T.C. Memo. 2006-278

UNITED STATES TAX COURT

HJ BUILDERS, INC., Petitioner v. COMMISSIONER OF INTERNAL

REVENUE, Respondent

PAUL W. AND CHARLENE R. WRIGHT, Petitioners v. COMMISSIONER OF

INTERNAL REVENUE, Respondent

Docket Nos. 8841-05, 8842-05. Filed December 28, 2006.

Joseph Jay Bullock and Karen Bullock Kreeck, for

petitioners.

S. Mark Barnes, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: Respondent determined deficiencies and

penalties in these consolidated cases with respect to petitioner

HJ Builders, Inc. (HJ Builders or the corporation), for its
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taxable year ended May 31, 2002, and with respect to petitioners

Paul W. and Charlene R. Wright (Mr. and Mrs. Wright,

respectively; the Wrights, collectively) for their taxable year

ended December 31, 2001, as follows:

 Penalty, I.R.C.

 Docket No. Deficiency Sec. 6662

 8841-05 $8,821 $1,764.20

 8842-05 55,562 11,112.40

After concessions by both parties, the issues remaining for

decision are: 

(1) Whether disbursements of funds from HJ Builders to

Mr. Wright are constructive dividends or repayments of loans;

(2) whether disbursements of funds by HJ Builders to and on

behalf of the Wrights’ church are deductible by HJ Builders as

charitable contributions of the corporation or should be

characterized as constructive dividends to the Wrights,

deductible as charitable contributions by the Wrights;

(3) whether expenses paid by HJ Builders with regard to a

Lexus SUV used by Mrs. Wright are business expenses deductible by

HJ Builders or are constructive dividends to the Wrights; and

(4) whether HJ Builders or the Wrights are liable for

accuracy-related penalties under section 6662.

Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and
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all Rule references are to the Tax Court Rules of Practice and

Procedure. All amounts have been rounded to the nearest dollar.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference. The

principal place of business of HJ Builders was in West Jordan,

Utah, at the time that the petition was filed at docket No.

8841-05. The Wrights resided in Salt Lake City, Utah, at the

time the petition was filed at docket No. 8842-05. 

At all times relevant to these cases, Mr. Wright was the

sole shareholder and president of HJ Builders, a corporation

engaged in residential construction and real estate development. 

Mr. Wright is known as Paul W. Wright, P. Wayne Wright, and Wayne

Wright. HJ Builders uses the cash method of accounting for tax

purposes.

Distributions to Mr. Wright

In 2001, Mr. Wright received a salary of $60,000 from

HJ Builders. Mrs. Wright received no wages from HJ Builders that

year. Additional miscellaneous checks totaling $72,000 were paid

to Mr. Wright by HJ Builders in 2001. These additional amounts

were not reported as income on the Wrights’ 2001 Federal income

tax return.

HJ Builders organized its receipts and disbursements using a

system of account codes, each identifying a different category of
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business assets, liabilities, and expenses. There is a unique

code attributable to “Loans payable P. Wayne Wright” under

HJ Builders’ accounting system. No code was used to classify the

checks to Mr. Wright totaling $72,000. HJ Builders did not

deduct any of the additional disbursements to Mr. Wright on its

corporate income tax return.

HJ Builders recorded a zero balance under the item “Loans

from shareholders” on Schedule L, Balance Sheet per Books, of its

Form 1120, U.S. Corporation Income Tax Return, for 2002, which

Mr. Wright signed as president of HJ Builders under penalties of

perjury, affirming that he had examined the return and its

accompanying schedules and statements and that they were true,

correct, and complete to the best of his knowledge.

There are purported loans from Mr. Wright to HJ Builders

recorded in the corporation’s handwritten ledger entitled “Wayne

Cash Loans to HJB”, none of which are corroborated by a formal

promissory note with principal and interest rate corresponding to

the amounts recorded in the ledger. The corporate records

contain no repayment schedules, notations of regular payments, or

interest calculations with respect to any loans from Mr. Wright

to HJ Builders.

A Line of Credit Promissory Note (first note) dated

September 1, 1995, bearing stated annual interest at 5 percent

and payable on demand, was signed by Mr. Wright. The first note
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states: “FOR VALUE RECEIVED, P. Wayne Wright, (“Borrower”)

promises to pay to the order of HJ Builders (“Lender”), the

principal sum of One Million Dollars ($1,000,000)”.

