# United **States Tax Court**

T.C. Memo. 2023

- 89

RICHARD JOHN CARDULLA

, Petitioner

v

. COMMISSIONER OF INTERNAL REVENUE, Respondent

—————

Docket N o. 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

s ellers received from the LLC its secured Note for $1,200,000 with 10% simple interest accruing yearly ; with payments of neither principal n or 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

p ayment 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 , N ote 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 07/19/232

[* 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 penalt y sustained.

—————

Richard John Cardulla , pro se

. Jeffrey L. H e inkel

, 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) , r espondent 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 Form s 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 Schedule s 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 ha s 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 benefit s of $ 8,451?

7 . Whether , for 2015, he is liable for a sec tion 6662(a) accuracy

related penal ty of $8,808 ? 2

All other adjustments made by respondent in determining the deficiencies in tax for the years at issue are computational

, result ing from the above referenced adjustments. Those computations and adjustments will not be discussed furthe r

.

2 Respondent has conceded the accuracy

- related penalty that he determined f or 2014.4

[* 4 ] Petitioner bears the burden of proof

. S ee Rule 142(a) (1)

. 3 W ith respect to the accuracy

- related penal ty , respondent bears a burden of production

. S ee § 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 o pening b rief 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 Sec tion 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). Sec tion 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 sec tion 7491(a)(2)(A) and (B). See, e.g.

, Mileham v. Commissioner , T.C. Memo. 2017

- 168, at *30. Petitioner neither propose s facts to support his compliance with the conditions of sec tion 7491(a)(2)(A) and (B) nor persuasively argue s that respondent bears the burden of proof on any issues because of sec tion 7491(a)(1). We therefore conclude that sec tion 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 year s 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 r eply, petitioner makes no systematic response. His Reply Brief is a
37

- page narrative, in itially attacking respondent’s attorneys and then comprising what amount s 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

T he 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 a ttorney. His mailing address was in California when he filed the P etition. 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 Str ee t

— L Street is real property in s outheast 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 record6

[* 6 ] contains two invoice s from Long Fence, both dated in February
2006 , both for delivery to L Street

, both billed to Cardulla P roperties,

one for the short

- term lease of “panels” and the second

, for $9,566

, for delivery and installation of a chain link fence.

Plaza Boulevar d

— P laz a 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 th e 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 t he T urner Road property is a house badly damaged by an earthquake

. P etitioner 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 P roperty

— 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 )

. M essrs

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

p roperty as his project

, in which Messrs. Hettelsater and Wagner and Equitable ( I nvestors) invested. After 20 years of unsuccessful development efforts, the I nvestors lost heart and w anted to sell their parcels. Petitioner thought he could save the project , and he offered to buy out the I nvestors, although he told the m 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 Mountai n

— Island Mountain is a limited partnership of which petitioner was a member

.

X

- Way Delt a

— X

- Way Delta, a single

- member limited liability

company (LLC) of which petitioner is the member. Petitioner formed X

Way Delta in 2005 as a vehicle by which to make good on his offer to buy
out the I nvestors . 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)

. F or a n unstated

“ valuable consideration

, ” each Investor releas ed 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 proper ty 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 “ t he 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 D e ed of T rust , “affecting the following parcel numbers [viz, five of the six parcels listed in the D eed of T rust ].”

T he Deed of Trust is dated January 4, 20 0 6. The parties to it ar e X

- Way Delta, “ Trustor” ; Chicago Title C o. , 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 T rust with P ower of S ale that property . . . described as

, ” and here are listed 6 of the 11 parcels constituting the X

- Way Delta property

. The Deed of Trust i s 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 . Petitioner8

[* 8 ] testified that he and the I nvestors 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 N ote, nor, when the N ote matured in 2018, did it pay the accrued interest or principal

. Petitioner claims that

, w hen the N ote matured, the creditors extended it s term to 2024

. In 2007, petitioner thought he had a buyer for the X

- Way Delta property
, bu t the potential sale fell through because of a downturn in the economy.

Petitioner believes that, since 2007

, environmental problem s 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 p roperty

. He believes that,

w ithout a $20,000 tax saving from the deduction of interest accruing on the Note, maintain ing the property would be “nonsurvivable .” He thinks that the value of the property lies i n holding onto it long enough, and then someone will be able to make use of minerals under it and deve lop it for hydrothermal energy.

X

- Way De lta d oes 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

. H e 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

- Way9

[* 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 issue d 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 report ed the ordinary income amounts from those schedules and increased his Schedule E, Part II income for each year accordingly.

As stated, p etitioner reported a loss from X

- Way Delta of $12 6,593 on his 201 5 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 result s in a difference of $ 44,1 97 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 enter e d 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 blan k. 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, i n 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 T hus, 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 prop r ietor

. E.g.

, Brown v. Commissioner , T.C. Memo. 2014

- 167, at * 3

.

