United States Tax Court

T.C. Memo. 2023-89

RICHARD JOHN CARDULLA,

Petitioner

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

—————

Docket No. 17579-18. Filed July 19, 2023.

—————

P engaged in numerous real estate-related activities 

with respect to which R disallowed his claimed losses and 

increased his gross income. Among P’s activities was the 

use of a single-member LLC, a disregarded entity, to 

purchase real estate. In exchange for the real estate, the 

sellers received from the LLC its secured Note for 

$1,200,000 with 10% simple interest accruing yearly; with

payments of neither principal nor interest due until 

expiration of the 12-year term of the note. Using the 

accrual method of accounting, the LLC accrued and 

deducted interest of $120,000 on account of the Note (no 

payment of principal had been made).

Held: Disallowance of numerous real estate-related

deductions sustained for lack of substantiation.

Held, further, Note was bona fide indebtedness.

Held, further, Note was a debt instrument having 

original issue discount.

Held, further, without a change in method of 

accounting, LLC could not for examination years accrue 

interest payments under OID rules.

Served 07/19/23
2

[*2] Held, further, LLC’s property was held for long-term 

appreciation and not in trade or business; interest on Note 

was investment interest subject to I.R.C. § 163(d) 

limitation on investment interest.

Held, further, increases in capital gain income 

sustained.

Held, further, adjustment to Social Security benefit 

sustained.

Held, further, accuracy-related penalty sustained.

—————

Richard John Cardulla, pro se.

Jeffrey L. Heinkel, Heather K. McCluskey, and Julia Kapchinskiy, for 

respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: By Notice of Deficiency dated July 26, 2018

(Deficiency Notice), respondent determined deficiencies in, and 

accuracy-related penalties with respect to, petitioner’s 2014 and 2015 

income tax liabilities as follows:1

Year Deficiency Accuracy-Related Penalty

§ 6662(a)

2014 $23,653 $4,731

2015 44,041 8,808

Petitioner made federal income tax returns for his taxable 

(calendar) years 2014 and 2015 on Forms 1040, U.S. Individual Income 

Tax Return. He included with each return two Schedules C, Profit or 

Loss From Business, and one Schedule E, Supplemental Income and 

1 Unless otherwise indicated, statutory references are to the Internal Revenue 

Code, Title 26 U.S.C. (Code), in effect at all relevant times, regulation references are 

to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times, 

and Rule references are to the Tax Court Rules of Practice and Procedure. All dollar 

amounts have been rounded to the nearest dollar.
3

[*3] Loss. The first Schedule C included with each return (Schedule 

C–1) is with respect to a real estate business named “X-Way Delta, LLC”

(X-Way Delta). The second Schedule C included with each return 

(Schedule C–2) is with respect to an unnamed real estate business.

The questions for decision are as follows.

1. Whether petitioner’s Schedules E income from partnerships

and S corporations should be increased by $4,241 and $109,755 for 2014 

and 2015, respectively?

2. Whether he is entitled to deduct additional Schedule E rental 

real estate expenses of $5,369 and $8,801 for those years, respectively?

3. Whether he is entitled to deduct Schedule C–2 total expenses 

of $29,258 and $51,000 for those years, respectively?

4. Whether he is entitled to deduct Schedule C–1 total expenses 

of $130,869 and $131,593 for those years, respectively?

5. Whether he has unreported capital gain income from Island 

Mountain, LP (Island Mountain), of $23,655 and $19,170 for those years, 

respectively?

6. Whether, for 2014, he must include in gross income Social 

Security benefits of $8,451?

7. Whether, for 2015, he is liable for a section 6662(a) accuracyrelated penalty of $8,808?2

All other adjustments made by respondent in determining the 

deficiencies in tax for the years at issue are computational, resulting

from the above referenced adjustments. Those computations and 

adjustments will not be discussed further.

2 Respondent has conceded the accuracy-related penalty that he determined 

for 2014.
4

[*4] Petitioner bears the burden of proof. See Rule 142(a)(1).3 With 

respect to the accuracy-related penalty, respondent bears a burden of 

production. See § 7491(c).

FINDINGS OF FACT

Preliminary Statement

Before making our findings of fact, we pause to address 

petitioner’s failure to comply with Rule 151, which addresses briefs. At 

the conclusion of the trial in this case, we ordered the parties to file 

briefs, setting a schedule for seriatim briefs, petitioner to open, 

respondent to answer, and petitioner to reply. We directed petitioner’s 

attention to Rule 151. Rule 151(e)(3) requires that an opening brief 

contain proposed findings of fact in the form of numbered concise 

statements of essential fact and not a discussion or argument relating 

to the evidence or the law. Petitioner’s Opening Brief violates the Rule 

in that petitioner makes 12 proposed findings, virtually none of which 

are concise statements of essential fact and most of which respondent 

correctly identifies as comprising legal argument and not statements of

fact.

For example, petitioner proposes that we find:

3. The facts support X-Way Delta’s property was not a 

capital asset under IRC section 1221(a)(1) in that a capital 

asset does not include “property held by the taxpayer 

primarily for sale to customers in the ordinary course of his 

trade or business.” . . . 

. . . .

3 Section 7491(a)(1) provides that, if a taxpayer offers credible evidence with 

respect to any issue relevant to determining his tax liability, the burden of proof with 

respect to the issue is on the Commissioner. See also Rule 142(a)(2). Section 7491(a)(1) 

applies only if the taxpayer complies with the relevant substantiation requirements in 

the Code, maintains all required records, and cooperates with the Commissioner with 

respect to witnesses, information, documents, meetings, and interviews. See

§ 7491(a)(2)(A) and (B). The taxpayer bears the burden of proving compliance with the 

conditions of section 7491(a)(2)(A) and (B). See, e.g., Mileham v. Commissioner, T.C. 

Memo. 2017-168, at *30. Petitioner neither proposes facts to support his compliance 

with the conditions of section 7491(a)(2)(A) and (B) nor persuasively argues that 

respondent bears the burden of proof on any issues because of section 7491(a)(1). We 

therefore conclude that section 7491(a)(1) does not apply in this case.
5

[*5] 6. The facts support that the deductions taken by 

Petitioner were necessary expenses in carrying on his 

business and were actually paid or accrued in the years in 

question. . . .

Petitioner’s Reply Brief also violates Rule 151(e)(3), which 

requires that, in a reply brief, a party “set forth any objections, together 

with the reasons therefor, to any proposed findings of any other party.”

Respondent in his Answering Brief proposed 222 findings of fact. 

In reply, petitioner makes no systematic response. His Reply Brief is a 

37-page narrative, initially attacking respondent’s attorneys and then 

comprising what amounts to additional testimony without significant 

citation of the record interspersed with apparent objections to eight or 

so of respondent’s proposed findings.

Petitioner has not provided us with usable proposed findings of 

fact. Moreover, because he failed to object to substantially all of 

respondent’s proposed findings, we must conclude that he accepts 

respondent’s unobjected-to proposed findings of fact as correct. See, e.g., 

Jonson v. Commissioner, 118 T.C. 106, 108 n.4 (2002), aff’d, 353 F.3d 

1181 (10th Cir. 2003).

