                               T.C. Memo. 2017-34



                         UNITED STATES TAX COURT



   MOHAMMAD M. ZARRINNEGAR AND MARY M. DINI, Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 23183-14, 15989-15.               Filed February 13, 2017.



      Basil J. Boutris and Jon Robert Vaught, for petitioners.

      Annie Lee, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      THORNTON, Judge: Respondent determined deficiencies in petitioners’

Federal income tax and section 6662(a) accuracy-related penalties, as follows:1



      1
       All section references are to the Internal Revenue Code in effect for the
years at issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure, unless otherwise indicated. Monetary amounts are rounded to the
nearest dollar.
                                        -2-

[*2]                                                   Penalty
                   Year          Deficiency          sec. 6662(a)

                   2010           $87,615              $17,523
                   2011           106,910               21,382
                   2012           147,904               29,580

After concessions,2 the issues for decision are: (1) whether petitioners are entitled

to deductions greater than respondent has allowed for supplies, marketing, and

office expenses; (2) whether petitioner husband is a real estate professional under

section 469(c)(7)(B); and (3) whether penalties under section 6662(a) are

appropriate.




       2
       Petitioners claimed deductions for “Rent or lease * * * Other business
property”, “Lab fees”, and “Continuing education” for 2011 and 2012.
Respondent initially disallowed these deductions but has since conceded them in
full.

      Petitioners also claimed deductions for “Depreciation and section 179
expense” for 2010, 2011, and 2012. Both parties have conceded portions of the
depreciation and sec. 179 expense deductions, leaving no issue to decide, as
follows:

                                         2010         2011          2012

       Respondent disallowed           $10,679      $34,177       $61,880
       Respondent conceded               -0-         27,769        58,035
       Petitioners conceded             10,679        6,408         3,845
       Remaining at issue                -0-          -0-            -0-
                                           -3-

[*3]                            FINDINGS OF FACT

       Petitioners owned and operated two businesses during the years at issue: a

dental practice and a real estate business.

Dental Practice

       Petitioners are both dentists. During the years at issue they worked at their

joint dental practice in shifts. Petitioner wife worked Mondays, Wednesdays,

Thursdays, and Fridays from 9 a.m. until 2:30 p.m. and some Saturdays from

8 a.m. until 12 p.m. Petitioner husband worked at the dental practice Mondays,

Wednesdays, Thursdays, and Fridays from 2:30 p.m. until 6 p.m.

Real Estate Business

       During the years at issue petitioners’ real estate business consisted of

petitioner husband’s real estate brokerage activity and four rental properties that

petitioners owned and petitioner husband managed. Petitioner wife did not

participate in the real estate business.

       Petitioner husband spent hundreds of hours on brokerage-related activities,

including brokers’ tours, listing searches, open houses, property viewings, and

client meetings. He also spent significant time each year managing petitioners’

four rental properties. All told, petitioner-husband spent over 1,000 hours on the

real estate business during each year at issue.
                                          -4-

[*4] Petitioners’ Tax Returns

      Petitioners filed a joint Federal income tax return for each year at issue. On

Schedules C, Profit or Loss From Business, attached to these returns, petitioners

reported gross income and total expenses of their dental practice as follows:3

                                   2010           2011       2012

             Gross income       $794,203        $704,945   $785,060
             Total expenses      326,399         322,239    404,534

      On Schedules E, Supplemental Income and Loss, attached to their returns,

petitioners reported losses from their real estate business of $221,582 for 2010;

$242,276 for 2011; and $220,788 for 2012.

Notices of Deficiency

      Respondent issued petitioners separate notices of deficiency for 2010 and

for 2011-12 disallowing deductions for certain expenses reported on petitioners’

Schedules C. Respondent also disallowed deductions for the losses reported on

petitioners’ Schedules E because he determined that they were passive activity

losses.




      3
        For each year at issue petitioners attached two Schedules C which together
represent the dental practice. The amounts we list represent the gross income and
total expenses of the dental practice as a whole.
                                         -5-

[*5] While residing in California, petitioners timely petitioned the Court with

respect to both notices. The cases have been consolidated for trial, briefing, and

opinion.

