                               T.C. Memo. 2016-57



                         UNITED STATES TAX COURT



                  CARLOS A. ARIZAGA, Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 25675-14.                          Filed March 28, 2016.



      Carlos A. Arizaga, pro se.

      Lori A. Amadei, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      LAUBER, Judge: With respect to petitioner’s Federal income tax for 2008,

the Internal Revenue Service (IRS or respondent) determined a tax deficiency of

$9,608, a late-filing addition to tax of $2,402 under section 6651(a)(1), and an
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[*2] accuracy-related penalty of $1,922 under section 6662(a).1 After concessions,

the principal issue for decision is whether petitioner is entitled to business-expense

deductions in excess of the amounts allowed by respondent. We hold that he is

entitled to a portion of the disputed deductions, but we will sustain an addition to

tax and penalty in amounts to be determined.

                               FINDINGS OF FACT

      The parties submitted before trial a partial stipulation of settled issues and a

stipulation of facts. We incorporate the stipulation of settled issues, the stipulation

of facts, and the related exhibits by this reference. Petitioner resided in California

when he filed his timely petition with this Court.

      During 2008 petitioner operated two distinct businesses as sole proprietor-

ships. The first, Number One Income Tax, engaged in preparation of income tax

returns for Latino customers. The second, El Papapollo Restaurant, was a Peru-

vian restaurant. Petitioner operated these two businesses in separate spaces in the

same strip mall. The principal issues in dispute involve the deductions he claimed

in connection with the restaurant.


      1
       Unless otherwise indicated, all statutory references are to the Internal
Revenue Code (Code), as amended and in effect for the taxable year in issue, and
all Rule references are to the Tax Court Rules of Practice and Procedure. We
round all monetary amounts to the nearest dollar.
                                        -3-

[*3] Petitioner started the restaurant business on January 1, 2008. He originally

planned that it would be a chicken rotisserie, but that would have required that he

purchase a very expensive new oven. So he changed gears and focused on the

cuisine of Peru, the country in which he was born and attended university.

      Petitioner had a full-time job with his tax-return-preparation business, and

he could devote only a few hours a day to the restaurant. He hired Jose Kanashiro

as a part-time chef and also hired a dishwasher and at least one waitress; he paid

all of them in cash. His then-girlfriend kept the books and did some manual work

in the restaurant; she later left him and took some of the business records with her.

The restaurant failed and closed in 2009 or 2010.

      On May 23, 2012, petitioner filed late his Federal income tax return for

2008. One week later he filed an amended return, which the IRS processed as his

return. This return included two Schedules C, Profit or Loss From Business. Peti-

tioner reported his income and expenses from El Papapollo Restaurant on Sched-

ule C-2. He testified that he prepared this schedule using the dollar amounts that

his ex-girlfriend, in her capacity as El Papapollo’s bookkeeper, had furnished him.

      On this Schedule C-2 petitioner reported gross receipts from customers of

$21,280. He reported no “cost of goods sold” on line 4; thus, his reported gross

profit was exactly equal to his gross receipts. On line 22 he reported “supplies” of
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[*4] $9,258; the IRS disallowed this deduction in its entirety for lack of

substantiation. Petitioner provided no documentation at trial to substantiate this

deduction, explaining that his ex-girlfriend had absconded with most of the

restaurant’s records. He credibly testified, however, that these “supplies” included

the food and other items that should have gone into his cost of goods sold.

      Petitioner reported no “wages” on line 26 of the Schedule C-2. Instead, he

claimed a deduction of $5,620 for “contract labor”; the IRS disallowed this deduc-

tion in its entirety for lack of substantiation. Petitioner provided no documenta-

tion at trial to substantiate this deduction. He credibly testified, however, that this

represented the cash compensation he had paid his cook, his dishwasher, and his

waitress.