Stipulation

The parties have stipulated certain facts and the authenticity of 

certain documents. The facts stipulated are so found, and the 

documents stipulated are accepted as authentic.

Petitioner

Petitioner is an attorney. His mailing address was in California 

when he filed the Petition. He has been involved in real estate activities 

for many years.

Real Properties

The following real properties figure in petitioner’s tax returns for 

2014 and 2015.

L Street—L Street is real property in southeast Washington, D.C.

During the years at issue, the property was a vacant lot. Up until 

sometime before 2014, petitioner was sole owner of the property. During 

his sole ownership, he installed a fence around the property. The record 
6

[*6] contains two invoices from Long Fence, both dated in February 

2006, both for delivery to L Street, both billed to Cardulla Properties, 

one for the short-term lease of “panels” and the second, for $9,566, for 

delivery and installation of a chain link fence.

Plaza Boulevard—Plaza Boulevard is a real property in National 

City, California. During the years at issue, it was a vacant lot. 

Petitioner plans to build a “speculation house” on the lot. The property 

was not rented during 2014 or 2015.

Turner Road—This property is in Bombay, California, next to 

property owned by X-Way Delta. On the Turner Road property is a 

house badly damaged by an earthquake. Petitioner has restored the 

house and uses it as an office and a place to stay when he is visiting the 

X-Way Delta property. Otherwise, the property is vacant.

L Street No. 2—A second property on L Street in southeast 

Washington, D.C.

Commercial Street—A property in San Diego, California.

Salton Sea Property—The Salton Sea is a shallow, landlocked, 

highly saline body of water in southern California. In 1985, petitioner 

and three others—Scott Hettelsater, Tom Wagner, and Equitable 

Finance (Equitable)—bought numerous parcels of real estate in 

proximity thereto (Salton Sea property). Messrs. Hettelsater and 

Wagner were longtime acquaintances of petitioner. Mr. Wagner was 

president of Equitable. Initially, each person owned his (its) parcels 

separately. Petitioner’s idea was to develop the Salton Sea property as 

a mobile home park or hot water spa. He viewed development of the 

property as his project, in which Messrs. Hettelsater and Wagner and 

Equitable (Investors) invested. After 20 years of unsuccessful 

development efforts, the Investors lost heart and wanted to sell their 

parcels. Petitioner thought he could save the project, and he offered to 

buy out the Investors, although he told them that he could not then

afford to pay cash. Petitioner formed X-Way Delta to purchase parcels 

from the Investors. Petitioner receives $5,000 a year from a fish farm

with an easement that allows the farm’s wastewater to pass through an 

unidentified portion of the Salton Sea property on its way to the sea.
7

[*7] Entities

The following entities figure in petitioner’s tax returns for 2014 

and 2015.

Island Mountain—Island Mountain is a limited partnership of 

which petitioner was a member.

X-Way Delta—X-Way Delta, a single-member limited liability 

company (LLC) of which petitioner is the member. Petitioner formed XWay Delta in 2005 as a vehicle by which to make good on his offer to buy

out the Investors. X-Way Delta acquired the Investors’ interests in 11 

of the parcels constituting the Salton Sea property. It acquired those 

interests (X-Way Delta property) by way of seven individual quitclaim 

deeds and one grant deed (collectively, Deeds). For an unstated

“valuable consideration,” each Investor released his (its) interests in 

certain of the 11 parcels in favor of X-Way Delta. All of the Deeds are 

dated either December 28 or 29, 2005. None was recorded. Absent from 

the record is any deed evidencing petitioner’s transfer of property to 

X-Way Delta.

In consideration of the X-Way Delta property, X-Way Delta

executed a document styled “Note Secured By Deed of Trust” (Note and 

Deed of Trust, respectively). The Note is dated December 29, 2005, and 

states that, for value received, X-Way Delta promises to pay to Equitable 

and Mr. Hettelsater $1,200,000 “with interest from January 1, 2006, 

until paid at the rate of 10% per annum.” It further states that “the

whole sum of principal plus accrued interest” is due and payable on or 

before January 1, 2018. It states that it is a purchase money mortgage. 

It concludes that it is secured by a Deed of Trust, “affecting the following 

parcel numbers [viz, five of the six parcels listed in the Deed of Trust].”

The Deed of Trust is dated January 4, 2006. The parties to it are 

X-Way Delta, “Trustor”; Chicago Title Co., a California corporation, 

“Trustee”; and Equitable and Mr. Hettelsater, “Beneficiaries.” The Deed

of Trust recites that X-Way Delta grants to Chicago Title Co. “in Trust 

with Power of Sale that property . . . described as,” and here are listed 6

of the 11 parcels constituting the X-Way Delta property. The Deed of 

Trust is recorded.

The record contains no contracts of sale for any parcels

constituting the X-Way Delta property. Nor were the parcels appraised 

before the Deeds were executed or the Note executed. Petitioner 
8

[*8] testified that he and the Investors were “thinking about 1,000 or 

1,200 an acre, around that.”

X-Way Delta paid no interest during the 12-year term of the Note, 

nor, when the Note matured in 2018, did it pay the accrued interest or 

principal. Petitioner claims that, when the Note matured, the creditors

extended its term to 2024.

In 2007, petitioner thought he had a buyer for the X-Way Delta

property, but the potential sale fell through because of a downturn in 

the economy.

Petitioner believes that, since 2007, environmental problems in 

the Salton Sea area have increased. He analogizes the area to the Love 

Canal. Because of environmental problems, he feels that the doors have 

shut to development of the X-Way Delta property. He believes that, 

without a $20,000 tax saving from the deduction of interest accruing on 

the Note, maintaining the property would be “nonsurvivable.” He thinks 

that the value of the property lies in holding onto it long enough, and 

then someone will be able to make use of minerals under it and develop 

it for hydrothermal energy.

X-Way Delta does not maintain books and records.

Petitioner’s Returns and Respondent’s Adjustments

Petitioner’s 2014 and 2015 returns are mostly handwritten, and 

neither return reports any taxable income or tax due. In processing 

those returns, respondent made numerous mathematical and 

computational corrections. One notable feature of both returns is that, 

on both, petitioner claims the same deduction for an X-Way Delta loss

twice, on separate schedules. For 2014, petitioner claimed an X-Way 

Delta loss of $125,869 on both Schedule C–1 and on Schedule E, Part II. 

For 2015, he did likewise with respect to an X-Way Delta loss of

$126,593. He testified that he did so because he did not know the 

difference between an S corporation and a single-member LLC.

Schedule E—Island Mountain and X-Way Delta

Petitioner’s returns for 2014 and 2015 both include a Schedule E. 

Part I of Schedule E is for reporting income or loss from rental real 

estate and royalties, and Part II is for reporting income or loss from 

partnerships and S corporations. Petitioner listed two pass-through 

entities in Part II of each Schedule E, Island Mountain and X-Way 
9

[*9] Delta, which petitioner mistakenly identified as an S corporation 

but which, as found, is a single-member LLC.4

Island Mountain issued petitioner for 2014 a corrected Schedule 

K–1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc.,

reporting $4,241 of ordinary income and $23,655 of long-term capital 

gain. It issued him for 2015 a Schedule K–1 reporting $2,332 of ordinary 

income and $19,170 of long-term capital gain. Respondent determined 

that petitioner had not reported the ordinary income amounts from 

those schedules and increased his Schedule E, Part II income for each 

year accordingly.

