T.C. Memo. 2008-208

UNITED STATES TAX COURT

ESTATE OF STROWN MARTIN, DECEASED, FANNIE L. MARTIN, 

SPECIAL REPRESENTATIVE, AND FANNIE L. MARTIN, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 10686-05. Filed August 28, 2008.

Alex J. Llorente, for petitioners (through trial only).

Karen Nicholson Sommers, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: Respondent determined deficiencies and

penalties with respect to the Federal income tax liabilities of

Strown Martin (decedent) and Fannie L. Martin (petitioner) as

follows:
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Penalty

Year Deficiency Sec. 6662(a)

2000 $231,305 $46,261

2001 5,771 1,154

2002 2,824 565

Unless otherwise indicated, all section references are to the

Internal Revenue Code in effect for the years in issue, and all

Rule references are to the Tax Court Rules of Practice of

Procedure. The issues for decision are:

(1) Whether an arbitration award of $616,600 is includable

in petitioners’ gross income for 2000 and, if so, whether they

are entitled to deduct from that income business startup costs

from prior years;

(2) whether petitioners may deduct losses from farming

activity claimed on Schedules F, Profit or Loss From Farming, for

the years in issue; 

(3) whether petitioners may deduct losses in excess of

$25,000 from rental real estate activity for the years in issue;

and 

(4) whether petitioners are liable for the accuracy-related

penalty under section 6662 for the years in issue.

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference. 

Decedent and petitioner resided in California at the time their

petition was filed.
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Both decedent and petitioner were teachers and held master’s

degrees. Petitioner taught accounting at the college level,

including courses in principles of accounting and payroll

accounting courses. 

 In 1976 decedent and petitioner purchased 80 acres of land

in California with the intention of starting a fruit and

vegetable farm after retirement. They retired in 1991.

 In 1994 petitioners sought farm loans from the branch of the

U.S. Department of Agriculture (USDA) that is now known as the

Farm Service Agency. Petitioners experienced discriminatory

treatment from the USDA with respect to their farm loans because

they were African-Americans. Eventually they presented a claim

to the USDA for damages suffered as a result of the

discrimination, and they joined a class action lawsuit involving

many similarly situated African-American farmers.

 Pursuant to settlement of the class action lawsuit, an

arbitrator appointed by a U.S. district court found that

petitioners were entitled to $50,000 for emotional distress and

$568,600 for lost net income from April 1, 1996, through December

31, 1999. The lost net income was calculated by projecting net

income from farming that petitioners would have received if the

loans they requested from the USDA had been processed. In 2000

petitioners received payment of $616,600 of the damages awarded
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by the arbitrator. (The $2,000 discrepancy between the amount

awarded and the amount paid is not explained in the record.) 

Decedent and petitioner timely filed their joint Federal

income tax returns for 2000, 2001, and 2002. They used the cash

method accounting system during these tax years. Decedent and

petitioner did not report any of the arbitration award received

as income on their 2000 return. On Schedules F attached to the

returns, they reported the following losses:

Year Farm Income Farm Expenses Net Farm Profit (Loss)

2000 -0- $47,406 ($47,406)

2001 -0- 41,374 (41,374)

2002 -0- 35,599 (35,599)

Most of the expenses claimed consisted of alleged mortgage

interest payments on decedent and petitioner’s farm in the annual

amount of $26,616. The claimed farm losses reduced their

reported adjusted gross income for each of the years. Decedent

and petitioner also reported rental activity losses on a Schedule

E, Supplemental Income and Loss, for each of the years in issue.

The Internal Revenue Service (IRS) examined the returns for

2000, 2001, and 2002. During the examination process petitioner

presented documents to substantiate the farm expenses claimed on

the returns. The documents included: (1) A large number of

canceled checks from 1994; (2) a statement of startup expenses

incurred in 1994 and 1995 with respect to clearing and preparing

the land for farming; and (3) monthly canceled checks from 2000
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to Sephardic Education Center in Jerusalem (Sephardic Center) in

the amount of $1,655.44 and to Rafael and Victoria Sarfatti (the

Sarfattis) in the amount of $562.50.