                                      OPINION

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

presumed correct, and the taxpayer bears the burden of proving those

determinations erroneous by a preponderance of the evidence. Rule 142(a); Welch

v. Helvering, 290 U.S. 111, 115 (1933).4

      Section 162(a) allows deduction of “all the ordinary and necessary expenses

paid or incurred during the taxable year in carrying on any trade or business”. An

expense is ordinary if it is customary or usual within a particular trade, business,

or industry or relates to a transaction “of common or frequent occurrence in the

type of business involved.” Deputy v. du Pont, 308 U.S. 488, 495 (1940). An

expense is necessary if it is appropriate and helpful for the development of the

business. Commissioner v. Heininger, 320 U.S. 467, 471 (1943). Personal, living,

and family expenses are generally not deductible. Sec. 262.




      4
       Petitioners do not assert and the record does not establish that the
requirements have been met to shift the burden of proof pursuant to sec. 7491(a).
                                        -6-

[*6] The taxpayer bears the burden of substantiating expenses underlying

claimed deductions by keeping and producing records sufficient to enable the

Commissioner to determine the correct tax liability. Sec. 6001; INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a), (e), Income Tax Regs.

Furthermore, section 274(d) imposes more rigorous substantiation requirements

for certain expenses, including those for meals and entertainment.

I.    Dental Practice Expense Deductions

      Petitioner husband testified that many of the dental practice receipts for the

years at issue had become unreadable because the ink had faded on account of

water damage or the passage of time. Consequently, petitioners offered credit card

statements at trial to substantiate expenses underlying the deductions at issue.

      A.     2010 Supplies Expense Deductions

      On their 2010 Schedules C petitioners claimed deductions of $42,807 for

“Supplies”. Respondent disallowed $11,813. The credit card statements

petitioners provided to substantiate the expenses showed only $35,956 in charges.

Petitioners therefore failed to offer any proof that $6,851 of the disallowed

$11,813 of supplies expense deductions was ever incurred.

      As for the remaining $4,962 of disallowed supplies expense deductions,

petitioners have conceded that several of the charges listed were not deductible,
                                        -7-

[*7] such as a $218 charge at Sports Authority, a $664 charge at A-1 Party Rental

Center, and approximately $429 in charges at various restaurants. More

fundamentally, petitioners failed to adequately substantiate at least $4,962 of the

charges they listed: Approximately $2,113 of the charges appear to have been at

various grocery stores, and $9,372 of the charges were at Costco. Aside from

petitioner husband’s vague and general testimony that the charges at grocery

stores were related to the dental practice and that the charges at Costco were for

“office goods”, petitioners offered no evidence to show specifically what items

were purchased or how they related to the dental practice. After careful review of

the record, we sustain respondent’s disallowance in full.

      B.     2010 Other Expenses Deductions

      On their 2010 Schedules C petitioners also claimed deductions of $18,946

for “Marketing” expenses. Respondent disallowed $9,305.5 The credit card

statements petitioners provided to substantiate the expenses show only $10,899 in

charges for marketing expenses; petitioners therefore failed to establish that

$8,047 of the disallowed $9,305 was ever incurred.


      5
      More precisely, respondent disallowed $9,305 of deductions for “Other
expenses”, a category that includes the deductions claimed for marketing
expenses. It appears from the parties’ arguments, however, that their dispute
concerns only the marketing subcategory of “Other expenses”.
                                        -8-

[*8] As for the remaining $1,258 of disallowed other expense deductions, $5,639

of the charges reported as marketing expenses was for meals at restaurants, and

petitioners have conceded that they did not adequately substantiate any of their

expenses for meals or entertainment. After careful review of the record, we

sustain respondent’s disallowance in full.

      C.    2011 Office Expense Deductions

      On their 2011 Schedules C petitioners claimed deductions of $10,237 for

“Office expense”, which respondent disallowed in full. According to petitioners’

summary of office expenses for 2011, their credit card statements for 2011 show

$13,837 of expenses.6

      Respondent has conceded that petitioners are entitled to deduct $4,814 of

office expenses on the basis of amounts shown in their credit card statements.

Petitioners have conceded that $442 of the expenses remaining in their summary is

not deductible.

      In addition to the expenses respondent has conceded are deductible,

petitioners have adequately substantiated $70 of the $260 deduction claimed for

      6
       Consistent with petitioner husband’s testimony and the documentary
evidence, it appears that petitioners arrived at the $10,237 deduction for office
expenses by totaling the amounts of expenses they believed were deductible and
then for good measure subtracting $3,600, to be conservative in claiming these
deductions.
                                        -9-

[*9] the purchase of office toys for their pediatric patients. They offered credit

card statements showing that they had spent $70 at toy stores; and petitioner

husband testified credibly that these purchases were used in connection with

pediatric patients. The credit card statement offered as evidence of the remaining

$190 was illegible; petitioners have failed to adequately substantiate this amount.