As stated, petitioner reported a loss from X-Way Delta of $126,593

on his 2015 Schedule E, Part II. He also reported there his Island 

Mountain long-term capital gain of $19,170. Netting the two amounts

($19,170 − 126,593 = $−107,423), he reported a Part II loss of $107,423

(Part II loss). On Part I of his 2015 Schedule E, he reported a net gain 

of $63,226. Subtracting his Part I gain of $63,226 from his Part II loss 

of $107,423 results in a difference of $44,197 or, in other words, a 2015 

Schedule E loss of $44,197. Petitioner should have carried that loss to 

the front page of his 2015 Form 1040 and entered it on line 17 (where 

Schedule E gain or loss is included in the computation of total income).

But he did not, leaving line 17 blank. In processing petitioner’s 2015 

return, respondent corrected for petitioner’s omission of a line 17 

amount. He entered into his computers −$44,197 as the amount that 

should have been reported as a 2015 Schedule E loss on line 17.

Subsequently, in determining a deficiency in petitioner’s tax for 

2015, respondent adjusted petitioner’s income by disallowing the 2015 

Schedule E, Part II loss of $107,423, presumably on the grounds that, 

X-Way Delta being a disregarded entity, Schedule E, Part II, reporting 

was inappropriate for any X-Way Delta loss and Island Mountain’s

capital gain should have been reported on Schedule D, Capital Gains 

and Losses.5 Respondent’s disallowance of the Part II loss exactly offset

4 Thus, we assume that, pursuant to Treasury Regulation § 301.7701-3(b), 

X-Way Delta is disregarded as an entity separate from its owner. For tax purposes,

X-Way Delta’s business is treated as a proprietorship of which petitioner is considered 

the proprietor. E.g., Brown v. Commissioner, T.C. Memo. 2014-167, at *3.

5 That explanation would appear to justify only reclassifying the $107,423 loss 

as a 2015 Schedule C loss of $126,593 and a 2015 Schedule D gain of $19,170, rather 

than disallowing the loss altogether. Such reclassification was unnecessary for the

$126,593 loss from X-Way Delta because petitioner had already reported that loss for 
10

[*10] the inclusion of that loss in the Schedule E amount that 

respondent treated petitioner as erroneously having omitted from

line 17. Accompanying the Deficiency Notice is Form 5278, Statement–

Income Tax Changes. The amount of the 2015 Schedule E adjustment 

for partnership and S corporation gains and losses is positive $109,755, 

which is the sum of the disallowed Part II loss of $107,423 and the 

omitted $2,332 of Island Mountain ordinary income from the corrected 

Schedule K–1.6

Schedule E—Rental Real Estate

On his 2014 and 2015 Schedules E, Part I, petitioner listed five 

rental properties: L Street, Plaza Boulevard, Turner Road, L Street

No. 2, and Commercial Street.

For neither year did he report any rents (or other income) from 

the first three properties. He reported total expenses for the five 

properties of $84,865 and $77,113 for those years, respectively. Of those

sums, $20,405 and $15,290 were the expenses allocable to the first three 

properties. The following Tables 1 and 2 detail what petitioner reported 

for 2014 and 2015 for those three properties.

second time on his 2015 Schedule C–1. As to the misreported $19,170 Island Mountain

long-term capital gain, respondent removed it from Schedule E and made a positive 

adjustment to petitioner’s 2015 Schedule D income in a like amount.

6 For 2014, petitioner also reported on Schedule E, Part II, an Island Mountain 

long-term capital gain ($23,655) and an X-Way Delta loss ($125,869) for the net Part 

II loss of $102,214. Petitioner had a Part I gain of $36,468, which, when added to the

Part II loss of $102,214, produced a Schedule E loss of $65,746, which petitioner did

enter on line 17 of his 2014 Form 1040. In processing petitioner’s 2014 return, 

respondent disregarded the Part II loss as a component of petitioner’s line 17 

Schedule E amount, entering into his computer only the Part I gain of $36,468. He 

then had no need to disallow the Part II loss because he had disregarded it, and his

Schedule E adjustment for 2014 includes only the unreported Island Mountain 

ordinary income amount of $4,241. As with 2015, petitioner had reported the $125,869

X-Way Delta loss for a second time on his 2014 Schedule C–1. Respondent increased 

petitioner’s Schedule D income by $23,655 on account of the Island Mountain longterm capital gain.
11

[*11] Table 1

2014

L Street Plaza Boulevard Turner Road

Income:

Rents 

received

— — —

Expenses:

Legal and 

professional 

fees $350

Repairs $500 6,000

Taxes 222 859

Utilities 224

Depreciation $2,443 1,014 8,793

Total

expenses $2,443 $1,736 $16,226

Loss: ($2,443) ($1,736) ($16,226)

Table 2

2015

L Street Plaza Boulevard Turner Road

Income:

Rents 

received

— — —

Expenses:

Repairs $1,000 $600

Taxes 231 861

Utilities 348

Depreciation $2,443 1,014 8,793

Total 

expenses $2,443 $2,245 $10,602

Loss: ($2,443) ($2,245) ($10,602)

Respondent disallowed any deduction for those expenses for lack 

of substantiation and on the grounds that the properties were not rental

properties.
12

[*12] As explained below, respondent also disallowed a deduction for 

the expenses petitioner reported on the Schedules C–2 but allowed some 

of those expenses as additional expenses on the Schedules E, Part I. The 

following Table 3 shows the resulting allowance of Schedule E, Part I,

expenses.

Table 3

Year 2014 2015

1. Rental expenses 

claimed on Schedule 

E, Part I $84,865 $77,113

2. Disallowed Schedule 

E, Part I, expenses (20,405) (15,290)

3. Additional Schedule 

E, Part I, expenses 

from Schedule C–2 25,774 24,091

4. Schedule E, Part I,

expenses allowed $90,234 $85,914

5. Schedule E, Part I

adjustment to 

taxable income

(line1–line 4) ($5,369) ($8,801)

Schedule C–2: Real Estate Business

Petitioner’s Schedules C–2 state that they relate to a real estate 

business of his. On the 2014 Schedule C–2, petitioner did not specify an 

accounting method. On the 2015 Schedule C–2, he checked the box 

“Accrual.” The following Table 4 shows petitioner’s Schedules C–2

reporting of income, expenses, and net profits.
13

[*13] Table 4

2014 2015

Income $36,000 $51,000

Tentative

expenses (29,258) (25,285)

Tentative 

profit 6,742 25,715

Home 

office 

expense

-0- (25,715)

Net 

profit

$6,742 $0

For 2015, petitioner intended to claim no home office expense

deduction. In error, however, he entered, $25,715, his 2015 tentative 

profit, on the line for reporting a home office expense and left blank the 

line to report his 2015 net profit. In processing his 2015 return 

respondent netted his reported home office expense against his tentative

profit and treated the difference—zero—as his 2015 Schedule C–2 

income.