In the notice of deficiency upon which this case is based, 

the following adjustments were made: (1) The full arbitration

award was included in petitioners’ gross income for 2000; (2) all

of the farm expenses claimed were disallowed because of lack of

substantiation; (3) the amount of losses from the rental real

estate activity for each year was reduced to $25,000, the maximum

deduction allowed per year for passive activity losses under

section 469(i); and (4) section 6662(a) accuracy-related

penalties were imposed. The IRS disallowed the farm expense

deductions in full because the 1994 and 1995 startup expenses

were not incurred during the years in issue, the monthly checks

to the Sephardic Center and to the Sarfattis did not establish

that payments were made on a mortgage debt, and petitioners did

not present any other evidence of a valid mortgage debt. 

OPINION

Arbitration Award as Income

Gross income, for purposes of calculating taxable income,

includes all income from whatever source derived. Sec. 61(a). 

Petitioners have not claimed that any exclusion applies to the

economic damages included in the arbitration award, and none

would apply. 
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Generally, cash basis taxpayers report income in the year of

receipt. Sec. 451(a). Because decedent and petitioner were cash

basis taxpayers in 2000, the arbitration award of $616,600 is

includable in their gross income for 2000. 

 Petitioner asserts that she filed amended returns for 1996-

99 allocating portions of the arbitration award as income to

those years. However, petitioner has neither produced copies of

amended returns nor identified any authority for allocating

portions of the arbitration award to prior tax years. In any

event, there is no authority for such an allocation.

Petitioners contend that if the arbitration award is

included in income, then startup costs decedent and petitioner

incurred in establishing the farming operation in 1994 and 1995

should be deducted against the amount of the award. Petitioners

bear the burden of proving entitlement to the claimed deductions. 

See Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992). As substantiation for expense deductions in 2000,

petitioner presented canceled checks and lists of startup

expenses from 1994 and 1995. However, there is no evidence as to

whether expenses incurred in 1994 and 1995 were claimed on

petitioners’ returns before 2000. There is no evidence that the

expenses were not taken into account by the arbitrator when the

projected net income from farming was calculated and included in

the economic damages portion of the arbitration award. 
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Petitioners have failed to satisfy their burden of proof. Under

these circumstances and on the record in this case, none of the

1994 and 1995 expenses may be deducted.

Schedule F Losses

Petitioner argues that the IRS erred by disallowing all

Schedule F losses for the years in issue. Petitioner also bears

the burden of proof with respect to these deductions, and she has

failed to satisfy that burden.

The IRS disallowed, for lack of substantiation, the Schedule

F farming expenses claimed for the years in issue. The notice of

deficiency explained that decedent and petitioner had neither

shown that the expenses claimed were incurred during the year in

issue nor that any portion of the $26,616 in annual payments

deducted on the Schedules F was payment of interest on a debt. 

Respondent also argues that petitioners were not engaged in

farming during 2000, 2001 and 2002, or at any time after 1995,

presumably because of the discrimination that they suffered. 

Petitioners did not report any income from farming during the

years in issue. 

During the examination and at trial petitioner presented

copies of monthly canceled checks in the amounts of either

$1,655.44 (made out to Sephardic Center) or $562.50 (made out to

the Sarfattis) to substantiate the claimed mortgage interest

expenses related to the farm in 2000. After trial petitioner
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moved to reopen the record for receipt of a copy of a deed of

trust, dated March 8, 1991, conveying property of decedent and

petitioner to Endowment Sephardic Educational Center, Maimonides

Research and Development Foundation, and Savings Mortgage

Corporation, in trust, as security for a promissory note of

$176,500. Respondent did not object, and the document was

received in evidence.

Petitioner, however, has provided no details about the terms

or subject matter of any loan agreement, and we have no basis for

determining what, if any, portions of the payments were

deductible interest. Petitioner did not identify or substantiate

the other expenses claimed on Schedules F. Thus deductions of

farm expenses for the years in issue were properly disallowed.

Schedule E Losses

In her brief petitioner argues that the IRS’s “complete

disallowance of all Schedule E losses” related to decedent and

petitioner’s rental real estate activity (passive activity

losses) for 2001 and 2002 is incorrect. Generally, passive

activity losses are not allowed to be deducted from income for

the taxable year in which they are incurred. Sec. 469(a). 

