                               T.C. Memo. 2018-129



                         UNITED STATES TAX COURT



      TERRY L. YARYAN AND DOROTHY H. YARYAN, Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 30424-15.                          Filed August 15, 2018.



      William L. Henry, David A. Sprecace, and Lucas P. Frei, for petitioners.

      Michael T. Garrett and Matthew A. Houtsma, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      KERRIGAN, Judge: Respondent determined the following deficiencies,

addition to tax, and accuracy-related penalties with respect to petitioners’ Federal

income tax for 2008, 2009, 2010, 2012, and 2013 (years in issue):
                                         -2-

[*2]                                           Addition to tax          Penalty
           Year            Deficiency          sec. 6651(a)(1)        sec. 6662(a)

           2008             $11,481                   ---                 ---
           2009              17,985                   ---                 ---
           2010                6,089                  ---                 ---
           2012              15,404                 $770                        (1)
           2013              27,249                   ---                $5,450

       1
        In the first amendment to answer respondent asserted that petitioners are
liable for the sec. 6662(a) penalty for 2012.

Unless otherwise indicated, all section references are to the Internal Revenue Code

(Code) in effect for the years 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.

       The issues for our consideration are: (1) whether petitioners may deduct

under section 166 business bad debts that they contend they incurred during the

years in issue;1 (2) whether petitioners are liable for the addition to tax for 2012;

and (3) whether petitioners are liable for the accuracy-related penalties for 2012

and 2013.


       1
       Petitioners conceded that if they are entitled to deductions for business bad
debts for the years in issue, their deductions for capital losses for 2010, 2012, and
2013 should be disallowed.
                                         -3-

[*3]                           FINDINGS OF FACT

       Some of the facts have been stipulated, and the stipulated facts and exhibits

are incorporated in our findings by this reference. Petitioners resided in Colorado

when they timely filed their petition.

I.     Petitioner’s Background and Relationship With Prime Realty, Inc.

       Terry L. Yaryan (petitioner) holds a bachelor’s degree and a master’s degree

in electrical engineering. In 1994 he joined UGC Consulting, a firm that

specialized in providing consulting services related to geographic information

systems. Petitioner retired in 2002.

       In 1994 petitioners purchased a home in Colorado from Prime Realty, Inc.

(Prime), a Colorado corporation. Petitioner met Leslie Olson (L. Olson), a general

contractor who worked on building custom homes and other projects through

Prime from at least 1994 to 2011. Prime was an S corporation, and its sole

shareholder was Pat Olson (P. Olson), L. Olson’s wife.

       Shortly after petitioner’s retirement, petitioners hired Prime as the general

contractor to work on a greenhouse that they planned to build on their property.

After completing work on petitioners’ home, L. Olson approached petitioner to

discuss Prime’s construction business. Generally, Prime’s business model at that

time was to build and market one new home at a time. Petitioner believed that
                                         -4-

[*4] Prime’s business model was inefficient, and he suggested a new strategy in

which Prime would focus on building three homes at once.

II.   Joint Venture Agreement

      L. Olson, with the assistance of his attorney, drafted a joint venture

agreement (JVA) that he presented to petitioner.2 On or about August 5, 2003,

petitioner and L. Olson, on behalf of Prime, executed the JVA. Dorothy H.

Yaryan (petitioner wife) was not a party to the JVA.

      The JVA named petitioner and Prime as joint venturers and stated the

purpose of the joint venture as follows: “[T]he Joint Venture is formed to invest

in real estate vacant lots and construct single family residences upon the Joint

Venture residential lots for the purpose of resale to the general public.” It

provided that the JVA “shall not be deemed, held, or construed as creating a tax

partnership between * * * [petitioner and Prime].”

      Pursuant to the JVA Prime would purchase residential lots in its name, and

petitioner would hold a secured interest in the lots for his contributions and for a




      2
        Petitioners describe their agreement as a “joint venture agreement”. We
use this term in our Findings to describe the agreement between petitioner and
Prime with no inference as to the type of arrangement formed between them.
                                         -5-

[*5] fee to be paid to him as required by the agreement. The terms of the JVA

applied only when Prime granted a deed of trust to petitioner.

      The JVA provided that petitioner “shall provide capital funds * * * as

needed to purchase mutually agreed upon vacant residential lots.” The residential

lots would be purchased by Prime, and Prime would be responsible for funding

construction of the residences on the lots, either with its own funds or with

“separate construction loans solely in the name of Prime”. The JVA stated that

“[t]he total amount invested * * * [by petitioner] shall not exceed $400,000 unless

mutually agreed” by petitioner and Prime.

      To the extent that Prime used petitioner’s funds to purchase a lot, the JVA

provided that “a promissory note payable to * * * [petitioner] secured by a deed of

trust for the specific lot * * * will be executed against the ownership of Prime”. It

provided further that petitioner “shall subordinate his interest in his deed of trust

to the interests of the construction lender and * * * shall promptly sign such

subordination agreement upon request by Prime”.

      The JVA provided that petitioner would be paid a sum equal to and not to

exceed 15% of his investment in a lot, “which sum shall be so stated in the

promissory note * * * for each lot subject to this Joint Venture Agreement and due

at closing.” Under the JVA Prime was to receive two fees for its services to the
                                          -6-

[*6] joint venture, both calculated as percentages of the costs associated with

constructing the residences on the lots. Prime would receive fees equal to (1) 8%

of construction costs as “compensation for construction supervision and

coordination”, payable at closing of the sale of the constructed residence, and (2)

7% of construction costs as an “overhead fee”, payable monthly based on the last

month’s construction costs and from the proceeds available from the construction

loan. The JVA provided that after all debts and liabilities of the joint venture had

been paid in full “investment distributions” of any remaining net proceeds from

the sale would be paid to Prime and petitioner “in the same proportions as the

investment made or obligation incurred” for the purchase of the lot and the

construction of the residence.

         The JVA stated that “[e]xcept as set forth in this Agreement” Prime and

petitioner “shall have equal rights in the management of the Joint Venture

business.” It provided further that Prime “shall be solely and exclusively

responsible for all aspects of development, design, construction, marketing, and

sale” of the residences built on the lots that were the subject of the JVA. With

respect to all joint venture lots it stated: “[I]t is understood that Leslie Olson * * *

shall be substantially in charge of the construction, development, and sale of the

lots.”
                                         -7-

[*7] III.    Activities Conducted Under the JVA

       A.    Joint Venture Profits 2004-06

       After executing the JVA petitioner worked with L. Olson in surveying and

selecting lots for the joint venture, and Prime purchased the lots that he and

L. Olson agreed upon. Prime was responsible for and performed the day-to-day

activities of constructing homes on the joint venture lots. From 2004 through

2006 petitioner and Prime, through the joint venture, completed 10 real estate

transactions. For each of these transactions petitioner advanced the funds needed

for Prime to purchase the lot or, in one instance, to acquire a purchase option.

