commissioner’s direct

examination; but because the Commissioner then agreed that he would not assert

objections about the scope of cross-examination, the Court then stated:
                                       - 32 -

[*32] THE COURT: Oh, well, then that is not a risk and they will not
      object that your questions in cross go outside the scope of the
      direct. Do you understand what I’m saying?

      MR. P. GRAFFIA: Yes, sir, one second please.

      THE COURT: I’ll be glad to explain it again.

      MS. M. GRAFFIA: That’s all right.

      THE COURT: Okay.

      MR. P. GRAFFIA: Your Honor, we will not be calling any further
      witnesses at this time.

Nonetheless, Paul did resume the witness stand (without objection) to substantiate

and comment on an additional exhibit, after which the Court asked--

      THE COURT: * * * Do you have any other evidence that you wish to
      offer?

      MR. P. GRAFFIA: No, Your Honor.

      THE COURT: Then I’d like to hear you tell me the Petitioners rest.

      MR. P. GRAFFIA: Petitioners rest, Your Honor.

      THE COURT: All right, Respondent.

      MS. CARBONE: Your Honor, Respondent is not going to call any
      witnesses. * * *

Petitioners made no response to counsel’s statement that respondent would call no

witnesses. To inform the parties’ posttrial briefing of the cases the Court then
                                       - 33 -

[*33] made preliminary observations about some of the evidence, including the

following:

      I just note that neither Mrs. Marilynne Graffia nor Mr. David Graffia
      testified. And all we have is rather summary testimony about their
      involvement from other witnesses, chiefly Mr. Graffia. We have a
      principle in evaluating evidence for which the case that we usually
      [c]ite is Wichita Elevator [sic] that says that where a party has the
      burden of proof on a point and they put on inferior evidence, not the
      best evidence[, t]hen we infer that if they’d put on the best evidence
      the facts might not have been in their favor. If the facts about Joe are
      important to the case and you don’t put on the testimony of Joe, it
      makes it sound like maybe they didn’t want Joe to testify because it
      wouldn’t have been so hot. Anyway, that principle is at work in
      evaluating testimony, and so it’s relevant to my consideration of that
      issue, I think.

      There can be no plausible suggestion that petitioners were lulled into

expecting that the Commissioner would call David or Marilynne as witnesses, nor

that petitioners were not warned that failing to call David and Marilynne might

work against petitioners’ case. Rather, petitioners made their own tactical

judgments after being explicitly warned.

II.   Disregarding fictitious arrangements

      We have found that the critical agreements underlying petitioners’

position--i.e., the royalty agreements between PCSC and Paul and Marilynne;

Paul’s $383,400 promissory note to Mr. Olson and David’s $385,000 promissory

note given to Mr. Olson; and David’s and Mr. Olson’s reciprocal $1 million
                                       - 34 -

[*34] notes--were not bona fide but were shams. “[W]e define ‘sham in

substance’ as the expedient of drawing up papers to characterize transactions

contrary to objective economic realities and which have no economic significance

beyond expected tax benefits.” Falsetti v. Commissioner, 85 T.C. 332, 347

(1985); see also Frank Lyon Co. v. United States, 435 U.S. 561, 572-573 (1978).

The Court of Appeals for the Seventh Circuit (to which an appeal would be taken

in this case) reviewed an instance in which “the tax court concluded that * * *

transactions were shams lacking economic substance”13 and held that the question

whether a contract is a sham “is ‘essentially a factual determination.’” Forseth v.

Commissioner, 845 F.2d 746, 748 (7th Cir. 1988) (quoting Thompson v.

Commissioner, 631 F.2d 642, 646 (9th Cir.1980), aff’g 66 T.C. 1024 (1976)),

aff’g 85 T.C. 127 (1985). Petitioners failed to put on a persuasive showing that

they entered into these agreements in good faith, intending to be bound by them


      13
         Notwithstanding the reference in Forseth v. Commissioner, 845 F.2d 746,
748 (7th Cir. 1988), aff’g 85 T.C. 127 (1985), to “shams lacking in economic
substance”, the same court later characterized Forseth as a case in which “there are
no transactions”, Yosha v. Commissioner, 861 F.2d 494, 500 (7th Cir. 1988), aff’g
Glass v. Commissioner, 87 T.C. 1087 (1986)--i.e., as if Forseth had involved sham
in fact rather than sham in substance. However, Yosha sustained the Tax Court’s
finding that a transaction “really occurred but has no economic substance”,
characterizing it as a “finding [that] is not clearly erroneous.” Id. Thus, the Court
of Appeals for the Seventh Circuit evidently treats both shams in fact and shams in
substance as factual issues.
                                        - 35 -

[*35] and expecting to have to honor them. On the contrary, these agreements and

the circumstances surrounding them bear indicia of being shams.

      Family members and friends may enter into bona fide agreements that will

be legally binding; but agreements between related parties may call for “close

scrutiny” in order to assure that they ought to be respected. Bhatia v.