      The remaining $8,321 in charges is composed of undifferentiated charges at

various stores. Apart from petitioner husband’s vague and general testimony,

petitioners offered no evidence to show what items were purchased or how they

related to petitioners’ dental practice. Consequently, after careful review of the

record we sustain $5,353 of respondent’s disallowance.7

      D.     2012 Office Expense Deductions

      On their 2012 Schedules C petitioners claimed deductions of $9,495 for

“Office expense”, which respondent disallowed in full. According to petitioners’

summary of office expenses for 2012, the credit card statements for 2012 show

$11,295 of expenses.8


      7
       That is, the original disallowance of $10,237 minus respondent’s
concession of $4,814 minus the additional $70 of expenses petitioners adequately
substantiated.
      8
      Consistent with petitioner husband’s testimony and the documentary
evidence, it appears that petitioners arrived at the $9,495 deduction for office
                                                                        (continued...)
                                         - 10 -

[*10] Respondent has conceded that petitioners are entitled to deduct $1,986 of

reported office expenses on the basis of amounts shown in their credit card

statements. Petitioners have conceded that $1,104 of the expenses remaining in

their summary is not deductible.

      In addition to expenses respondent has conceded are deductible, petitioners

have adequately substantiated $579 of the expenses underlying deductions they

claimed. Petitioners offered credit card statements showing that they spent $388

at “Peninsula Eye”, and petitioner husband testified credibly that this charge was

for “professional goggles” used in the course of petitioners’ dental practice to keep

pathogens from entering the eyes. Petitioners also offered credit card statements

showing that they paid $191 to “United Collection”, and petitioner husband

testified credibly that this charge was for a debt collection fee.

      The remaining $7,627 in expenses listed in petitioners’ summary are

composed of undifferentiated expenses from various stores.9 Apart from petitioner


      8
       (...continued)
expense by totaling the amount of expenses they believed were deductible and
then for good measure subtracting $1,800, to be conservative in claiming these
deductions.
      9
        In fact, the credit card statements do not reflect some of the expenses listed
in petitioners’ summary, such as a June 28, 2012, charge of $56 and an August 13,
2012, charge of $114, both at the U.S. Postal Service. And some of the charges
                                                                         (continued...)
                                         - 11 -

[*11] husband’s vague and general testimony, petitioners did not offer any

evidence to show what items were purchased or how they related to petitioners’

dental practice. Consequently, after careful review of the record, we sustain

$6,930 of respondent’s disallowance.10

      Petitioners ask us to estimate their deductible expenses under the so-called

Cohan rule. See Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir. 1930). While

it is true that “a court should allow the taxpayer some deductions if the taxpayer

proves he is entitled to the deduction but cannot establish the full amount

claimed”, Edelson v. Commissioner, 829 F.2d 828, 831 (9th Cir. 1987), aff’g T.C.

Memo. 1986-223, “the Cohan rule does not ‘require that such latitude be

employed’”, Norgaard v. Commissioner, 939 F.2d 874, 879 (9th Cir. 1991)

(quoting Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957)), aff’g in

part, rev’g in part T.C. Memo. 1989-390. “[T]o qualify for the estimation

treatment under Cohan, the taxpayer must establish that he is entitled to some



      9
        (...continued)
listed appear to have been refunded, such as the August 21, 2012, charge of $57 at
“Amazon Mktplace Pmts”; the credit card statements list a refund of the same
amount from what appears to be the same vendor on September 7, 2012.
      10
       That is, the original disallowance of $9,495 minus respondent’s
concession of $1,986 minus the additional $579 of expenses petitioners adequately
substantiated.
                                       - 12 -

[*12] deduction.” Id. (citing Edelson, 829 F.2d at 831). As Cohan puts it:

“Absolute certainty in such matters is usually impossible and is not necessary”, but

a court “should make as close an approximation as it can, bearing heavily if it

chooses upon the taxpayer whose inexactitude is of his own making.” Cohan v.

Commissioner, 39 F.2d at 543-544.

      After a thorough review of the record, we are convinced that estimating is

not appropriate in this case. To the extent we have sustained respondent’s

disallowances, we have done so because petitioners have failed to offer any

evidence that certain expenses were in fact incurred and because petitioners’ lack

of receipts, confusing and inconsistent accounting techniques, and vague

testimony leave us with no reasonable means of differentiating or estimating

which of the reported expenses were incurred in connection with the dental

practice as ordinary and necessary business expenses. Having reviewed the

testimony and exhibits thoroughly, we conclude that there is no basis for allowing

an estimated amount in addition to the amounts already allowed.