       For 2004-06 petitioners reported profits from the joint venture’s real estate

transactions on their jointly filed Forms 1040, U.S. Individual Income Tax Return.

For each of these years they reported the profits as “Other income” on line 21 of

the Form 1040. For 2004-07 petitioners did not file Schedules C, Profit or Loss

From Business.
                                        -8-

[*8] B.      Homes Built on Inwood Place and Grande River

             1.    Inwood Place Home

      On March 29, 2006, petitioners paid $106,8753 toward the purchase of a lot

in the Painter’s Ridge subdivision at 1381 Inwood Place, Castle Rock, Colorado

(Inwood Place). Before closing petitioners paid an additional $13,600 to Prime to

cover costs at closing, including $5,000 in earnest money and $721 in prepaid

taxes. Prime purchased Inwood Place on March 30, 2006. On the same date

Prime executed a promissory note for $135,000 payable to petitioner with no

interest. The note stated that it was secured by a deed of trust for Inwood Place.

      A home was constructed on Inwood Place and was completed in 2007. The

Inwood Place home did not sell quickly. On January 30, 2008, petitioner

advanced Prime an additional $25,000, which Prime needed as working capital

and which was tied to the sale of Inwood Place. L. Olson on behalf of Prime

executed a promissory note payable to petitioner for $25,000 with an interest rate

of 15%. The note provided that principal and interest would be paid upon the sale

of Inwood Place. Petitioner did not record this note.




      3
       After the closing on Prime’s purchase of Inwood Place petitioners received
an overpayment refund of $278.
                                        -9-

[*9] After Inwood Place failed to sell for an extended period, L. Olson had

discussions with Prime’s construction lender, Bank of Choice, about converting

the outstanding construction loan on Inwood Place into a permanent loan if he

could arrange to lease the property. Petitioner first became aware that Inwood

Place had been leased and was occupied when Bank of Choice contacted him to

request that he subordinate his loan interest to a new loan between Bank of Choice

and Prime. Petitioner agreed to subordinate his interest because he believed that if

he did not then Bank of Choice would refuse to convert Prime’s construction loan,

and Prime would lose Inwood Place before it could be sold.

      In early 2011 petitioner met with an officer at Bank of Choice regarding the

outstanding loan for Inwood Place. During that meeting petitioner learned that

L. Olson had misrepresented himself as the owner of Prime and that P. Olson was

Prime’s sole owner. Petitioner learned that Prime had no retained earnings or

working capital and no substantial physical assets. After this meeting petitioner

was concerned that he would not be repaid and Prime would stop making

payments on the Inwood Place loan and allow the property to go into foreclosure.

      During 2011 Prime found buyers for Inwood Place. Petitioner refused

initially to release the deed of trust for Inwood Place. However, he was told that

Bank of Choice was not going to extend Prime’s loan for Inwood Place and that
                                         - 10 -

[*10] Prime had a limited time to dispose of the property. Petitioner agreed to

release the deed of trust for Inwood Place for $30,000. However, he stated in a

letter to the title company that he was not releasing Prime’s obligations on the

promissory notes that had been tied to the sale of Inwood Place. On October 27,

2011, Prime sold Inwood Place and petitioner received a payoff of $30,000.

      Prime did not repay petitioner any additional amounts for his advances for

the purchase of Inwood Place or the $25,000 advance that Prime used as working

capital. Petitioners’ net loss (i.e., total advances over total receipts) in connection

with Inwood Place was $115,197, calculated as follows:

           Advances for costs at closing                 $13,600
           Lot purchase price                            106,875
           January 30, 2008, additional advance            25,000
           Less: Overpayment refund                          (278)
           Less: Payoff at sale                           (30,000)
            Net loss                                     115,197

             2.     Grande River Home

      On August 28, 2007, Prime purchased a lot at 7718 Grande River Court,

Parker, Colorado (Grande River). Grande River was within the Tallman Gulch

subdivision (Tallman Gulch). Petitioner had found Tallman Gulch when
                                       - 11 -

[*11] searching for lots outside of the Painter’s Ridge subdivision. He knew the

original planner and developer of Tallman Gulch, Arieh Szigeti.

      Petitioners paid $191,277 toward the purchase of Grande River. Before

closing petitioners also paid Prime $10,000 to use as earnest money, and they paid

$1,151 in real estate taxes for the property. On the date of purchase Prime

executed a promissory note payable to petitioner for a principal amount of

$232,792, with no interest. The note was payable upon the sale of a home on

Grande River, and the note stated that it was secured by a deed of trust for the

property.

      During 2008 L. Olson reduced Prime’s construction crews, and Prime fell

behind schedule building the home on Grande River. Petitioner helped with

landscaping the property. Petitioners paid expenses of $15,362 for landscaping

Grande River. Prime reimbursed petitioners $9,675 of these expenses.

      During construction of the Grande River home petitioner suggested that

Prime should enter the home in the 2009 “Parade of Homes” (Parade), a trade

show that he believed would bring many prospective buyers to view the property,

and L. Olson agreed. Construction of the Grande River home was completed in

2009, and the home was successfully entered in the Parade. Petitioners took

pictures of the property and produced marketing materials to be handed out to
                                       - 12 -

[*12] viewers during the Parade. Following the Parade in 2009 the loans that

Prime had outstanding on both Grande River and Inwood Place were nearing

expiration.

      At petitioner’s request, L. Olson authorized Bank of Choice to discuss the

two loans with petitioner directly. Petitioner wanted to ensure that the loans were

extended so that Prime did not lose the homes before they could be sold profitably.

He met with employees from Bank of Choice at Grande River, and they toured the

home together. After viewing the Grande River home Bank of Choice agreed that

Prime’s construction loan for Grande River should be extended and that the

interest rate should be reduced.

      In October 2009 L. Olson informed petitioner that he could not afford to

make the monthly interest payment due on Prime’s loan with Bank of Choice for

Grande River. Petitioner paid the interest due in October 2009 and continued to

make monthly interest payments directly to Bank of Choice through April 2010.

He made total interest payments of $29,443 on Prime’s loan for Grande River. He

also paid $6,058 for Grande River’s property taxes.

      Grande River sold on August 6, 2010. Before the sale petitioner was aware

that the selling price would not be enough to cover the full amount that Prime

owed to him and Bank of Choice for Grande River. L. Olson agreed to sign
                                         - 13 -

[*13] deficiency notes for Bank of Choice and for petitioner to cover amounts that

remained outstanding after the sale of Grande River. At the request of L. Olson

petitioner released the deed of trust and the promissory note payable to him for

Grande River.

      Upon the sale of Grande River petitioner received a payoff of $86,698.

