                        T.C. Memo. 2006-147



                      UNITED STATES TAX COURT



           JOSEPH AND MARLENE SCHNELL, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 3372-05.               Filed July 10, 2006.



     Joseph and Marlene Schnell, pro se.

     Theresa G. McQueeney, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COHEN, Judge:   Respondent determined deficiencies of $4,879,

$4,594, and $4,546 in petitioners’ Federal income taxes for 2001,

2002, and 2003, respectively.   Respondent also determined

accuracy-related penalties under section 6662(a) of $975.80,

$906.60, and $909.20 for the years in issue, respectively.
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       After concessions by the parties, the issues for decision

are:

       (1) Whether petitioners are entitled to bad debt deductions

of $34,500, $34,000, and $35,000, for 2001, 2002, and 2003,

respectively;

       (2) whether petitioners are entitled to deductions for

advertising expenses of $1,500 and office expenses of $2,500 in

2001; and

       (3) whether petitioners are liable for the accuracy-related

penalties for the years in issue.

       Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

                          FINDINGS OF FACT

       Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

Petitioners resided in Babylon, New York, at the time that they

filed the petition.

       During the years in issue, Joseph Schnell (petitioner) was a

plumber, and Marlene Schnell (Schnell) (collectively,

hereinafter, referred to as petitioners) was a legal secretary.

Petitioners are cash basis taxpayers.
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     On March 31, 1986, petitioner incorporated Barad Plumbing

Corp. (Barad) in the State of New York, County of Suffolk.     Barad

has never filed corporate Federal income tax returns.    To date,

Barad has not dissolved, but its status is listed by the NYS

Department of State, Division of Corporations, as inactive.

     Sometime after petitioner was licensed as a master plumber

and incorporated Barad, he, as agent for Barad, entered into

contracts with the City of New York (the City).   Barad was later

declared to be in default of those contracts.   Barad ceased

performing plumbing services around 1989.

     Petitioners filed Form 1040, U.S. Individual Income Tax

Return, for 2001 reporting Schnell’s wages of $46,406 and

claiming business losses of $38,500.   On Schedule C, Profit or

Loss From Business, for Barad, petitioner claimed $34,500 of bad

debts, $1,500 of advertising expenses, and $2,500 of office

expenses.   A tax refund of $3,946, the amount of Federal income

tax withheld from Schnell’s wages for the year, was requested by

petitioners.

     For 2002, petitioners reported Schnell’s wages of $48,461.91

and claimed business losses from bad debts of $34,000.   A tax

refund of $3,532, the amount of Federal income tax withheld from

Schnell’s wages for the year, was requested by petitioners.

Similarly, for 2003, petitioners reported Schnell’s wages of

$50,587.63 and claimed business losses from bad debts of $35,000.
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A tax refund of $3,653, the amount of Federal income tax withheld

from Schnell’s wages for the year, was requested by petitioners.

     For each of the years in issue, the Schedule C for Barad

reflected zero gross receipts and zero cost of goods sold.

Therefore, petitioners did not report any gross income for Barad.

It was the practice of petitioners, over many years (including

the years in issue), to calculate and claim the amount of bad

debt necessary in order to arrive at zero taxable income and to

request a refund in the amount equal to Schnell’s Federal income

tax withholdings for that year.   Petitioner did not consult any

tax professional regarding his tax returns.

                             OPINION

Bad Debt Deduction and Advertising and Office Expense Deductions

     Section 166(a) allows a deduction for “any debt which

becomes worthless within the taxable year.”   However, worthless

debts arising from unpaid wages, fees, and similar items of

taxable income are not deductible as a bad debt unless the

taxpayer has included the amount in income for the year for which

the bad debt is deducted or for a prior tax year.   See Gertz v.

Commissioner, 64 T.C. 598, 600 (1975); sec. 1.166-1(e), Income

Tax Regs.; see also Prowse v. Commissioner, T.C. Memo. 2006-120;

Crosson v. Commissioner, T.C. Memo. 2003-170.   “‘It is well

settled that a taxpayer is not allowed to reduce ordinary income

actually received by the amount of income he failed to receive.’”
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Ratcliff v. Commissioner, T.C. Memo. 1983-636 (citing Hendricks

v. Commissioner, 406 F.2d 269, 272 (5th Cir. 1969), affg. T.C.