Commissioner, T.C. Memo. 1996-429 (“close scrutiny of transactions between

taxpayers and their controlled corporations”). When family members Paul,

Marilynne, and David allege agreements between and among themselves and

PCSC (owned by Marilynne and David) and their friend Mr. Olson, they invite

such scrutiny--and cannot bear up under it. The royalty agreements, which were

between PCSC (owned by David and Marilynne) and Marilynne and Paul,

provided not for commissions but rather for substantial set annual fees for the use

of a program that had no demonstrated profit potential, and these agreements thus

reveal a pronounced “absence of arm’s length dealing”, Falsetti v. Commissioner,

85 T.C. at 348 (citing Estate of Franklin v. Commissioner, 64 T.C. 752 (1975),

aff’d, 544 F.2d 1045 (9th Cir. 1976))--especially with regard to Marilynne, who

had no role at all in the development of the program. The supposed obligations

canceled each other out (i.e., Paul executes a note but it is ultimately offset by

supposed royalties; David and Mr. Olson exchange $1 million notes). See Kaplan
                                         - 36 -

[*36] v. Commissioner, T.C. Memo. 2005-218 (“petitioner purportedly would

have owed the new corporation $800,000, which would have been exactly offset

by the $800,000 that the new corporation purportedly would have owed petitioner.

These circumstances further denote ‘the inherent lack of substance in the loans.’”

(quoting Oren v. Commissioner, T.C. Memo. 2002-172, aff’d, 357 F.3d 854

(8th Cir. 2004))). “The presence of deferred debt that is in substance or in fact not

likely to be paid”--i.e., virtually all of the debts at issue here--“is an indicium of

lack of, or exaggeration of, economic substance.” Horn v. Commissioner, 90 T.C.

908, 938 (1988); see also Broz v. Commissioner, 137 T.C. 46, 61(2011) (“The

taxpayer has not made an economic outlay, however, if the lender is a related party

and if repayment of the funds is uncertain”). “[F]actors demonstrating that the

debt was sham and not genuine are: no arm’s-length negotiations occurred

between the parties * * *; the loan did not require security, guaranty, or collateral;

the note did not state when interest had to be paid; * * * [the obligor] made no

payment on the loan for a significant period”, Gurdin v. Commissioner, T.C.

Memo. 1987-69--factors present in whole or in part with each of the debts at issue

here.

        As the Court of Appeals for the Seventh Circuit has explained:
                                        - 37 -

[*37]         The freedom to arrange one’s affairs to minimize taxes
              does not include the right to engage in financial fantasies
              with the expectation that the Internal Revenue Service
              and the courts will play along. The Commissioner and
              the courts are empowered, and in fact duty-bound, to
              look behind the contrived forms of transactions to their
              economic substance and to apply the tax laws
              accordingly. * * *

Saviano v. Commissioner, 765 F.2d 643, 654 (7th Cir.1985), aff’g 80 T.C. 955

(1983). When we take that look behind the Graffias’ papers, we find no economic

reality.

III.    Royalty fee income

        Cash basis taxpayers such as Paul and Marilynne must include amounts in

their income when those amounts are actually or constructively received. 26

C.F.R. sec. 1.451-1(a), Income Tax Regs.; see Corliss v. Bowers, 281 U.S. 376,

378 (1930) (“income that is subject to a man’s unfettered command and that he is

free to enjoy at his own opinion may be taxed to him as his income, whether he

sees fit to enjoy it or not”). Petitioners argue that Paul actually received some

royalty payments from PCSC and that Paul and Marilynne constructively received

the remainder of the royalty income from PCSC.14 The Commissioner responds

        14
         Although this contention results in taxable income to petitioners,
petitioners make this contention to support their position that PCSC as payor was
entitled to deduct those royalty payments (and that the losses they generated were
                                                                       (continued...)
                                       - 38 -

[*38] that PCSC lacked the funds to make any royalty payments to Paul or

Marilynne, and that they did not actually or constructively receive the royalty

income. The Commissioner is correct.

      A.     Actual receipt

      Petitioners contend that Paul actually received royalty payments of

$155,000 and $250,000 from Mr. Olson (or his companies), but they point to no

cash, check, or bank transfer effectuating those payments. They argue that actual

receipt happened when PCSC assigned to Paul its interests in contracts with Mr.

Olson (i.e., PCSC’s Facilitation Agreement with Olson Contractors and the

Purchase and Sale Agreement with THI). However, as we noted above, there is no

proof that PCSC included these amounts in income before deducting them as

payments to Paul; there is no evidence documenting Paul’s receipt of these funds;

and there is no evidence that Mr. Olson made the alleged payments during the

years in issue. Thus, we conclude that Paul did not actually receive $155,000 or

$250,000 in royalty fees from Mr. Olson or his companies.