After the sale he asked L. Olson for the signed deficiency note for the remaining

amount that had been owed under the original promissory note. L. Olson

requested that the deficiency note be discounted. Petitioner had numerous

conversations with L. Olson about the deficiency that he believed he was owed for

Grande River. In late 2010 L. Olson told him that Prime would not pay to cover

any of the deficiency. Petitioners’ net loss for Grande River was $156,918,

calculated as follows:

            Earnest money                             $10,000
            Prepaid real estate taxes                    1,151
            Lot purchase price                        191,277
            Landscaping expenses                       15,362
            Construction loan interest                 29,443
            Property taxes paid                          6,058
            Less: Landscaping reimbursements            (9,675)
                                         - 14 -

[*14]         Less: Payoff at sale                        (86,698)
               Net loss                                   156,918

        C.    Tallman Lots 37 and 40

        In late 2007 and early 2008 petitioner and L. Olson had agreed to acquire

two lots in Tallman Gulch. No homes were ever constructed on these lots.

              1.    Tallman Lot 37

        On November 29, 2007, petitioners paid $269,137 toward Prime’s purchase

of a lot at 7753 Merryvale Trail, Parker, Colorado, which was designated lot 37 in

Tallman Gulch (Tallman lot 37). Petitioners had paid previously $10,000 in

earnest money for Prime to purchase Tallman lot 37, and before closing they paid

$1,604 in real estate taxes. On November 30, 2007, Prime purchased Tallman

lot 37 and issued a promissory note payable to petitioner for $321,007. The note

had no interest rate, was payable upon the sale of a home on Tallman lot 37, and

stated that it was secured by a deed of trust for the property.

        On December 28, 2007, Prime executed a quitclaim deed for Tallman lot 37

that transferred its interest in the lot to petitioners for consideration of $10.

Petitioner canceled Prime’s promissory note for Tallman lot 37 and released the

deed of trust referenced in the note. Soon after petitioners acquired ownership of
                                        - 15 -

[*15] Tallman lot 37, Bank of Choice granted them a $199,125 loan, which was

secured by a deed of trust for the property in the bank’s name.

      In July 2011 Bank of Choice failed. The Federal Deposit Insurance

Corporation, acting as receiver for Bank of Choice, sold the assets and liabilities

of Bank of Choice to Bank Midwest, N.A. (Bank Midwest), including petitioners’

note. Petitioners were notified that Bank Midwest would not agree to extend the

maturity date for their note.

      In January 2012 Bank Midwest filed a lawsuit in the District Court, Douglas

County, State of Colorado, to obtain a judgment against petitioners for the full

principal and unpaid interest due on the note. Petitioners did not contest this

lawsuit. Bank Midwest obtained a judgment for $210,694. The bank foreclosed

on Tallman lot 37 and took possession of the property, and on June 20, 2012, the

property was sold at a foreclosure sale for $89,125.

      After the foreclosure sale Bank Midwest notified the district court that the

judgment against petitioners was partially satisfied. In 2015 petitioners executed a

Compromise Settlement and Mutual Release Agreement with an assignee of Bank

Midwest, which released all claims and satisfied the judgment against them for

$27,000.
                                        - 16 -

[*16]         2.    Tallman Lot 40

        On or about January 7, 2008, petitioners paid $20,000 in earnest money to

reserve an option to purchase a lot at 7905 Merryvale Trail, Parker, Colorado,

which was lot 40 in Tallman Gulch (Tallman lot 40). Petitioner reserved the

option to purchase in his own name, and not in Prime’s name. On January 6,

2009, he executed an Agreement to Amend/Extend Contract, which stated that the

deadline for exercising the purchase option was 14 days after the date of sale of

Grande River or no later than January 7, 2010. The agreement provided that the

$20,000 in earnest money would be credited against the purchase price of Tallman

lot 40 but would remain nonrefundable if the buyer did not close on the property.

        Petitioner never exercised his option to purchase Tallman lot 40. He

attempted unsuccessfully to have the deadline for the option to purchase extended.

Petitioner did not recover the $20,000 in earnest money.

IV.     Advances to Szigeti and DHP Holdings, LLC

        In 2006 and 2008 petitioners made advances to DHP Holdings, LLC (DHP),

an entity operated by Szigeti and Szigeti’s business partner Harry Markle, and to

Szigeti individually. These advances were not made pursuant to the JVA.

        On September 20, 2006, petitioner paid a $150,000 advance to DHP. For

this advance petitioner received a document entitled “Receipt of Investment
                                       - 17 -

[*17] Funds”, signed by Markle, which stated: “This document is for the purpose

of acknowledging the receiving of funds for investment purposes. * * * The

Szigeti/Markle group has received * * * funds from Terry Yaryan for the purpose

of investing in various projects. Those projects and equity stakes to be determined

in a separate agreement.”

      Around September 30, 2008, petitioners advanced an additional $15,000 to

Szigeti. A handwritten check stub for this advance describes the amount as a

“loan to Arieh Szigeti * * * to be repaid by 10/30/08.” Petitioners’ original filed

income tax returns for the years in issue did not report losses or claim any

deductions in connection with the advances to DHP and Szigeti.

V.    Petitioners’ Tax Reporting

      Petitioners prepared their original income tax returns for years 2008-13

themselves.

      A.      Original Returns for 2008-10

      Petitioners filed joint Forms 1040 for 2008-10. They paid their reported tax

liabilities. On petitioners’ Form 1040 for 2010 they deducted a capital loss of

$3,000 for Grande River. On Schedule D, Capital Gains and Losses, Part II,

Long-Term Capital Gains and Losses, they reported a basis in Grande River of

$202,428, a sale price of $86,698, and a net long-term capital loss of $115,730.
                                        - 18 -

[*18] B.     Original Return for 2011

             1.    Theft Loss Deduction

      For 2011 petitioners deducted $573,398 for a “fraudulent theft loss” on

Schedule A, Itemized Deductions, of their Form 1040. They detailed the loss on

Form 4684, Casualties and Thefts, Section B, Business and Income-Producing

Property. On the Form 4684 they reported losses for Grande River, Tallman

lots 37 and 40 (together, Tallman lots), and Inwood Place, and they identified the

losses collectively as the “Prime Realty-Olson Fraud theft”. For each of the

properties they reported their basis in the property as the amount of the loss. The

Form 4684 included the following information regarding the reported losses:

           Item              Grande River        Tallman lots       Inwood Place

  Cost or adjusted basis       $156,963           $300,741           $115,694
  Insurance or other
   reimbursement                  ---                 ---                 ---
  Fair market value
   before theft                 202,124             349,328           150,951
  Fair market value
   after theft                    ---                 ---                 ---
  Reported loss                 156,963             300,741           115,694
                                        - 19 -

[*19] After filing their 2011 Form 1040, petitioners filed tentative claims for net

operating loss (NOL) carrybacks for 2008, 2009, and 2010 for the reported theft

loss. The Internal Revenue Service (IRS) processed and allowed the claims for

NOL carrybacks and, as a result, issued petitioners a refund for each of the years

2008-10.

