# PURSUANT TO INTERNAL REVENUE CODE SECTION 7463(b),THIS OPINION MAY NOT BE TREATED AS PRECEDENT FOR ANY OTHER CASE.T.C. Summ ary Opi ni on 20 14 -1 08

UNITED STAT ES TAX COURT

TORY M. WATSON, Peti ti on er v . COMM ISSI ONER OF INTERNAL REVENUE, Resp on de nt

Doc ke t No . 26 03 2- 11 S. Fi le d Dec em be r 8, 2 01 4.

E. Rhe ttBu ck , Jr., fo r pe ti ti on er. Po rti a Neo m i Ro se , forres po nd en t.

SUMM ARY OPINION MORR ISON, Ju dg e: Thi s ca se was h eardpu rs ua ntto sec ti on 74 63 of t he In te rn al Rev enue Co de ineffe ctwhen th e p et it io n was fil ed . Purs ua ntto sec ti on-2
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74 63 (b ), th e d eci si on to be en te redis no t re vi ewab le by any ot he r co urt, an d t hi s op in io n s ha ll no t b e tr eat edas p rece de ntforan y ot he r cas e. 1 The res po nd en t (r eferredto he re as th e “ IRS” ) is su eda no ti ce o f de fic ie nc y to th e p et it io ne r, Tory M. W at so n (r eferredto he re as “ W at so n” ), fo r th e 2 00 5 a nd 20 06 tax y ears de te rm in in g: (1) in co m e-t ax de fic ie nc ie s o f $2 ,28 2 for20 05 an d 2 $2 6,2 57 for20 06 ; (2 ) ad di ti on s t o t ax for20 06 of $ 5,6 33 un de r se ct io n 6 65 1( a)(1 )
an d $ 6,2 59 un de r se ct io n 6 65 1( a)(2 ); a nd(3) anaccu racy-rela te d p en al ty for 2 00 6 of $5 ,25 1 u nd er s ect io n 6 66 2( a). Afte r tr ia l the pa rti es set tl edm an y of the is su es . The remaini ng is su es to be
res ol ve d i nv ol ve th e ta x t reat m en t o f cert ai n b us in es s ex pe ns es of LLCs W at so n own ed . Spe ci fic al ly, th e rem ai ni ng is su es are: (1 ) The am ou ntof t he ren ta l-e xp en se de du ct io n fo r Sky li ne Mo ti on Pic tures , LLC, for20 05 . W e h ol d t ha t the am ou ntis $1 6,6 05
. (2 ) The am ou ntof t he co nt ract -labo r-ex pe ns e d educ ti on for Sky li ne Mo ti on Pi ctur es , LLC, for 2 00 5. We ho ldth atth e am ou ntis $7 5,1 53
.

All subs eque ntsec ti onrefe ren ces are t o t he Int ern al Rev enue Co de in 1 effe ctforth e y ears at i ss ue . All R ul e refe ren ces are t o t he Tax C ou rt Rul es of Prac ti ce an d P ro cedur e. All do ll ar am ou nt s ar e ro un de d t o t he ne ares t d ol la r. 2-3
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(3 ) The am ou ntof t he co nt ract -labo r-ex pe ns e d educ ti on for Sky li ne Mo ve m en t, LLC, for20 06 . W e h ol d t ha t the am ou ntis $1 4,7 78
. (4 ) The am ou ntof t he co nt ract -labo r-ex pe ns e d educ ti on for Lib erat io n Fi na nc ia l, LLC, fo r 20 06 . W e h ol d tha t the am ou ntis $8 ,90 0. Bac kg ro un d The st ip ul at edfact s an d t he supp le m en ta l s ti pu la ti on of f act s ar e in co rp or at edby thi s re fere nc e. W at so n re si de d i n Tex as at t he ti m e h e fi le d t he pe ti ti on . Fro m 20 02 th ro ug h 2 00 6 Wats on was a n e m pl oyee in th e m ortg ag e in du st ry . Duri ng 20 05 W at so n was em pl oyed b y DSG Mo rtg ag e, LLC, andFir st Cap it al Mo rtg ag e Co rp . as alo anori gi na to r. Duri ng 20 06 W at so n was em pl oyed by Firs t Capi ta l M ortg ag e Co rp . as alo anori gi na to r. W at so n p rep aredhi s o wn fe de ral -in co m e-t ax returns for20 05 an d 2 00 6. He fil edth es e returns lat e. W at so n’s 2 00 5 re turnin cl ud edSch edul es C, “ Pro fitor Los s Fr om

Bu si ne ss ,” fo r two LLCs tha t h e o wne d andop erat ed : Br it t an d Sky li ne Mo ti on Pic tu res . Thro ug h B rit t, Wats onen ga ge d i n t he bu si ne ss of
m ak in g andsel li ng clo th in g. Th ro ug h S kylin e Mo ti on Pic tu res , W at so n e ng ag ed in th e b us in es s o f pr oduc in g fi lm s an d o th er en te rta in m en t.-4
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Dur in g 2 00 6 Wats on ab an do ne d S kylin e Mo ti on Pic tu res ’ bu si ne ss of pr oduc in g fi lm s an d o th er en te rta in m en t. He ch an ge d t he na m e o f th e LLC to Sky li ne Mo ve m en t. Thr ou gh Sky li ne Mo ve m en t, Wats on en ga ge d i n web si te de si gn an d o th er co ns ul ti ng servi ces . On h is 20 06 return h e in cl ud eda Sch edul e C fo r Sky li ne Mo ve m en t. He al so in cl ud eda Sch edul e C fo r Lib erat io n F in an ci al , LLC, ano th er LLC th athe own edan d o pe rat ed . Thro ug h Li be rat io n F in an ci al , W at so n a dv is edm ortg ag e co m pa ni es on im

