                        T.C. Memo. 2007-12



                      UNITED STATES TAX COURT



              YUNG AND ANITA F. CHONG, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 19581-04.            Filed January 17, 2007.



     Yung and Anita F. Chong, pro sese.

     Rebecca Duewer-Grenville, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     HOLMES, Judge:   Yung Chong gave money to his brother to help

open a business in Beijing.   He had another business in this

country, and he and his wife, Anita, claimed large deductions on

their 1998 tax return for losses from both.     The Commissioner

disallowed almost all of them due to a near complete lack of

records.   The Chongs blame this in part on a catastrophe suffered
                                 - 2 -

when a labor dispute at the Chong brothers’ store in Beijing

turned ugly--the store was ransacked and looted, and his brother

had to skedaddle out of China.

                         FINDINGS OF FACT

     Yung Chong works full time as a driver for Federal Express,

but he has a strong entrepreneurial spirit that impels him to

seek out business opportunities.    His brother, Lok Chong, shares

his spirit, and they began to collaborate in 1993 when Lok found

a market in China for leftover chicken parts and Yung found a way

to buy those chicken parts from large chicken producers in the

United States.   The Chong brothers did quite well for several

years until those they called the “big boys” began selling

directly to China.   The Chongs’ chicken parts business dried up

and a few years passed while Lok and Yung looked for a new

opportunity.

     Lok, who is an Australian citizen, moved to Beijing in 1997

and spotted an opportunity to import Western food for the growing

expatriate population there.   Lok took the leftover money from

the chicken venture, Yung supplied some additional capital,1 and

Gourmet Down Under was born.   Gourmet Down Under specialized in

importing and distributing Australian dairy products, but also

sold American beef and even some authentic Mexican food.   Lok


     1
       Available records do not show how much Yung Chong
contributed to the venture over the years, but the parties agreed
that he had contributed at least $88,500 by the end of 1998.
                                  - 3 -

opened his shop next to the U.S. embassy, and at first the store

did well.   But then, in 1999, Lok discovered that several of his

employees were importing yogurt from France in direct competition

with Gourmet Down Under.    Even worse, they were using company

facilities, storage, delivery trucks, and business contacts to do

so.   Lok fired five employees.    Unfortunately, he fired them

during Chinese New Year--which, as he credibly testified, is a

big taboo in Chinese culture.

      Retribution was swift:   the storefront was torched, the

office was ransacked, and the bank account was drained.

Everything was destroyed, including the business records.     Lok

filed a police report with the Beijing Public Security Bureau,

but made no effort to reconstruct the store’s daily business

records from prior years.    The only documentation from the 1998

tax year was a general profit and loss statement and a balance

sheet, both of which Lok sent to Yung in early 1999.     There were

no records to support the revenue and expenses that Yung and his

wife reported on their 1998 return, or to prove Yung’s percentage

ownership of the business during the year.     The only thing that

can be determined about Yung’s interest, and even that by

testimony alone, is that he owned one-third of the business by

the end of 1998.
                                - 4 -

     Back in the United States, Yung was working at his regular

full-time job as well as industriously developing ways to make

money on the side.   The main focus of his efforts was NuSkin, a

multilevel marketing company.    Yung acted as an independent

contractor for NuSkin, incurring various business expenses such

as gas, car maintenance and insurance, tolls, and business meals.

By his own testimony, Yung was very frugal in his day-to-day

expenses:   he scheduled his business meetings to avoid paying

multiple tolls; he bought “a few” used cars rather than a new car

and got special deals from a mechanic when he needed those cars

repaired; and he treated his prospective clients to meals at only

inexpensive restaurants.    Yung kept receipts for many of his

expenses but, as with Gourmet Down Under, he did not have the

sort of systematic records of income and expenses customarily

kept by businessmen.

     In April 1999, Yung filed a joint tax return with his wife,

Anita.   They did not use a professional preparer, and claimed

more than $40,000 in partnership losses and thousands more in

self-employment expenses.    The effect on their tax bill was

dramatic--if allowed, the losses would completely eliminate their

combined taxable income.    The Commissioner sent the Chongs a

notice of deficiency, denying each of the claimed deductions,

stating “it has not been established that the expenses were

incurred and paid during the taxable year.”    The Commissioner
                              - 5 -

also added a 20-percent penalty under section 6662(a)2 for

negligence or disregard of the rules and regulations or,

alternatively, for substantially understating the amount of

income tax due.