Memo. 1967-140).    Petitioners used the cash method for reporting

income and deductions.    Fees for services by Barad that allegedly

were owed by the City have never been included in income, and

unpaid amounts, even if earned, do not constitute "bad debts"

within the meaning of section 166 for which a deduction for

worthlessness may be claimed.    See Crosson v. Commissioner,

supra.   Therefore, as a matter of law and without regard to the

burden of proof, respondent properly disallowed the bad debt

deductions for each of the years in issue.

     In regard to the advertising and offices expenses, section

162(a) permits a deduction for all “ordinary and necessary

expenses paid or incurred during the taxable year in carrying on

any trade or business”.    Petitioners bear the burden of proving

their entitlement to the claimed deductions.    Rule 142(a);

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

Banker v. Commissioner, T.C. Memo. 1999-351.     Taxpayers must

establish that expenses deducted are ordinary and necessary and

must maintain records sufficient to substantiate the amounts of

the deductions claimed.    Sec. 6001; sec. 1.6001-1(a), Income Tax

Regs.    If the taxpayers do not retain the required records and

produce credible evidence, the burden of proof does not shift to

respondent.    Sec. 7491(a)(2)(A) and (B).   Petitioners failed to
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produce any evidence to substantiate the advertising and office

expenses claimed by them.   Therefore, respondent properly

disallowed the advertising and office expense deductions in 2001.

Section 6662(a) Accuracy-Related Penalty

     Section 6662(a) imposes a penalty in an amount equal to

20 percent of the underpayment of tax attributable to one or more

of the items set forth in section 6662(b).     Respondent asserts

that the underpayment attributable to the disallowed deductions

was due to negligence or disregard of rules or regulations.      See

sec. 6662(b)(1).   Section 6662(c) defines “negligence” as

including any failure to make a reasonable attempt to comply with

the provisions of the Internal Revenue Code and defines

“disregard” as including any careless, reckless, or intentional

disregard.   Negligence also includes a failure to keep adequate

books and records or to substantiate items properly.     Sec.

1.6662-3(b)(1), Income Tax Regs.   Negligence is strongly

indicated where “a taxpayer fails to make a reasonable attempt to

ascertain the correctness of a deduction * * * on a return which

would seem to a reasonable and prudent person to be ‘too good to

be true’ under the circumstances”.     Sec 1.6662-3(b)(1)(ii),

Income Tax Regs.   Disregard of the rules and regulations is

“careless” if the taxpayer does not exercise reasonable diligence

to determine the correctness of a return position and is

“reckless” if “the taxpayer makes little or no effort to
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determine whether a rule or regulation exists, under

circumstances which demonstrate a substantial deviation from the

standard of conduct that a reasonable person would observe.”

Sec. 1.6662-3(b)(2), Income Tax Regs.

     The section 6662(a) penalty is not imposed with respect to

any portion of the underpayment as to which the taxpayer acted

with reasonable cause and in good faith.   Sec. 6664(c)(1); see

also Higbee v. Commissioner, 116 T.C. 438, 448 (2001).   The

decision as to whether a taxpayer acted with reasonable cause and

in good faith is made by taking into account all of the pertinent

facts and circumstances.   Sec. 1.6664-4(b)(1), Income Tax Regs.

Relevant factors include the taxpayer’s efforts to assess his or

her proper tax liability, including an honest misunderstanding of

fact or law that is reasonable in light of all of the facts and

circumstances.   Id.

     Petitioner has made no argument that penalties should not be

sustained.   Petitioner argues:

          The Petitioner, over the years, would try many
     different ways to resolve his losses. This was a major
     mistake and a costly one on the Petitioner’s part in
     learning that going against a municipal agency with
     unlimited funds is an impossible task, especially when
     you have no income. This is why the Petitioner started
     writing off his losses as a bad debt knowing the IRS
     [Internal Revenue Service] would pick it up and
     challenge his claims and provide the Petitioner with an
     avenue for a ruling by a U.S. court, granting the
     Petitioner the right to declare the City of New York a
     “bona fide debt”.
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     Petitioner’s statement is an admission that he knew that his

claims were likely to be disallowed by the IRS.       He disregarded

the applicable rules or regulations.       He never consulted a tax

professional to determine whether his return position was

correct.   We conclude that he knew that his claims were improper.

Therefore, the accuracy-related penalties for the years in issue

are sustained.

     We have considered the arguments of the parties that were

not specifically addressed in this opinion.       Those arguments are

either without merit or irrelevant to our decision.

     To reflect the foregoing,


                                              Decision will be entered

                                         under Rule 155.