             2.    Notice of Deficiency for 2011

      The IRS examined petitioners’ 2011 return. On April 1, 2013, the IRS

issued a notice of deficiency disallowing the claimed theft loss deduction. On

April 10, 2013, petitioner sent a letter to the Taxpayer Advocate expressing

concerns about the notice of deficiency. The letter stated: “For your record, we

have no business or business expenses.” Petitioners did not file a petition in this

Court to challenge the determinations in the notice of deficiency for 2011, and the

IRS assessed the proposed deficiency, accuracy-related penalty, and accrued

interest for 2011 on September 23, 2013.

      C.     Original Return for 2012

      On December 23, 2013, petitioners filed their Form 1040 for 2012.

Petitioners’ IRS account transcript shows that they requested an extension of time

to file their 2012 tax return not later than October 15, 2013. On the 2012 Form

1040 they carried forward the NOL from the theft loss reported for 2011. They
                                         - 20 -

[*20] reported negative income on line 21 of the 2012 Form 1040, which offset all

income from other sources.

        Additionally, on petitioners’ 2012 Form 1040 they deducted a capital loss of

$3,000 for Tallman lot 37. On Schedule D, Part II, they reported a total long-term

capital loss of $119,868 in connection with the foreclosure of the property.

        D.    Original Return for 2013

        On petitioners’ Form 1040 for 2013 they carried forward the remaining

amount of the NOL from the reported 2011 theft loss. The NOL carryforward

offset substantially their income for 2013. On Schedule D, Part II, for 2013

petitioners carried forward the reported long-term capital loss for Tallman lot 37.

They deducted a $3,000 capital loss for 2013 based on the carryforward from

2012.

VI.     Notice of Deficiency for Years in Issue

        After disallowing any deduction for petitioners’ reported theft loss for 2011,

the IRS conducted an examination of their NOL carrybacks and carryforwards for

the years in issue. The IRS determined petitioners were not entitled to deduct the

NOL carrybacks and carryforwards because they did not incur an ordinary theft

loss under section 165 and their losses were capital losses.
                                       - 21 -

[*21] Respondent issued a notice of deficiency on September 2, 2015, disallowing

deductions for the NOL carrybacks and carryforwards for the 2011 theft loss for

the years in issue. The notice of deficiency allowed petitioners a $3,000 long-term

capital loss deduction for each of 2010, 2012, and 2013. The notice of deficiency

determined an addition to tax under section 6651(a)(1) for 2012 and an accuracy-

related penalty under section 6662(a) for 2013. The record includes a completed

Civil Penalty Approval Form dated January 8, 2015, with a signature on the line

provided for “Group Manager Approval to Assess Penalties Identified Above”.4

VII. Respondent’s Amended Answer

      On November 10, 2016, respondent filed the first amendment to answer

(amended answer). In the amended answer respondent asserted that petitioners are

further liable for the section 6662(a) accuracy-related penalty for 2012.

Respondent’s counsel and Associate Area Counsel, who was respondent’s

counsel’s immediate supervisor, signed the amended answer.




      4
       As explained infra pp. 44-46, we are reopening the record to admit the
Civil Penalty Approval Form and declaration of IRS group manager Vera Goggins
insofar as it authenticates the Civil Penalty Approval Form for purposes of Fed. R.
Evid. 902(11).
                                        - 22 -

[*22] VIII. Amended Returns

      In July 2017 petitioners with the assistance of a certified public accountant

completed a Form 1040X, Amended U.S. Individual Income Tax Return, for each

year in issue and for 2011. On these returns petitioners conceded that they are not

entitled to the theft loss reported originally for 2011 pursuant to section 165 and

made changes to reflect that concession. Respondent did not process or otherwise

accept these returns.

      Petitioners reported and claimed deductions for business bad debts pursuant

to section 166 on their amended returns. For 2008 they deducted a business bad

debt of $165,000 not related to petitioner’s arrangement with Prime. For 2010

they deducted business bad debts of $457,704, including the following items:

(1) $156,963 for Grande River; (2) $280,741 for Tallman lot 37; and (3) $20,000

for Tallman lot 40. For 2011 petitioners deducted a business bad debt of $115,694

for Inwood Place.

      Petitioners prepared two amended returns for 2009; on one they deducted an

NOL carryforward from 2008, and on the other they deducted an NOL carryback

from 2010. On the amended returns for 2012 and 2013 petitioners reported NOL

carryforwards to reflect business bad debt deductions on prior years’ returns.
                                          - 23 -

[*23]                                  OPINION

        The parties agree that petitioners are not entitled to the theft loss deduction

they originally claimed for 2011 and the carryforwards and carrybacks related to

it. Petitioners contend that they are entitled to deduct ordinary losses and NOL

carryforwards and carrybacks for business bad debts pursuant to section 166.

Respondent contends that petitioners’ advances to Prime or others for the joint

venture properties and the advances to DHP and Szigeti do not satisfy the

requirements for deductible business bad debts under section 166.

I.      Business Bad Debt Deductions

        Deductions are a matter of legislative grace, and taxpayers bear the burden

of proving their entitlement to any deduction allowed by the Code. INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Petitioners have not claimed or

shown that the burden of proof as to any relevant factual issue should shift to

respondent under section 7491(a). They bear the burden of establishing that they

are entitled to any bad debt deductions for the years in issue.

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

worthless within the taxable year.” For taxpayers other than corporations, section

166(d) provides that section 166(a) does not apply with respect to any

“nonbusiness debt”. A nonbusiness debt is a debt other than one created or
                                        - 24 -

[*24] acquired in connection with a trade or business of the taxpayer or the loss

from the worthlessness of which is incurred in the taxpayer’s trade or business.

Sec. 166(d)(2). For a nonbusiness bad debt the taxpayer is allowed a short-term

capital loss for the taxable year in which the debt becomes completely worthless.

Sec. 166(d)(1); sec. 1.166-5(a)(2), Income Tax Regs. Business bad debts may be

deducted against ordinary income, whether wholly or partially worthless during

the taxable year, and may be carried back or forward as part of the “net operating

loss deduction” under section 172. Sec. 1.166-3, Income Tax Regs.

      Section 172 permits a deduction for the full amount of allowable NOL

carrybacks from subsequent years and carryovers from previous years, as long as

taxable income for the current year is not less than zero. Sec. 172(a), (b)(2).

Petitioners bear the burden of establishing both the existence of the NOL and the

amount of any NOL that may be carried forward. See Rule 142(a)(1); United

States v. Olympic Radio & Television, Inc., 349 U.S. 232, 235 (1955); Keith v.

Commissioner, 115 T.C. 605, 621 (2000).