     The Chongs were California residents when they petitioned

this Court, and there was a short trial in San Francisco.

                             OPINION

I.   Partnership Loss

     In early 1999, Lok Chong sent his brother a profit-and-loss

statement for Gourmet Down Under.   Lok didn’t send a Schedule K-

1, nor did he provide any records to verify the business purpose

of the many expenses shown on the statement.   This statement

showed a total partnership loss of over $120,000 for the year,

about $40,000 of which was attributed to Yung.   Yung claimed his

loss on his Schedule C as an “other expense,” but has since

conceded that it should have been reported as a partnership loss

on Schedule E.

     There are four questions which must be answered before we

can determine whether Yung was entitled to a partnership loss:

(1) did a partnership exist; (2) if there was a partnership, what

was Yung’s distributive share; (3) what was the partnership’s




     2
       All section references are to the Internal Revenue Code in
effect for 1998. Rule references are to the Tax Court Rules of
Practice and Procedure.
                                 - 6 -

total loss; and (4) how much of that loss, if any, can Yung

claim.

     A.      Did the partnership exist?

     Section 761(a) defines a partnership to include

“unincorporated organization through or by means of which any

business, financial operation, or venture is carried on, and

which is not, within the meaning of this title, a corporation or

a trust or estate.”

     The Commissioner concedes that the Chong brothers had a

partnership that began in 1993 when they started importing

chicken parts into China from the United States.     We find that

the brothers continued to seek out new ventures for their China

enterprise even after the chicken parts business ended--and

because a partnership continues until “no part of any business,

financial operation, or venture of the partnership continues to

be carried on by any of its partners,” sec. 708(a) and (b)(1)(A),

Lok and Yung continued to be partners at least until 1999 when

Lok escaped the destruction of Gourmet Down Under.     Exactly how

long the partnership continued after Gourmet Down Under cratered

doesn’t matter.     The only relevant issue is whether the

partnership was valid and continuing at the end of the 1998 tax

year.     We find that it was.
                               - 7 -

     B.   What was Yung’s distributive share?

     A distributive share is the portion of a partnership’s

income and losses which flows through to an individual partner.

Normally, each partner’s distributive share is set out in a

partnership agreement.   Sec. 704(a).    When a partnership

agreement is silent, each partner’s distributive share is

determined by his interest in the partnership.     Sec. 704(b)(1).

A partner’s interest is determined by looking at “all facts and

circumstances relating to the economic arrangement of the

partners.”   Sec. 1.704-1(b)(3)(i), Income Tax Regs.    There is a

presumption that each partner has a per capita share in the

partnership, but this may be rebutted by facts and circumstances

showing a different arrangement.   Id.

     Based on the testimony of both Lok and Yung, and the profit

and loss statement for 1998, we find that Yung had a one-third

interest in the partnership at the end of 1998.     However, it is

somewhat unclear whether he held a one-third interest for the

entire tax year, or just at the end.     Yung testified that he

contributed $10,000 during 1998, but then in the answering brief

accepted respondent’s statement that he didn’t make any capital

contributions after 1995.   A partner’s distributive share must

take into account the various partnership interests throughout

the year as well as the length of time each interest was held,

sec. 706(d), but we do not find Yung’s assertion that he made an
                                - 8 -

additional contribution (unsupported by any check or money order

receipt) in 1998 to be credible.    We therefore find that he had a

one-third interest in the partnership throughout the year.

     C.     What were the partnership’s total losses?

     Just like individuals, partnerships must keep records to

support claims of income, deductions, credits, etc.     See sec.

1.6001-1(a), Income Tax Regs.    Such records must show a

sufficient business connection for any deductions.      Gorman v.

Commissioner, T.C. Memo. 1986-344.      When it is evident that there

were business-related expenses but the taxpayer is unable to

produce records, we do have the authority to estimate, Cohan v.

Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930), but have to

have something on which to base our estimate. Williams v. United

States, 245 F.2d 559, 560 (5th Cir. 1957).     Section 274(d)

further limits our discretion by adding requirements for

substantiating certain kinds of expenses--a burden we can’t lift

by relying on the Cohan rule.    Sanford v. Commissioner, 50 T.C.

823, 827-828 (1968), affd. per curiam 412 F.2d 201 (2d Cir.

1969).

     This is a real problem for the Chongs, because Yung himself

had no first-hand knowledge of the partnership’s income and

expenses.    And Lok’s bookkeeping was very informal--he admitted

that he fed his family by withdrawing inventory from the store,

and he failed to produce a single receipt, deposit slip, or check
                               - 9 -

book in support of the summary profit-and-loss statement.    Even

by the end of the trial, the only record that either brother

produced to prove any item of the partnership’s income and

expenses for the 1998 tax year remained that same profit-and-loss

statement.   Lok claims, and we believe, that he paid Chinese

taxes on the partnership income, but Yung didn’t submit any

Chinese tax returns--or any other records for that matter--into

evidence.

     We do find that the primary reason there is so little in the

way of documentation is that all the records were destroyed in

1999.   The Chong brothers--particularly Lok, since he was the

onsite manager of Gourmet Down Under--should have tried to

salvage or reconstruct what records he could.    See, e.g., Cox v.

Commissioner, T.C. Memo. 1980-244.     This sort of “reasonable

reconstruction” is always a good practice, and it is required for

expenses (like the travel expenses that the partnership claimed)

subject to section 274's limitations.    Sec. 1.274-5T(c)(5),

Temporary Income Tax Regs., 50 Fed. Reg. 46022 (Nov. 6, 1985);

see Seckel v. Commissioner, T.C. Memo. 1974-170.     We have not

seen any evidence of any such reconstruction by either Yung or

Lok; we therefore are unable to apply such a defense to this

case.   The lack of records--compounded by the absence of any

testimony by Lok about any specific items of income or loss--
                                - 10 -

leads us to find that the partnership has not proven its actual

losses for the 1998 tax year.

     D.     How much of a loss, if any, can Yung claim?

     Even if we could determine the partnership’s total losses,

Yung would still only be able to claim his share of such losses

to the extent of his adjusted basis.     Sec. 704(d); Sennett v.

Commissioner, 80 T.C. 825 (1983), affd. 752 F.2d 428 (9th Cir.

1985).     Adjusted basis is essentially the partner’s contribution

to the partnership increased by his distributive share of

partnership income and decreased by cash distributions and his

share of partnership losses.     Sec. 705(a).   A partner’s

distributive share of income or losses automatically flows

through to him.     See sec. 702(a); sec. 1.702-1(a), Income Tax

Regs.     But his adjusted basis can’t go below zero; if his

distributive share of partnership losses is greater than his

available adjusted basis, the excess loss can’t be claimed in

that year but must instead be carried forward until he once again

has adjusted basis available to offset the loss.      See sec. 1.704-

1(d)(1), Income Tax Regs.

     To determine Yung’s adjusted basis in the Chong brothers’

partnership at the end of 1998, we must know how much he

contributed to the partnership and his annual distributive share

of partnership income and/or losses since the partnership began.

Both Yung and Lok credibly testified that there had never been a
                                - 11 -

cash distribution made to Yung, so we needn’t concern ourselves

with that portion of the adjusted basis equation.     And the

Commissioner has conceded that Yung contributed at least $88,500

to the partnership since 1993.     However, even if we take that as

a starting point to determine his adjusted basis, we have no

record of Yung’s distributive share of income or losses in the

partnership during the previous five years.     A line item on the

1998 balance sheet shows “losses carried forward,” which implies

Yung was unable to claim prior losses due to a zero adjusted

basis.     But the Court probed the Chong brothers on their

understanding of partnership tax law and finds that this item on

the statement is, more likely than not, Lok’s estimate of prior

losses that should have been claimed but weren’t.

      It is simply impossible to state with any certainty what

Yung’s adjusted basis was.     It is therefore impossible for us to

say how much of any potential loss Yung could have claimed in

1998.     Because we are unable to determine how much loss Yung

could potentially have claimed, we sustain the Commissioner’s

disallowance of the partnership loss on this alternate ground as

well.