      On line 8 of the Schedule C-2, petitioner claimed a deduction of $2,880 for

advertising; the IRS disallowed this deduction in its entirety for lack of substantia-

tion. The only relevant evidence that petitioner submitted at trial was a copy of a

full-page advertisement from the local Spanish-language newspaper featuring a

photograph of petitioner, his then-girlfriend, and Jose Kanashiro urging people to

dine at El Papapollo. Petitioner testified that this ad ran monthly for at least part

of 2008 and cost up to $100 per month.
                                         -5-

[*5] The IRS allowed in connection with the restaurant petitioner’s claimed de-

ductions for utilities, telephone, alarm system, repairs, and office expenses. Re-

spondent initially disallowed petitioner’s claimed deduction of $23,580 for rent,

but before trial conceded this deduction in full when petitioner produced the lease.

Respondent initially disallowed petitioner’s claimed deduction of $1,519 for taxes

and license fees but conceded all but $191 of this deduction before trial. The par-

ties have also stipulated that petitioner for 2008 is entitled to a standard deduction

of $5,450 and a personal exemption of $3,500.

                                      OPINION

I.    Burden of Proof

      The Commissioner’s determinations in a notice of deficiency are generally

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

The taxpayer must establish his entitlement to deductions allowed by the Code and

substantiate the amounts of claimed deductions. INDOPCO, Inc. v. Commission-

er, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a), Income Tax Regs. Petitioner does

not contend, and the evidence does not establish, that the burden of proof shifts to

respondent under section 7491(a) as to any issue of fact. See sec. 7491(a)(1).
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[*6] II.     Expense Deductions

       Taxpayers must maintain sufficient records to establish their claimed de-

ductions, retain these records for as long as the contents may become material, and

keep these records available for inspection. Sec. 6001; sec. 1.6001-1(a), (e), In-

come Tax Regs. In certain circumstances, the Court may approximate the amount

of an expense if the taxpayer proves it was incurred but cannot substantiate the ex-

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

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

sioner, 85 T.C. 731, 742-743 (1985). The failure to keep and produce appropriate

records counts heavily against a taxpayer’s attempted proof. Rogers v. Commis-

sioner, T.C. Memo. 2014-141, at *17. None of the deductions at issue is subject to

the heightened substantiation requirements of section 274(d).

       Respondent concedes that petitioner conducted a restaurant business during

2008 and has allowed as deductions most of the expenses that petitioner incurred.

In operating his restaurant petitioner necessarily incurred labor costs for his cook,

his dishwasher, and a waitress, as well as cost of goods sold for the food he

served. In the absence of adequate documentation we will estimate these expenses

under the Cohan rule, bearing heavily against petitioner because of his failure to

maintain adequate records. See Cohan, 39 F.2d at 544; Williams v. United States,
                                        -7-

[*7] 245 F.2d 559, 560 (5th Cir. 1957) (noting that trial courts have “considerable

latitude in making estimates of amounts probably spent in the light of accepted

practice amongst law-abiding businessmen of moral standing considering the

nature and kind of records which might reasonably be kept for such expendi-

tures”).

      We conclude that respondent properly disallowed petitioner’s claimed de-

ductions of $9,258 for supplies and $5,620 for contract labor and find that no

deduction should be allowed in either of those categories. However, upon careful

review of the entire record and our evaluation of petitioner’s credibility, we con-

clude that he is entitled to a deduction of $6,000 for cost of goods sold and a de-

duction of $4,000 for wages for 2008 in connection with his restaurant. See Musa

v. Commissioner, T.C. Memo. 2015-58, at *44 (applying Cohan rule and allowing

compensation deduction on the basis of credible testimony from restaurant own-

er’s workers); Heinbockel v. Commissioner, T.C. Memo. 2013-125, at *67-*68

(applying Cohan rule and allowing deduction for cost of goods sold equal to 50%

of gross receipts).

      In support of his claimed deduction of $2,880 for advertising expenses, peti-

tioner introduced a copy of a full-page ad that ran monthly in the local Spanish-

language newspaper. He produced no evidence of what he paid for this ad but
                                         -8-

[*8] testified that it ran for most of the year and cost up to $100 per month. Upon

review of this advertisement and our evaluation of petitioner’s credibility, we

conclude that he is entitled to a deduction of $500 for advertising for 2008 in

connection with his restaurant. See Rodriguez v. Commissioner, T.C. Memo.