      To deduct a loss as a business bad debt a taxpayer must show that he or she

was engaged in a trade or business and that the purported bad debt was

proximately related to the trade or business. Putoma Corp. v. Commissioner, 66

T.C. 652, 673 (1976), aff’d, 601 F.2d 734 (5th Cir. 1979); sec. 1.166-5(b), Income
                                        - 25 -

[*25] Tax Regs. The taxpayer must establish that the amount claimed as a

deduction represents a bona fide debt. Sec. 1.166-1(c), Income Tax Regs. Gifts or

contributions to capital may not be deducted as bad debts under section 166. Kean

v. Commissioner, 91 T.C. 575, 594 (1988); sec. 1.166-1(c), Income Tax Regs.

The taxpayer also must prove the worthlessness of the debt and the year in which

it became worthless. Am. Offshore, Inc. v. Commissioner, 97 T.C. 579, 593

(1991). Respondent argues that petitioners have not met any of these criteria to

deduct business bad debts.

      A.     Trade or Business

      The Code does not define the term “trade or business”. Deciding whether

the activities of a taxpayer constitute a trade or business requires an examination

of the specific facts in each case. Higgins v. Commissioner, 312 U.S. 212, 217

(1941). The taxpayer must participate in the activity with continuity and

regularity, and the primary purpose for engaging in the activity must be for income

or profit. Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).

      The management of one’s investments, no matter how extensive, is not

considered a trade or business. Whipple v. Commissioner, 373 U.S. 193 (1963);

Higgins v. Commissioner, 312 U.S. at 218. The taxpayer’s activities as an

investor may produce income or profit, but profit from investment is not taken as
                                         - 26 -

[*26] evidence that the taxpayer is engaged in a trade or business. Any profit so

derived arises from the successful conduct of the trade or business of the

corporation or other venture in which the taxpayer has taken a stake, rather than

from the taxpayer’s own activities. Whipple v. Commissioner, 373 U.S. at 202.

The objective facts surrounding a taxpayer’s advances, rather than his or her

subjective intent, controls in determining whether the advances should be treated

as trade or business or investment activity. See Litwin v. United States, 983 F.2d

997, 1000 (10th Cir. 1993).

             1.     Joint Venture Properties

      Petitioners contend that petitioner was in the trade or business of investing

in vacant lots, constructing single-family residences, and selling residences to the

public, as stated in the JVA. They argue that the JVA required that petitioner and

Prime “have equal rights in the management of Joint Venture business” and that

petitioner had the right and responsibility to participate in all aspects of the joint

venture. They contend that petitioner actively participated with continuity and

regularity with the objective of making the joint venture properties as profitable as

possible. The parties agree that petitioners were not in a trade or business of

lending funds.
                                        - 27 -

[*27] Under the terms of the JVA petitioner held certain rights to participate in the

joint venture. Those rights were to participate in the selection of vacant lots and in

the management of activities to the extent not otherwise provided in the JVA.

Petitioner’s responsibility under the JVA was to provide funds to Prime for the

purchase of the lots. The JVA provided that Prime was “solely and exclusively

responsible for all aspects of development, design, construction, marketing, and

sale” of the properties. Prime was required to incur the risk associated with

building and marketing the constructed residences by financing construction with

its own funds or loans held solely in its name.

      Petitioner testified credibly that he did perform some work in connection

with the joint venture properties before and during the years in issue. He worked

with L. Olson in selecting the vacant lots that Prime purchased, he interacted with

Prime’s construction lender to extend Prime’s loans, and he performed some

landscaping and marketing work in preparation for the Parade. Generally,

petitioner’s work was directed towards helping Prime sell the constructed homes

at a profit, but he was not required under the JVA to perform these activities.

      A common factor distinguishing the conduct of a trade or business from

investment is the receipt by the taxpayer of compensation other than the normal

investor’s return. Whipple v. Commissioner, 373 U.S. at 202-203. Compensation
                                        - 28 -

[*28] other than the normal investor’s return generally means income received by

the taxpayer directly for his or her services rather than indirectly from the success

of the enterprise in which he or she has invested. Id. at 203. The income that

petitioner received from the joint venture properties was not compensation for his

services.

      Under the terms of the JVA petitioner’s compensation for the joint venture

properties was directly linked to his providing capital to Prime. For each property

the principal amount that he was owed under the promissory note represented a

return of his investment, plus an additional 15%. The income that he received did

not depend on the amount of services that he provided but depended instead on

Prime’s successful activities as the builder and marketer of the properties. The

facts and circumstance indicate that petitioner’s role in the development and sale

of the joint venture properties was that of an investor, rather than an individual

engaged in a trade or business.

      Petitioners contend that they were engaged in one or multiple real property

trades or businesses. Section 1221(a)(1) defines a capital asset as “property held

by the taxpayer * * * but does not include * * * property held by the taxpayer

primarily for sale to customers in the ordinary course of his trade or business”.

Petitioners contend that Prime held the constructed homes on the joint venture
                                         - 29 -

[*29] properties for sale to customers in the ordinary course of business and that

because of petitioner’s participation in the JVA with Prime they should be allowed

to report losses for the properties as ordinary, rather than capital, losses.

      The Court of Appeals for the Tenth Circuit has concluded that the following

factors are relevant for determining whether real property is held by the taxpayer

in a trade or business: (1) the purpose for which the property was acquired, (2) the

activities of the taxpayer and those acting on his or her behalf, (3) the continuity of

sales and their frequency, and (4) any other fact relevant to the determination of

whether a sale was a transaction of a trade or business. Brown v. Commissioner,

448 F.2d 514, 516-517 (10th Cir. 1971), aff’g 54 T.C. 1475 (1970). Petitioners

did not own the properties that were developed and sold under the JVA. Petitioner

provided capital for Prime’s purchases of vacant lots and received promissory

notes which were tied to sales of homes to be constructed by Prime on the lots.

Pursuant to the terms of the JVA petitioner never held properties for sale to

customers, and petitioners did not report income related to a purported trade or

business on their tax returns. Petitioner in a letter to the Taxpayer Advocate

indicated that he did not have a business and had no business expenses. Prime

held, developed, and sold the joint venture properties in its name.
                                         - 30 -

[*30] Even if we accepted petitioners’ contention that Prime’s activities should be

treated as part of petitioner’s trade or business for the years in issue, only two

properties, Inwood Place and Grande River, could be considered part of the

purported real property trade or business with Prime. Construction of the home on

Inwood Place was completed in 2007, and the Grande River home was completed

in 2009. Petitioner and Prime did not attempt to develop or sell any other real

properties until Grande River sold in 2010 and Inwood Place sold in 2011. Sales

of two properties for all of the years in issue cannot be called frequent.