Respondent disallowed all of petitioner’s Schedule C–2 expenses

for both 2014 and 2015 on the grounds that petitioner had not shown

that he had incurred the expenses or, if he had, that they were paid 

during the taxable year for ordinary and necessary business purposes.

To effect that disallowance, respondent increased petitioner’s reported 

Schedule C–2 income by $29,258 and $51,000 for 2014 and 2015, 

respectively. 7

Additionally, believing that, for each year, petitioner had 

misreported the expenses from rental real estate on Schedule C–2, 

respondent, for each year, moved a portion of those expenditures to the 

year’s Schedule E, Part I. Respondent began with the total expenses 

petitioner had reported on each Schedule C–2, $29,258 and $51,000, for 

2014 and 2015, respectively. He reduced each total by the amount of 

depreciation claimed—$3,484 and $1,194, respectively—and, for 2015, 

the home office expense of $25,715. The resulting differences are the 

7 Petitioner conceded at trial that he had no home office expense for 2015.
14

[*14] amounts shown on the following Table 5, which he allowed as 

Schedule E, Part I, expenses. See supra Table 3.

Table 5

2014 2015

Total 

expenses $29,258 $51,000

Depreciation (3,484) (1,194)

Home office 

expense -0- (25,715)

Difference $25,774 $24,091

The depreciation expenses reported on the 2014 and 2015 

Schedules C–2 relate to a computer, a small trailer, a backhoe, and a 

scooter, as evidenced by depreciation schedules petitioner provided.

Respondent made no adjustments to the Schedule C–2 income 

amounts petitioner reported, which, at trial and on brief, petitioner

admits were gross income from Island Mountain and from his other real 

estate activities.

Schedules C–1: X-Ray Delta

For each of 2014 and 2015, petitioner’s Schedule C–1 identifies

X-Way Delta as the relevant business and reports that X-Way Delta uses 

the accrual method of accounting. The schedules report income, 

expenses and profit or loss as follows.
15

[*15] Table 6

2014 2015

Income:

Gross receipts $5,000 $5,000

Expenses:

Mortgage interest 120,000 120,000

Legal and professional

services 5,000 5,000

Office expense 120 100

Taxes and licenses 3,422 3,997

Travel 1,326 1,440

Utilities 496 501

Other 505 535

Total expenses $130,869 $131,5938

Income (loss): ($125,869) ($126,593)

Petitioner identified the $5,000 of gross receipts for each year as

payment from the fish farm for its easement.

Claiming that petitioner had not shown that either year’s

Schedule C–1 expenses were incurred or, if incurred, were paid during 

the taxable year for ordinary and necessary business purposes, 

respondent disallowed deductions for all the reported expenses, 

increasing petitioner’s taxable income by $130,869 and $131,593 for 

2014 and 2015, respectively.

Capital Gains

Respondent made positive adjustments of $23,655 and $19,170 to 

petitioner’s gross income for 2014 and 2015, respectively, to account for 

the long-term capital gains reported to petitioner on the Island 

Mountain Schedules K–1.

8 The sum of total expense is $131,573, and income should be $126,573. The 

parties can correct for those errors during the Rule 155 computations.
16

[*16] 2014 Social Security Benefit

Petitioner reported on his 2014 return a taxable Social Security 

benefit of $9,942. In processing petitioner’s return, respondent

disregarded that entry because he believed that petitioner had 

computed his taxable Social Security benefit erroneously. Respondent

treated petitioner as having reported zero benefit. In his adjustments 

to petitioner’s 2014 income, respondent made a positive adjustment of 

$8,451 for Social Security benefits received.

Penalty Approval

Revenue Agent (RA) Keith Kawamoto conducted respondent’s 

examination of petitioner’s 2014 and 2015 returns. He prepared a 

penalty approval form that included a section 6662 accuracy-related 

penalty for 2014 attributable to both petitioner’s negligence and his 

substantial understatement of income tax. RA Kawamoto’s acting direct 

supervisor, Ella Chernyak, signed the penalty approval form on 

June 26, 2017, which was before respondent issued the Deficiency

Notice.

OPINION

I. Schedule E—Island Mountain and X-Way Delta

A. Island Mountain

Respondent would increase petitioner’s gross income by $4,241 

and $2,332 for 2014 and 2015, respectively, on account of those amounts’

being reported to petitioner as his distributive shares of Island 

Mountain’s ordinary income for those years.

At trial, in response to the Court’s question whether petitioner

saw any error in the positive adjustment of $4,241 for 2014, he answered 

“no.” Nevertheless, petitioner argues on brief that the adjustment is 

improper because he did report that income on his 2014 return. 

Petitioner reported a profit of $6,742 on his 2014 Schedule C–2. He 

claims that the $10,983 that he entered on the first page of his 2014 

Form 1040, line 12, “Business income or (loss),” was the sum of his 

distributive share from Island Mountain, $4,241, and his Schedule C–2 

profit, $6,742.

Petitioner did not net his 2014 Schedule C–1 and C–2 profits and 

losses before entering an amount on Form 1040, line 12. When $6,742
17

[*17] is subtracted from the amount he did enter on line 12, $10,983, the

difference is $4,241. The coincidence between that difference and 

respondent’s same adjustment for unreported income from Island 

Mountain leads us to accept petitioner’s explanation that he reported

that income along with his Schedule C–2 profit on line 12, and we so 

find. We do not sustain respondent’s adjustment in that amount.

For 2015, petitioner claims that the $51,000 of gross income that 

he reported on the 2015 Schedule C–2 included not only his $35,000 

annual fee as general partner of Island Mountain but also his $2,332 

distributive share of its ordinary income. For 2015, it would be quite 

the coincidence if the $35,000 annual fee, the $2,332 Island Mountain 

ordinary income, and whatever other amounts are included in the gross 

income reported on the Schedule C–2 end up being a round $51,000. 

Petitioner has not convinced us, and we will not disturb respondent’s 

positive adjustment of $2,332.

B. X-Way Delta

Because X-Way Delta is not an S corporation (or a partnership), 

we see no error in respondent’s 2015 Schedule E adjustment disallowing 

the Part II loss of $107,423.

C. Total Schedule E Adjustments

Respondent erred in increasing petitioner’s Schedule E, Part II 

income by $4,241 for 2014, but he did not err in increasing his 

Schedule E, Part II income by $109,755 ($2,332 + 107,423 = $109,755)

for 2015.

II. Schedule E—Rental Real Estate: L Street, Plaza Boulevard, 

Turner Road

A. Introduction

Respondent disallowed any deduction for Table 1 and 2 expenses

for lack of substantiation and because the properties were not rental 

properties.

Section 162(a) “allow[s] as a deduction all the ordinary and 

necessary expenses paid or incurred during the taxable year in carrying 

on any trade or business.” Section 212(1) and (2) similarly allows an 

individual a deduction for all the ordinary and necessary expenses paid 

or incurred during the taxable year for the production or collection of 
18

[*18] income or the management, conservation, and maintenance of 

property held for the production of income. Section 167(a) “allow[s] as a 

depreciation deduction a reasonable allowance for the exhaustion, wear 

and tear . . . (1) of property used in the trade or business, or (2) of 

property held for the production of income.”