      14
        (...continued)
then properly passed through to Marilynne and David), and that Marilynne’s
contribution of royalties back to PCSC increased her basis in PCSC (and entitles
her to deduct the passed-through losses). We discuss those corollary issues below.
                                        - 39 -

[*39] Petitioners also contend that Paul received $385,000 in royalty payments

when PCSC canceled Paul’s note in 2005 to setoff royalty payments due him for

2005 and 2006, and that this cancellation income was reported on Paul’s 2005

Schedule C.

      While it is possible for the setoff of a debt to result in income either as a

form of a payment due or discharge of indebtedness income under section 108, see

OKC Corp. v. Commissioner, 82 T.C. 638, 647-649 (1984), neither would be

appropriate in this case, because we conclude for the following reasons that the

note Paul executed in favor of Mr. Olson was not genuine indebtedness.

      The parties contend that Mr. Olson advanced some compensation to Paul as

they worked on deals together and that Paul was to repay these amounts from

profits that they hoped the deals would generate. Any such arrangement was not

documented, and we are not convinced that they ever agreed to it. Even if we

credit their story, however, Mr. Olson’s alleged transfers to Paul were not made at

arm’s length, did not comport with normal business practice, and were not treated

as loans either by Mr. Olson or by Paul until well over 10 years later when they

were ostensibly memorialized in the note Paul executed. Paul did not make any

principal or interest payments on the debt before it was canceled, and the debt did
                                       - 40 -

[*40] not have a fixed due date. See Frierdich v. Commissioner, 925 F.2d 180,

182-184 (7th Cir. 1991), aff’g T.C. Memo. 1989-393.

      Moreover, the conditional nature of Paul’s supposed obligation adds

additional support to our conclusion. An obligation is less likely to be a true debt

if it will be repaid only from the profits of a business. Zappo v. Commissioner, 81

T.C. 77, 88-89 (1983) (citing Lemery v. Commissioner, 52 T.C. 367 (1969), aff’d,

451 F.2d 173 (9th Cir. 1971)). Mr. Olson was supposedly to be repaid when the

ventures turned a profit (which they never did). The note Paul executed in 2004

did not recharacterize the conditional obligation (which we find to be the most that

the parties may have intended) into a genuine indebtedness.

      Accordingly, Paul should not have included income from cancellation of the

Paul Graffia note on his 2005 Schedule C. See Hudson v. Commissioner,

103 T.C. 90, 108 (1994), aff’d, 71 F.3d 877 (5th Cir. 1995). Petitioners make no

other contentions regarding Paul or Marilynne’s actual receipt of royalty

payments. Accordingly, we conclude that neither Paul nor Marilynne actually

received royalty payments in cash or property.

      B.     Constructive receipt

      Petitioners also contend that royalty payments were constructively received

by Paul and Marilynne when the payments became contractually due to them, and
                                        - 41 -

[*41] that constructive receipt cannot be defeated by PCSC’s mere lack of ready

funds, citing Sainte Claire Corp. v. Commissioner, T.C. Memo. 1997-171, aff’d

without published opinion sub nom. Boccardo v. Commissioner, 164 F.3d 629

(9th Cir. 1998).

      26 C.F.R. section 1.451-2(a), Income Tax Regs., describes the doctrine of

constructive receipt as follows:

      Income although not actually reduced to a taxpayer’s possession is
      constructively received by him in the taxable year during which it is
      credited to his account, set apart for him, or otherwise made available
      so that he may draw upon it at any time, or so that he could have
      drawn upon it during the taxable year if notice of intention to
      withdraw had been given. However, income is not constructively
      received if the taxpayer’s control of its receipt is subject to substantial
      limitations or restrictions. * * *

Whether a taxpayer constructively received income “is essentially a question of

fact.” Avery v. Commissioner, 292 U.S. 210, 214 (1934); see also Willits v.

Commissioner, 50 T.C. 602, 612-613 (1968). There is no constructive receipt if

the payor lacks the funds to make the payments that are due. Estate of Noel v.

Commissioner, 50 T.C. 702, 706-707 (1968); Wise v. Commissioner, T.C. Memo.

1997-135.

      However, as petitioners contend, there may be constructive receipt of an

amount due the taxpayer where a debtor, who is experiencing a lack of ready cash,
                                        - 42 -

[*42] has the ability to borrow the funds necessary for payment. But PCSC’s

financial situation is easily distinguishable from that of the obligor in Sainte Claire

Corp., who had a net worth of over $50 million, had substantial income, and had a

ready ability to borrow the funds necessary to satisfy his obligation. PCSC’s

situation, on the other hand--no bank account, no cash, no book value, and no

paying customers--is more like that of the obligor in Rhombar Co. v.

Commissioner, 47 T.C. 75, 85-86 (1966), aff’d, 386 F.2d 510 (2d Cir. 1967),

where nonpayment of amounts due was the result of the obligor’s “stringent cash

position” and the unpaid amounts were, consequently, held not constructively

received by the obligees.