      Petitioners owned Tallman lot 37 during the years in issue. After petitioners

acquired ownership of the lot from Prime in December 2007, petitioner canceled

Prime’s note for Tallman lot 37. Therefore, the terms of the JVA did not apply to

this lot during the years in issue.

      Petitioner’s purpose for acquiring Tallman lot 37 from Prime was to use it

as collateral for a loan to replenish petitioners’ bank accounts until such time as he

could recoup his investment in one or more of the other properties that Prime had

purchased. He testified that he intended to resell the lot to Prime so that Prime

could build a home on the lot and sell it to customers. No development occurred

while petitioners owned the lot.
                                        - 31 -

[*31] They held Tallman lot 37 from 2007 until 2012, when it was repossessed for

failure to repay their loan, and during that time they did not acquire any other lots

or make any sales of real property. The relevant factors do not support a

conclusion that petitioners held Tallman lot 37 for sale to customers in the

ordinary course of a trade or business. There was never any development on

Tallman lot 37.

      Neither petitioner nor Prime ever held an ownership interest in Tallman

lot 40. Petitioner held an option to purchase this lot, but he never advanced the

funds to purchase it. The terms of the JVA did not apply to Tallman lot 40, and it

cannot be considered part of the purported real property trade or business

conducted by petitioner through the JVA for the years in issue.

      With respect to the joint venture lots purchased and developed under the

terms of the JVA, petitioners’ reliance on cases that determine a taxpayer’s

principal purpose for owning real property is misplaced, because they did not own

or sell these properties. Petitioner had no responsibility to develop or market the

lots to customers; he held an investment interest. Although petitioners owned

Tallman lot 37, they did not develop, market, or sell it. We conclude that

petitioners were not in engaged in a trade or business for the sale of real property

during the years in issue.
                                        - 32 -

[*32]         2.    2008 Loss

        On their amended return for 2008 petitioners claim for the first time a bad

debt deduction for advances made to Szigeti and to DHP. Their dealings with

Szigeti and DHP were not conducted under the terms of the JVA. Petitioners

provided no evidence showing how the advanced funds were used.

        The receipt that Markle signed for the 2006 advance states that the funds

were received for investment purposes and that equity stakes would be determined

in further documentation. Petitioners provided no evidence about activities,

continuous or otherwise, that they performed for a trade or business in connection

with these advances. We conclude that the $165,000 was not advanced for a

business purpose because petitioners were not engaged in a trade or business in

connection with these advances.

        B.    Bona Fide Debts

        Since we have concluded that petitioners were not engaged in a trade or

business during the years in issue, we now consider whether there was

nonbusiness bad debt. Petitioners are required to show that the losses associated

with the joint venture properties and the 2008 loss were due to the worthlessness

of a bona fide debt in order to claim a deduction under section 166. See sec.

1.166-1(c), Income Tax Regs. “A bona fide debt is a debt which arises from a
                                        - 33 -

[*33] debtor-creditor relationship based upon a valid and enforceable obligation to

pay a fixed or determinable sum of money.” Id. Whether an advance gives rise to

a bona fide debt for Federal tax purposes is determined from all the facts and

circumstances. Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493 (1980).

Where the facts indicate that no bona fide debt was created, an advance may

properly be classified as a contribution to capital. See Davis v. Commissioner, 69

T.C. 814, 835-836 (1978); Rutter v. Commissioner, T.C. Memo. 2017-174.

      Petitioners contend that the advances made to Prime through the JVA

created bona fide debts. They argue that the payments cannot be considered

equity payments because petitioner obtained promissory notes secured by deeds of

trust and because he held no ownership interest in Prime. Respondent contends

that petitioners’ advances in this case did not create bona fide debts and that the

advances were more akin to equity than debt.

      In resolving questions of debt versus equity, courts have identified and

considered various factors. See Calumet Indus., Inc. v. Commissioner, 95 T.C.

257, 285 (1990). Those factors include: (1) the names given to the certificates

evidencing the indebtedness, (2) the presence or absence of a fixed maturity date,

(3) the accrual and payment of interest, (4) the source of payments, (5) the right to

enforce payments, (6) participation in management as a result of the advances,
                                         - 34 -

[*34] (7) the status of the advances in relation to regular corporate creditors,

(8) the intent of the parties, (9) the identity of interest between creditor and

shareholder, (10) thin or adequate capitalization, (11) the risk involved in making

the advances, (12) the use to which the advances were put, (13) the ability of the

borrower to obtain credit from other sources, and (14) the failure of the debtor to

repay. Dixie Dairies Corp. v. Commissioner, 74 T.C. at 493; see also Am.

Offshore, Inc. v. Commissioner, 97 T.C. at 602-606; Goldstein v. Commissioner,

T.C. Memo. 1980-273. The above factors are only aids in evaluating whether the

transferred funds should be regarded as risk capital or as bona fide loans made

pursuant to a debtor-creditor relationship. Fin Hay Realty Co. v. United States,

398 F.2d 694, 697 (3d Cir. 1968); see Calumet Indus., Inc. v. Commissioner, 95

T.C. at 285-286. No single factor is determinative, and not all factors are

applicable in each case. Dixie Dairies Corp. v. Commissioner, 74 T.C. at 493.

             1.     Inwood Place

      Petitioners on their amended 2011 tax return claim a bad debt deduction of

$115,694 for Inwood Place. The notice of deficiency on which this case is based

does not cover 2011. Petitioners had received previously a separate notice of

deficiency for 2011 and had not filed a petition with this Court. On September 23,
                                        - 35 -

[*35] 2013, respondent assessed the determined deficiency, accuracy-related

penalty, and accrued interest for that year.

      The Tax Court is a court of limited jurisdiction, and we may exercise our

jurisdiction only to the extent authorized by Congress. See sec. 7442; Naftel v.

Commissioner, 85 T.C. 527, 529 (1985). We do not have jurisdiction to determine

whether the tax for any year not included in the notice of deficiency has been

overpaid or underpaid. Sec. 6214(b). Therefore, we cannot determine that

petitioners are eligible for a bad debt deduction for 2011.

             2.     Grande River

      Petitioners claimed a bad debt deduction on their 2010 amended return of

$156,963 for Grande River. For Grande River, Prime issued petitioner a

promissory note which stated that it was secured by a deed of trust. A genuine

debtor-creditor relationship must be accompanied by “more than the existence of

corporate paper encrusted with the appropriate nomenclature captions.” Tyler v.

Tomlinson, 414 F.2d 844, 850 (5th Cir. 1969).

      The promissory note for Grande River lacked a fixed maturity date and

stated that payment would be due upon the sale of a home on the property. The

note stated that petitioner was the beneficiary of a deed of trust for the property,

but no provision in the note stated a date upon which petitioner could
                                         - 36 -

[*36] unconditionally demand payment and after which Prime would be in default.

The fact that the note provided an open-ended, rather than fixed, date for

repayment indicates that petitioner’s advances were equity investments and not

bona fide debts.