An additional promissory note (second note) dated March 22,

1996, for the principal amount of $337,500, payable on demand to

Mr. Wright by HJ Builders, bearing stated annual interest at

9.5 percent, or 12 percent if payment is not made upon demand,

was signed on behalf of HJ Builders by Mr. Wright and an

unidentified person. The second note is unsecured. The second

note is not listed in the “Wayne Cash Loans to HJB” ledger. 

Attached to the second note is one page from a mortgage agreement

dated March 22, 1996, between Mr. Wright and Draper Bank, signed

by Mr. Wright in his personal capacity but stating that the loan

is for the specified business purpose of purchasing investment

property. The bank loan is for the principal amount of $337,500

as well and charges rates of interest identical to those in the

second note but has a stated maturity date of April 1, 1999, and

is secured by the underlying real estate.

A handwritten document entitled “Wayne’s Ledger” lists

disbursements of funds by check number and amount from HJ

Builders to Mr. Wright from July 1997 through December 2002. No

specific promissory notes or other loan documents are associated

with any entries. A notation “loans to Wayne YE 5/31/02” is

written next to a bracketed total of $132,000 in disbursements
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made between June 5, 2001, and April 2, 2002, which includes the

$72,000 amount in dispute.

On February 11, 2002, the corporate office of HJ Builders

was burglarized. The police report made by Mr. Wright lists the

items reported stolen or destroyed in the incident. No

promissory notes were reported stolen or destroyed.

Charitable Contributions

The Wrights are active and contributing members of their

church community, and Mr. Wright is especially involved as a

leader in church youth group activities. The Wrights wrote

personal checks to their church totaling $28,750 in 2001 but

deducted only $18,000 in charitable contributions on their 2001

joint income tax return.

Additional checks were written from an HJ Builders account

to the Wrights’ church in the amount of $4,120 to fund a youth

trip and to a bus company in the amount of $1,276 to facilitate

the trip. HJ Builders did not receive a written acknowledgment

from the Wrights’ church indicating that the corporation had made

any charitable contributions to the church, and no charitable

contribution deductions were claimed by HJ Builders on its tax

return for 2002. Instead, the amounts expended by HJ Builders to

and for the benefit of the church youth group were deducted as

various business expenses on the corporation’s income tax return. 

The $4,120 disbursement was deducted in the corporate records as
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a “Commission Expense” under “Cost of Goods Sold”. The $1,276

disbursement was deducted by the corporation as an “Advertising”

expense.

Lexus Payment

On July 10, 2001, HJ Builders made a payment of $12,155 to

“Lexus”. While there was a 2000 Lexus SUV registered to

Mr. Wright individually in 2001, no Lexus was registered in the

name of HJ Builders until the corporation acquired a 2003 Lexus

SUV. The check stub from the payment to Lexus listed the item

under the corporation’s code for “Loans payable P. Wayne Wright”. 

The bill from Lexus was in Mr. Wright’s personal name, not in the

name of HJ Builders. No expense deduction was claimed by

HJ Builders for the payment to Lexus. The 2000 Lexus SUV was

driven exclusively by Mrs. Wright, who was not a salaried

employee of the corporation and was listed as a “housewife” on

the Wrights’ 2001 return. No mileage logs were kept by

Mrs. Wright or the corporation with respect to the 2000 Lexus.

Notices of Deficiency

The Internal Revenue Service (IRS) commenced an audit of the

Wrights’ 2001 Form 1040, U.S. Individual Income Tax Return,

because of the large percentage of charitable contributions

claimed ($18,000) to reported income ($61,176). The examining

agent also observed that the Wrights’ standard of living did not

appear supportable on their reported income. When the agent
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asked for substantiation of the charitable contributions, he was

initially given an alleged receipt from the Wrights’ church

showing $18,000. When he asked for copies of checks associated

with the payments, he was presented with a new tithing donation

slip for the amount of $28,750, which showed the same dates of

contributions as the prior receipt but different amounts. The

larger amounts were substantiated with copies of checks.