      On the evidence before us we find that PCSC did not have enough funds

and was not in a position to borrow sufficient outside funds in an arm’s-length

transaction to satisfy its royalty obligations. On the basis of those findings we

conclude that neither Paul nor Marilynne constructively received royalty fees due

from PCSC. As a result, the fees are not includable in their gross income for 2005,

2006, or 2007.15

      15
         The Commissioner amended his answer to include the alternative
contention that, if PCSC was engaged in a trade or business for profit (as we hold
it was in part III.A below), then the royalties should be taxable income to Paul and
Marilynne. However, since we find that the royalties were fictitious, we do not
                                                                       (continued...)
                                          - 43 -

[*43] IV.    Pass-through of PCSC losses

      Petitioners contend that David and Marilynne in their capacity as

S corporation shareholders are entitled to deduct their respective shares of PCSC

losses for the years in issue. See sec. 1366(a)(1). In order to be entitled to flow-

through deductions for losses attributable to PCSC, Marilynne and David must

show: (a) that PCSC was a business entered into for profit, (b) that the

shareholders materially participated in PCSC’s activities, (c) that PCSC in fact

incurred losses, and (d) that the shareholders had bases in PCSC equal to the

amount of the losses claimed. As we explain below, petitioners succeed in

establishing the first of these prerequisites, and Marilynne succeeds at the second,

but they fail at showing the remainder.

      A.     PCSC’s trade or business

      A taxpayer who is carrying on a trade or business may deduct ordinary and

necessary expenses incurred in connection with the operation of the business. Sec.

162(a). However, a taxpayer generally may not deduct expenses incurred in

connection with a hobby or other nonprofit activity to offset taxable income from

other sources. Sec. 183(a). Section 183(c) defines an “activity not engaged in for


      15
        (...continued)
sustain this alternative contention.
                                         - 44 -

[*44] profit” as “any activity other than one with respect to which deductions are

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

section 212.” An activity constitutes a “trade or business” within the meaning of

section 162--and it escapes the limitation of section 183--if the taxpayer’s actual

and honest objective is to realize a profit. Osteen v. Commissioner, 62 F.3d 356,

358 (11th Cir. 1995), aff’g in part, rev’g in part T.C. Memo. 1993-519. The

expectation of profit need not have been reasonable; however, the taxpayer must

have entered into the activity, or continued it, with the objective of making a

profit. Hulter v. Commissioner, 91 T.C. 371, 393 (1988); 26 C.F.R. sec. 1.183-

2(a), Income Tax Regs.16

      The Commissioner contends that PCSC was not a business entered into for

profit; therefore, deductions relating to its losses should be disallowed. Whether


      16
         Section 1.183-2(b), Income Tax Regs., provides a list of factors to be
considered in the evaluation of a taxpayer’s profit objective: (1) the manner in
which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his
advisers; (3) the time and effort expended by the taxpayer in carrying on the
activity; (4) the expectation that assets used in the activity may appreciate in
value; (5) the success of the taxpayer in carrying on other similar or dissimilar
activities; (6) the taxpayer’s history of income or losses with respect to the
activity; (7) the amount of occasional profits, if any, from the activity; (8) the
financial status of the taxpayer; and (9) elements of personal pleasure or
recreation. At least five of these factors--i.e., numbers 1, 2, 3, 8, and 9--are plainly
in petitioners’ favor; and the Commissioner’s contentions to the contrary focus on
Marilynne and David and ignore Paul’s substantial work.
                                        - 45 -

[*45] petitioners through PCSC engaged in construction project financing with the

requisite objective of making a profit is one of fact to be resolved on the basis of

all the surrounding facts and circumstances. Lemmen v. Commissioner, 77 T.C.

1326, 1340 (1981); 26 C.F.R. sec. 1.183-2. We have found that PCSC was

seriously active in real estate development and financing and had a genuine profit

motive. Although Paul was not an owner of PCSC, he acted as its agent with the

express authorization of PCSC’s owners (Paul’s wife and his son), and he and they

clearly hoped and intended for PCSC to be profitable. Although PCSC was not

profitable during the years in issue, Paul developed an expertise in construction

financing (including tenant improvement financing), and the work that he did

during the years in issue laid the groundwork for the later successful competition

of Market Square Project in Zion, Illinois, and for other development projects that

had a possibility of coming to fruition. The royalty agreements that purported to

transfer to PCSC the rights to the Tenant Improvement Program were fictitious,

but the Graffia family’s collective intention to make money through PCSC was

not. Accordingly, we conclude that PCSC was a business engaged in for profit.

      B.     Deductions underlying PCSC’s losses

      In order to deduct losses passed through to them from PCSC, petitioners

must establish, inter alia, that PCSC in fact incurred the claimed losses of
                                        - 46 -

[*46] $447,693 in 2005, $491,323 in 2006, and $137,378 in 2007. See Burke v.

Commissioner, T.C. Memo. 1995-608. Petitioners have not explained how those

reported losses were calculated or indicated which PCSC deductions might

account for them; and the only evidence of PCSC expenses that potentially could

be deductible relates to royalty payments and credit card expenses, which we now

discuss.