2009-22, 97 T.C.M. (CCH) 1090, 1093 (applying Cohan rule and allowing de-

duction for advertising expenses on the basis of credible testimony).

       Respondent allowed all but $191 of petitioner’s claimed deduction of

$1,519 for taxes and license fees. In an effort to substantiate the balance of the

claimed deduction, petitioner produced evidence that he had paid $144 for a

business permit in November 2007. Because petitioner is a cash-basis taxpayer

and paid this fee in 2007, it is not a deductible expense for 2008. We accordingly

sustain respondent’s disallowance of the balance of this deduction.

III.   Addition to Tax and Penalty

       A.    Section 6651(a)(1)

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

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

failure to file the return, not to exceed 25% in the aggregate. Petitioner did not file

his 2008 Federal income tax return, due for filing on April 15, 2009, until May 23,

2012. He produced no evidence that this three-year delay in filing was “due to
                                          -9-

[*9] reasonable cause and not due to willful neglect.” See sec. 6651(a)(1). We

will accordingly sustain an addition to tax (in an amount to be determined) for

failure to file timely his 2008 return.

      B.     Section 6662(a)

      Section 6662 imposes a 20% penalty upon the portion of any underpayment

attributable to (among other things) negligence or disregard of rules or regulations.

The term “negligence” includes any failure to make a reasonable attempt to com-

ply with the tax laws, and “disregard” includes any careless, reckless, or inten-

tional disregard. Sec. 6662(c). Negligence also includes any failure to keep ade-

quate books and records or to substantiate items properly. Sec. 1.6662-3(b)(1),

Income Tax Regs.; see Olive v. Commissioner, 139 T.C. 19, 43 (2012), aff’d, 792

F.3d 1146 (9th Cir. 2015).

      With respect to an individual taxpayer’s liability for a penalty, section

7491(c) places on the Commissioner the burden of production, thereby requiring

the Commissioner to come forward with sufficient evidence indicating that im-

position of a penalty is appropriate. Higbee v. Commissioner, 116 T.C. 438, 446-

447 (2001). Once the Commissioner meets his burden of production, the taxpayer

bears the burden of proving that the Commissioner’s determination is incorrect.

Ibid.; see Rule 142(a); Welch v. Helvering, 290 U.S. at 115. We find that respon-
                                       - 10 -

[*10] dent has discharged his burden of production by showing that petitioner

failed to keep adequate records. See sec. 1.6662-3(b)(1), Income Tax Regs.

      Section 6664(c)(1) provides an exception to the imposition of the accuracy-

related penalty if the taxpayer establishes that there was reasonable cause for, and

that he acted in good faith with respect to, the underpayment. The decision as to

whether the taxpayer acted with reasonable cause and in good faith is made on a

case-by-case basis, taking into account all pertinent facts and circumstances. See

sec. 1.6664-4(b)(1), Income Tax Regs. Circumstances that may signal reasonable

cause and good faith “include an honest misunderstanding of fact or law that is

reasonable in light of all of the facts and circumstances, including the experience,

knowledge, and education of the taxpayer.” Ibid.

      Petitioner’s primary occupation was preparing Federal income tax returns

for customers of his Schedule C-1 business. He had considerable experience pre-

paring tax returns, knew that entries on a return must be properly substantiated,

and knew that records must be kept to document those entries. Although he may

have honored these principles when representing others, he was clearly negligent
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[*11] when preparing and filing his own return for 2008. We will accordingly

sustain an accuracy-related penalty (in an amount to be determined).2

      To reflect the foregoing,


                                        Decision will be entered under Rule 155.




      2
        On his 2008 return petitioner claimed a standard deduction of $5,450 and
one personal exemption of $3,500. Because of a transcription error, the IRS
mistakenly reduced these two amounts in the notice of deficiency. Respondent
conceded these issues before trial, stipulating that petitioner is entitled to a stan-
dard deduction of $5,450 and one personal exemption of $3,500. Needless to say,
petitioner is not liable for any penalty on account of this error by the IRS.