       The note that petitioner held for Grande River did not require any periodic

accrual or payment of interest. It required only that Prime pay a fixed amount at

the time it sold the property. A true lender is concerned with interest, and

petitioner’s failure to include a separate interest rate for the note indicates that he

expected to take an equity stake in the development of Grande River rather than

act as a bona fide creditor. See Am. Offshore, Inc. v. Commissioner, 97 T.C. at

605.

       The absence of a fixed maturity date and a payment schedule indicates that

repayment was tied to the fortunes of Prime’s business, a sign of an equity

advance rather than a bona fide debt. Estate of Mixon v. United States, 464 F.2d

394, 404 (5th Cir. 1972). Repayment of petitioner’s advance was contingent on

Prime’s sale of the home. Petitioner had no right to demand payment unless and

until Prime made a sale. If repayment is possible only out of the borrower’s

earnings, the transaction appears to be a contribution to capital. Am. Offshore,

Inc. v. Commissioner, 97 T.C. at 602.
                                        - 37 -

[*37] Petitioner did not receive promissory notes from Prime for the advances

paid for Grande River after its purchase, including the payments advanced for

landscaping expenses, construction loan interest, and property taxes. Petitioner

testified that L. Olson promised to repay him if petitioner agreed to make the

construction loan interest payments beginning in October 2009. Petitioner also

testified that at this time he began to suspect that Prime was broke. His failure to

obtain or request formal promissory notes or other security under these

circumstances indicates that these payments were not intended to be bona fide

debt.

        After October 2009 petitioner believed that Prime was struggling to pay

expenses. He testified that he continued to make the interest payments on Prime’s

construction loan for Grande River because he feared that if he did not Prime

would default on the loan and lose the property before it could be sold and before

he could recoup his already substantial investment. Advances made to an

insolvent debtor generally do not create debts for tax purposes but are

characterized as capital contributions or gifts. See Dixie Dairies Corp. v.

Commissioner, 74 T.C. at 496-497. The chance that petitioner’s continued

advances would be repaid was far more speculative than any third-party creditor

would accept. See Fin Hay Realty Co., 398 F.2d at 697.
                                        - 38 -

[*38] We conclude that petitioner’s transfers of funds to Prime for Grande River

did not create bona fide debt. Consequently, we do not need to address whether

the purported debts became wholly worthless in the years in issue.

             3.    2008 Loss

      Petitioners did not claim a deduction for the 2008 loss on their original

income tax return filed for any of the years in issue. At trial they provided

evidence of payments made in 2006 and 2008, and they contend that they never

received repayment from DHP or Szigeti for these advances. The receipt signed

by Markle records that petitioner advanced $150,000 “for the purpose of investing

in various projects” and specifically provides that the parties’ “equity stakes” in

these projects will be determined in a separate agreement.

      The only evidence that petitioners provided with respect to the 2008

advance to Szigeti is a home equity line of credit activity record, which shows a

$15,000 draw on petitioners’ account, and a copy of a check stub, which

purportedly describes the purpose of the advance but was not attached to the actual

check. The check stub reporting petitioners’ advance to Szigeti describes the

payment as a loan, but petitioners did not provide a note or any other

documentation reflecting the parties’ mutual intent to create a debtor-creditor
                                         - 39 -

[*39] relationship. The check stub does not describe any loan terms except that

the amount was to be repaid in one month.

        With respect to both the 2006 and 2008 advances, there is no evidence that

interest was charged and no indication as to how petitioners’ funds would be used

or what the expected source of their repayment would be. Petitioners’ evidence is

insufficient to establish that there was a debtor-creditor relationship for the 2006

and 2008 advances. They are not entitled to a deduction under section 166 for the

2008 loss because there was no bona fide debt. See sec. 1.166-1(c), Income Tax

Regs.

              4.    Tallman Lot 37

        On their amended return for 2010 petitioners claimed a bad debt deduction

of $280,741 for Tallman lot 37. Prime issued a promissory note payable to

petitioner for $321,007 in connection with the initial purchase of this lot. On

December 28, 2007, Prime executed a quitclaim deed for Tallman lot 37 that

transferred its interest in the lot to petitioners. Petitioner canceled Prime’s

promissory note for the lot and released the deed of trust at the beginning of 2008.

Prime was no longer a debtor and petitioner was no longer a creditor. Since there

was no bona fide debt, petitioners are not entitled to a bad debt deduction. See id.
                                           - 40 -

[*40]            5.    Tallman Lot 40

        On their amended return for 2010 petitioners claimed a bad debt deduction

of $20,000 for Tallman lot 40. Petitioner reserved the option to purchase Tallman

lot 40 in his own name, and not in Prime’s name. He did not purchase Tallman

lot 40 and did not recover the $20,000 in earnest money.5 Petitioners did not lend

anyone any money with respect to Tallman lot 40, and therefore they cannot claim

a bad debt deduction. See id.

                 6.    Conclusion

        We conclude that petitioners did not have any bona fide debts during the

years in issue. They are not entitled to the NOL carryback and carryforwards

related to bad debt deductions that they claimed on their amended returns for the

years in issue.

II.     Section 6651(a)(1) Addition to Tax

        Section 6651(a)(1) imposes an addition to tax if the taxpayer fails to file his

or her income tax return by the required due date (including any extension of time

for filing). A taxpayer has the burden of proving that failure to timely file was due

to reasonable cause and not willful neglect. See sec. 6651(a)(1); Higbee v.

Commissioner, 116 T.C. 438, 447 (2001).

        5
            Petitioner purchased an option to purchase, which expired.
                                        - 41 -

[*41] Under section 7491(c) the Commissioner bears the burden of producing

evidence with respect to the liability of the taxpayer for any additions to tax. See

Higbee v. Commissioner, 116 T.C. at 446-447. Petitioners’ IRS account transcript

reflects their request for an extension of time to file their 2012 income tax return

not later than October 15, 2013. They filed their 2012 return on December 23,

2013. Respondent has met the burden of production.

       Petitioners provided no explanation as to why their tax return was filed late

for 2012. We sustain respondent’s determination of the addition to tax under

section 6651(a)(1).

III.   Section 6662(a) Penalties

       Respondent determined that for 2012 and 2013 petitioners are liable for

accuracy-related penalties pursuant to section 6662(a). Section 6662(a) and (b)(1)

and (2) imposes a 20% penalty on any portion of an underpayment of Federal

income tax that is attributable to negligence or disregard of rules or regulations or

a substantial understatement of income tax. An understatement of income tax is

substantial if it exceeds the greater of 10% of the tax required to be shown on the

return for the taxable year or $5,000. Sec. 6662(d)(1). Petitioners reported no tax

liability for 2012 or 2013. As determined in the notice of deficiency petitioners’

understatements of income tax for these years were substantial.
                                        - 42 -

[*42] The Commissioner bears the burden of production with respect to penalties.

