                            T.C. Memo. 1997-177



                          UNITED STATES TAX COURT



             MACK L. MCCOY AND CATHERINE MCCOY, Petitioners v.
                COMMISSIONER OF INTERNAL REVENUE, Respondent


       Docket No. 9638-95.                Filed April 14, 1997.


       Mack L. McCoy, pro se.

       Gregory J. Powers, for respondent.


                            MEMORANDUM OPINION

       NAMEROFF, Special Trial Judge:     This case was heard pursuant

to the provisions of section 7443A(b)(3)1 and Rules 180, 181, and

182.       Respondent determined a deficiency in petitioners' 1991

Federal income tax in the amount of $4,200 and an accuracy-

related penalty under section 6662(a) in the amount of $840.


       1
        All section references are to the Internal Revenue Code
in effect for the year at issue. All Rule references are to the
Tax Court Rules of Practice and Procedure.
                               - 2 -


     The issues for decision are:   (1) Whether petitioners are

entitled to a section 162 deduction for accrued expenses of

$15,000; and (2) whether petitioners are liable for the section

6662(a) accuracy-related penalty.

                            Background

     Some of the facts have been stipulated, and they are so

found.   The stipulation of facts and the attached exhibits are

incorporated herein by this reference.   At the time they filed

their petition, petitioners resided in Thousand Oaks, California.

References to petitioner are to Mack L. McCoy.

     Petitioner is an architect by trade.    In 1991, petitioner

managed an interior design firm that built model homes for

homebuilders.   He worked 30 hours per week as a W-2 wage earner.

     Petitioner also acted as a consultant to various individuals

under his proprietorship named Mack McCoy.    As Mack McCoy’s

proprietor, petitioner provided his clients with management

services, such as marketing and overall management advice and

internal work scheduling.   Petitioner indicated that his

consulting business had been on-going for about 20 years.    In

1991, petitioner had one main client, a structural engineer, who

paid petitioner $2,000 per month for about five months of

services.   The 1991 Schedule C for Mack McCoy reflects gross

income of $10,913.64.   Petitioner used the cash method of

accounting to report Mack McCoy’s income and expenses.
                                 - 3 -


     Petitioner allegedly formed another proprietorship in 1991

named The Real McCoy (Real McCoy).       Petitioner's testimony

surrounding the existence and operation of Real McCoy was

sketchy.    We surmise, however, that petitioner had a plan to

build industrialized (i.e., prefabricated) housing, and Real

McCoy was conceptualized to engage in the actual manufacture of

the industrialized homes.

     Petitioner took no formal steps to set up Real McCoy, and he

stated it was formed just in his mind.       Petitioner also indicated

that he intended someday to create a formal structure, but that

in 1991 it was just an idea.     Real McCoy did not generate any

revenue for petitioner and, ultimately, never manufactured

anything.     Since 1991, petitioner said he took no steps to

establish Real McCoy as an on-going business because “the market

totally went dead”.     Petitioner intended to use the accrual

method of accounting to report Real McCoy’s income and expenses.

     Petitioner did not invest money into Real McCoy.      He stated,

however, that, while wearing his Mack McCoy hat, he drafted

architectural plans (the plans) and “sold” them to Real McCoy for

$15,000.    Petitioner indicated that the plans were a useful tool

to solicit potential investors because they allowed him to

demonstrate his product on paper.    Petitioner valued these plans

at $15,000.    Petitioner testified that he arrived at the above
                                - 4 -


figure using prevailing rates for similar types of architectural drawings.

     According to petitioner, as proprietor of both businesses,

he took the following actions with respect to the plans:    (1)

Mack McCoy drew-up the architectural plans; (2) Real McCoy agreed

to purchase the plans from Mack McCoy for $15,000; (3) Mack McCoy

delivered the plans to Real McCoy; and (4) Mack McCoy issued a

$15,000 bill to Real McCoy.    Petitioner did not have any written

documentation supporting the purported transaction.    Real McCoy

never paid Mack McCoy for the plans, and Mack McCoy did not

institute legal action against Real McCoy for nonpayment.