5 T hat 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 th e $126,593 loss from X

- Way Delta because petitioner had already reported that loss for10

[* 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 201 5 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

re ntal properties : L Street , Plaza Boulevard

, Turner Road

, L Street No. 2 , and Commercial Street

. For neither year did he report any rents (or other in come) from the first three propertie s. He reported total expenses for the five properties of $84,865 and $ 77,113 for those years , respectively. Of th ose

sum s , $20,405 and $15,290 wer e the expenses allocable to the first three properties

. The following T ables 1 and 2 detail what petitioner reported for 2014 and 2015 for those three properties.

second time on his 2 015 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, a n Island Mountain long

- term capital gain ( $23,655 ) and a n 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. I n 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. A s w ith 2015 , petitioner had reported the $125,869 X

- Way Delta loss for a second time on his 2 0 14 Schedule C

– 1. Respondent increased petitioner’s Schedule D income by $ 23,655 on account of the Island Mountain long

term capital gain.11

[* 11 ] Table 1

2014

L Street Plaza Boul evard Turner Road

Income:

Rents received — — —

Expenses:

Legal and professional fees $350

Repairs $ 5 00 6,000

Taxes 222 85 9

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 $ 6 00

Taxes 2 3 1 8 61

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 a ny deduction for th ose expenses for lack of substantiation and on the grounds that the properties were not rental properties

.12

[* 12 ] As explained below, r espondent also disallowed a deduction for the expenses petitioner reported on the Schedule s C

– 2 but allowed some of those expenses as additional expenses on the Schedule s E, Part I

. The following T able 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 $ 8 5,914

5. Schedule E, Part I adjustment to taxable income (line 1

– 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

. O n t he 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

T entative

e xpenses ( 29,258 ) ( 25,285 )

Tentative

p rofit 6,742 25,715

Home

o ffice

e xpense - 0

- ( 25,715 )

Net

p rofit $6,742 $0

For 2015, petitioner intended to claim no home office expense deduction

. In error, however, he entered , $25,715

, his 2015 tentative profi t, 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 pe titioner’s Schedule C

– 2 expenses for both 2014 an d 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

A dditionally, 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 $2 5 ,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

e xpenses $ 29,258 $51,000

Depreciation ( 3,484 ) ( 1,194 )

Home office

expense

- 0

- ( 2 5

, 715 )

Difference $ 25, 774 $2 4 ,091

The depreciation expense s 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 gr oss 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 identif ies X

- Way Delta as the relevant business and report s that X

- Way Delta uses the accrual method of accounting. The schedule s 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 3,4 2 2 3,997

Travel 1,326 1, 440

Utilities 496 5 01

Other 505 535
Total expenses $ 130,869 $ 131,5 9 3 8
Income (loss): ( $ 125,869 ) ( $1 26,5 9 3 )

Petitioner identif i ed the $5,000 of gross receipts for each year as payment from the fish farm for its easement

. Claiming that petitioner had not show n 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 Gain s

Respondent made positive adjustments of $2 3 ,655 and $19,170 to petitioner’s gross income for 2014 and 201 5 , respectiv e ly

, 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 b enefit 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 petiti oner 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 receiv ed.

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 201 4 and 20 1 5, respectively , on account of those amounts ’ being reported to petitioner as his distributive share s of Island Mountain’s ordinary income for those years.

At trial, in response to the Court’s question whether petitioner saw any error in th e positive adjustment of $ 4,241 for 2014

, he answered “no.” Nevertheless, p etitioner argues on brief that t he adjustment is improper because he did report that income on his 2 014 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 $ 6,74217

[* 17 ] is subtracted from the amount he did enter on line 12, $10,983, the difference is $ 4,241

. The coincidence between th at difference and respondent’s same adjustment for unreported income from Island Mountain leads us to accept petitioner’s explanation that he reported th at 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 incl uded not only his $35,000 annual fee as general partner of Island Mounta in 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

. Petit ioner 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 no t an S corporation (or a partnership)

,
w e see no error in respondent’s 2015 Schedule E adjustment disallowing the Part II loss of $ 107,423

.

C. Total Schedule E Adjustments

Respondent err ed 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

— R ental Real Estat e : 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 ] a s 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 an d necessary expenses paid or incurred during the taxable year for the production or collection of18

[* 18 ] income or the management, conservation, and maintenance of property held for the production of income. Section 167(a) “ allow [ s ] as a deprec i ation deduc tion 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 dedu ction for depreciation , “the taxpayer must show that the property was used in a trade or business (or other profit

oriented 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.” C l uck 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 o f 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

W e start and end with the question of whether petitioner has substantiated the Table 1 and 2 expenditures for which he has claimed deduction s

. 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 expenditure s

.19

[* 19 ] Petitioner has failed to carry his burden of proof. F or failure of substantiation, we sustain respondent’s disallow ance of any deduction for the four described Table 1 and 2 expenditures

.

F or similar reason s, 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.