When the agent asked about the $72,000 in distributions to

Mr. Wright, the representative of the corporation and of the

Wrights initially had no explanation. Later the agent was told

that the distributions were loan payments, but no supporting

documentation was presented.

When the agent asked about travel expense substantiation, he

was presented with bills for travel for various family members,

including the Wrights’ teenaged children, and for greens fees for

golf outings. No contemporaneous records substantiating the

business purpose of certain trips were provided.

The notices of deficiency determined that checks amounting

to $72,000 were taxable to Mr. Wright as constructive dividend

income. The notices disallowed the business expense deductions

claimed by HJ Builders for the $4,120 disbursement directly to

the Wrights’ church and the $1,276 disbursement to the bus

company. Those amounts were recharacterized as constructive

dividends by the corporation to Mr. Wright. The notices allowed
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to the Wrights on Schedule A, Itemized Deductions, deductions for

the entire $28,750 that was paid directly by the Wrights to their

church in 2001. The notices determined that the $12,155 payment

to Lexus by HJ Builders was for a personal vehicle and treated

the payment of the personal expense as taxable constructive

dividend income to Mr. Wright. The notices also determined

negligence penalties under section 6662 with respect to the

Wrights and HJ Builders.

OPINION

Our Findings of Fact describe in some detail the documentary

evidence presented during trial and the progress of the audit

that resulted in the statutory notices in issue in these cases,

and we discuss that evidence further below in relation to

specific issues. Because the only witness presented by

petitioners was Mr. Wright, many of the issues depend, at least

in part, on the credibility of petitioners’ evidence. 

Unfortunately, we must conclude that much of the evidence is

unreliable. The record establishes that expenses were mislabeled

and that the nature of certain of them was thus concealed;

explanations were inconsistent and/or belated; and recollection

was nonexistent or faulty.

Mr. Wright testified that he purposely understated his

charitable contributions on his personal return because he

understood that the actual amount was not fully deductible. The
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more plausible explanation is that he was advised that, in view

of his reported income, claiming the actual amount of charitable

contributions would increase the likelihood of audit. The cash

contributions made would have approached but not exceeded the 

50-percent limitation of section 170(b)(1), and the charitable

contributions made from corporate funds would have brought the

amount to more than 50 percent of the reported income. 

Respondent now would allow all of the charitable contributions

because of the increase in the Wrights’ reportable income,

subject to overall reductions in accordance with section 68(a)

applicable to 2001.

Cash Disbursements to Mr. Wright

Respondent argues that the $72,000 in disbursements at issue

from HJ Builders to Mr. Wright was dividend distributions and

taxable income to the Wrights. Petitioners argue that the

disbursements were in repayment of loans previously made by

Mr. Wright to the corporation. 

The evidence presented by petitioners is inconsistent

regarding the nature of the cash payments. Petitioners argue

that the amounts in Wayne’s Ledger reflect repayments of previous

loans made by Mr. Wright to HJ Builders. However, a handwritten

notation on Wayne’s Ledger instead states that the disbursements

between June 5, 2001, and May 2, 2002, totaling $132,000 reflect

loans to Mr. Wright. We conclude that Wayne’s Ledger is
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inconclusive regarding both whether there were any loans from

Mr. Wright to the corporation and whether the $72,000 in

disbursements to Mr. Wright in 2001 was in repayment of those

purported loans.

We also are not persuaded that the promissory notes that

were presented by petitioners represent true indebtedness of the

corporation. Even though the first note clearly states that the

borrower is Mr. Wright and the lender is HJ Builders, petitioners

argue that the names of the parties in the document are reversed

and that Mr. Wright in fact advanced money on several different

occasions to HJ Builders pursuant to the first note. The first

note is a general line of credit and bears stated annual interest

at 5 percent, but the corporation’s handwritten loan ledger lists

several loans at various interest rates. Neither the corporation

nor Mr. Wright has presented any record of an accounting for any

alleged advancements, repayments, or accruals of interest

regarding funds lent pursuant to the first note. There is no

record that links the first note explicitly to any actual

monetary advance by Mr. Wright to HJ Builders.