pr ov in g the ir o ve ral l p erfo rm an ce an d th e p erfo rm an ce o f th ei r lo anoff ic ers . All thr ee LLCs (Sky li ne Mo ti on Pi ctur es /S kylin e Mo ve m en t, Br it t, an d Li be rat io n F in an ci al ) were d is reg ard ed
en ti ti es forfed eral tax pu rp os es . There fo re, Watso n i s t reat edforfed eral tax pu rp os es as i f he op erat edth e LLCs a s s ol e p ro pr ie to rs hi ps . The IR S d oe s n ot ch al le ng e th e ex is te nc e o f th e b us in es se s t he LLCs co nduc te d o r th atth e bu si ne ss es were o pe rat edforpro fit
. On the Sch edul e C fo r Sky li ne Mo ti on Pic tu res for20 05 W at so n c la im ed bu si ne ss -ex pe ns e d educ ti on s o f $2 91 ,55 8. Onth e Sch edul e C fo r Bri ttfor20 05 W at so n c la im edbu si ne ss -ex pe ns e d educ ti on s o f $1 0,8 39 . W at so n re po rte d t ha t ne it he r bu si ne ss ha d g ro ss in co m e fo r 20 05 . On th e Sch edul e C fo r Sky li ne Mo ve m en t fo r 20 06 W at so n c la im edbu si ne ss -ex pe ns e d educ ti on s o f $1 52 ,94 0. On the Sch edul e C fo r Lib erat io n F in an ci al for20 06 W at so n c la im edbu si ne ss --5
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ex pe ns e d educ ti on s o f $2 08 ,42 6. Wats on rep orte d g ro ss in co m e fo r bo th Sky li ne Mo ve m en t an d Li be rat io n F in an ci al for20 06
. On Au gu st9, 2 01 1, the IRS m ai le d ano ti ce o f de fic ie nc y to W at so n fo r bo th 20 05 an d 2 00 6. In th e n ot ic e o f de fic ie nc y , th e IRS di sa ll owe d:

C al l b us in es s- ex pe ns e d educ ti on s t ha t Wats oncla im edon th e Sch edul e C fo r Sky li ne Mo ti on Pic tu res for20 05 ,

C al l b us in es s- ex pe ns e d educ ti on s t ha t Wats oncla im edon th e Sch edul e C fo r Bri ttfor20 05 ,

C $7 0,0 16 of the bu si ne ss -ex pe ns e d educ ti on s t ha t Wats on cla im edon th e Sch edul e C fo r Sky li ne Mo ve m en t fo r 20 06 , and

C $9 7,9 73 of the bu si ne ss -ex pe ns e d educ ti on s t ha t Wats on cla im edon th e Sch edul e C fo r Lib erat io n F in an ci al for 20 06
. The IRS al so de te rm in edth atfor20 05 W at so n h adearn ed$6 7 i n i nt eres t an d
rece iv ed$1 ,37 6 a tt rib ut ab le to a refu ndfro m th e St at e o f Il li no is Rev enue Dep artm en t. The IRS al so m ad e co m pu ta ti on al ad

jus tm en ts forbo th y ears to W at so n’s s el f-em

pl oym en t t ax es , adju st edgro ss in co m e, it em iz edde du ct io ns , and
ne t o pe rat in g l os se s. Th e IRS de te rm in ed : (1 ) in co m e-t ax de fic ie nc ie s o f $2 ,28 2 fo r 20 05 an d $ 26 ,25 7 fo r 20 06 ; (2 ) ad di ti on s t o t ax for20 06 of $ 5,6 33 un de r-6
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se ct io n 6 65 1( a)(1 ) an d $ 6,2 59 un de r se ct io n 6 65 1( a)(2 ); a nd(3) anaccu racyrel at edpe na lty

for20 06 of $ 5,2 51 un de r se ct io n 6 66 2( a). The cas e was tri edinHou st on , Texa s. Aft er tria l the pa rti es reac he d a pa rti al set tl em en t. The pa rti es ag reedth at : (1 ) W at so n’s i nc om e fo r 20 05 is in crea se d b y

$6 7 fo r in te res t an d $ 1,3 76 forth e ref un d fr om th e St at e o f Il li no is Rev enue Depa rtment; (2) an y ad jus tm en ts to W at so n’s s el f-em pl oym en t t ax es , ad jus te d g ro ss in co m e, it em iz edde du ct io ns , andne t o pe rat in g l os se s fo r 20 05 an d 20 06 are co m

pu ta ti on al ; an d (3 ) fo r 20 06 W at so n i s l iabl e fo r ad di ti on s t o t ax un de r se ct io n 6 65 1( a)(1 ) an d (2 ) an d ape na lt y un de r se ct io n 6 66 2( a) fo r an y un de rp aym en t tha t i s d et erm in ed . As fo r th e Sch edul e-C a dju stm en ts , itap pe ars to us th atth e se tt le m en t ag reem en t re so lv edall Sch edul e-C a dju st m en ts ex cep t fo r th e fo ll owi ng fou r cat eg or ie s:

C a ren ta l-e xp en se de du ct io n fo r Sky li ne Mo ti on Pic tu res for20 05 ,

C a co nt ract -labo r-ex pe ns e d educ ti on forSky li ne Mo ti on Pic tu res for 20 05 ,

C a co nt ract -labo r-ex pe ns e d educ ti on forSky li ne Mo ve m en t fo r 20 06 , an d

C a co nt ract -labo r-ex pe ns e d educ ti on forLib erat io n F in an ci al for 20 06
.-7
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The fol lo win g t ab le s s umm ari ze: (1) th e cat eg or ie s o f Sch edul e-C e xp en se s t ha t W at so n re po rte d; (2) th e am ou nt s Wats on cla im edon hi s re tu rn s fo r eac h cat eg ory ; (3 ) th e am ou nt s al lo wedinth e n ot ic e o f de fic ie nc y foreach cat eg ory ; an d (4 ) th e p art ie s’ po si ti on s re ga rd in g t he de du ct ib le am ou nt s fo r eac h c at eg ory , as refl ect edinth e p le ad in gs , th e co nc es si on s m ad e attri al , th e se tt le m en t ag reem en t, an d t he bri efs
. Skyline Motion P ictures ( 2005)