             1.     PCSC’s royalty expenses

      For three related reasons, PCSC could not properly deduct the royalty

expenses underlying its claimed losses. First, petitioners simply failed to

substantiate the deductions. The royalty agreements that supposedly generated the

royalties were fictitious, and no royalties were in fact paid.

      Second, PCSC lacked sufficient basis in the Paul Graffia note to support the

deduction. PCSC deducted $385,000 as royalty expense in each of 2005 and 2006

not as the result of claiming to pay cash in that amount but rather as the supposed

result of cancelling Paul’s note in that amount. The royalty deductions therefore

depend on PCSC’s basis in Paul’s note. PCSC claims that its basis in Paul’s note

is $385,000, because David acquired it for his own note in that amount (thus

giving David a basis of $385,000 in Paul’s note) and then contributed it to PCSC,

which took a carryover of that basis. Since we find that both notes did not
                                         - 47 -

[*47] evidence genuine indebtedness, they will not yield any basis to support

PCSC’s deductions. Kaplan v. Commissioner, T.C. Memo. 2005-218 (basis not

increased by a “purported loan * * * [that] involved no actual economic outlay”).

      Third, as a timing matter, section 267 bars PCSC’s deductions for the years

in issue. Generally, an accrual-method taxpayer like PCSC may deduct ordinary

and necessary business expenses in the tax year that all events have occurred that

establish the fact of the liability, the amount of the liability is set, and economic

performance has occurred with respect to the liability. 26 C.F.R. sec. 1.446-

1(c)(1)(ii)(A), Income Tax Regs. However, when those business expenses are

owed to a related cash-basis taxpayer, section 267(a)(2) provides that an accrual-

basis taxpayer may deduct them only in the tax year that the amount involved is

includable in the gross income of the cash-basis payee. Both Paul and Marilynne

are related to PCSC for purposes of section 267. See sec. 267(b)(2), (c)(2), (e)(1).

PCSC uses the accrual method of accounting; Paul and Marilynne use the cash

method of accounting. As we concluded above, the royalty fees ostensibly due

from PCSC to Paul and Marilynne were not includable in Paul’s or Marilynne’s

gross income for 2005, 2006, or 2007. Thus, pursuant to section 267(a)(2), the

royalty fees would not be deductible to PCSC for any of those years.
                                       - 48 -

[*48]         2.    Credit card expenditures

        A taxpayer may deduct ordinary and necessary expenses paid or incurred in

carrying on a trade or business. Sec. 162(a). A taxpayer, however, must maintain

records sufficient to substantiate his claimed deductions. See sec. 6001; 26 C.F.R.

sec. 1.6001-1(a).

        Petitioners’ evidence with regard to PCSC credit card expenses incurred on

David’s credit card is limited to a 2005 year-end statement that is marked with

handwritten notes totaling the expenditures that petitioners claim to be attributable

to PCSC. The alleged PCSC expenses are commingled with hundreds of other

transactions listed on the statement, some of which appear personal and others of

which are evidently related to another business in which David had an interest.

We have no reliable way of determining which particular credit card purchases

may have been for PCSC or determining the business purpose for those particular

purchases, nor even for determining the purchases for which PCSC claimed

deductions. There is no evidence with regard to any 2006 or 2007 credit card

purchases or payments. The substantiation here is inadequate to support section

162 business expense deductions. Accordingly, to the extent PCSC attempted to

deduct amounts charged to David’s credit card, those deductions are not allowed

to PCSC for 2005, 2006, or 2007.
                                        - 49 -

[*49] We can find no other evidence to support any other PCSC deductions for

2005, 2006, or 2007. Since no allowable deductions have been established for

PCSC for 2005, 2006, or 2007, petitioners have failed to carry their burden to

prove that PCSC incurred tax losses in any amounts for those years. Accordingly,

the entirety of Marilynne’s and David’s deductions for their respective shares of

PCSC’s losses are unsubstantiated. Our analysis could end there, but we briefly

address the remaining prerequisites that petitioners had the burden to satisfy.

      C.     Shareholders’ material participation

      Section 469 generally disallows the current deduction of any “passive

activity” loss. A passive activity is any trade or business in which the taxpayer

does not “materially participate”. Sec. 469(c)(1). Material participation is defined

as involvement in the operations of the activity that is “regular”, “continuous”, and

“substantial”. Sec. 469(h)(1); 26 C.F.R. sec. 1.469-5T(a), Temporary Income Tax

Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988). It is clear that Paul was regularly,

continuously, and substantially engaged on behalf of PCSC in attempting to enter

into development and financing deals during the years in issue and in preceding

years. But since his wife Marilynne and his son David were the PCSC

shareholders who claimed the loss deductions on their tax returns, it is their status
                                        - 50 -

[*50] that matters; and the IRS contends that neither Marilynne nor David

“materially participated” in PCSC.