A taxpayer must keep books or records that substantiate the 

expenses underlying each deduction claimed on his or her return. 

§ 6001; Roberts v. Commissioner, 62 T.C. 834, 836 (1974). Claiming a 

deduction on an income tax return is not sufficient to substantiate the 

underlying expense. Wilkinson v. Commissioner, 71 T.C. 633, 639 

(1979). Rather, an income tax return “is merely a statement of the

[taxpayer’s] claim . . . ; it is not presumed to be correct.” Roberts, 62 T.C. 

at 837. With respect to a deduction for depreciation, “the taxpayer must 

show that the property was used in a trade or business (or other profitoriented activity). In addition, the taxpayer must establish the 

property’s depreciable basis, by showing the cost of the property, its 

useful life, and the previously allowable depreciation.” Cluck v. 

Commissioner, 105 T.C. 324, 337 (1995). A depreciation schedule alone 

is insufficient to substantiate the deduction. See Holden v. 

Commissioner, T.C. Memo. 2015-131, at *65–66.

Under Cohan v. Commissioner, 39 F.2d 540, 543–44 (2d Cir. 

1930), if a taxpayer claims a deduction but cannot fully substantiate the 

underlying expense, the Court in certain circumstances may 

approximate the allowable amount, “bearing heavily if it [so] chooses 

upon the taxpayer whose inexactitude is of his own making.” The Court 

must have some factual basis for its estimate, however, else the 

allowance would amount to “unguided largesse.” Williams v. United 

States, 245 F.2d 559, 560 (5th Cir. 1957); accord Eze v. Commissioner, 

T.C. Memo. 2022-83, at *5–6.

B. Discussion

We start and end with the question of whether petitioner has

substantiated the Table 1 and 2 expenditures for which he has claimed 

deductions. He has not. Putting aside depreciation for the moment, the

remaining expenditures in the table are legal and professional fees, 

repairs, taxes, and utilities. Petitioner has failed to direct us to material 

in the record substantiating those expenditures—i.e., to whom paid, for 

what purpose, when paid, what evidence of payment, and the like. Nor 

has petitioner provided a factual basis from which, pursuant to Cohan, 

we could approximate the amount of any of those expenditures. 
19

[*19] Petitioner has failed to carry his burden of proof. For failure of 

substantiation, we sustain respondent’s disallowance of any deduction 

for the four described Table 1 and 2 expenditures.

For similar reasons, we disallow any deduction for the 

depreciation deductions on Tables 1 and 2. For each of 2014 and 2015, 

petitioner claimed for L Street a depreciation deduction of $2,443. We 

are satisfied that in 2006, petitioner paid $9,566 to install a fence around 

the property. Petitioner has pointed us to no evidence of any other 

expenditure for a depreciable improvement to the property. And with 

respect to the 2006 expenditure, petitioner has failed to show that any 

depreciable basis remained to be claimed for either 2014 or 2015.

With respect to Plaza Boulevard and Turner Road, petitioner 

attached to his 2014 and 2015 returns schedules that purport to show 

the computation of the depreciation claimed for each of those properties. 

And while the computations for Plaza Boulevard match the amounts on 

Tables 1 and 2, petitioner has failed to explain what property was 

depreciable with respect to Plaza Boulevard, which we have found to

have been a vacant lot during the years at issue. With respect to Turner 

Road, the schedules show for each year total depreciation of $2,038, yet,

on his returns, as shown on Tables 1 and 2, petitioner reported $8,793

of depreciation. And while there may be property subject to depreciation 

on the Turner Road property, petitioner has failed to propose facts from 

which we could find its cost, useful life, and the remaining recoverable 

basis during the years at issue. He has failed to prove his entitlement 

to any depreciation deduction for either Plaza Boulevard or Turner Road 

for either of the years at issue, and we sustain respondent’s disallowance 

of any deduction.

III. Schedule C–2 Expenses

As shown on Table 4, petitioner reported tentative Schedule C–2 

expenses of $29,258 and $25,285 for 2014 and 2015, respectively. 

Respondent disallowed any Schedule C–2 deduction for those expenses 

but allowed portions, $25,774 and $24,091, for those years, respectively,

as Schedule E, Part I expenses. See supra Tables 3 and 5. Respondent 

disallowed the differences, $3,484 and $1,194, as unsubstantiated 

depreciation expenses. Petitioner has no objection to respondent’s first 

action but contests respondent’s disallowance of the depreciation 

deductions. Petitioner has presented depreciation schedules for each 

year that list a computer, a small trailer, a backhoe, and a scooter, and, 

for each item, purport to show the date purchased, the cost, prior 
20

[*20] depreciation, method of depreciation, useful life, and the year’s 

claimed depreciation. He has not, however, pointed us to evidence in 

the record corroborating the unsubstantiated figures asserted on those 

schedules. We will not disturb respondent’s disallowance of the 

Schedule C–2 depreciation deductions. See, e.g., Anyanwu v. 

Commissioner, T.C. Memo. 2014-123, at *28–29 (sustaining the 

Commissioner’s disallowance of a taxpayer’s depreciation deduction 

where the taxpayer did not provide any testimony or other evidence at 

trial to explain the numbers appearing on the depreciation schedule 

filed with her return).

Respondent did not err in increasing petitioner’s reported 2014 

Schedule C–2 income by $29,258 and, considering petitioner’s error in

claiming a $25,715 deduction for the business use of his home,

respondent did not err in increasing his 2015 reported Schedule C–2 

income by $51,000.

IV. Schedule C–1 Expenses

A. Introduction

Respondent disallowed petitioner’s Schedule C–1 expense 

deductions of $130,869 and $131,593 for 2014 and 2015, respectively, on 

the grounds that petitioner had not shown that expenses were incurred 

or, if incurred, were paid during the taxable year for ordinary and 

necessary business purposes.

B. Interest Expense

1. Introduction

The largest of the disallowed expense deductions is an interest 

expense of $120,000 for each year. The Note obligated X-Way Delta to 

pay Equitable and Mr. Hettelsater principal of $1,200,000 plus accrued 

interest (10% per annum) on or before January 1, 2018.

Section 163(a) “allow[s] as a deduction all interest paid or accrued 

within the taxable year on indebtedness.” There is an exception to this 

general rule. Section 163(h)(1) provides that in the case of a taxpayer 

other than a corporation, no deduction shall be allowed for personal 

interest which is paid or accrued during the tax year. Personal interest 

does not include interest allocable to a trade or business, investment 

interest, or interest taken into account in computing gain or loss from a 

passive activity (passive activity interest). § 163(h)(2). The amount 
21

[*21] allowed as a deduction for investment interest for any tax year 

shall not exceed the net investment income of the taxpayer for the 

taxable year. § 163(d)(1). Passive activity interest is taken into account 

in determining passive activity losses, the deduction of which is limited 

to passive activity income. See § 469(a)(1), (d)(1).

Section 163(e) addresses debt instruments issued with original 

issue discount (OID) and provides that the issuer of a debt instrument 

with OID is allowed a deduction for the taxable year equal to the 

aggregate daily portions of the OID.