Item Amount

per return Amount

allowed in notice of defic iency Parties’ positions Adver tising $20,734 -0- $20,565 (as se ttled) Business use of home 16,877 -0- -0- ( as settled) Car and tr uck expenses 8,489 -0- 2,430 (as se ttled) Contract labor 85,843 -0- 78,861 (Watson) 1 -0- ( I RS) Depr eciation 8,621 -0- 4,625 (as se ttled) L eg al & profe ssional service s 15,822 -0- 8,480 (as se ttled) Offic e expense 2,901 -0- 11,767 (as se ttled) Rent or lease of “[o]ther business proper

ty” 22,769 -0- 23,055 (Watson) -0- ( I RS) Supplies 15,392 -0- -0- 2 Trave l 26,491 -0- -0- 2 Meals and e ntertainment 12,287 -0- -0- 2 Utiliti es 10,035 -0- 794 (as se ttled)-8
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“Other expenses” 45,297 -0- 15,431 (as se ttled)
Total 291,558 -0- 64,092 (settled as de ductible) plus 101,916 (still sought by

Watson) This amount is ex plained infra Discussion part 2.a. 1 Watson did notargue for any deduction at tria l or on brief . These a re de emed c oncede d. 2 See, e.g ., Hedrick v. Commiss ioner, 63 T.C. 395, 396-397 ( 1974). Britt (2005)

Item Amount

per return Amount

allowed in notice of defic iency Parties’ positions Supplies $421 -0- $5,420 (as se ttled) “Other expenses” 10,418 -0- -0- ( as settled) Total 10,839 -0- 5,420 (settled as de ductible) Skyline Movement (2006)

Item Amount

per return Amount

allowed in notice of defic iency Parties’ positions Adver tising $1,643 $1,643 $1,643 1 Car and tr uck expenses 33,225 33,225 33,225 1 Contract labor 26,870 -0- $14,778 (Watson) 2 -0- ( I RS) Depr eciation 13,056 13,056 13,056 1 L eg al & profe ssional service s 4,350 4,350 4,350 1 Rent or lease of “[o]ther business proper

ty” 2,100 2,100 2,100 1-9
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Supplies 9,235 9,235 9,235 1 Trave l 6,912 5,169 1,237 (as se ttled) Meals and e ntertainment 26,135 1,565 486 (as se ttled) Utiliti es 6,289 6,289 6,289 1 “Other expenses” 23,125 6,292 8,617 (as se ttled)
Total 152,940 82,924 80,238 3 plus 14,778 (still sought by

Watson) Neither party soug ht an amount diffe rent than the amount allowed in the noticeof 1 defic iency
. This amount is ex plained infra Discussion part 2.b. 2 This consists of: (1) amounts agree d to in settlement and (2) a mounts determined in 3 notice of de ficienc y

in categ ories for

which neither

party soug ht an amount diffe rent than the amount allowed in the notice of def iciency
. L ibera tion Financia l (2006)

Item Amount

per return Amount

allowed in notice of defic iency Parties’ positions Adver tising $27,125 $27,125 $27,125 1 Contract labor 45,548 -0- 260,582 (Watson) -0- ( I RS) L eg al & profe ssional service s 3,875 3,875 3,875 1 Offic e expenses 36,030 36,030 36,030 1 Supplies 13,516 13,516 13,516 1 Taxes and license s 1,350 1,350 1,350 1 Trave l 4,291 552 2,480 (as se ttled) Meals and e ntertainment 38,513 3,779 2,672 (as se ttled) Utiliti es 18,393 18,393 18,393 1-1 0-

“Other expenses” 19,785 5,833 7,111 (as se ttled)
Total 208,426 110,453 112,552 3 plus 60,582 (still sought by

Watson) Neither party soug ht an amount diffe rent than the amount allowed in the noticeof 1 defic iency
. This amount is ex plained infra Discussion part 2.c. 2 This consists of: (1) amounts agree d to in settlement and (2) a mounts determined in 3 notice of de ficienc y

in categ ories for

which neither

party soug ht an amount diffe rent than the amount allowed in the notice of def iciency
. Dis cu ss io n Gen eral ly, th e ta xp ay er b ears th e b ur de n o f pr ov in g, b y a pr ep on de ran ce o f th e ev id en ce, tha t the de te rm in at io ns inth e n ot ic e o f de fic ie nc y are erro ne ou s. Ru le 14 2( a)(1 ); Welc h v . Helv eri ng , 29 0 U.S. 1 11 , 11 5 (1 93 3) . Sect io n 7 49 1( a) im po se s the bu rd enof p ro of on th e IRS with re sp ectto factis su es forwhi ch th e ta xp ay er: (1) co m

pl ie d wi th th e subs ta nt ia ti on requi rem en ts of t he Int ern al Rev enue Co de ; (2 ) m ai nt ai ne d a ll reco rd s re qu ire d u nd er the Int ern al Rev enue Co de ; (3 ) co op erat edwith re as on ab le reque st s b y th e IRS for

witne ss es , in fo rm at io n, d oc um en ts , m eet in gs , andin te rv ie ws; an d (4 ) in tro du cedcred ib le
ev id en ce. Cre di bl e ev id en ce i s the qu al it y of e vi de nc e whi ch th e Co urt wo ul d fi nd
su ffi ci en t upo n wh ic h t o b as e a d eci si on on th e is su e in th e ta xp ay er’s fav or , ab se ntan y

co nt rary evi de nc e. See, e.g ., Hig be e v . Comm is si on er, 1 16 T.C. 43 8, 44 2 (2 00 1) . W at so n a rg ue s t ha t h e h as sat is fie d t he co nd it io ns requi redto im po se-1 1-

th e b ur de n o f pr oo f on th e IRS . W e n eedno t d eci de whet he r se ct io n 7 49 1( a) im po se s the bu rd enof p ro of on th e IRS . This is be cau se ou r fi nd in gs are supp orte d b y

th e p rep on de ran ce o f th e ev id en ce. See Knu ds env. Co m m is si on er, 13 1 T.C. 1 85 , 18 9 (2 00 8)
. Sect io n 1 62 (a) aut ho riz es a de du ct io n fo r or di na ry an d n eces sa ry