      Especially in light of the fact that neither of them testified, the record does

not show a substantial quantum of PCSC activity by either of them during the

years in issue. As for Marilynne, however, petitioners’ principal contention17 is

that Paul’s activity is properly attributed to her under 26 C.F.R.

sec. 1.469-5T(f)(3), Temp. Income Tax Regs.:

      Participation of spouse. In the case of any person who is a married
      individual (within the meaning of section 7703) for the taxable year,
      any participation by such person's spouse in the activity during the
      taxable year (without regard to whether the spouse owns an interest in
      the activity and without regard to whether the spouses file a joint
      return for the taxable year) shall be treated, for purposes of applying
      section 469 and the regulations thereunder to such person, as
      participation by such person in the activity during the taxable year.

Paul’s participation is thus treated as participation by Marilynne, and her

participation was therefore material.

      As for David, we have found that he maintained full-time employment

outside of PCSC, and that it was Paul, not David, who performed substantially all


      17
        Petitioners made this contention as early as their first pretrial
memorandum filed in October 2010 and repeated it at trial (at which Paul testified
that Marilynne was a “spousal activity participant”) and in both of their post-trial
briefs. The Commissioner has never answered or even addressed this contention
or paragraph (f)(3) of the regulation.
                                       - 51 -

[*51] of PCSC’s activities during the years in issue. We have found that David

did not expend as much as 100 hours per year working for PCSC in any of the

years in issue or in preceding years. We conclude that he has not satisfied any of

the standards in section 469 or 26 C.F.R section 1.469-5T(a), for material

participation in PCSC; and David’s deductions for losses from PCSC are

disallowed for the years in issue under section 469(a), to the extent they exceed

income from his passive activities.

      D.     Shareholders’ basis

      A shareholder’s initial basis in his stock corresponds to the cost of the stock

plus capital contributions. Secs. 1011-1016; Pugh v. Commissioner, 213 F.3d

1324, 1330 (11th Cir. 2000), rev’g T.C. Memo. 1999-38. Neither David nor

Marilynne substantiated an amount paid as the initial cost of the stock, and to

establish basis both of them depend on showing subsequent contributions of

capital--as to which neither of them testified. Petitioners argue that Marilynne’s

contribution of capital was her ostensible assignment of royalties. Likewise,

petitioners argue that David’s main contributions of capital were his contribution

of Paul’s note for $385,000 (which David acquired by trading his own equivalent

note) and his exchange of his $1 million note for THI’s $1 million note. However,

we have found these transactions to be fictitious. Because the notes did not result
                                       - 52 -

[*52] in any real change in the economic situations of the parties, the notes did not

establish any basis in the PCSC stock for David or Marilynne. See Kaplan v.

Commissioner, T.C. Memo. 2005-218 (basis not increased by a “purported loan

* * * [that] involved no actual economic outlay”).

      David also contends that he made credit card expenditures on PCSC’s

behalf that increase his basis in PCSC. And it is true that “an outlay by a

stockholder in behalf of his corporation, absent any fixed obligation for

repayment, is generally regarded as a contribution to capital which should be

added to the basis of his stock.” Koree v. Commissioner, 40 T.C. 961, 965 (1963).

However, because David failed to substantiate the business purpose of his credit

card expenditures--i.e., because he failed to show that he did in fact make

expenditures on PCSC’s behalf--the factual predicate for his contention is simply

absent. See Kaplan v. Commissioner, T.C. Memo. 2005-218 (“Petitioner bears the

burden of proving that he incurred the claimed expenses, that they were paid to

protect or enhance the value of his investment * * *, and that they were

contributions to * * * capital”).

      Consequently, neither shareholder could claim any loss deductions derived

from PCSC. Bertoli v. Commissioner, 103 T.C. 501, 515-516 (1994).
                                        - 53 -

[*53] V.     NOL carryover deductions

      Paul and Marilynne assert that they were each entitled to deductions for

2005, 2006, and 2007 of NOL carryovers from 2000 and 2003. In general, a

taxpayer is entitled to deduct, as an NOL for a taxable year, an amount equal to the

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

taxpayer claiming an NOL deduction must file with his return “a concise statement

setting forth the amount of the * * * [NOL] deduction claimed and all material and

pertinent facts relative thereto, including a detailed schedule showing the

computation of the * * * [NOL] deduction.” 26 C.F.R. sec. 1.172-1(c), Income

Tax Regs. Paul and Marilynne both bear the burden of establishing the existence

of NOLs in prior years and the amount that may be carried forward to the years in

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

have jurisdiction to consider such facts related to closed years that are not directly

in issue, to the extent that those facts may be relevant to our redetermination of tax

liabilities for the years that are before the Court. See sec. 6214(b); Cluck v.

Commissioner, 105 T.C. 324, 330 (1995).