Respondent argues that petitioner may not deduct the interest 

accrued on the Note because the interest did not accrue on a bona fide 

loan and, if it did, the X-Way Delta property was held for investment 

and, thus, petitioner’s deductions were limited. Petitioner answers in 

rebuttal that the Note evidenced a bona fide loan, that the interest was 

incurred in his trade or business, and that interest accrued on real 

estate you own is deductible: “If you use the accrual method of 

accounting, you can deduct interest over the period it accrues, regardless 

of when you pay it.”

2. Bona Fide Loan

“A bona fide debt is a debt which arises from a debtor-creditor 

relationship based upon a valid and enforceable obligation to pay a fixed 

or determinable sum of money.” Treas. Reg. § 1.166-1(c). “Whether an 

advance gives rise to a bona fide debt for Federal tax purposes is 

determined from all the facts and circumstances.” 2590 Assocs., LLC v. 

Commissioner, T.C. Memo. 2019-3, at *21. Where the facts indicate that 

no bona fide debt was created, an advance may indicate some other 

relationship between the alleged debtor and creditor. For example, an 

advance to a corporation may properly be classified as a contribution to 

capital, see, e.g., Davis v. Commissioner, 69 T.C. 814, 835 (1978), or an 

advance to a family member may actually be a gift, see, e.g., Bragg v. 

Commissioner, T.C. Memo. 1993-479, 1993 WL 413014, at *14.

The objective factors here indicate that the Note constituted bona 

fide debt. By its own terms, it is a promise to pay money. It provides 

that, “for value received,” the maker, X-Way Delta promises to pay two 

named persons a fixed sum, along with interest, on or before a date 

certain. It is secured by the Deed of Trust. And although it was not paid 

on the last date prescribed for payment, petitioner testified without 

contradiction that the creditors had extended the due date. In any 
22

[*22] event, validity of debt is determined upon issuance. If the Note 

was valid debt when issued, the failure to pay principal upon maturity, 

even without extension of the due date, would not have caused the debt

to be invalid.

We have said that the objective of the inquiry into the bona fides 

of a debt is not to count factors but to evaluate them. 2590 Assocs., T.C. 

Memo. 2019-3, at *23. “The factors,” we have said, “aid in our 

determination of whether the parties intended to create indebtedness 

with a reasonable expectation of repayment and whether that

expectation comported with economic reality.” Id. Equitable and 

Mr. Hettelsater transferred interests in discernable parcels of real 

estate to X-Way Delta in consideration of a promise to pay in the future

$1,200,000 (plus interest), the whole obligation secured by a deed of 

trust. We have no idea whether this was a fair exchange or not. 

Nevertheless, although petitioner and Messrs. Hettelsater and Wagner

(president of Equitable) were longtime acquaintances, there is no 

indication of any family relationship, and respondent has constructed no 

narrative of X-Way Delta and the Investors contributing the Note and 

parcels of real estate, respectively, to a joint venture. We conclude, and

find, that the Note constituted bona fide debt.

3. Accounting for Interest

a. Introduction

Although X-Way Delta had no obligation to pay either interest or 

principal on the Note before its maturity on January 1, 2018, petitioner

reported on the Schedules C–1 for each of 2014 and 2015 an interest 

deduction of $120,000. Petitioner believed that he had elected an 

accrual method of accounting for X-Way Delta and that the interest 

expense for the Note accrued ratably. Apparently, petitioner was not 

aware of the rules for deducting OID. Because of that failure, we must 

also be concerned with the rules for changing a method of accounting.

b. OID

A debt instrument has OID if the stated redemption price at 

maturity exceeds the issue price. See § 1273(a)(1). In general, the term 

“stated redemption price at maturity” means interest and other 

amounts payable at maturity other than interest paid periodically at 

least annually. See § 1273(a)(2). Unless there were a prepayment, the 
23

[*23] stated redemption price at maturity of the Note would be 

$2,640,000 ($1,200,000 + ((0.1 × $1,200,000) × 12) = $2,640,000).9

Section 1274 addresses the issue price of certain debt instruments 

issued for property. The section applies to debt instruments given in 

consideration for the sale of property if (1) the stated redemption price 

at maturity exceeds, where there is adequate stated interest, the stated 

principal amount and (2) payments are due more than six months after 

the sale or exchange of the property. See § 1274(c)(1). Section 1274 

provides the issue price of the Note because it was given in consideration 

for the sale of property and the two further conditions set forth in section 

1274(c)(1) are met. To begin with, the Note has adequate stated 

interest. This is so because the stated principal amount for it—

$1,200,000—is less than the imputed principal amount of it—

$1,574,700.10 See § 1274(c)(2). Moreover, payments are due more than 

six months after the sale or exchange of the property. See

§ 1274(c)(1)(B). Because the Note has adequate stated interest, its issue 

price is the stated principal amount, $1,200,000. See § 1274(a)(1).

Subtracting the issue price of the Note—$1,200,000—from the 

stated redemption prices at maturity—$2,640,000—yields OID of 

$1,440,000. See § 1273(a)(1).

Section 163(e)(1) allows as a deduction to the issuer for any 

taxable year that portion of the OID with respect to a debt instrument 

that is equal to the aggregate daily portions of the OID for days during 

such year.11 The daily portions of OID are determined under section

1272(a) (without regard to the rules for acquisition premium and de 

minimis OID). See Treas. Reg. §§ 1.163-7, 1.1272-1. Applying a yield to 

maturity of 6.79114% compounded annually, respondent has calculated

OID interest accruals for the Note of $137,850 and $147,211 for 2014 

9 Petitioner claimed a deduction for X-Way Delta of $120,000 of accrued 

interest for each year from 2006 through 2015. That fact supports a finding that the 

Note called for simple interest at a rate of 10% a year.

10 The imputed principal amount of the Note is the sum of the present values 

as of the issue date of all payments, including interest, due under it using a test rate 

of interest as determined under Treasury Regulation § 1.1274-4. See Treas. Reg. 

§ 1.1274-2(c)(2). Compounding annually and using a test rate of 4.40%, see Rev. Rul. 

2005-66, Table 1 (Long Term), 2005-2 C.B. 686, 687, the imputed principal amount for 

all payments due under the Note—$2,640,000—is $1,574,700.