II.   Real Estate Professional

      Respondent argues that section 469(a) requires disallowance of petitioners’

claimed deductions for losses from their real estate business. Respondent does not
                                         - 13 -

[*13] contest the existence or amounts of the losses or argue that the claimed

deductions are disallowed or limited by any other provision or principle of law.

      The Internal Revenue Code generally disallows a deduction for losses from

passive activities of individuals and certain entities but allows such losses to be

carried over and treated as a deduction allocable to such activity in the next

taxable year. Sec. 469(a) and (b). A passive activity is a trade or business in

which the taxpayer does not materially participate. Sec. 469(c)(1). Material

participation is regular, continuous, and substantial involvement in business

operations. Sec. 469(h)(1).

      As a general rule, rental activities are per se passive whether or not the

taxpayer materially participates. Sec. 469(c)(2). As an exception, however, rental

activities of taxpayers in real property trades or businesses (real estate

professionals) are not treated as passive if the material participation requirement is

satisfied. Sec. 469(c)(7).

      Under section 469(c)(7)(B) a taxpayer is a real estate professional if:

             (i) more than one-half of the personal services performed in
      trades or businesses by the taxpayer during such taxable year are
      performed in real property trades or businesses in which the taxpayer
      materially participates, and
                                          - 14 -

[*14]          (ii) such taxpayer performs more than 750 hours of services
        during the taxable year in real property trades or businesses in which
        the taxpayer materially participates.

In the case of a joint return, these requirements are met if and only if either spouse

separately satisfies them. Id. Because petitioner wife did not participate in the

real estate business, we consider whether petitioner husband’s activities satisfy

this test.

        A taxpayer’s material participation is determined separately with respect to

each rental property unless the taxpayer makes an election to treat all interests in

rental real estate as a single rental real estate activity. Sec. 469(c)(7)(A); sec.

1.469-9(e)(1), Income Tax Regs. Petitioners concede they made no such election.

        A taxpayer can satisfy the material participation requirement if the

individual meets any one of seven tests, including the following: “(2) The

individual’s participation in the activity for the taxable year constitutes

substantially all of the participation in such activity of all individuals (including

individuals who are not owners of interests in the activity) for such year”. Sec.

1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725-5726 (Feb. 25,

1988).

        Respondent has conceded that petitioner husband’s participation in each of

his real estate activities for each year at issue constitutes substantially all of the
                                        - 15 -

[*15] participation in each activity of all individuals. The material participation

element of the real estate professional test is therefore met.

       Consequently, the elements of the real estate professional test remaining are

(1) whether more than one-half of the personal services performed in trades or

businesses by petitioner husband during each year at issue were performed in real

property trades or businesses, and (2) whether petitioner husband performed more

than 750 hours of services during each year at issue in real property trades or

businesses. Because, as discussed more fully below, we find that petitioner

husband worked fewer than 1,000 hours per year at the dental practice and more

than 1,000 hours per year at the real estate business, both of these elements are

met.

       Section 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727

(Feb. 25, 1988), provides:

       The extent of an individual’s participation in an activity may be
       established by any reasonable means. Contemporaneous daily time
       reports, logs, or similar documents are not required if the extent of
       such participation may be established by other reasonable means.
       Reasonable means for purposes of this paragraph may include but are
       not limited to the identification of services performed over a period of
       time and the approximate number of hours spent performing such
       services during such period, based on appointment books, calendars,
       or narrative summaries.
                                        - 16 -

[*16] A postevent “ballpark guesstimate” is not sufficient. Moss v.

Commissioner, 135 T.C. 365, 369 (2010).

      To establish the hours petitioner husband spent each year on his real estate

business, petitioners offered petitioner husband’s testimony and logs of hours for

2010, 2011, and 2012; each log showed that petitioner husband spent more than

1,000 hours per year on real estate activities.11 Petitioner husband testified

credibly that the logs had been prepared contemporaneously. He also testified

credibly and at great length about the logs’ contents; he was able to recall

extensive details relating to the entries. Petitioners also offered the testimony of

several other witnesses, including petitioner wife. All this testimony was credible

and tended to corroborate petitioner husband’s logs and testimony. We therefore

find that petitioner husband worked more than 1,000 hours per year at the real

estate business.