      Although both Paul and Marilynne filed with their returns schedules

calculating their NOL carryovers for 2005, 2006, and 2007, these are merely

statements of their claims and do not establish the correctness of the facts stated
                                        - 54 -

[*54] therein. See Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979). Neither

Paul nor Marilynne offered any evidence to substantiate their alleged losses in

2000 and 2003 that gave rise to the NOL carryover deductions they presently

claim for the years before us. (They did not even offer into evidence their 2000

and 2003 returns, which might have shown, at least generally, the origin and

nature of the supposed losses.) Accordingly, they have failed to substantiate their

respective NOL carryovers and are not entitled to claim any NOL deductions for

the years in issue.

      Petitioners argue that, because the loss-generating years are “closed years”,

the IRS is barred by the statute of limitations from disallowing the NOL

deductions. This argument is without merit. If the loss-generating prior years are

“closed” for purposes of the statute of limitations (section 6501), then for those

years that statute bars the assessment of tax but does not bar “adjustments” or

“disallowances” that eliminate the loss (and that eliminate NOL deductions in

other, “open” years). For the years in issue the period of limitation for

assessments is still open (because of the IRS’s issuance of the notice of deficiency

and petitioners’ commencement of these cases; see sec. 6503(a)(1)); and if

petitioners cannot show the existence of prior-year losses that can be carried into

these years, then the disallowance of the NOL deductions in these years must be
                                       - 55 -

[*55] sustained, and the resulting deficiencies must be determined. Petitioners

suggest that NOLs may be disallowed, notwithstanding the years’ being “closed”,

only in a circumstance where the taxpayer seeks a refund of tax; but there is no

such rule. See Cluck v. Commissioner, 105 T.C. at 330 (“the Commissioner may

recompute a taxpayer’s taxable income or loss for a year in which the statute of

limitations would otherwise bar assessment in order to redetermine the amount of

the NOL deduction claimed in an open year”); State Farming Co. v.

Commissioner, 40 T.C. 774, 781-783 (1963).

VI.   Paul’s Schedule C expenses

      Paul contends that he is entitled to the following deductions and offsets that

he claimed on a Schedule C attached to his 2005 return:

      •     $8,601 for “Rent/Lease - Other Business Property”;

      •     $40,000 for “Legal and Professional Services”;

      •     $155,803 for “Interest - Other”; and

      •     $109,000 for “Returns and allowances”.

However, there is no evidence that in 2005 Paul paid any of the actual expenses he

reported on his 2005 Schedule C. Paul argues this is because the expenses were

actually paid by Mr. Olson dating back to 1996 but were suspended until Paul

repaid Mr. Olson. Paul claims that the expenses were deductible to him in 2005
                                        - 56 -

[*56] when PCSC discharged the Paul Graffia note (which was originally given to

Mr. Olson), because the expenses were then deemed paid by Paul. Paul’s

argument is without merit.

      First, we have already concluded that the Paul Graffia note did not evidence

a genuine indebtedness, so its cancellation is a nonevent for tax purposes. Second,

even if the debt was genuine, it is well settled that expenses of a cash method

taxpayer are deductible in the year in which the expense is paid, even though paid

with borrowed funds, and the deduction may not be postponed to the year in which

repayment of the borrowed funds is made. See Crain v. Commissioner, 75 F.2d

962, 964 (8th Cir. 1935); Harris v. Commissioner, 11 T.C. 864, 867 (1948).

Accordingly, Paul is not entitled to the 2005 Schedule C deductions or offsets that

he claimed.

VII. Unreported income

      The Commissioner contends that David and Amy had $8,757 of capital gain

income in 2007 from the sale of stock or bonds but reported only $4,265 on their

2007 Federal income tax return. David and Amy did not testify on this issue, and

they offered no other evidence to challenge the IRS’s determination that David

and Amy realized but did not report the additional $4,492 of capital gain income

in 2007. In their brief, they stress that on their 2007 tax return they did report
                                         - 57 -

[*57] capital gain of $4,265--a fact not inconsistent with (but rather presumed in)

the notice of deficiency--but they point to no evidence, testimonial or

documentary, to dispute their receipt of the additional gain of $4,492. In the

absence of any evidence, we cannot say that they made a showing that the

determination was “without any rational foundation”. Cf. Ruth v. United States,

823 F.2d 1091, 1094 (7th Cir. 1987). Accordingly, we sustain the IRS’s

determination on this issue.

VIII. Accuracy-related penalties

      Section 6662 imposes an “accuracy-related penalty” of 20% of the portion

of the underpayment of tax that is attributable to the taxpayer’s negligence or

disregard of rules or regulations or that is attributable to any substantial

understatement of income tax. Under section 7491(c), the Commissioner bears the

burden of production and must produce sufficient evidence that the imposition of

the penalty is appropriate in a given case. Once the Commissioner meets this

burden, the taxpayer must come forward with persuasive evidence that the

Commissioner’s determination is incorrect. Rule 142(a); Higbee v.

