                              T.C. Memo. 2018-147



                         UNITED STATES TAX COURT



           JEFFREY B. YAPP AND TAMARA A. YAPP, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 13805-14.                         Filed September 10, 2018.


      Bertram Paul Husband, Richard Warren Craigo, and Jeffrey M. Wong, for

petitioners.

      Paulmikell A. Fabian, Mark A. Nelson, Sarah A. Herson, and Amy B.

Ulmer, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


      COHEN, Judge: Respondent determined a $475,135 deficiency and a

$95,027 section 6662(a) accuracy-related penalty with respect to petitioners’

Federal income tax for 2010. After concessions, the issues for decision are:
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[*2] (1) whether payments made for legal and professional services and wage

payments are deductible as expenses of a business operated by Jeffrey B. Yapp (J.

Yapp), (2) whether payments and other reported expenses are deductible as

expenses of a business operated by Tamara A. Yapp (T. Yapp, and together with J.

Yapp, petitioners), and (3) whether petitioners are liable for the section 6662(a)

accuracy-related penalty. All section references are to the Internal Revenue Code

in effect for 2010, and all Rule references are to the Tax Court Rules of Practice

and Procedure.

                               FINDINGS OF FACT

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

incorporated in our findings by this reference. Petitioners resided in Oregon when

they filed their petition.

NXTM, LLC

       J. Yapp was an employee of MTV Networks (MTV) from 2004 until 2009.

During his employment at MTV, he was involved in the development of a web-

based promotional platform for music artists (platform). At some point in 2009,

MTV decided not to pursue further development of the platform, and J. Yapp

asked MTV to allow him to continue developing the platform on his own.
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[*3] On July 16, 2009, J. Yapp formed NXTMUSIC, LLC, as a single-member

Delaware limited liability company. The company’s name was changed to

NXTM, LLC (NXTM), on August 5, 2009. On that same date J. Yapp executed

NXTM’s first operating agreement. On August 31, 2009, NXTM entered into an

assignment agreement (assignment) with MTV under which NXTM received the

rights to the platform in exchange for repaying MTV’s prior investment and

development costs and paying MTV royalties from future sales. Following this

assignment MTV employees associated with the platform worked for NXTM.

      NXTM used the platform to operate as a musical artist promotional

company. Taylor Swift was the principal musical artist promoted on the platform.

To fund further development of the platform NXTM pursued a two-phase

investment strategy. The first phase included raising funds from friends and

family; the second phase was to pursue institutional investors.

      As J. Yapp carried out his investment strategy for NXTM, he amended its

LLC operating agreement several times. J. Yapp executed an agreement dated

January 1, 2010, that amended and restated NXTM’s first operating agreement in

preparation for the company to start the institutional investment phase. No

additional members were added to NXTM through this agreement. In February

2010 J. Yapp negotiated attorney’s fees NXTM owed to a reduced amount totaling
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[*4] $120,000 for work previously performed for NXTM, and he paid the fees out

of NXTM’s bank account. On March 18, 2010, NXTM’s operating agreement was

further amended to add 2 “Class A Common Members” and 17 “Series A Preferred

Members”. The new members included individuals who contributed funding

during the friends and family investment phase. On September 16, 2010, NXTM’s

operating agreement was amended to add its institutional investors as members.

Real Food Real Life, LLC

      During 2009 and 2010 T. Yapp worked to establish her own health food

business. T. Yapp had been introduced to probiotic supplements during her efforts

to find treatments for medical conditions suffered by petitioners’ son. T. Yapp

began working with an Australian company called A.G.M. Foods Pty. Ltd., doing

business as Grainfields (AGM), whose fermented probiotic supplements she had

used previously. T. Yapp believed that, if she incorporated AGM’s unpleasant

tasting supplements into better tasting products, there was an opportunity to

market and sell probiotic supplements in the United States. On January 1, 2009,

T. Yapp entered into a distribution agreement (distribution agreement) with AGM.

Under its terms AGM would help T. Yapp develop her own line of probiotic

products in exchange for T. Yapp’s marketing and selling AGM’s supplements in

the United States. In October 2009 T. Yapp formed Real Food Real Life, LLC
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[*5] (RFRL), as a single-member California limited liability company to pursue

this opportunity.