ex pe ns es th atwere p ai d o r in cu rreddu rin g t he tax ab le y ear i n c arrying on th e ta xp ay er’s tra de or b us in es s, i nc lu di ng ren ta l p aym en ts , sec ti on 1.1 62 -1 (a), In co m e Tax Reg s., an d p aym en ts forservi ces , sec ti on1.1 62 -7 (a), In co m e Tax Reg s. An
ex pe ns e is “ or di na ry ” if

eit he r itis cu st om ary orus ua l wi th in th e p art ic ul ar trad e, bu si ne ss , or i ndus try or i t re la te s t o atrans act io n “ of co m m on or f reque nt oc cu rren ce i n the type o f bu si ne ss in vo lv ed .” Depu ty v. duPo nt , 30 8 U.S. 4 88 , 49 5 (1 94 0) . An ex pe ns e is “ ne ces sary ” if itis bo thap pr op ria te an d h el pf ul to th e ta xp ay er’s trad e o r bu si ne ss , see , e.g., Welch v. Hel ve rin g, 2 90 U.S. at 1 13 , andit is di rect ly con ne ct edwith o r pe rta in s d ire ct ly to the tax pay er’s trad e o r bu si ne ss , se c. 1.1 62 -1 (a), In co m e Tax Reg s. Be in g a n e m pl oyee is co ns id ereda tr ad e o r bu si ne ss , andth us th e o rd in ary an d n eces sary ex pe ns es of e m

pl oym en t ar e de du ct ib le un de r se ct io n 1 62 (a), p ro vi de d, h owe ve r, th atth e em pl oyee can no t s eek rei m bu rs em en t o f th e ex pe ns es fro m th e em pl oyer. See, e.g ., Ben so n v . Co m m is si on er, T.C. Mem o. 2 00 7- 11 3, 9 3 T.C.M . (CCH) 1 19 9, 1 20 1 (2 00 7)-1 2-

(ci ti ng Po de m s v . Comm is si on er, 2 4 T.C. 2 1, 2 3 (1 95 5) ). Pers on al , fam il y , and li vi ng ex pe ns es are g en eral ly notde du ct ib le . Sec. 2 62 (a). If the tax pa y er es tabl is he s t ha t the tax pa y er p ai d o r in curreda de du ct ib le
ex pe ns e b utdo es no t es tabl is h t he am ou ntof the expe ns e, th enth e co urt m ay es ti m at e th e am ou ntof t he all owabl e d educ ti onif t he re i s s uf fic ie ntev id en ce i n th e rec or d t o p ro vi de a rat io na l b as is for th e es ti m at e. Co ha n v . Comm is si on er, 3 9 F.2 d 5 40 , 54 2- 54 4 (2 d C ir. 1 93 0) ; Van ic ekv. Co m mis si on er, 8 5 T.C. 7 31 , 74 2- 74 3 (1 98 5) . If th e ev id en ce i n t he reco rddo es no t p ro vi de a rat io na l b as is forth e es ti m at e, th e cl ai m edde du ct io n m us t b e d is al lo wed . Vani cekv. Co m m is si on er, 85 T.C. 73 1 a t 7 42 -7 43
. 1. Ren ta l-e xp en se de du ct io n fo r 20 05 W at so n c la im eda ren ta l-e xp en se de du ct io n o f $2 2,7 69 on th e Sch edul e C fo r Sky li ne Mo ti on Pic tu res for20 05 . In the no ti ce o f de fic ie nc y , th e IRS di sa ll owe d t ha t d educ ti on . At tri al an d o n b rie f W at so n a ss ert edth athe is en ti tl ed to a ren ta l-e xp en se de du ct io n o f $2 3,0 55 forSky li ne Mo ti on Pic tures for20 05
co ns is ti ng of:

C $4 ,50 0 tha t Wats on all eg ed ly pai d t o Gerry Lice a to ren t a u ni t in anun id en ti fie d b ui ld in g a s an off ic e fo r Sky li ne Mo ti on Pi ctur es forFeb ru ary, Marc h, an d Ap ril 20 05 ,-1 3-

C $1 5,6 05 th atW at so n a ll eg ed ly pai d t o S arah Bajwa to ren t Un it71 1
as anoff ic e fo r Sky li ne Mo ti onPic tu res forJu ne th ro ug h Dec em be r 20 05 , and

C $2 ,95 0 tha t Wats on all eg ed ly pai d t o l eas e a h ou se inLos Ang el es for
on e weekfor

bu si ne ss m eet in gs forSky li ne Mo ti on Pic tu res . The IRS d is pu te s t he de du ct ib il it y of any rent al ex pe ns e fo r Sky li ne Mo ti on Pi ctur es for

20 05
. As d is cu ss edm or e fu ll y

be lo w, we ho ldth atW at so n i s en ti tl edto a to ta l
ren ta l-e xp en se de du ct io n o f $1 6,6 05 forSky li ne Mo ti on Pic tu res for20 05 , whi ch
co ns is ts of:

C Zero of the $4 ,50 0 a ll eg ed ly pai d t o Gerry Lice a,

C $1 3,6 55 of the $1 5,6 05 all eg ed ly pai d a s re ntforUni t 7 11 , and

C $2 ,95 0 o f th e $ 2,9 50 pa idto lea se th e h ou se inLos Ang el es . a. Ren ta l-e xp en se de du ct io ns forren ta l o f anoff ic e fro m Gerry Lice a W at so n t es ti fie d t ha t h e p ai d $ 4,5 00 to Gerry Lice a to lea se “ a u ni t i n a di ffer en t b ui ld in g” (i.e ., di ffer en t fr om 12 5 Eas t 1 3t h S tre et , Chi cag o, Il li no is , whi chwas t he off

ic e o f Sky li ne Mo ti on Pic tu res be gi nn in g i n J un e 2 00 5) at t he rat e o f $1 ,50 0 p er m on th forFeb ru ary, Marc h, an d Ap ril 20 05 . The d oc um en ta ry ev id en ce co nf