Unlike the general line of credit in the first note, the

second note is for a specific amount purportedly advanced from

Mr. Wright to HJ Builders. However, the second note is neither

listed in the corporation’s handwritten ledger of “Wayne Cash

Loans to HJB” nor taken into account for book purposes on the
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balance sheets of HJ Builders. There is no corporate record of

any interest payments or repayment schedules in connection with

the second note. Thus the first and second notes are unreliable

and unpersuasive evidence in support of petitioners’ position

that the $72,000 in disbursements to Mr. Wright in calendar year

2001 was in repayment of prior loans by Mr. Wright to

HJ Builders.

Other conflicting evidence in the record prevents us from

concluding either that the disbursements to Mr. Wright were in

repayment of prior loans or that any such loans ever existed. 

Although HJ Builders had an accounting code for loans payable to

Mr. Wright, no code was used to classify the payments totaling

$72,000 to Mr. Wright in 2001, and HJ Builders recorded no

shareholder loans on its Federal tax return. Petitioners have

also claimed that the loan documents were stolen in a burglary of

HJ Builders’ offices on February 11, 2002. However, no loan or

other corporate documents are included in the list of stolen

items provided to the police. Mr. Wright’s uncorroborated

testimony that the loan documents were stolen in the burglary is

unpersuasive. See Simpson v. Commissioner, T.C. Memo. 1999-274,

affd. 23 Fed. Appx. 425 (6th Cir. 2001). 

Petitioners have presented no reliable promissory notes,

security agreements, payment schedules, amortization schedules,

notations of regular payments, interest calculations, or any
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other similar documents to substantiate their claim that the

$72,000 in miscellaneous checks paid to Mr. Wright over the

course of 2001 was in repayment of loans from Mr. Wright to the

corporation. See Meier v. Commissioner, T.C. Memo. 2003-94.

Petitioners have not persuaded us that any loans from Mr. Wright

to HJ Builders existed during the years in issue, and thus we

must conclude that the cash disbursements to Mr. Wright in 2001

were not made in repayment of such alleged loans.

Even if petitioners had presented consistent and credible

evidence that the cash payments to Mr. Wright were in repayment

of prior loans to the corporation, we would conclude, based on

the facts and circumstances of these cases, that those prior

loans were in reality equity contributions and not debt.

Claims of a debt relationship in a transaction between

controlling shareholders and their closely held corporations

warrant heightened scrutiny because, unlike the situation in an

arm’s-length transaction between unrelated parties, there is an

opportunity and often a motivation to have investments treated as

debt obligations rather than as capital contributions. Fin Hay

Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968);

Cuyuna Realty Co. v. United States, 180 Ct. Cl. 879, 883-884, 382

F.2d 298, 300-301 (1967). When presented with the issue of

whether a purported loan is debt or equity, the courts have

generally weighed the following factors:
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(1) the intent of the parties; (2) the identity between

creditors and shareholders; (3) the extent of

participation in management by the holder of the

instrument; (4) the ability of the corporation to

obtain funds from outside sources; (5) the “thinness”

of the capital structure in relation to debt; (6) the

risk involved; (7) the formal indicia of the

arrangement; (8) the relative position of the obligees

as to other creditors regarding the payment of interest

and principal; (9) the voting power of the holder of

the instrument; (10) the provision of a fixed rate of

interest; (11) a contingency on the obligation to

repay; (12) the source of the interest payments;

(13) the presence or absence of a fixed maturity date;

(14) a provision for redemption by the corporation;

(15) a provision for redemption at the option of the

holder; and (16) the timing of the advance with

reference to the organization of the corporation. [Fin

Hay Realty Co. v. United States, supra at 696.]

The factors applicable to these cases all weigh in favor of

reclassifying any alleged loans from Mr. Wright to the

corporation as equity investments. 

First, where funds advanced to a corporation by its

shareholders are proportional to the advancing shareholders’

equity interest in the corporation, there is an identity between

the purported creditor and the purported lender, which gives rise

to a strong inference that the funds advanced are additional

contributions to risk capital rather than loans. Segel v.

Commissioner, 89 T.C. 816, 830 (1987). In these cases,

Mr. Wright, the purported creditor, was the sole shareholder of

the purported debtor, HJ Builders. Mr. Wright was also the

corporation’s sole officer and had complete managerial control

over the corporation. Thus, the interests of debtor and creditor
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here are identical, and the lack of true bargaining between the

parties prevents us from accepting the form of the instrument

without an inquiry into the economic reality of the transaction. 