II.   Schedule C Deductions

        In addition to full-time employment and his interest in the

partnership with his brother, Yung also pursued a multilevel

marketing business with NuSkin.     He reported this business on his
                               - 12 -

1998 Schedule C, and it showed nearly $10,000 in income that was

almost entirely offset by expenses.     We agree with Yung that it

“is just common sense” that he would incur expenses in earning an

income from his side business.   And the Commissioner doesn’t

dispute many of Yung’s expenses--he disallowed only those

deductions that are subject to the limitations of section

274(d).3

     To claim a deduction for any item described in section

274(d), a taxpayer must substantiate his deduction with “adequate

records,” such as a logbook or diary, or “sufficient evidence

corroborating the taxpayer’s own statement,” such as the

statement of the person(s) entertained.    Sec. 274(d); sec. 1.274-

5T(c)(2)(i) and (3)(i), Temporary Income Tax Regs., 50 Fed. Red.

46017, 46020 (Nov. 6, 1985).   These substantiation records must

explain:   (A) the amount of the expense; (B) the time and place

the expense was incurred; (C) the business purpose of the

expense; and, where applicable, (D) the business relationship to

the taxpayer of the person(s) entertained.    Sec. 274(d).   Yung

didn’t meet these standards for any of the disallowed deductions-

-not even breaking down any of his categories of expense into




     3
       These include the deductions for repair and maintenance on
Yung’s cars: Section 1.274-5T(b)(6)(i)(A), Temporary Income Tax
Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985), specifically lists “the
cost of maintenance and repairs” as one of the “expenditure[s]
with respect to an item of listed property” covered by section
274(d)(4).
                               - 13 -

individual items.   He is therefore not entitled to the disputed

Schedule C deductions.

III. Penalty Under Section 6662(a)

     The final issue is whether the Chongs are liable for a 20-

percent accuracy-related penalty under section 6662(a) for

neglecting or disregarding the tax rules and regulations, or for

substantially understating their income tax.     The Chongs have the

burden of proving that the Commissioner’s imposition of this

penalty was in error.    See Rule 142(a).   They can do this by

showing that, under all the facts and circumstances, they acted

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

1.6664-4(b)(1), Income Tax Regs.

     With regard to the partnership loss, we find that the Chongs

did have reasonable cause to claim the loss and acted in good

faith.   Partnership tax law is a deceptively complex area.      A

reasonable and prudent person with their background and

experience wouldn’t necessarily know to ask about such things as

adjusted basis and distributive shares.     In fact, if such a

person received a balance sheet and profit-and-loss statement

like Yung did, it is much more likely that he would rely on the

totals provided in those papers.     This is especially true in this

case, where Lok was a trained accountant (albeit not one trained

in U.S. accounting rules) who was in control of all the

partnership’s records.
                               - 14 -

     On the other hand, we find that the Chongs did not act

reasonably and prudently in taking the disallowed Schedule C

deductions.   Section 274(d)’s substantiation rules are not

complex, nor are they so little known as to be a trap for the

average taxpayer.    The Chongs could have done any number of

things to discover what was needed to claim the business

deductions.   They could have contacted a professional tax

preparer or, if they didn’t want to spend money on professional

assistance, they could have contacted the IRS directly for

advice.   The IRS annually publishes an up-to-date version of

Publication 463--Travel, Entertainment, Gift, and Car Expenses.

This publication outlines in detail the various business expense

deductions which are available and the records required to

substantiate them.    The fact that Yung didn’t try to keep any

sort of ledger or even keep all of his receipts re-enforces our

conclusion that the Chongs did not act reasonably.    We find that

the Chongs were negligent, and disregarded the rules and

regulations, in claiming their disallowed Schedule C deductions.

                             CONCLUSION

     The Chongs are not entitled to their claimed deductions for

either the partnership loss or the Schedule C business expenses,

and the Commissioner was correct in imposing an accuracy-related

penalty under section 6662(a) for their disallowed Schedule C
                              - 15 -

deductions.   However, the Chongs are not liable for a penalty

under that section for claiming a partnership loss.



                                    Decision will be entered

                               under Rule 155.