irms th atW at so n m ad e o ne $1 ,50 0 p aym en t t o Gerry Lice a.-1 4-

Howev er, Watso n’s t es ti m on y ab ou t the all eg edoff

ic e was va gu e an d t en ta ti ve . He di d n ottel l u s t he ad dr es s o f th e “ di ffer en t b ui ld in g” . He supp li edno ot he r de ta il s ab ou t the off

ic e o r wha t h e u se d i t fo r. No d oc um en ts inth e rec or d
co rro bo rat e Watso n’s t es ti m on y . His v ag ue , un co rro bo rat edtes ti m on y was t oo weakto be cred ib le on th is po in t. Co ns eque nt ly, W at so n i s n oten ti tl edto an y de du ct io n fo r ren ta l p aym en ts to Gerry Lice a fo r anoff ic e fo r Sky li ne Mo ti on Pi ctur es for

20 05
. b. Ren ta l-e xp en se de du ct io n fo r ren ta l o f Uni t 7 11 Uni t 7 11 was aco nd om in iu m lo ft wi th a ki tc he n a nda be dr oo m ina res id en ti al bu il di ng at 1 25 East13 th Str eet , Chi cag o, Il li no is . Duri ng 20 05 , W at so n o wne d a ndli ve d i n Un it14 06 , als o a t 1 25 East13 th Str eet , Chi cag o, Ill in oi s. W at so n e xp la in edinde ta il ho w he u se d Un it71 1: He kep t au di ov is ua l equi pm en t i n t he un it , he wro te m ov ie scr ip ts inth e u ni t, an d h e m etth ere wi th Sky li ne Mo ti on Pic tu res ’ co nt ract or s. Wats on ’s tes ti m on y was c red ib le . W e h ol d th atth e ren t p aym en ts forUni t 7 11 were an ord in ary an d n eces sa ry bu si ne ss ex pe ns e. To p ro ve th e am ou ntof r en t h e p ai d fo r Uni t 7 11 , W at so n p ro vi de d aco py of th e si gn edlea se ag reem en t fo r Uni t 7 11 . The ag reem en t re qu ire d Wats on to-1 5-

pa y a m on th ly rentof $ 1,9 50 pe r m on th an d $ 50 pe r m on th fora pa rk in g s pa ce. The term of t he lea se was fr om

Ju ne 4, 2 00 5, t o J un e 4 , 20 06 . W at so n a ls o pr ov id edco pi es of t he se ch eck s an d c le ared -ch eckim ag es writ te n o n S kylin e Mo ti onPic tu re’s b an k a cco un t, wri tt ento Sara h B ajwa:

C a ch eckda te d M ay 26 , 20 05 , for$1 ,95 0 fo r “ de po si t” for“ Uni t 14 06 ”,

C a ch eckda te d M ay 26 , 20 05 , for$1 ,75 5 fo r “ Ju ne 20 05 ren t” ,

C a ch eckda te d J ul y

18 , 20 05 , for

$1 ,95 0 fo r “ Ju ly Rent#7 11 ”,

C a ch eckda te d Au gu st1, 2 00 5, fo r $1 ,95 0 fo r “ Aug us t Re nt#7 11 ”,

C a ch eckda te d S ep te m be r 2, 2 00 5, fo r $2 ,00 0 fo r “ Sep t ‘05 Ren t an d Park in g” , and

C a ch eckda te d Oct ob er 4 , 20 05 , for$2 ,00 0 fo r “ Oct R en t - Ap t # 71 1”
. W at so n t es ti fie d t ha t the fir stch eck , whi ch was n ot edas “ de po si t” for “ Uni t 14 06 ”, actua ll y

rel at edto Uni t 7 11 , no t Un it14 06 . W e ta ke th is to be tru e. Howev er, the ch eckap pe ars to be a pa ym en t o f a s ecu rit y de po si t, n otren t. Secu rit y de po si ts are n otde du ct ib le , if atall , un ti l the y ear a ctua ll y for fei te d. W il li am s v . Comm is si on er, T.C. Mem o. 1 99 8- 93 , 75 T.C.M. (CCH) 1 93 3, 1 93 8 (1 99 8)
.-1 6-

On the ba si s o f W at so n’s t es ti m on y , cop ie s o f ch eck s an d c le ared -ch eck im ag es , andth e si gn edlea se ag reem en t, we fi ndth atW at so n p ai d $ 1,7 55 forren t fo r Ju ne 20 05 , $1 ,95 0 fo r ren t fo r Ju ly 200 5, $ 1,9 50 forren t fo r Aug us t 2 00 5, $2 ,00 0 fo r ren t fo r Sep te m be r 20 05 , and$2 ,00 0 fo r ren t fo r Oct ob er 2 00 5. W at so n t es ti fie d t ha t h e p ai d re ntforNov em be r an d Dec em

be r 20 05 , bu t h e co ul d n otfin d c he ck s o r ot he r do cu m en ts to subs ta nt ia te th e p aym en ts . W e fo un d hi s t es ti m on y

cred ib le . W e fi ndth athe pa id$2 ,00 0 fo r ren t fo r eac h o f th es e two
m on th s. Co ns eque nt ly, W at so n i s en ti tl edto de du ct$1 3,6 55 forren ti ng Uni t 7 11 fo r Sky li ne Mo ti on Pic tu res for20 05
. c. Ren ta l-e xp en se de du ct io n fo r le as e o f a h ou se inLos Ang el es W at so n c la im eda ren ta l-e xp en se de du ct io n fo r Sky li ne Mo ti on Pic tures for a $ 2,9 50 pa ym en t m ad e in 20 05 . At tri al W at so n t es ti fie d t ha t the pu rp os e o f th e pa ym en t was to lea se a fu rn is he d, s in gl e-fa m il y ho us e fo r Sky li ne Mo ti on Pic tu res to be us edforon e weekof b us in es s m eet in gs whi le he att en de d t he Los Ang el es In te rn at io na l Fi lm