See Fin Hay Realty Co. v. United States, supra at 697. 

Second, when a corporation receives financing that it could

not acquire on similar terms from a commercial lender, the

character of that financing may be considered equity, not debt. 

Id.; Segel v. Commissioner, supra at 828-829. Attached to the

second note is a mortgage from Draper Bank for the same principal

amount as the second note and with terms identical to it, except

that the mortgage has a stated maturity date and is secured by

the underlying realty. Regarding the relationship between the

second note and the mortgage document, Mr. Wright testified at

trial:

Later on, when my funds were depleted and I wasn’t

able to loan the corporation money, I then approached

commercial lending institutions who, because of the

number of years that I’ve been in the business and had

established a track record, they were willing to loan

me personally funds that I then loaned to the

corporation. 

Comparing the second note and the related mortgage document, the

second note had no stated maturity date and was not secured,

which put Mr. Wright in a riskier position than Draper Bank. 

Draper Bank, as a disinterested lender, provided the loan to

Mr. Wright for a fixed maturity date and required collateral as

security for repayment. See Fin Hay Realty Co. v. United States,
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supra at 696. Had the corporation actually paid him interest,

Mr. Wright would have received the exact same interest, or

compensation for the use of his money, as he was required to pay

to Draper Bank on its related mortgage. However, Mr. Wright’s

purported loan to the corporation was a much riskier investment

than the Draper Bank mortgage because it was unsecured and thus

logically would have commanded a higher interest rate in the

market to compensate Mr. Wright adequately for the increased

risk. Mr. Wright could have gained no economic advantage from

the nominal interest he would have received from the corporation

on the second note, which supports respondent’s argument that the

second note was a contribution of risk capital to the corporation

and not evidence of true indebtedness. 

Finally, no interest payments were ever made to Mr. Wright,

and no interest was accrued with regard to any alleged loans. A

purported lender who does not insist on interest payments is

considered to be interested in the future earnings of the

corporation and takes the investment risk of a contributor to

capital, rather than that of a true lender. Segel v.

Commissioner, supra at 833. A disinterested lender in an

arm’s-length transaction would insist on interest accruals and

payments. A disinterested lender would also insist on

memorializing the loan and its terms in a formal promissory note,

none of which exist to corroborate the alleged loans recorded in
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the corporate ledger “Wayne Cash Loans to HJB”. Therefore, we

conclude that any alleged loans from Mr. Wright to HJ Builders

were equity contributions to risk capital rather than true debt. 

See Fin Hay Realty Co. v. United States, 398 F.2d at 696; Segel

v. Commissioner, supra at 832. Thus the disbursements totaling

$72,000 in 2001 were dividend distributions taxable to

Mr. Wright.

On brief, petitioners assert for the first time that HJ

Builders did not have enough earnings and profits in calendar

year 2001 to allow for dividend treatment of the distributions

paid out to Mr. Wright that year. Petitioners argue that

adjustments should be made to HJ Builders’ stated earnings and

profits to account for previous distributions to Mr. Wright that

should have been treated, for both book and tax purposes, as

dividend distributions but were not. Respondent argues that

allowing this belated argument would prejudice respondent.

The Court has consistently allowed a party to rely on a

theory only if the opposing party is provided with fair warning

and is not prejudiced by the need to gather additional evidence

to address the opposing party’s theory adequately. Seligman v.

Commissioner, 84 T.C. 191, 198-199 (1985), affd. 796 F.2d 116

(5th Cir. 1986). Although petitioners claim that Wayne’s Ledger

represents amounts distributed to Mr. Wright that reduced

HJ Builders’ earnings and profits balance in previous years,
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there is inadequate evidence in the record to support

petitioners’ contentions and calculations. The ledger is

unreliable for the reasons previously indicated. Raising the

issue of the proper calculation of earnings and profits for the

first time on brief has deprived respondent of the opportunity to

consider the issue and to examine and/or produce relevant

evidence. Therefore, we shall not consider petitioners’ earnings

and profits argument. 