      Throughout 2009 and 2010 T. Yapp worked to develop RFRL’s product

line. She worked to formulate new recipes that incorporated AGM’s supplements

to achieve products with better taste, texture, and shelf life. When T. Yapp

developed a workable recipe, she sent it to AGM, and AGM would use her recipe

to produce a commercial-level product trial run. AGM then sent samples of the

trial run products to T. Yapp. T. Yapp used the product samples to refine further

RFRL’s products by conducting focus groups and giving the samples away in

exchange for feedback. She also wrote and posted articles on RFRL’s website,

recorded a video presentation for Whole Foods, and met with numerous doctors

and experts to promote RFRL.

      T. Yapp took steps to launch RFRL’s product line commercially. She hired

designers to create RFRL’s logo, slogan, and product labels. Together with her

daughter and brother-in-law, she researched options for shipping RFRL’s

products. T. Yapp also restructured RFRL in order to separate RFRL-branded

products from her anticipated non-health food product lines. In May 2010 she

formed Fermactive, LLC, as a single-member Delaware limited liability company
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[*6] that would serve as a parent company with separate divisions for RFRL and

other products.

      In November 2010 AGM obtained certifications that the RFRL-branded

products it produced were Kosher, Pareve, and organic. During the month of

December 2010, T. Yapp solicited and received pre-orders of RFRL products.

The first shipment of finished RFRL-branded products arrived in the United States

in late December 2010. The products sustained damage during shipment that

delayed their ultimate delivery to RFRL. RFRL officially launched its products at

a party hosted by NXTM on February 25, 2011.

Tax Reporting for 2009 and 2010

      Petitioners used the same certified public accountant (C.P.A.) to prepare and

jointly file their Forms 1040, U.S. Individual Income Tax Return, for 2009 and

2010. Petitioners provided their C.P.A. with only the general ledgers their

bookkeeper kept to record income and expenses for NXTM, RFRL, and their

household. For both years petitioners treated their respective businesses, NXTM

and RFRL, as disregarded entities for tax purposes and included Schedules C,

Profit or Loss From Business, with their jointly filed Forms 1040. Though NXTM

kept its books using the accrual method of accounting, petitioners filed their 2009

income tax return using the cash method on the Schedule C prepared for NXTM.
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[*7] For 2009 petitioners reported net negative income of $559,179. For 2010

they claimed a net operating loss (NOL) carryover of $557,423 from 2009.

Petitioners’ 2010 return included personal expenses as part of RFRL’s business

deductions and failed to continue to take depreciation deductions claimed for

2009.

        The Internal Revenue Service (IRS) conducted an examination of

petitioners’ returns for 2009 and 2010. As a result, the IRS determined

adjustments to petitioners’ 2009 gross income that increased it from !$559,179 to

$284,785. These adjustments included the disallowance of $122,737 claimed as

part of a deduction for NXTM’s wage expenses paid for 2009. The IRS also

disallowed $120,000 claimed as part of a deduction for legal and professional

services expenses for NXTM. These expenses were actually paid in 2010. The

IRS also disallowed all deductions claimed for RFRL-related expenditures.

        The IRS adjustments did not result in a deficiency for petitioners’ 2009

taxable year. The IRS disallowed in full petitioners’ $557,423 NOL carryforward

for 2010. On March 28, 2013, the group manager for the IRS examiner executed a

Civil Penalty Approval Form (penalty approval form) approving the section

6662(a) and (b)(2) underpayment penalty for a substantial understatement of

income tax that was determined in the notice of deficiency dated March 17, 2014.
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[*8]                                 OPINION

I.     Business Expense Deductions

       Taxpayers are required to maintain sufficient records to establish the

amount and purpose of any deduction. Sec. 6001; Higbee v. Commissioner, 116

T.C. 438, 440 (2001); sec. 1.6001-1(a), (e), Income Tax Regs. The taxpayer has

the burden of proving entitlement to his or her deductions claimed. See New

Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Rockwell v.

Commissioner, 512 F.2d 882, 886 (9th Cir. 1975), aff’g T.C. Memo. 1972-133.

This includes the burden of substantiation. Hradesky v. Commissioner, 65 T.C.

87, 90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976).

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

expenses paid or incurred during the taxable year in carrying on any trade or

business”. An expense is ordinary if it is normal, usual, or customary in the

taxpayer’s trade or business, and it is necessary if appropriate or helpful for such

business. See Deputy v. du Pont, 308 U.S. 488, 495 (1940); see also Lingren v.