Petitioner stated that Real McCoy did not pay Mack McCoy because

“the entity never got going” and that Mack McCoy did not sue Real

McCoy because “there was nothing to gain.”

     On petitioners' 1991 Schedule C for Real McCoy, petitioner

claimed a $15,000 deduction for the accrued cost of the plans.

He did not, however, include $15,000 of income on the Schedule C

for Mack McCoy.   In the notice of deficiency, the Commissioner

determined that petitioners were not entitled to the $15,000

deduction because they failed to establish that they incurred an

ordinary and necessary business expense and because their method

of accounting for this deduction did not clearly reflect income.

                              Discussion

     We begin our discussion by stating that respondent’s

determination is presumed correct, and petitioner bears the
                               - 5 -


burden of proving otherwise.   Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933).   Moreover, petitioner must prove

entitlement to any deduction claimed.     New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934).

     The issue before us is whether petitioner is entitled to

accrue $15,000 as a deduction for 1991.     We hold that he is not

because he failed to prove that he incurred that expense.

     Section 162(a) permits the deduction of ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on a trade or business.   The question of whether a

taxpayer is engaged in the active conduct of a trade or business

requires an examination of all relevant facts and circumstances.

Commissioner v. Groetzinger, 480 U.S. 23, 36 (1987).    To be

deductible under section 162, expenses must relate to a trade or

business functioning at the time the expenses are incurred.

Hardy v. Commissioner, 93 T.C. 684, 687 (1989), affd. on this

point in an unpublished order of the Court of Appeals for the

Tenth Circuit filed October 29, 1990.    Further, the expense must

have been incurred after the taxpayer’s trade or business

actually commenced; expenses incurred prior to that time are

nondeductible pre-opening expenses.     Jackson v. Commissioner, 86

T.C. 492, 514 (1986), affd. 864 F.2d 1521 (10th Cir. 1989);

Goodwin v. Commissioner, 75 T.C. 424, 433 (1980), affd. without

published opinion 691 F.2d 490 (3d Cir. 1982); McManus v.
                               - 6 -


Commissioner, T.C. Memo. 1987-457, affd. without published

opinion 865 F.2d 255 (4th Cir. 1988).

     Real McCoy was not a functioning business in 1991.   By

petitioner’s own admission, it was just an idea in his mind that

never materialized.   Petitioner took no formal actions to

establish Real McCoy as a going concern, and he has yet to

commence any sort of manufacturing activity.   Moreover, Real

McCoy did not generate any revenue for petitioner and,

ultimately, never manufactured anything.   In sum, even though

petitioner intended to someday build industrialized housing, he

failed to demonstrate that he actually carried on that activity

during 1991.

     Petitioner did not incur a binding and enforceable liability

that would have entitled him to a deduction under section 162.

Generally, an accrual method taxpayer deducts expenses in the

year in which they are incurred, regardless of when they are

actually paid.   Heitzman v. Commissioner, 859 F.2d 783, 787 (9th

Cir. 1988), affg. T.C. Memo. 1987-109.   A liability is incurred

for income tax purposes in the tax year in which:   (1) All events

have occurred that establish the fact of the liability; (2) the

amount of the liability can be determined with reasonable

accuracy; and (3) economic performance has occurred with respect

to the liability.   Sec. 1.461-1(a)(2), Income Tax Regs.; see also

sec. 461(h).   In order to be accruable, a liability must be
                               - 7 -


binding and enforceable; the liability must not be contingent on

a future event; the amount of liability must be certain; and

there must be a reasonable belief on the part of the debtor that

the liability will be paid.   Putoma Corp. v. Commissioner, 66

T.C. 652, 660 (1976), affd. 601 F.2d 734 (5th Cir. 1979); United

Control Corp. v. Commissioner, 38 T.C. 957, 967 (1962).   We need

not dwell on this matter at length as petitioner failed to

demonstrate that Real McCoy incurred a binding and enforceable

liability.

