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Tax Court In Brief: What Happened When Tax Return Preparer Assisted Clients In Creating New Entity As S Corporation

Tax Court In Brief: What Happened When Tax Return Preparer Assisted Clients In Creating New Entity As S Corporation

Bailey v. Commissioner, T.C. Memo. 2021-55 | May 10, 2021, | Pugh, J. | Dkt. No. 5477-14

Short Summary

Mr. Bailey working as an unenrolled tax return preparer assisted clients (Uwe Zink and Gary Skuro) in creating a new entity, Interradiology, Inc. (Interradiology) organized under the laws of Arizona and elected to be treated as an S corporation for Federal tax purposes in 2017. Therefore, Mr. Bailey prepared and filed Forms 1120S, U.S. Income Tax Return for an S Corporation, for Interradiology for tax years 2007 through 2012. Also, he held 10% of the shares of Interradiology during the tax year 2008 and 20% during tax years 2009 through 2012.

Mr. Bailey prepared and filed petitioners’ Forms 1040, U.S. Individual Income Tax Return, for the years in issue. He timely filed their 2008 and 2012 Forms 1040, but he untimely filed their 2009, 2010, and 2011 Forms 1040 on March 9, 2011, November 29, 2011, and February 19, 2013, respectively. The 2010 and 2011 returns both reported tax due, which the IRS assessed before the issuance of the notices of deficiency for those years.

Regarding petitioners’ Forms 1040, Mr. Bailey reported gross income by adding together any wages, Schedule C business income, capital gain, and taxable Social Security benefits, plus the distributive shares of Interradiology’s income petitioners received during each year. Mr. Bailey offset this income in part with the standard deduction in 2010 and Schedule A itemized deductions in 2008, 2009, 2011, and 2012. In respect to petitioner’s Schedules C, Mr. Bailey reported gross profits and offset those profits in part with business expense deductions, including rent he paid for the Broadway office.

The IRS audited petitioners’ Forms 1040 and Interradiology’s Forms 1120S for the years in issue, resulting in the issuance of notices of deficiency to petitioners for tax years 2008 to 2013, adjusting the petitioners’ distributive shares of Interradiology’s income upward, and reducing the Schedule C deductions. Some of the adjustments included reclassifying petitioners’ mortgage interest expense deductions as home mortgage interest expense deductions, so the respondent also adjusted the corresponding Schedule A deductions.

Petitioners timely filed petitions with the United States Tax Court challenging the proposed adjustments. The respondent sent to the petitioners a proposed stipulation of settled issues. Both parties signed the document which was filed on November 21, 2019. The proposed stipulation stated: (i) that two of the substantive issues were resolved; (ii) that the remaining issues involve primarily substantiation of business expenses and itemized deductions, additions to tax, and penalties; (iii) that petitioners had raised new issues requesting additional deductions not originally claimed; (iv) agreements regarding Interradiology’s income, deductions and the amounts of Mr. Bailey’s distributive share of Interradiology’s income; (v) that petitioners did not receive the capital gain relating to Interradiology that had been reported on their Forms 1040 for 2010 and 2012.

After the document was submitted, the respondent filed a motion for leave to file the first amendment to answer under I.R.C. §6651(a)(2). The motion requests additions to tax for failure to timely pay tax shown on petitioners’ Forms 1040 for 2010 and 2011 which continue to accrue since the issue of notices of deficiency. At trial, the parties filed their first stipulation of facts showing the parties’ agreement outlined in detail the time and manner of determination of the I.R.C. §6662 penalties for each year, and the parties’ agreement that respondent had satisfied the requirements of section 6751(b) for each penalty determined in the statutory notices.

Key Issue:

  • Whether Petitioners are: (1) entitled to additional mortgage interest expenses for 2010; (2) entitled to vehicle depreciation and expenses deductions for 2008, 2009, and 2010; (3) entitled to professional fees deductions for 2009 and 2010; (4) entitled to additional home office expenses for 2011 and 2012; (5) liable for an addition to tax according to section 6651(a)(1); and (6) liable for the accuracy-related penalty under section 6662.

Primary Holdings

  • (1) Petitioners offered no support for the increased amounts of mortgage expenses they claimed in their amended returns. The Court held that petitioners are not entitled to any additional mortgage interest expense deductions.
  • (2) Petitioner’s record does not show that petitioners converted the vehicle to business use at any point. Also, there isn’t documentary evidence to support deductions for vehicle expenses in amounts greater than those previously allowed by respondent. The Court held that petitioners are not entitled to deduct any vehicle depreciation or additional vehicle expenses.
  • (3) Petitioner’s legal fees reported are related to an unsuccessful malpractice suit Mr. Bailey commenced against his attorney and an expert witness. The Court held that petitioners are not entitled to deduct professional fees.
  • (4) Petitioners failed to provide any supporting documents for these new and increased deductions. The Court held that petitioners are not entitled to any additional home office expenses deductions.
  • (5) Petitioners did not address or dispute those additions to tax at trial and have neither contended nor shown that they had reasonable cause for filing late or not paying the tax due. The Court held that the additional tax will be sustained.
  • (6) Petitioners offered no evidence of reasonable cause or of the manner in which Mr. Bailey made erroneous entries on Interradiology’s or petitioners’ returns. The Court held that I.R.C. 6662 penalties will be sustained.