W ith respect to Plaza Boulevard and Turner Road

, petitioner attached to his 2014 and 2015 returns schedules that purport to show the c omputation of the depreciation claimed for each of those properties. And while the comput ation s for Plaza Boulevard match the amount s 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. W ith 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 de preciation 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

, p etitioner 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 Table s 3 and 5

. Respondent disallowed the difference s, $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, prior20

[* 20 ] depreciation, method of depreciation, useful life, and the year’s claimed depreciatio n. 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. Th e Note obligated X

- Way Delta to pay Equitable and Mr. Hett elsater 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 amount21

[* 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 p assive activity income

. See § 469(a)(1), (d)(1).

S ection 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 up on 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

, s ee, 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

- 47 9 , 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, “ f or value received ,” the maker, X

- Way Delta promis e s 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 any22

[* 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 Assoc s

. , 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 th at 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 petit ioner and Messrs. Hettelsater and Wagner (president of E qui table) were long time acquaintances

, there is no indication of any family relationship , and respondent has constructed no narrative of X

- Way Delta and the I nvestors contributing the N ote 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 Delt a 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, the23

[* 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

— $1,5 74,700

. 10 S ee § 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. A pplying a yield to maturity of 6.79114% compounded annually , r espondent has calculated O ID 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.
200 5

- 66

, Table 1 (Long Term), 200 5

- 2 C.B. 686

, 687 , the imputed principal amount for all payments due under the Note

— $2,640,000

— is $1,5 74, 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 accrual s 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, th e 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 Y ield 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 , r espondent determined OID interest accruals for each year as follows (rounded) :

Accrual year A IP at beginning of year OID AIP at end of year

2006 $ 1,200,000 $ 81,49 4 $ 1,281,49 4

2007 1,281,49 4 87,028 1,368,52 2

2008 1,368,52 2 92,938 1,461,4 60

2009 1,461,4 60 99,2 50 1,560,7 10

2010 1,560,7 10 105,9 90 1,666, 700

2011 1,666, 700 113,18 8 1,779,88 8

2012 1,779,88 8 120,87 5 1,900,762

2013 1,900,762 129,083 2,029,84 6

2014 2,029,84 6 137,8 50 2,167,695

2015 2,167,695 147,211 2,314,90 7

2016 2,314,90 7 157,20 9 2,472,115

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

$1,440,00125

[* 25 ] trade or business. Treas . Reg. § 1.446

- 1(d)(2). X

- Way Delta did not maintain books and records

, and p etitioner use s 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 business es , 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 precl uded 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 . L arger accruals under the OID rules occur towa rds the end of the term of the Note. Neither has p etitioner 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 20 14 and 2015 on the Note constitut es 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

, a ctivities 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 bas is and finding that the

13 On the 2014 Schedule C

– 2, petitioner checked no box indicating an y 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 $1 30,154, “ 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 o f none rose to the level of carrying on a trade or business )

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

.

Activit ies relating to undeveloped real property are subject to a facts and c ircumstances test to determine whether the activit ies 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. Conn e r , 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 eng aged 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 econom y

. Petitioner believes that, since then

, environmental problems in the Salton Sea area have increase d . He analogizes the Salton Sea area to the Love Canal , and he believes that the doors to development of the p roperty 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 pur chasers or development opportunities for it

.

Petitioner has failed to convince us that, during 2014 and 201 5

, 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 (a s 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 pa id the investors for what may have been more than 1,000 acre s. A nd , 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 re ntal was more than an i ncidental 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

.

P erhaps because respondent sees the easem ent rental as incidental to holding the property for investme nt (i.e. , for appreciation )

, he does not argue for application of the passive activity loss rules. S ee Temp. Treas. Reg. 1.469

- 1T(e)(3)(vi)(B).

And perhaps because under that temporary re gulation the easement rental is incidental to holding the property for investme n t, 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 section s 163(d)(5) (A)(i ) and 469(e)(1 )

. We accept that X

- Way Delta’s 2014 and 2015 interest payments w e re payments of investment interes t. 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 se r vices, 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, 3 28 (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 the28

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

expenses , and petition er 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 adjustment s

.

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, h e 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 adjus t ment s

. We sustain the adjustment s

.

V I I

. 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 super visory 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 accuracy

related penalt y on the grounds that, for 201 5 , petitioner underpaid his income tax because of his substantially understat ing 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 zero

tax liability on the 201 5 return

. Thus, for 201 5 , his understatement of income tax was both equal to (100% of) the tax required to be shown on30

[* 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 accuracy

related penalt y that petitioner ’ s 201 5 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, the n 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 t he 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 second

guess the extent of the RA ’ s or the supervisor ’ s deliberations about whether penalties should be imposed. W e 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 penalt y because supervisory approval is sufficient to establish a penal t y was warranted. That is not the case.31

[* 31 ] Petitioner’s remaining arguments misapprehend the accuracy

related penalty , which

, here

, we impose on the portion of petitioner’s 2015 underpayment of tax a ttributable to his substantial understatement of his income tax

. Respondent did not penalize petiti oner for entering amounts on the wrong schedule s; he penalized him for substanti ally understating his income tax

. See § 6662 (d)(2).

We uphold the accuracy

- related penalty for 2015.

VI I I

. Conclusion

To reflect the foregoing,

Decision will be entered under Rule 155

.