Commissioner, T.C. Memo 2016-213.

       A taxpayer is not carrying on a trade or business for section 162(a) purposes

until the business is functioning as a going concern and performing the activities

for which it was organized. Richmond Television Corp. v. United States, 345 F.2d
                                        -9-

[*9] 901, 907 (4th Cir. 1965), vacated and remanded on other grounds, 382 U.S.

68 (1965); see also Glotov v. Commissioner, T.C. Memo. 2007-147. Business

operations with respect to the activity must have actually commenced. See

McKelvey v. Commissioner, T.C. Memo. 2002-63, aff’d, 76 F. App’x 806 (9th

Cir. 2003). “Until that time, expenses related to that activity are not ‘ordinary and

necessary’ expenses currently deductible under section 162 * * * but rather are

‘start-up’ or ‘pre-opening’ expenses.” See Woody v. Commissioner, T.C. Memo.

2009-93, slip op. at 9-10 (citing Hardy v. Commissioner, 93 T.C. 684, 687-688

(1989), aff’d in part, remanded in part, 1990 U.S. App. Lexis 19670 (10th Cir.

Oct. 29, 1990)), aff’d, 403 F. App’x 519 (D.C. Cir. 2010). Startup expenses,

although not deductible during the pre-opening phase, may generally be deducted

or capitalized and deducted over time upon a taxpayer’s becoming actively

engaged in business pursuant to section 195. Sec. 1.195-1T, Temporary Income

Tax Regs., 73 Fed. Reg. 38910 (July 8, 2008).

      A.     NXTM

             1.    Legal and Professional Services

      Petitioners concede that respondent properly disallowed the NXTM

Schedule C deductions claimed for legal and professional services for 2009. They

nonetheless argue that legal fees of $120,000 paid by NXTM in February 2010 are
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[*10] deductible from their 2010 gross income. Respondent’s position is that

since NXTM became a multimember LLC in 2010 it should be treated as a

partnership for tax purposes. According to respondent, J. Yapp failed to

substantiate that his outside basis in his NXTM partnership interest was sufficient

to allow him to deduct the full amount of the legal fees paid.

      J. Yapp testified at trial that when NXTM paid the legal fees in February

2010 it was still a single-member LLC. He further testified that NXTM did not

admit new members until March 2010. The NXTM operating agreement and

subsequent amendments in evidence support J. Yapp’s testimony that NXTM

remained a single-member LLC until the second amendment to the operating

agreement was executed in March 2010. A single-member LLC is disregarded as

an entity separate from its owner for Federal income tax purposes unless it elects

otherwise. See secs. 301.7701-2(a), 301.7701-3(b)(i) and (ii), Proced. & Admin.

Regs. Petitioners also provided evidence that NXTM paid $120,000 for legal fees

in 2010, including company emails negotiating the reduction and payment of legal

fees owed, bank statements showing wire transfers from NXTM’s account, and a

copy of a cleared electronic check drawn on NXTM’s account. These documents,

coupled with J. Yapp’s testimony, are credible evidence that NXTM paid legal

fees of $120,000 during February 2010 and that at the time of payment NXTM
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[*11] was a single-member LLC and therefore a disregarded entity. Since NXTM

was not a partnership at the time the legal fees were paid, J. Yapp is not required

to substantiate his outside basis in his NXTM partnership interest in order to

deduct the full amount of the legal fees paid. Cf. sec. 704(d). We conclude that

petitioners are entitled to a deduction of $120,000 for these expenses.

             2.    Wages

      Petitioners contend that respondent improperly disallowed $122,737 of a

deduction for wages claimed on their 2009 return for NXTM, which was part of

the NOL carryover claimed for 2010. Respondent disallowed this portion of the

wage deduction claimed for NXTM for lack of substantiation. While 2009 is not a

year in issue in this case, we may determine the correct amount of NOL for a year

not in issue as a preliminary step in determining the correct amount of an NOL

carryover to a taxable year in issue. Sec. 6214(b); Calumet Indus., Inc. v.