Key Points of Law 

  • Originally, the burden of proof in cases before the Court is on the taxpayer. See Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115, 54 S. Ct. 8, 78 L. Ed. 212, 1933-2 C.B. 112 (1933).
  • R.C. § 7491(a)(1) provides that the Commissioner shall have the burden of proof when the taxpayer introduces credible evidence concerning any factual issue relevant to ascertaining the liability of the taxpayer for any tax imposed by subtitle A or B. See Higbee v. Commissioner, 116 T.C. 438, 441-442 (2001).
  • The Commissioner does not bear the burden of disproving deductions that a taxpayer belatedly claims. See Sham v. Commissioner, T.C. Memo. 2020-119, 38-39; Rappaport v. Commissioner, T.C. Memo. 2006-87, 2006 WL 1083434, at 4.
  • Rule 91(e) states that a stipulation shall be treated, to the extent of its terms, as a conclusive admission by the parties to the stipulation, unless otherwise permitted by the Court or agreed upon by those parties.
  • Stipulations of settlement are usually enforced when a request to withdraw them is made close to trial. See Dorchester Indus. Inc. v. Commissioner, 108 T.C. 320, 334-335 (1997).
  • Taxpayers have the burden of proving entitlement to their claimed deductions. See New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440, 54 S. Ct. 788, 78 L. Ed. 1348, 1934-1 C.B. 194 (1934).
  • According to I.R.C. §6001, taxpayers are required to maintain sufficient records to establish the amount and purpose of any deduction. See Higbee v. Commissioner, 116 T.C. at 440.
  • The taxpayer’s failure to keep and present records counts heavily against a taxpayer’s attempted proof. See Rogers v. Commissioner, T.C. Memo. 2014-141, at 17.
  • Amended returns are merely statements of petitioners’ position and not evidence of the contents. See McLaine v. Commissioner, 138 T.C. 228, 245 (2012); Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979); Roberts v. Commissioner, 62 T.C. 834, 837 (1974).
  • Reg. §1.167(a)-11(1)(i) states that the depreciation of an automobile begins when the taxpayer places the asset in service and ends when it is retired from service.
  • Automobiles are classified as three-year property for depreciation purposes. See Rev. Proc. 87-56, 1987-2 C.B. 674.
  • R.C. §274(d) specify substantiation requirements for vehicle expenses which require a taxpayer to substantiate by adequate records or by sufficient evidence corroborating the taxpayer’s own statement.
  • The taxpayer must demonstrate when taking vehicles expenses: (i) the amount of the expense, (ii) mileage for each business use of the vehicle as well as the total mileage for all purposes during the taxable period, (iii) the time and place of the travel or use, and (iv) the business purpose of the expense. See Treas. Reg. §1.274-5 (j)(2); §1.274-5T (b)(6); Shea v. Commissioner, 112 T.C. 183, 186- 188 (1999).
  • To substantiate by adequate records, a taxpayer must provide an account book, a log, or similar record and documentary evidence which together are sufficient to establish each element with respect to an expenditure. See Treas. Reg. §1.274-5T (c)(2)(i).
  • The legal fees are deductible if its origin and character of the claim were related to a businessSee generally United States v. Gilmore, 372 U.S. 394983 S. Ct. 6239 L. Ed. 2d 570, 1963-1 C.B. 356 (1963).
  • R.C. §280A(a) bars deductions for a home used by the taxpayer as a residence during the taxable year.
  • R.C. §280A(c)(1)(A) and (B) establish that the taxpayer can deductions for a home when part of the taxpayer’s home was used on a regular basis as the principal place of business for their trade or business or as a place of business used by clients or customers in meeting or dealing with them in the normal course of their trade or business (and allocate the expenses to that part of their home).
  • R.C. § 7491(c) states that respondent has the burden of production with respect to the liability of any individual for penalties and additions to tax.
  • In any event, the respondent has the burden of proving the increased amounts claimed in the amendment to the answer if we grant the respondent’s motion. See Rule 142(a)(1).
  • R.C § 6651(a)(1) and (2) imposes an addition to tax for the late filing of a return and an addition to tax for late payment of the amount shown as tax on the return.
  • R.C. §6651(a)(1) requires the respondent to meet the burden of production with respect to late filing under See Wheeler v. Commissioner, 127 T.C. 200, 207-208 (2006); and Higbee v. Commissioner, 116 T.C. at 446-447.
  • Respondent “bears the overall burden of proof with respect to his increases in the additions to tax”. See Rader v. Commissioner, 143 T.C. 376, 389 (2014).
  • R.C. § 6662(a), (b)(1) and (2) imposes a penalty equal to 20% of the portion of an underpayment of tax required to be shown on the return that is attributable to “negligence or disregard of rules or regulations” and/ or a “substantial understatement of income tax.”
  • R.C. § 6662(c) states that negligence includes “any failure to make a reasonable attempt to comply with the provisions of this title”. See Allen v. Commissioner, 92 T.C. 1, 12 (1989).
  • R.C. § 6664(c)(1) establishes that once the Commissioner has met the burden of production, the taxpayer must come forward with persuasive evidence that the penalty is inappropriate. See Higbee v. Commissioner, 116 T.C. at 448-449.
  • Reg § 1.6664-4 (b)(1) states that the decision as to whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all of the pertinent facts and circumstances. Also, that the most important factor in determining reasonable cause and good faith is the extent of the taxpayer’s effort to assess his or her proper income tax liability.

Insight:  The Bailey decision shows that taxpayers have the burden of proof of their entitlement to deductions. Accordingly, they have to keep request books and records in order to prove their request.

Have a question? Contact Jason Freeman, Freeman Law, Texas.

Jason Freeman

Mr. Freeman is the founding and managing member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney. Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service.
He was honored by the American Bar Association, receiving its “On the Rise – Top 40 Young Lawyers” in America award, and recognized as a Top 100 Up-And-Coming Attorney in Texas. He was also named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas” by AI.

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