Fes ti va l. We fou ndW at so n’s t es ti m on y cred ib le
. Co ns eque nt ly, W at so n i s en ti tl edto de du ctth e $ 2,9 50 pa ym en t as a ren ta l ex pe ns e fo r Sky li ne Mo ti on Pic tu res for20 05
. 3 W at so n t es ti fie d t ha t h e st ay edat t he ho us e dur in g t he week . Thu s, the 3 ex pe ns e co ul d a rg uabl y

be a “ lo dg in g” ex pe ns e subjec t t o the “ st ric t- (co nt in ue d...)-1 7-

2. Co nt ract -labo r-ex pe ns e d educ ti on s fo r 20 05 an d 2 00 6 As d is cu ss edm or e fu ll y

be lo w, we ho ldth atW at so n i s en ti tl edto co nt ract labo r-ex pe ns e d educ ti on s o f:

C $7 5,1 53 for

Sky li ne Mo ti on Pic tu res for20 05 ,

C $1 4,7 78 for

Sky li ne Mo ve m en t fo r 20 06 , and

C $8 ,90 0 fo r Lib erat io n F in an ci al for20 06
. a. Co nt ract -labo r-ex pe ns e d educ ti on forSky li ne Mo ti on Pic tures for 20 05 W at so n c la im eda co ntract -labo r-ex pe ns e d educ ti on of $ 85 ,84 3 o n t he Sch edul e C fo r Sky li ne Mo ti on Pic tu res for20 05 . The IR S d is al lo wedth e de du ct io n i n fu ll . At tri al an d o n b rie f W at so n a ss ert edth athe is en ti tl edto a co nt ract -labo r ex pe ns e d educ ti on of $ 81 ,76 7 fo r Sky li ne Mo ti on Pic tu res for 20 05
. Howev er, dur in g t ria l Wats onco nc ed edth atfou r expe ns es in cl ud edinth e $ 81 ,76 7 to ta li ng $2 ,90 6 a re n otde du ct ib le . Thes e ex pe ns es in cl ud ed : (1 ) a ch eckda te d Ja nu ary 4, 2 00 5, wri tt ento BenGol dh irs h fo r $3 53 ; (2 ) a ch eckda te d Ap ril 10 , 20 05 , writ te n t o C omm erci al Edi so n fo r $1 41 ; (3 ) a ch eckda te d Oct ob er 1 1, 2 00 5, writ te n t o A B C hi cag ol an d fo r $5 00 ; an d (4 ) a ch eckda te d J un e 2 2, 2 00 5, wri tt en (...co nt inue d) 3 subs ta nt ia ti on ” requi rem en ts of s ec. 2 74 (d )(1 ) an d s ec. 1 .27 4- 5T(b )(2 ), Tem po rary In co m e Tax Reg s., 5 0 F ed . Reg . 46 01 4 (No v. 6 , 19 85 ). Howev er, the IRS d idno t ch al le ng e th e d educ ti on on th is gro un d.-1 8-

to Duo Co ns ul ti ng for$1 ,91 2, wh ic h was co un te d t wice inth e $ 81 ,76 7 t ot al . W e th eref or e co ns id er tha t i t i s Wats on ’s po si ti on th atth e d educ ti bl e am ou ntof t hi s cat eg ory of e xp en se s i s $ 81 ,76 7 m in us $2 ,90 6, o r $7 8,8 61 . The IR S d is pu te s t he de du ct ib il it y

of a ny con tra ct -labo r ex pe ns es forSky li ne Mo ti on Pic tu res for20 05
. To d oc um en t tho se ex pe ns es W at so n p ro vi de d num ero us co pi es of c he ck s, cl eare d- ch eckim ag es , parti al ba nkst at em en ts , anda few i nv oi ces . W at so n a ls o pr ov id edco pi es of t he no n- di sc lo su re ag reem en ts th athe en te redin to with s om e of th e co nt ractlab or ers forSky li ne Mo ti on Pic tu res . The co pi es of c he ck s, cl eare d- ch eckim ag es , ban k s ta te m en ts , andin vo ic es th atW at so n p ro vi de d
subs ta nt ia te th e am ou nt s h e p ai d a s co nt ract -labo r ex pe ns es forSky li ne Mo ti on Pi ctur es for

20 05 . Furt he rm or e, W at so n c red ib ly test ifi edto th e b us in es s p ur po se fo r ne arl y all of t he co nt ract -labo r ex pe ns es forSky li ne Mo ti on Pic tures for20 05 fo r whi ch he see ks a de du ct io n; on ly a few of the ex pe ns es rep orte d fo r Sky li ne Mo ti onPic tu res ap pe ar t o b e n on de du ct ib le
. On the ba si s o f W at so n’s cr ed ib le tes ti m on y an d t he co rro bo rat in g do cu m en ta ry

ev id en ce, we h ol d t ha t h e is en ti tl edto a co nt ract -labo r-ex pe ns e de du ct io n o f $7 5,1 53 forSky li ne Mo ti on Pic tu res for 20 05 . The fo ll owi ng tab le
su m m ari zes th e d educ ti bi li ty of th e co nt ract -labo r ex pe ns es forSky li ne Mo ti on Pi ctur es for

20 05 :-1 9- Skyline Motion P ictures ( 2005) Contract-la

bor expenses ($81,767 cla imed on brief) Payee Amount

claimed on brief Amount

deductible Reasoning A B Chicag oland $500 -0- Watson concede d at trial Be n Goldhirsh 353 -0- Watson concede d at trial Brian B ubser 1,750 $1,750 Ex pense of designing Skyline’s website Com Ed 141 -0- Watson concede d at trial Design 4 U 585 -0- Watson testified that the expense was to install 17 curta ins in Unit 1406, which was his persona l residenc e at the time. This is a non-de ductible persona l expense. 1 Duo Consulti ng 3,824 1,913 Ex pense w as included twic e J elena Z anko 27,575 27,575 Consulti ng , promotional, marketing , cre ative, and writingservice s J elena Z anko 104 104 Reimbursement to J elena Z anko for

her pa y ment of Skyline Motion P ictures’ business expenses J onathan J acobs 4 -0- Watson could not remember purpose M W Design 600 600 Design service s and print coor dination Mike L aha 5,084 5,084 Consulti ngservice s; provided advice on the film industry , including pr oduction, budg eting , and scre enwriting Mike L aha 170 170 Reimbursement to Mike L aha f or his pay ment of Skyline Motion P ictures’ business expenses Nicole Cava llo 21,025 21,025 Consulti ngservice s Nicole Cava llo 20 20 Reimbursement to Nicole Cava llo for her pay ment of Skyline Motion P ictures’ business expenses-2 0-