Commissioner, 116 T.C. 438, 446-447 (2001).
                                         - 58 -

[*58] A.     Substantial understatement

      By definition, an understatement of income tax for an individual is

substantial 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). The notices of deficiency show that for

each of the years in issue, Paul’s and David and Amy’s understatements will

exceed both $5,000 and 10% of the tax required to be shown. Accordingly, the

Commissioner has met his burden of production.

      B.     Negligence

      The notices of deficiency issued to Marilynne show that understatements of

her tax is less than $5,000 in each of the years in issue; i.e., they are not

“substantial understatements”. However, the Commissioner asserts that Marilynne

is liable for section 6662 accuracy-related penalties because her underpayments of

tax were attributable to her negligence with regard to the rules or regulations. For

purposes of section 6662, the term “negligence” includes a failure to exercise

ordinary and reasonable care in the preparation of a tax return. 26 C.F.R. sec.

1.6662-3(b)(1), Income Tax Regs. Negligence is defined as a lack of due care or

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

circumstances. Neely v. Commissioner, 85 T.C. 934 (1985). The term “disregard”

includes any careless, reckless, or intentional disregard of rules or regulations.
                                         - 59 -

[*59] Sec. 6662(c). It also “includes any failure by the taxpayer to keep adequate

books and records or to substantiate items properly.” 26 C.F.R. sec.

1.6662-3(b)(1), Income Tax Regs. As we noted above, taxpayers are required to

retain their books and records “so long as the contents thereof may become

material in the administration of any internal revenue law.” In these cases, records

substantiating the alleged NOLs from 2000 and 2003 became material for the

years in dispute when Marilynne deducted such NOLs on her returns.

      Because the PCSC pass-through deductions that Marilynne wrongly claimed

were almost exactly offset by the fictitious royalty income she reported,

Marilynne’s understatements are attributable almost entirely to her claimed NOL

deductions generated in 2000 and 2003. But when those 2000 and 2003 records

became material to her dispute as to 2005, 2006, and 2007, she failed to keep

adequate books and records and to properly substantiate those NOL deductions.

We find her negligent in this failing.

      C.     Defenses

      Although otherwise liable for the accuracy-related penalty, a taxpayer may

avoid the liability if he successfully invokes one of three other provisions, which

we briefly consider: First, section 6662(d)(2)(B) provides that an understatement

may be reduced where the taxpayer had substantial authority for his treatment of
                                        - 60 -

[*60] any item giving rise to the understatement. There is no authority that would

warrant Paul’s, Marilynne’s, or David and Amy’s positions. Second, section

6662(d)(2)(B) provides that an understatement may be reduced where the relevant

facts affecting the item’s treatment were adequately disclosed on his tax return and

the taxpayer had a reasonable basis for his treatment of that item. These criteria

are not met here. Third, section 6664(c)(1) provides that, if the taxpayer shows,

first, that there was reasonable cause for a portion of an underpayment and,

second, that he acted in good faith with respect to that portion, then no

accuracy-related penalty shall be imposed with respect to that portion. Whether

the taxpayer acted with reasonable cause and in good faith depends on the

pertinent facts and circumstances, including his efforts to assess his proper tax

liability, his knowledge and experience, and the extent to which he relied on the

advice of a tax professional. 26 C.F.R. sec. 1.6664-4(b)(1), Income Tax Regs.

      Petitioners’ brief argues (but Marilynne did not testify) that Paul and

Marilynne “exercised diligent care in conforming their conduct and tax treatment

with pertinent statutes and regulations.” We cannot say that Paul or Marilynne has

proved either “good faith” or “reasonable cause”. They both failed to show that

they kept adequate books and records to substantiate their respective NOL

deductions. Nor has Paul shown adequate records to substantiate any of the other
                                       - 61 -

[*61] deductions he claimed for the years in issue. Paul prepared both his and

Marilynne’s returns for the years in issue, but petitioners made no showing that, in

so doing, Paul relied on documentation adequate to substantiate the deductions he

and Marilynne claimed on their returns. Accordingly, the IRS’s determinations

with regard to Paul’s and Marilynne’s accuracy-related penalties under section

6662(a) are sustained.

      Similarly, petitioners’ brief argues that David and Amy “exercised diligent

care in conforming their conduct and tax treatment with pertinent statutes and

regulations.” Even though David and Amy hired an independent tax professional

to prepare their returns, we cannot say that David and Amy have shown “good

faith” or “reasonable cause”. David and Amy have failed to show that they kept

adequate books and records or provided their return preparer with records to

substantiate PCSC’s deductions that flowed through to their returns. In fact, they

made no showing whatsoever as to the information that they provided to their

return preparer, nor as to any advice that the return preparer gave to them.

Moreover, the fictitious nature of David’s indebtedness to support his purported

basis in PCSC is inconsistent with a taxpayer’s acting in “good faith”.

Accordingly, the IRS’s determinations with regard to David and Amy’s accuracy-

related penalties under section 6662(a) are sustained.
                                      - 62 -

[*62] Because we have sustained in full the adjustments that the IRS made in its

notices of deficiency,


                                               Decisions will be entered for

                                     respondent.