     During opening argument, respondent likened petitioners'

situation to those disallowed by section 267, in support of the

claim that Real McCoy's deduction should not be allowed until an

equal amount of income is recognized by Mack McCoy.   Generally,

section 267 requires accrual basis taxpayers to defer deductions

for amounts payable to a related person, as specified in section

267(b), until such time as the amount is includable in the

recipient's gross income.

     We need not make a determination as to whether petitioner’s

situation falls within the specified relationships found within

section 267(b).2   Section 1.267(a)-1(c), Income Tax Regs.,

reflects a general principle of tax law that no deduction is


     2
        Sec. 267(b) does not explicitly make reference to
transactions carried out by two proprietorships owned by a single
taxpayer, although the underlying rationale of sec. 267 appears
to be applicable.
                                - 8 -


allowed for an unpaid expense that arises from a transaction that

is not bona fide.    We find that the Real McCoy’s alleged

liability did not arise from a bona fide arm’s-length

transaction.   Rather, as the record reveals, the liability arose

from a dubious transaction carried out in petitioner’s own mind

and is not supported by economic reality.     Petitioner’s attempt

to use differing methods of reporting income in order to obtain

this artificial deduction will not be permitted.

     For the above reasons, we hold that petitioners are not

entitled to deduct the $15,000 as an accrued business expense

under section 162.    We, therefore, do not have to decide whether

their method of accounting for that deduction clearly reflects

income.

     We next consider whether petitioners are liable for the

section 6662(a) accuracy-related penalty asserted against them.

We hold that they are.

     Section 6662 imposes a penalty equal to a 20 percent portion

of the underpayment attributable to, inter alia, negligence or

disregard of rules or regulations.      "Negligence" includes failure

to make a reasonable attempt to comply with the law, and the term

"disregard" includes careless, reckless, or intentional

disregard.   Sec. 6662(c).   The penalty does not apply to any

portion of an underpayment for which there was reasonable cause

and with respect to which the taxpayer acted in good faith.      Sec.
                                - 9 -


6664(c); sec. 1.6664-4(a), Income Tax Regs.   The Commissioner’s

determination imposing the accuracy-related penalty is presumed

correct, and the taxpayers bear the burden of proving that they

are not liable.    Rule 142(a); Tweeddale v. Commissioner, 92 T.C.

501, 505 (1989).

     Petitioner’s only contention raised as a defense to the

accuracy-related penalty is his reliance on respondent’s

Publication 334, entitled "Tax Guide for Small Business".

Petitioner indicated that the following two paragraphs on page

11, of the 1993 tax year version, support his deduction and

establish that his method of accounting for that deduction

clearly reflects income:

     Business and personal items. You may account for business
     and personal items under different accounting methods.
     Thus, you may figure the income from your business under an
     accrual method even though you use the cash method to figure
     personal items.

     Two or more businesses. If you operate more than one
     business, you generally may use a different accounting
     method for each separate and distinct business if the method
     you use for each clearly shows your income. For example, if
     you operate a personal service business and a manufacturing
     business, you may use the cash method for the personal
     service business but you must use the accrual method for the
     manufacturing business. [Emphasis added.]

     Petitioner’s reliance on the above passages does not

establish reasonable cause to support his position.    Petitioner

misunderstands these paragraphs and incorrectly applied them to

his factual situation.   For example, the second paragraph

comports with code section 446(d) in stating, generally, that a
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taxpayer with two separate and distinct businesses may use

different methods of accounting to report income for each

business.   This provision does not have application to

petitioners’ situation, however, as Real McCoy is not a separate

and distinct trade or business and the deduction claimed by Real

McCoy did not arise from a bona fide transaction.

     As illustrated, the above passages do nothing to assist

petitioner in demonstrating reasonable cause.   Since petitioner

has not raised any other arguments in his defense, we find that

he has failed to satisfy his burden.   Accordingly, we hold

petitioners liable for the accuracy-related penalty asserted

against them.

     To reflect the foregoing,

                                         Decision will be entered

                                    for respondent.