Patrick L oughman 1,250 1,250 Consulti ngservice for the f ilm indus try Patrick L oughman 1,500 -0- The memo line on the c heck r eads “ Personal loan” a nd Watson did notprese nt evidence sufficie nt to overcome the implication that this i s not deductible. 1 Paul Niemeyer of Nieme yer I llustrations 5,750 5,750 Artwork se rvice s, designed a movie poste r
Proline Mecha nical Inc. 158 158 Service call to balanc e the bulb in a projector Watson used for business pre sentations Quist Intera ctive 7,500 7,500 Web desig n and deve lopment service s SPOT Animation 1,000 1,000 Animation service s; created a mar ketingtrailer Tony Gonzalez 1,620 -0- Watson testified that this ex penses wa s for elec trical wor

k done in Unit 1406, which wa s his persona l residenc e at the time. This is a nondeductible pe rsonal expense. 1 Tony Gonzalez 1,255 1,255 Electric al work f or communications in Unit711, which wa s Watson’s office at the time. Total 81,767 75,153 See sec . 262(a)
. 1 b. Co nt ract -labo r-ex pe ns e d educ ti on forSky li ne Mo ve m en t fo r 20 06 W at so n c la im eda co ntract -labo r-ex pe ns e d educ ti on of $ 26 ,87 0 o n t he Sch edul e C fo r Sky li ne Mo ve m en t fo r 20 06 . The IR S d is al lo wedth e d educ ti on in fu ll . At tri al an d o n b rie f W at so n c on te nd edth athe is en ti tl edto a co nt ract -labo r ex pe ns e d educ ti on of o nl y $1 4,7 78 forSky li ne Mo ve m en t fo r 20 06 . The IR S-2 1-

di sp ut es th e d educ ti bi li ty of an y co nt ract -labo r ex pe ns es forSky li ne Mo ve m en t fo r 20 06
. To d oc um en t the co nt ract -labo r ex pe ns es forSky li ne Mo ve m en t fo r 20 06 , W at so n s ub m it te d n um ero us co pi es of c he ck s, cl eare d- ch eckim ag es , andba nk st at em en ts fro m

hi s p ers on al ba nkacco un t. The se subs ta nt ia te th e am ou nt s W at so n p ai d a s co nt ract -labo r ex pe ns es forSky li ne Mo ve m en t fo r 20 06
. Fu rth erm or e, W at so n c red ib ly test ifi edto th e b us in es s p ur po se forall of t he
co nt ract -labo r ex pe ns es for Sky li ne Mo ve m en t fo r 20 06 forwhi chhe see ks a de du ct io n. On the ba si s o f W at so n’s cr ed ib le tes ti m on y an d t he co rro bo rat in g do cu m en ta ry

ev id en ce, we h ol d t ha t Wats on is en ti tl edto a co nt ract -labo r-ex pe ns e de du ct io n o f $1 4,7 78 forSky li ne Mo ve m en t fo r 20 06 . The fo ll owi ng tab le
su m m ari zes th e d educ ti bi li ty of th e co nt ract -labo r ex pe ns es forSky li ne Mo ve m en t fo r 20 06 : Skyline Movement (2006) Contract-la

bor expenses ($14,778 cla imed on brief) Payee Amount

claimed on brief Amount

deductible Reasoning J acob Watson $630 $630 Business a rtwork se rvice s; creation of artwor k for She Be ads, which w as a business Watson consulted for

in 2005.-2 2-

J elena Z anko 13,425 13,425 Business mar keting , writing , and consulting service s Kurt Kroe ck 400 400 Business a rtwork se rvice s Nicole Cava llo 323 323 Business mar ketingand consultingservice s Total 14,778 14,778
c. Co nt ract -labo r-ex pe ns e d educ ti on forLib erat io n F in an ci al for20 06 W at so n c la im eda co ntract -labo r-ex pe ns e d educ ti on of $ 45 ,54 8 o n t he Sch edul e C fo r Lib erat io n F in an ci al for20 06 . The IR S d is al lo wedth e d educ ti on in ful l. At t ria l an d o n b rie f W at so n c on te nd edth athe is en ti tl edto a co nt ract labo r-ex pe ns e d educ ti on of $ 60 ,58 2 fo r Lib erat io n F in an ci al for20 06 . The IR S di sp ut es th e d educ ti bi li ty of an y co nt ract -labo r ex pe ns es forLib erat io n F in an ci al fo r 20 06
. To d oc um en t the co nt ract -labo r ex pe ns es forLib erat io n F in an ci al for20 06 , W at so n p ro vi de d n um ero us co pi es of c he ck s, cl eare d- ch eckim ag es , andba nk st at em en ts . Thes e subs ta nt ia te so m e o f th e am ou nt s t ha t Wats on cla im s h e p ai d a s co nt ract -labo r ex pe ns es for Lib erat io n F in an ci al for

20 06 . Furt he rm or e, W at so n cred ib ly test ifi edto th e b us in es s p ur po se for so m e o f th e co nt ract -labo r ex pe ns es fo r Lib erat io n F in an ci al for20 06 forwhi ch he see ks a de du ct io n. Howev er, fo r m an y

of t he co nt ract -labo r ex pe ns es th atW at so n re po rte d fo r Lib erat io n F in an ci al for