Sec. 7491(c). Once the Commissioner meets this burden, the taxpayer must come

forward with persuasive evidence that the Commissioner’s determination is

incorrect. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.

Section 6751(b)(1) provides that “[n]o penalty under this title shall be assessed

unless the initial determination of such assessment is personally approved (in

writing) by the immediate supervisor of the individual making such determination

or such higher level official as the Secretary may designate.” In Graev v.

Commissioner (Graev III), 149 T.C. __ (Dec. 20, 2017), supplementing and

overruling in part Graev v. Commissioner (Graev II), 147 T.C. 460 (2016), we

held that the Commissioner’s burden of production under section 7491(c) includes

establishing compliance with the supervisory approval requirement of section

6751(b).

      Trial of this case was held, and the record was closed, before we vacated our

decision in Graev II and issued Graev III. In the light of the Court’s decision in

Graev III, we ordered respondent to file a response addressing the effect of section

6751(b) on this case and directing the Court to any evidence of supervisory

approval of the penalties in the record of this case.
                                       - 43 -

[*43] On January 10, 2018, respondent filed a seriatim answering brief,

addressing for the first time the issue of compliance with section 6751(b) as it

relates to the penalties determined in this case. Respondent asserted the penalty

against petitioners for 2012 in the amended answer. In Roth v. Commissioner,

T.C. Memo. 2017-248, at *10-*11 (citing Chai v. Commissioner, 851 F.3d 190,

221 n.24 (2d Cir. 2017), aff’g in part, rev’g in part T.C. Memo. 2015-14), this

Court observed that the Commissioner routinely asserts section 6662 penalties in

answers and that we have jurisdiction over them pursuant to section 6214(a). We

held that the Commissioner may, consistent with both Chai and Graev III, assert

additional penalties in the answer and that a delegate of the Chief Counsel for the

IRS (who represents the Commissioner) is the proper individual to do so in this

Court. Roth v. Commissioner, at *11.

      We held in Roth v. Commissioner, at *11, that IRS counsel, serving as the

Chief Counsel’s delegate, had complied with section 6751(b)(1) by obtaining the

approval and signature of the Associate Area Counsel who was her immediate

supervisor. In this case the Associate Area Counsel acting as respondent’s

counsel’s immediate supervisor signed the amended answer. Therefore,

respondent has met the burden of production for 2012.
                                       - 44 -

[*44] Respondent also bears the burden of proof with respect to the 2012 penalty,

because it was asserted for the first time in respondent’s answer. See Rule 142(a).

The evidence establishes that petitioners’ understatement of income tax for 2012

was substantial within the meaning of section 6662(d)(1), and therefore

respondent has met the burden of proof.

      Respondent determined the accuracy-related penalty for 2013 in the notice

of deficiency and did not provide at trial evidence of supervisory approval of the

penalty pursuant to section 6751(b)(1). In response to the Court’s order dated

January 10, 2018, respondent moved to reopen the record to offer into evidence

(1) the declaration of Ms. Goggins, the group manager6 of the IRS examiner that

conducted the examination of petitioners’ returns for the years in issue, and (2) a

Civil Penalty Approval Form signed by the supervisor and dated before the

issuance of the notice.

      Reopening the record for the submission of additional evidence lies within

the Court’s discretion. Zenith Radio Corp. v. Hazeltine Research, Inc., 401 U.S.


      6
        Ms. Goggins signed the form as “Group Manager”. However, the Internal
Revenue Manual (IRM) as then in effect, see IRM pt. 20.1.1.2.3(1), (8) (Aug. 5,
2014), specified that the approval must be by the “immediate supervisor”, as the
statute requires. The presumption of regularity, see Walker v. Commissioner, T.C.
Memo. 2018-22, at *19 n.6, warrants the presumption that Ms. Goggins was the
immediate supervisor.
                                        - 45 -

[*45] 321, 331 (1971); Butler v. Commissioner, 114 T.C. 276, 286-287 (2000).

We will grant a motion to reopen the record only if the evidence relied on is not

merely cumulative or impeaching, is material to the issues involved, and probably

would change some aspect of the outcome of the case. Butler v. Commissioner,

114 T.C. at 287.

      The evidence that is the subject of respondent’s motion would not be

cumulative of any evidence in the record, and it would not be impeaching material.

Respondent bears the burden of production with respect to penalties and would

offer the evidence as proof that the requirements of section 6751(b)(1) have been

met. The subject evidence is material to the issues involved in the case, and we

conclude that the outcome of the case will be changed if we grant respondent’s

motion.

      In petitioners’ response to respondent’s motion they argue that “[i]t would

not be in the best interests of justice to reopen the record when the law was clear at

the time the record closed.” When this case was submitted and the record closed,

Graev III had not been issued and petitioners had not raised section 6751(b) as an

issue. Respondent was justified in concluding that introduction of the Civil

Penalty Approval Form was not necessary. We agree with respondent that the
                                       - 46 -

[*46] Civil Penalty Approval Form is not cumulative and is material to the penalty

issue in this case.

      We also agree with respondent that the Civil Penalty Approval Form is a

record kept in the ordinary course of a business activity and is authenticated by the

declaration of the immediate supervisor. See Fed. R. Evid. 803(6), 902(11).

Petitioners do not challenge the evidence as unreliable. We will admit the Civil

Penalty Approval Form into evidence and the declaration for the purpose of

authentication under rule 902(11) of the Federal Rules of Evidence. See Clough v.

Commissioner, 119 T.C. 183, 190-191 (2002). Respondent has met the burden of

production for the penalty for 2013.

      Once the Commissioner meets the applicable burden, the taxpayers must

come forward with persuasive evidence that the penalty is inappropriate because,

for example, they acted with reasonable cause and in good faith. Sec. 6664(c)(1);

Higbee v. Commissioner, 116 T.C. at 448-449. Petitioners have not shown

reasonable cause for the underpayments of tax for 2012 and 2013. At the time that

petitioners filed their 2012 and 2013 income tax returns, respondent had already

issued the 2011 notice. The 2011 notice disallowed in full the reported theft loss

to which petitioners’ claimed NOL carryforwards for 2012 and 2013 related.
                                       - 47 -

[*47] Petitioners contend that petitioner consulted a lawyer, a tax preparer, and

IRS publications concerning theft loss deductions before filing the 2011 Form

1040. Petitioners claimed both ordinary loss and capital loss deductions for

several properties. They did not act with reasonable cause and in good faith when

they continued to claim NOL carryforwards for a purported theft loss for which

they knew that deductions had been fully disallowed. We hold that petitioners are

liable for the accuracy-related penalties under section 6662(a) for 2012 and 2013.

      To reflect the foregoing,


                                                Decision will be entered

                                       under Rule 155.