11 There is no indication that the parties to the Note elected under section 

1274A(c) to use the cash method.
24

[*24] and 2015, respectively.12 Pursuant to section 163(e)(1), petitioner 

would normally be able to deduct those amounts as interest accruals

unless limited by the rules addressing investment interest. However, 

petitioner may not be entitled to deduct the OID accruals of $137,850 

and $147,211 for 2014 and 2015 because they exceed the ratable 

accruals of interest ($120,000 for each year) that X-Way Delta reported.

c. Change in Method of Accounting

We begin by saying that petitioner has not convinced us that, the 

OID rules aside, X-Way Delta could use an accrual method of 

accounting. A taxpayer with two or more separate and distinct trades 

or businesses may use a different method of accounting for each. See

§ 446(d); Treas. Reg. § 1.446-1(d)(1). Nevertheless, a trade or business 

will not be considered separate and distinct unless the taxpayer 

maintains a separable and complete set of books and records for such a 

12 Yield to maturity is the discount rate that, when used in computing the 

present value of the principal and interest payments, produces an amount equal to the 

issue price of the debt instrument. Treas. Reg. § 1.1272-1(b)(1)(i). Applying that

discount rate (6.79114%) to the adjusted issue price (AIP) of the Note at the beginning 

of each year, respondent determined OID interest accruals for each year as follows

(rounded):

Accrual year AIP at beginning 

of year

OID AIP at end of year

2006 $1,200,000 $81,494 $1,281,494

2007 1,281,494 87,028 1,368,522

2008 1,368,522 92,938 1,461,460

2009 1,461,460 99,250 1,560,710

2010 1,560,710 105,990 1,666,700

2011 1,666,700 113,188 1,779,888

2012 1,779,888 120,875 1,900,762

2013 1,900,762 129,083 2,029,846

2014 2,029,846 137,850 2,167,695

2015 2,167,695 147,211 2,314,907

2016 2,314,907 157,209 2,472,115

2017 2,472,115 167,885 2,640,000

$1,440,001
25

[*25] trade or business. Treas. Reg. § 1.446-1(d)(2). X-Way Delta did 

not maintain books and records, and petitioner uses the cash receipts 

and disbursements method of accounting for his other business 

activities.13 It is, therefore, not clear that X-Way Delta is a business

separate and distinct from his other businesses, for which petitioner 

uses the cash method of accounting. Nevertheless, it appears that 

petitioner has used an accrual method with respect to X-Way Delta for 

some time, and any change would require the consent of the 

Commissioner. See § 446(e); Treas. Reg. § 1.446-1(e)(2)(i) (expressly 

bringing a change from an improper or unpermitted method of 

accounting within the ambit of section 446(e)). Thus, without the 

Commissioner’s permission, petitioner would be precluded from 

deducting interest accruals on the Note under the OID rules if those 

deductions exceeded the ratable accruals petitioner had been deducting, 

which they do. Larger accruals under the OID rules occur towards the 

end of the term of the Note. Neither has petitioner asked respondent to 

change X-Way Delta’s method of accounting nor has respondent made 

any change.14

4. Character of the Interest

The interest accrued in 2014 and 2015 on the Note constitutes

either interest allocable to a trade or business, investment interest, 

passive activity interest, or, if none of the former, personal interest.

A taxpayer may have separate and distinct activities within the 

same broad category of business. Resser v. Commissioner, T.C. Memo. 

1991-423. Generally, activities carried out by a taxpayer-owned entity, 

even a single-member LLC that is a disregarded entity, are viewed as 

activities separate from the taxpayer’s, and the entity is tested on a 

stand-alone basis to see whether the activities rise to the level of a trade 

or business. See, e.g., Conner v. Commissioner, T.C. Memo. 2018-6, 

at *26–30 (considering the activities of each of taxpayer husband’s four 

disregarded-entity LLCs on a stand-alone basis and finding that the 

13 On the 2014 Schedule C–2, petitioner checked no box indicating any

accounting method; on the 2015 Schedule C–2 he checked the accrual box. Apparently, 

the 2015 Schedule C–2 is in error because, at trial, petitioner testified that the accruals 

from Schedules C–1, X-Way Delta, were the only accruals on his return.

14 Assuming that the Note is valid indebtedness, respondent computes a section 

481(a)(2) adjustment for 2014 (the earliest open year) increasing X-Way Delta’s gross 

income by $130,154, “representing the sum of the excess deductions claimed in prior 

years under the simple interest method compared to the deductions that would have 

been allowable under the OID rules for those years.”
26

[*26] activities of none rose to the level of carrying on a trade or 

business), aff’d, 770 F. App’x 1016 (11th Cir. 2019).

Activities relating to undeveloped real property are subject to a 

facts and circumstances test to determine whether the activities rise to 

the level of a trade or business. See Polakis v. Commissioner, 91 T.C. 

660, 669–70 (1988). It is not a trade or business where development 

activities are in the exploratory or formative stages. Conner, T.C. Memo. 

2018-6, at *25. Among the tests that the courts have come to rely on in 

determining the nature of the taxpayer’s activities with respect to real 

estate are the following:

the nature and purpose of the acquisition of the property 

and the duration of the ownership; the continuity of sales 

or sales-related activity over a period of time; the volume 

and frequency of sales; the extent to which the taxpayer or 

his agents have engaged in sales activities by developing or 

improving the property, soliciting customers, and 

advertising; and the substantiality of sales when compared 

to other sources of taxpayer’s income.

Polakis, 91 T.C. at 670.

X-Way Delta acquired its property after 20 years of petitioner’s 

failed attempts to develop it and after the Investors lost faith in its 

potential. X-Way Delta has not sold or developed the property, and the 

one potential sale of the property in 2007 fell through because of a 

downturn in the economy. Petitioner believes that, since then,

environmental problems in the Salton Sea area have increased. He 

analogizes the Salton Sea area to the Love Canal, and he believes that

the doors to development of the property have been shut. He thinks that 

the value of the property is in holding onto it long enough, and then 

someone will be able to make use of minerals under it or develop it for 

hydrothermal energy. He has not shown that he advertised the property 

or otherwise sought purchasers or development opportunities for it.

Petitioner has failed to convince us that, during 2014 and 2015,

X-Way Delta’s activities with respect to its property amounted to a trade 

or business. X-Way Delta was holding its property for long-term 

appreciation. And while petitioner reported $5,000 of receipts each year 

on Schedule C–1 as payment for an easement granted to a fish farm, he 

has not shown that the easement burdened property owned by X-Way 

Delta (as opposed to petitioner’s portion of the Salton Sea property,
27

[*27] which he has not shown that he transferred to X-Way Delta). In 

any event, $5,000 is less than one-half of one percent of the $1,200,000 

that X-Way Delta claims to have paid the investors for what may have 

been more than 1,000 acres. And, even if the easement did burden a 

portion of X-Way Delta’s property (nothing in the record tells us how 

much), petitioner has failed to convince us that the easement rental was

more than an incidental aspect of what was overwhelmingly an 

investment purpose for holding the property. See, e.g., Anderson v. 

Commissioner, T.C. Memo. 1982-576, 1982 Tax Ct. Memo LEXIS 169, 

at *19; Treas. Reg. § 1.469-4(b)(1). Accordingly, petitioner cannot

deduct the interest X-Way Delta accrued on the Note for 2014 or 2015 

as interest allocable to trade or business.

Perhaps because respondent sees the easement rental as 

incidental to holding the property for investment (i.e., for appreciation), 

he does not argue for application of the passive activity loss rules. See

Temp. Treas. Reg. 1.469-1T(e)(3)(vi)(B).

And perhaps because under that temporary regulation the

easement rental is incidental to holding the property for investment, he

is willing to concede that, if the property is not trade or business 

property, it is property held for investment (and the interest is not 

personal interest), despite the poor fit under sections 163(d)(5)(A)(i) and

469(e)(1). We accept that X-Way Delta’s 2014 and 2015 interest 

payments were payments of investment interest. Petitioner’s deduction 

of that interest for each year cannot exceed his net investment income. 

See § 163(d)(1). We leave that computation to the parties under Rule 

155.