20 06 , itap pe ars to us , on th e b as is of h is tes ti m on y an d-2 3-

th e m em or an du m

li ne s o n s ev eral of the ch eck s t ha t h e p ro vi de d a s p ro of of pa ym en t, tha t al l the pa ym en ts he m ad e to Mel is saDeSi tt er, Ben Gol dh irs h, Dom in ic Garn er, J on atha n J on es , Reg in al d R ay , andTon y Gon zal ez ar e rel at edto hi s emplo ym en t. In20 06 W at so n was em pl oyed as a lo anori gi na to r by Firs t Cap it al Mo rtg ag e. Lib erat io n F in an ci al was i n the bu si ne ss of m an ag em en t co ns ul ti ng an d a dv is edpri m ari ly m ortg ag e co m pa ni es , in cl ud in g F irs t Capi ta l Mo rtg ag e, in ord er t o h el p i m pr ov e th e o ve ral l p erfo rm an ce o f eac h c om pany and it s l oa n o ffi cers . W at so n a ss ert edth atno ne of t he ex pe ns es he cla im s as de du ct io ns forLib erat io n F in an ci al were re la te d t o h is em pl oym en t as a lo an or ig in at or forFir stCap it al Mo rtg ag e. The p aym en ts th atW at so n m ad e to Mel is sa DeSi tt er, Ben Gol dh irs h, Do min ic Garn er, J on athan J on es , Reg in al d R ay , and Ton y Gon zal ez al l ap pe ar t o b e fo r se rv ic es th es e in di vi du al s p erfo rm edin
co nn ect io n wi th hi s emplo ym en t as a lo anori gi na to r. Thes e ex pe ns es are de du ct ib le on ly if W at so n c ou ldno t s eekrei m bu rs em en t fr om

hi s emplo y er. See Po de m s v . Comm is si on er, 2 4 T.C. at23 . The rec or d d oe s n otsupp ort the pr op os it io n t ha t Wats on co ul d n otsee k re im bu rs em en t fo r th es e ex pe ns es . The refo re the y

are n otde du ct ib le
. On the ba si s o f W at so n’s cr ed ib le tes ti m on y with re sp ectto so m e o f th es e ex pe ns es an d c orro bo rat in g d oc um en ta ry ev id en ce, we h ol d t ha t h e is en ti tl edto a-2 4-

co nt ract -labo r-ex pe ns e d educ ti on of $ 8,9 00 forLib erat io n F in an ci al for20 06
. The fol lo win g t ab le su m

m ari zes th e d educ ti bi li ty of th e co nt ract -labo r ex pe ns es th atW at so n re po rte d fo r Lib erat io n F in an ci al for20 06 : L ibera tion Financia l (2006) Contract-la

bor expenses ($60,582 cla imed on brief) Payee Amount

claimed on brief Amount

deductible Reasoning Be n Goldhirsh $663 -0- Watson testified that Ben G oldhirsh provided loan-proc essingservice s in the mortga g e loan business and that expenses paid to Goldhirsh wer e incur

red on be half of his e mployer. These e x penses a

ppear to be re lated to Watson’s employ ment as a loa

n orig inator and not his Schedule- C business of manag ement consulting
. Brian B ubser 2,000 $2,000 Website and graphic design Dominic Gar ner 14,650 -0- Watson testified that Dominic Garne r per formed “[l] ead g ener ation, communication with borrowe rs, g oing a

nd g etting a

pplications signe d, pickingup documents”. The memo lines on all the che cks re ad “A dvance ”. The se expenses appea r to be re lated to Watson’s employ ment as a loan orig inator and not his Schedule- C business of mana g ement consulting
. Holly Ba rtle 250 250 Promotional work J acob Watson 1,200 1,200 Marke ting, de sign, a nd artwor k service s J elena Z anko 3,000 3,000 Marke ting a nd writingservice s J ennife r McCullah 250 250 Promotional work J onathan Jones 8,065 -0- Watson testified that J onathan Jones perfor med service s that were “ver

y simil ar to Dominic Gar ner” . The memo lines on the c hecks r ead-2 5- either “ Commi ssions” or “a dvance ”. The se expenses appea

r to be re lated to Watson’s employ ment as a loa

n orig inator and not his Schedule- C business of manag ement consulting
. Kurt Kroe ck 1,700 1,700 Marke ting, de sign, a nd artwor k service s L eticia Winn 250 250 Promotional work Melissa DeSitter 26,554 -0- Watson testified that Melissa DeSitter was like a n executive assistant for his consultingbusiness and that she “ sent out and conf irmed that lea d mailing c ampaigns were g oing out, de alt with borrowe rs, dea lt with lead companies” and “communicat[ ed] with borrower s, lenders, title companies, pr ospects, closingag ents in the mortg ag e consultingbusiness”. The f ew memo lines available rea d “[Month] Bonus” . These expenses appea

r to be re lated to Watson’s employ ment as a loa

n orig inator and not his Schedule- C business of manag ement consulting
. Nicole Cava llo 500 -0- The memo line on this chec k rea ds “re pay ment of loan”. This sug g ests that the pay ment was the repa y ment of loan princ ipal, which is nondeductible. Watson did not testify what this pay ment was for
. Reg inald Ray 350 -0- Watson testified that Regina ld Ray “provide d some sort of closingactivities with a borr ower ”. These e x penses a

ppear to be re lated to Watson’s employ ment as a loa

n orig inator and not his Schedule- C business of manag ement consulting
. Satin Grable 250 250 Promotional work Tony Gonzalez 900 -0- Watson testified that this ex pense w as to have elec trical wor

k done, but he c ould not remember wher e it was done ; the work may have be en done at Unit 711 or at his employer’ s office . These expenses appea

r to be e x penses Watson paid on behalf of his employer. Total 60,582 8,900-2 6-

Inreac hi ng ou r ho ld in gs , we hav e co ns id eredall arg um en ts m ad e, an d, t o th e ex te ntno t m en ti on ed , we con cl ud e th atth ey are m oo t, i rrel ev an t, o r witho ut
m eri t. To re fle ctth e fo reg oi ng , Deci si on wil l b e en te redun de r Ru le 15 5.