Commissioner, 95 T.C. 257, 274-275 (1990). Deductions may include a

reasonable allowance for salaries or other compensation for services actually

rendered. Compensation is deductible under section 162(a)(1) only if it is (1)

reasonable in amount, (2) based on services actually rendered, and (3) paid or

incurred. Eller v. Commissioner, 77 T.C. 934, 962 (1981).
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[*12] In support of their contention petitioners offered evidence in the form of a

general ledger listing numerous payments to several individuals under the heading

“payroll” and bank statements showing electronic transfers from NXTM’s

account. At trial J. Yapp briefly testified that when MTV assigned the platform to

NXTM the MTV employees associated with the platform’s development came to

work for NXTM. Petitioners produced no corroborating witnesses or other

contemporaneous employment-related documents such as employment contracts,

Forms W-2, Wage and Tax Statement, or Forms 1099-MISC, Miscellaneous

Income, to substantiate their claim. Petitioners failed to provided any details

regarding the number of NXTM’s employees, their job descriptions, or the

amounts that NXTM was obligated to pay them. Petitioners thus failed to meet

their burden to substantiate entitlement to a deduction for wages paid greater than

that allowed by respondent.

      B.     RFRL Expenditures

      Petitioners contend that their expenditures related to developing RFRL’s

product line qualify as deductible business expenses under section 162.

Respondent contends that even though petitioners paid these expenses they are

startup expenditures subject to the limitations of section 195 as opposed to section

162 business expenses. Respondent further argues that even if RFRL qualified as
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[*13] an active trade or business, petitioners failed to substantiate the expenses

that they deducted for RFRL.

      Section 195(a) provides the general rule that no current deduction shall be

allowed for startup or pre-opening expenses. Section 195(c) defines “start-up

expenditures” to include any amount:

             (A) paid or incurred in connection with--

                    (i) investigating the creation or acquisition of an active
             trade or business, or

                   (ii) creating an active trade or business, or

                    (iii) any activity engaged in for profit and for the
             production of income before the day on which the active trade
             or business begins, in anticipation of such activity becoming an
             active trade or business, and

             (B) which, if paid or incurred in connection with the operation
      of an existing active trade or business * * * would be allowable as a
      deduction for the taxable year in which paid or incurred.

Startup expenses, although not deductible during the pre-opening phase, may

generally be deducted or capitalized and deducted over time upon a taxpayer’s

becoming actively engaged in a trade or business pursuant to section 195. Sec.

1.195-1T, Temporary Income Tax Regs., supra; see Woody v. Commissioner, slip

op. at 10.
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[*14] Whether a taxpayer’s activities constitute the carrying on of a trade or

business requires an examination of the facts and circumstances of each case. See

Commissioner v. Groetzinger, 480 U.S. 23, 36 (1987); see also Woody v.

Commissioner, slip op. at 9-10. When determining whether a trade or business

exists the Court focuses on three factors: (1) whether the taxpayer undertook the

activity intending to earn a profit, (2) whether the taxpayer is regularly and

actively involved in the activity, and (3) whether the taxpayer’s activity has

actually commenced. See Woody v. Commissioner, slip op. at 11.

      When, as a threshold matter, did T. Yapp complete RFRL’s startup phase

and become actively engaged in business? Petitioners both testified at trial about

T. Yapp’s efforts to research and develop an RFRL-branded product line.

Generally, their testimony suggested that RFRL’s business was still in

development and had not begun operating in 2010. T. Yapp testified about testing

and experimenting with different RFRL product recipes; learning about the

potential health benefits of using probiotic products; and creating RFRL’s product

line through trial and error. Numerous email conversations, cost analyses, online

educational articles, bank records, credit card statements, and canceled checks in

evidence also demonstrate that RFRL remained in the startup phase throughout

2010. Significantly, the first delivery of market-ready RFRL products did not
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[*15] arrive in the United States until late December 2010, and shipping-related

damage delayed the products’ delivery to RFRL even further. Petitioners

launched RFRL’s products at an official launch party in February 2011.

      T. Yapp's description of her activities during 2010 and the corroborating

documentation persuade us that the definition of startup expenses in section 195(c)

is applicable to those activities. The preponderance of the evidence leads to the

conclusion that petitioners’ RFRL-related activities did not rise to the level of a

trade or business until the company’s official launch in February 2011 at the

earliest. It was at this point that RFRL actually commenced offering probiotic

health food for sale. See, e.g., Koenig v. Commissioner, T.C. Memo. 1998-215,

slip op. at 13-14 (citing Kennedy v. Commissioner, T.C. Memo. 1973-15), aff’d,

221 F.3d 1348 (9th Cir. 2000). Since all the expenses at issue in this case were

paid or incurred before the February 2011 launch, we conclude that they qualify as

startup expenditures. As such the RFRL-related expenses are subject to the

provisions of section 195 and cannot currently be deducted under section 162. See

Hardy v. Commissioner, 93 T.C. 684. We sustain respondent’s determination in

the notice to disallow deductions for these expenses.
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[*16] II.    Accuracy-Related Penalty

      Section 6662(a) and (b)(2) imposes a 20% accuracy-related penalty on any

underpayment of Federal income tax attributable to 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 or $5,000. Sec.