Charitable Contributions

Respondent disallowed the $4,120 payment to the Wrights’

church directly and the $1,276 payment for the benefit of the

church’s youth group that were initially claimed as business

expenses of the corporation, characterized the amounts as

constructive dividends to Mr. Wright, and now proposes to treat

the amounts as charitable contributions deductible on the

Wrights’ Federal tax return for 2001.

When a corporation pays the personal expenses of a

shareholder without expectation of repayment, it may make a

constructive dividend distribution taxable to the shareholder. 

Magnon v. Commissioner, 73 T.C. 980, 993-994 (1980). Whether a

constructive dividend exists turns on whether the distribution

was primarily for the benefit of the shareholder. Hood v.

Commissioner, 115 T.C. 172, 179-180 (2000). Mr. Wright testified

at trial that he was personally involved as a counselor in his
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church’s youth activities and felt he had a responsibility toward

the youth in his church, which factors led him to cause the

checks to be issued to and for the benefit of his church. Such

charitable motivations, absent some link to the corporation, are

personal. These payments by the corporation bestowed an economic

benefit on Mr. Wright, who was the true charitable donor based on

the economic reality of the transactions, and thus the

distributions out of the corporation to facilitate the youth

retreat from the Wrights’ church were taxable constructive

dividend income to Mr. Wright.

Lexus

Petitioners dispute respondent’s determination that the

$12,155 paid to Lexus on July 10, 2001, was a constructive

dividend to Mr. Wright. Though HJ Builders did not deduct the

$12,155 payment to Lexus as a business expense on its Form 1120,

petitioners now argue that the purchase of the Lexus was a

capital expenditure by the corporation and not properly

characterized as an actual or constructive payment to Mr. Wright.

The Lexus vehicle for which payment was made by the

corporation was registered in the name of Mr. Wright

individually, not HJ Builders. The vehicle was driven

exclusively by Mrs. Wright, who was not a salaried employee of

the corporation. The corporation’s check stub characterized the

payment to Lexus as a loan payable to P. Wayne Wright. 
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Petitioners have presented no reliable evidence that the

Lexus was a business asset. Although Mr. Wright testified that

his wife used the Lexus exclusively for business, she did not

appear at trial. Deductions related to passenger vehicles are

not allowable unless the taxpayer substantiates by adequate

records, or by sufficient evidence corroborating the taxpayer’s

own statement, the time, place, and business purpose of the

vehicle’s use. Sec. 274(d)(4). Although HJ Builders did not

claim a business expense deduction for the payment to Lexus,

petitioners argue that the payment is not income to the Wrights

because the Lexus vehicle was a business asset. No records of

use of the vehicle were provided by petitioners. Therefore, we

conclude that the $12,155 payment to Lexus was a personal expense

of the Wrights paid by the corporation and thus a constructive

dividend distribution out of the corporation to Mr. Wright in

2001. Magnon v. Commissioner, supra at 993-994. 

Section 6662 Penalties

Section 6662 imposes a 20-percent accuracy-related penalty

on any underpayment of Federal income tax attributable to a

taxpayer’s substantial understatement of income tax or negligence

or disregard of rules or regulations. Sec. 6662(a) and (b)(2). 

Section 6662(c) defines “negligence” as including any failure to

make a reasonable attempt to comply with the provisions of the
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Internal Revenue Code and defines “disregard” as any careless,

reckless, or intentional disregard. 

Petitioners have conceded that many of the claimed business

expenses disallowed by respondent in the notices of deficiency

were personal expenses of the Wrights, not deductible by HJ

Builders, and represent additional income to the Wrights. The

evidence includes failure to maintain adequate records or to

substantiate deductions, mislabeling of expenses, and the errors

now conceded by petitioners. Petitioners have not addressed, at

trial or on brief, the accuracy-related penalties determined by

respondent pursuant to section 6662. Thus we deem petitioners to

have conceded their liability for the penalties. See, e.g.,

Levin v. Commissioner, 87 T.C. 698, 722-723 (1986), affd. 832

F.2d 403 (7th Cir. 1987); Hendricks v. Commissioner, T.C. Memo.

2001-299.

 Therefore, petitioners are liable for the accuracy-related

penalties determined under section 6662.

To reflect the foregoing,

Decisions will be entered

under Rule 155.