C. Other Disallowed Schedule C–1 Expenses

Petitioner claimed expense deductions (other than for the accrual 

of interest) of $10,869 and $11,593 for 2014 and 2015, respectively, for 

legal and professional services, office expense, taxes and licenses, travel, 

utilities, and other expenses (together, noninterest expenses).

Petitioner argues that he substantiated the noninterest expenses 

during respondent’s examination of his 2014 and 2015 returns.

Tax Court proceedings are de novo reviews of the taxpayer’s 

liability. Greenberg’s Express, Inc. v. Commissioner, 62 T.C. 324, 328 

(1974). The notice of deficiency is the starting point for our review, and 

“our determination as to a [taxpayer’s] tax liability must be based on the 

merits of the case and not any previous record developed at the 
28

[*28] administrative level.” Id. Respondent disallowed the noninterest 

expenses, and petitioner has failed to substantiate those expenses. We 

will sustain respondent’s disallowance.

V. Capital Gains

Island Mountain reported to petitioner capital gain income of 

$23,655 and $19,170 for 2014 and 2015, respectively. Petitioner 

misreported those amounts on his 2014 and 2015 Schedules E. 

Respondent, in effect, disregarded those erroneous Schedule E 

inclusions and increased petitioner’s 2014 and 2015 Schedule D income

by like amounts. Petitioner failed to address the issue on brief, and we 

see no error. We sustain the adjustments.

VI. Social Security Benefit

Petitioner reported a 2014 Social Security benefit of $9,942. 

Respondent disregarded that reported amount because he believed that 

petitioner had erroneously computed the taxable portion of the benefit. 

Instead, he increased petitioner’s income for Social Security benefits by

$8,451, which he describes as a computation adjustment. Petitioner has 

shown no error in respondent’s adjustments. We sustain the 

adjustments.

VII. Accuracy-Related Penalty

A. Introduction

Section 6662(a) and (b)(1) provides for an accuracy-related 

penalty of 20% of the portion of an underpayment of tax required to be 

shown on a return attributable to negligence or disregard of rules and 

regulations (without distinction, negligence). Section 6662(a) and (b)(2) 

provides for the same penalty amount on the portion of an 

underpayment of tax attributable to any substantial understatement of 

income tax. In the case of an individual, there is a substantial 

understatement of income tax for a year if the amount of the 

understatement exceeds the greater of (1) 10% of the tax required to be 

shown on the return for the tax year or (2) $5,000. § 6662(d)(1)(A). The 

amount of an understatement is reduced if there is substantial authority 

for the taxpayer’s treatment of an item on his return. See 

§ 6662(d)(2)(B)(i). Also, the amount of the understatement is reduced 

for any item that is adequately disclosed in the taxpayer’s return, or in 

an attached statement, if there is reasonable basis for the taxpayer’s 

treatment of the item. See § 6662(d)(2)(B)(ii). Finally, section 6664(c)(1) 
29

[*29] provides a reasonable cause exception to imposition of the section 

6662(a) accuracy-related penalty on that portion of an underpayment for 

which it is shown that there was reasonable cause and the taxpayer 

acted in good faith.

Only one accuracy-related penalty may be applied with respect to 

any given portion of an underpayment even if that portion is subject to 

the penalty on more than one of the grounds set out in section 6662(b). 

Treas. Reg. § 1.6662-2(c).

B. Burden of Production

1. Introduction

The Commissioner bears a burden of production with respect to 

the accuracy-related penalty including making a prima facie case that 

the section 6751(b)(1) requirement for written supervisory approval has 

been met. E.g., DeCrescenzo v. Commissioner, T.C. Memo. 2023-7, 

at *18. Section 6751(b)(1) provides: “No penalty under this title shall be 

assessed unless the initial determination of such assessment is 

personally approved (in writing) by the immediate supervisor of the 

individual making such determination or such higher level official as the 

Secretary may designate.”

2. Penalty Approval

We have found that Ms. Chernyak, RA Kawamoto’s acting direct 

supervisor, signed the penalty approval form before respondent issued 

the Deficiency Notice. Petitioner does not question that finding, nor 

does he argue that approval should have come sooner (or does the record 

provided any basis for an argument to that effect). The record is

sufficient for us to conclude that respondent has made a prima facie case

with respect to the penalty approval required by section 6751(b)(1).

3. Grounds for the Penalty

Respondent has also made a prima facie case for the accuracyrelated penalty on the grounds that, for 2015, petitioner underpaid his 

income tax because of his substantially understating the tax he was 

required to show on his return. The amount of tax petitioner was 

required to show was approximately the amount of the deficiency in tax 

shown in the first paragraph of this report. Petitioner reported a zerotax liability on the 2015 return. Thus, for 2015, his understatement of 

income tax was both equal to (100% of) the tax required to be shown on 
30

[*30] the return and more than $5,000. In other words, it was a 

substantial understatement of income tax. See § 6662(d)(1)(A).

Respondent claims as an alternative basis for the accuracyrelated penalty that petitioner’s 2015 underpayment of tax was due to 

negligence. We need not reach that question.

C. Burden of Proof

Respondent having met his burden of production with respect to 

the penalty, the burden of proof (viz, the risk of nonpersuasion) is with 

petitioner, which includes the burden to prove any affirmative defense. 

See, e.g., Fabian v. Commissioner, T.C. Memo. 2022-94, at *38. 

Petitioner makes no claim to any affirmative defense.

As we understand petitioner’s arguments they are as follows:

Respondent’s Attorney claims IRS Sec 6662(a) applies 

because no adequate records were kept by Petitioner[,] . . .

[and] since her superiors approved the penalties, then that 

constitutes proof of their validity. . . .

. . . It appears that Respondent’s Attorney’s position . . . is 

that if income is reported on the wrong schedule, it is in 

fact classified as unreported and the penalty should apply.

. . . Respondent’s Attorney maintains that the mere fact of 

using the wrong schedule is enough to trigger the 

application of the penalty.

Petitioner’s first argument may misunderstand the section 

6751(b)(1) approval process. Penalty approval here was obtained before 

the Deficiency Notice was issued, not by respondent’s counsel but by RA 

Kawamoto from her supervisor, Ms. Chernyak. In any event, 

supervisory approval is merely procedural and does not establish the 

substantive validity of the penalty. As we have said: “We do not secondguess the extent of the RA’s or the supervisor’s deliberations about 

whether penalties should be imposed. We confine our search to seeking 

evidence of written supervisory approval.” Cattail Holdings, LLC v. 

Commissioner, T.C. Memo. 2023-17, at *11. Petitioner may be

mischaracterizing respondent’s argument to be that we have to uphold 

the penalty because supervisory approval is sufficient to establish a 

penalty was warranted. That is not the case.
31

[*31] Petitioner’s remaining arguments misapprehend the accuracyrelated penalty, which, here, we impose on the portion of petitioner’s 

2015 underpayment of tax attributable to his substantial 

understatement of his income tax. Respondent did not penalize 

petitioner for entering amounts on the wrong schedules; he penalized 

him for substantially understating his income tax. See § 6662(d)(2).

We uphold the accuracy-related penalty for 2015.

VIII. Conclusion

To reflect the foregoing,

Decision will be entered under Rule 155.