However, section 469(i) allows a deduction not to exceed $25,000

for a portion of passive activity losses attributable to rental

real estate activities in which the taxpayer actively

participated during the taxable year.
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The IRS permitted petitioners to deduct Schedule E losses up

to the $25,000 limit for each year. For 2000 the IRS allowed

petitioners the full amount of Schedule E deductions claimed,

which totaled $17,435. The IRS also permitted petitioners to

deduct $25,000 of their passive activity losses from their rental

real estate activities for 2001 and 2002 and advised them in the

notice of deficiency that they may carry forward the excess

losses into subsequent tax years indefinitely. Petitioner

presents neither evidence nor argument showing that she is

entitled to deduct more than the amounts allowed in the statutory

notice.

Accuracy-Related Penalty

Petitioner contests the imposition of accuracy-related

penalties for the tax years in issue. Section 6662 imposes a 20-

percent accuracy-related penalty on any underpayment of Federal

income tax attributable to a taxpayer’s negligence or disregard

of rules or regulations, or substantial understatement of income

tax. Sec. 6662(a) and (b)(1) and (2). Section 6662(d)(1)(A)

defines “substantial understatement of income tax” as an amount

exceeding the greater of 10 percent of the tax required to be

shown on the return or $5,000. Under section 7491(c), respondent

bears the burden of production with regard to penalties and must

come forward with sufficient evidence indicating that it is

appropriate to impose penalties. See Higbee v. Commissioner, 116
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T.C. 438, 446 (2001). However, once respondent has met the

burden of production, the burden of proof remains with the

taxpayer, including the burden of proving that the penalties are

inappropriate because of reasonable cause or substantial

authority. See Rule 142(a); Higbee v. Commissioner, supra at

446-447.

Respondent’s burden of production has been met. Respondent

has shown that: (1) Decedent and petitioner substantially

understated their income tax by failing to report any of the

$616,600 arbitration award received in 2000; (2) decedent and

petitioner’s 2001 return contained an understatement of income

tax exceeding $5,000; (3) decedent and petitioner deducted

farming expenses of $47,406, $41,273, and $35,599 for 2000, 2001

and 2002, respectively, and they failed to maintain or produce

records to substantiate those deductions; and (4) decedent and

petitioner were negligent and disregarded rules by deducting

passive activity losses beyond the $25,000 allowed for their

rental real estate activity.

The accuracy-related penalty under section 6662(a) will not

be imposed with respect to any portion of the underpayment as to

which the taxpayer acted with reasonable cause and in good faith. 

Sec. 6664(c)(1). The decision as to whether a taxpayer acted

with reasonable cause and in good faith is made by taking into

account all of the pertinent facts and circumstances. Sec.
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1.6664-4(b)(1), Income Tax Regs. The most important factor is

the extent of the taxpayer’s effort to assess his or her proper

tax liability. Id. An honest misunderstanding of fact or law

that is reasonable in light of the experience, knowledge, and

education of the taxpayer may indicate reasonable cause and good

faith. Higbee v. Commissioner, supra at 449. 

Petitioner is a retired accounting teacher and has taught

college-level accounting courses. However, she failed to report

the $616,600 arbitration award received in 2000. While she

presented evidence of expenses in prior years claiming offsets to

income from the years in issue, petitioner does not cite, and we

do not find, any authority that would allow petitioners, as cash

basis taxpayers, to recalculate their Federal income tax

liability using the accrual method of accounting. 

Petitioner did not maintain or provide any receipts for the

farming expenses claimed on Schedules F for the years in issue. 

Decedent and petitioner claimed unsupported farm and rental real

estate losses. All of these claims, without any reasonable cause

given, suggest lack of good faith on the part of decedent and

petitioner, especially in light of their education and expertise. 

Because petitioner presented neither evidence nor argument that

the positions taken on the returns were either reasonable or in

good faith, petitioners are liable for accuracy-related penalties

under section 6662 for all of the years in issue.
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In reaching our decision, we have considered all arguments

made by the parties. To the extent not mentioned or addressed,

they are irrelevant or without merit.

To reflect the foregoing,

Decision will be entered for

respondent.