      11
        Petitioner husband testified that throughout the years at issue he had high
hopes for the brokerage side of the business, despite the financial malaise
burdening the housing market. Undaunted despite earning only $8,500 in
brokerage fees during the years at issue, petitioner-husband testified that he
poured hundreds of hours each year into broker’s tours, listing searches, open
houses, property viewings, client meetings, and other related activities, likening
his efforts to the early labors of Bill Gates and Mark Zuckerberg, who toiled in
obscurity and relative poverty before reaping fabulous profits.
                                        - 17 -

[*17] We also find, on the basis of petitioners’ credible testimony, that petitioner

husband worked at the dental practice Mondays, Wednesdays, Thursdays, and

Fridays from 2:30 p.m. until 6 p.m., for a total of 14 hours per week (that is,

approximately 728 hours per year, if petitioner husband worked every week).

Petitioner wife worked at the dental practice Mondays, Wednesdays, Thursdays,

and Fridays from 9 a.m. to 2:30 p.m. and some Saturdays from 8 a.m. until 12 p.m.

Petitioner husband’s logs of real estate activities, and the testimony of the various

witnesses about the time petitioner husband spent on real estate activities, tend to

corroborate--at least indirectly--petitioner husband’s limited schedule at the dental

practice in the light of the time he was spending in pursuit of his real estate

business. After careful review of all the evidence, giving due account to the

credibility of petitioners and the other witnesses, we are persuaded that petitioner

husband worked fewer than 1,000 hours at the dental practice in each year at issue.

      We therefore conclude that petitioner husband’s participation in real estate

activities for 2010, 2011, and 2012 meets the test in section 469(c)(7)(B).

Consequently, section 469 does not disallow petitioners’ deductions for losses

from rental properties, and respondent’s determination in this regard is not

sustained.
                                         - 18 -

[*18] III.   Section 6662(a) Penalties

      Section 6662(a) and (b)(1) imposes an addition to tax of 20% on the portion

of an underpayment attributable to any one of various factors, one of which is

“[n]egligence or disregard of rules or regulations.”12

      Negligence includes any failure to make a reasonable attempt to comply

with the provisions of the Internal Revenue Code, and “‘disregard’ [of rules or

regulations] includes any careless, reckless, or intentional disregard.” Sec.

6662(c). Negligence is determined by testing a taxpayer’s conduct against that of

a reasonable, prudent person. Zmuda v. Commissioner, 731 F.2d 1417, 1422 (9th

Cir. 1984), aff’g 79 T.C. 714 (1982).

      As noted earlier, a taxpayer is required to substantiate expenses underlying

claimed deductions by keeping and producing records sufficient to enable the

Commissioner to determine the correct tax liability. Sec. 6001; INDOPCO, Inc. v.

Commissioner, 503 U.S. at 84; sec. 1.6001-1(a), (e), Income Tax Regs.

      Petitioners overstated deductions in the following amounts for the following

expenses:




      12
        Respondent has the burden of production with respect to the penalties.
See sec. 7491(c).
                                           - 19 -

[*19]             Deductions        2010             2011     2012

                 Depreciation    $10,679            $6,408   $3,845
                 Supplies         11,813              -0-      -0-
                 Other             9,305              -0-      -0-
                 Office            -0-               5,353    6,930
                  Total           31,797            11,761   10,775

        Petitioners have conceded they cannot substantiate the portions of their

depreciation deductions listed above.13 And insofar as we have sustained

respondent’s disallowances of other claimed deductions, as listed above, we have

done so because petitioners did not produce records sufficient to substantiate the

expense deductions. Respondent has met his burden of production to show that

petitioners were negligent and disregarded the applicable regulations insofar as

they overstated their deductions.

        A penalty under section 6662(a) does not apply to any part of an

underpayment of tax if there was reasonable cause for such portion and the

taxpayer acted in good faith with respect to such portion. Sec. 6664(c)(1).

Petitioners bear the burden of proving reasonable cause and good faith. See

Higbee v. Commissioner, 116 T.C. 438, 449 (2001). Petitioners do not contend--

nor does the record demonstrate--that they had reasonable cause or acted in good




        13
             See supra note 2.
                                       - 20 -

[*20] faith with respect to the portions of the underpayments that are sustained in

the foregoing analysis.14

      Accordingly, we sustain the section 6662(a) penalties with respect to the

underpayments attributable to petitioners’ overstatement of deductions, as listed

above.

      To reflect the foregoing,


                                                     Decisions will be entered under

                                                Rule 155.




      14
        Petitioners argued that a sec. 6662(a) penalty should not apply to any
underpayments attributable to disallowance of the deduction for real estate losses,
but they did not argue similarly with respect to the disallowances we have
sustained.