6662(d)(1)(A). As determined in the notice of deficiency petitioners’

understatement of income tax for 2010 was substantial, and respondent determined

the penalty under section 6662(a) and (b)(2) for that year.

      Under section 7491(c) respondent has the burden of production with respect

to the accuracy-related penalty. See Higbee v. Commissioner, 116 T.C. 438, 446

(2001). To satisfy respondent’s burden of production under section 7491(c),

respondent must produce evidence showing, inter alia, that respondent’s

representatives complied with section 6751(b)(1). See Graev v. Commissioner,

149 T.C. ___, ___ (slip op. at 14) (Dec. 20, 2017), supplementing and overruling

in part 147 T.C. 460 (2016). The record contains a penalty approval form that

shows that respondent’s representatives complied with section 6751(b)(1).

Responded has met the burden of production in this case. See id. at ___, slip op.

at 22. As respondent has done so, it is petitioners’ burden to establish that the
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[*17] imposition of the penalty is not appropriate. See Higbee v. Commissioner,

116 T.C. at 447.

      Section 6664(c)(1) provides an exception to the section 6662(a) penalty if it

is shown that there was reasonable cause for any portion of the underpayment and

the taxpayer acted in good faith. The determination of whether a taxpayer acted

with reasonable cause and in good faith is made on a case-by-case basis, taking

into account all the pertinent facts and circumstances. Sec. 1.6664-4(b)(1),

Income Tax Regs. The most important factor is the extent of the taxpayer’s effort

to assess his or her proper tax liability. Id. Circumstances that may indicate

reasonable cause and good faith include an honest misunderstanding of fact or law

that is reasonable in view of the taxpayer’s experience, knowledge, and education.

Id.

      According to petitioners, the penalties are not applicable because they relied

upon their C.P.A. to report the Federal income tax liabilities shown on their joint

returns. Under certain circumstances a taxpayer’s reliance upon professional

advice may establish the taxpayer’s reasonable cause and good faith with respect

to an underpayment of tax. To establish reasonable cause through reliance on

professional advice the taxpayer must prove that (1) the adviser was a competent

professional who had sufficient expertise to justify reliance, (2) the taxpayer
                                       - 18 -

[*18] provided necessary and accurate information to the adviser, and (3) the

taxpayer actually relied in good faith on the adviser’s judgment. Neonatology

Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d

Cir. 2002). Reliance on a return preparer is not reasonable where “even a cursory

review” of the tax return would reveal errors. Metra Chem. Corp. v.

Commissioner, 88 T.C. 654, 662 (1987).

      Petitioners have not established that they provided their C.P.A. with

complete and accurate information. T. Yapp testified at trial that they provided

their C.P.A. with only the general ledgers that their bookkeeper kept to record

income and expenses for NXTM, RFRL, and the Yapp household.

      Furthermore, J. Yapp admitted at trial that he approved the filing of the

returns without fully reviewing them. Had petitioners reviewed the returns, they

would have noticed the numerous mistakes that they claim their C.P.A. made, such

as selecting the wrong accounting method for reporting NXTM’s taxable income

in 2009, including personal expenses as part of RFRL’s business deductions, and

failing to continue to claim on the 2010 return depreciation deductions claimed for

2009. The identified mistakes undermine any assumption that the preparer was a

competent professional merely because he was a C.P.A. Petitioners’ purported

reliance on their C.P.A. does not establish that they acted with reasonable cause
                                        - 19 -

[*19] and in good faith. Therefore, the Court sustains respondent’s determination

that petitioners are liable for the section 6662(a) accuracy-related penalty for

2010.

        We have considered all of the parties’ arguments, and, to the extent not

addressed above, we conclude that they are moot, irrelevant, or without merit. To

reflect the foregoing,


                                                 Decision will be entered

                                        under Rule 155.
