T.C. Memo. 1999-303

UNITED STATES TAX COURT

KANHUA & LIHYING YOUNG, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 8215-98. Filed September 15, 1999. 

Lihying Young, pro se.

Roger W. Bracken, for respondent.

MEMORANDUM OPINION

PANUTHOS, Chief Special Trial Judge: Respondent determined

deficiencies in petitioners' Federal income taxes in the amounts

of $4,230 and $1,330 for the taxable years 1994 and 1995. 

Respondent also determined petitioners were liable for accuracyrelated penalties under section 6662(a) in the amounts of $846

and $266 for 1994 and 1995, respectively. Unless otherwise
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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 and Procedure. 

The issues for decision are: (1) Whether petitioners

properly reported amounts of rental income and deductions on

Schedule E of their 1994 and 1995 Federal income tax returns; (2)

whether petitioners are entitled to deduct S corporation losses

claimed on Schedule E of their 1994 and 1995 Federal income tax

returns; and (3) whether petitioners are liable for the accuracyrelated penalty pursuant to section 6662(a) for both years 1994

and 1995. Petitioners filed a timely petition with this Court. 

At the time of filing the petition, petitioners resided in

Rockville, Maryland.

Background

Petitioner Kanhua Young was employed as an economist by the

U.S. Department of Commerce during the years in issue.

Petitioner Lihying Young (hereinafter petitioner) is also an

economist and the sole owner and president of OMNIX, an S

corporation. To the extent that OMNIX conducted any business

activity, such activity occurred at petitioners' home.

Petitioners timely filed their 1994 and 1995 Federal income

tax returns. Petitioners reported the following items of income

and expense on their Federal tax returns for the years in issue:
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Form 1040 - Individual Income Tax Return

 1994 1995

Wages $79,880 $82,153

Taxable interest 793 521

Dividend income 1,082 1,046

Taxable refunds -0- 1,714

Capital gain/loss (1,095) 2,085

Schedule E (set forth below) (22,321) (13,032)

Total income 58,339 74,487

 Less: Itemized deductions 19,493 19,260

 Exemptions 4,900 5,000

Taxable income 33,946 50,227

Schedule E - Supplemental Income and Loss

 1994 1995

Rents received $20,400 $20,400

Expenses:

 Insurance $1,078 $955

 Mortgage interest 7,233 8,169

 Taxes 1,945 1,989

 Utilities 689 1,063

 Depreciation 1,863 1,863

 Total 12,808 14,039

Income 7,592 6,361

 Less: Loss from S corp.

 (Schedule K-1) 29,913 19,393

Net Loss (22,321) (13,032)

OMNIX reported the following items of income and expense:
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Form 1120S - Income Tax Return for an S Corporation

 1994 1995

Gross receipts $11,000 $9,000

Deductions:

 Rent $20,400 $20,400

 Tax/licenses 155 649

 Advertising 977 989

 Professional dues &

 subscriptions 2,037 3,683 

Photocopying & postage 10,685 205

 Books & supplies 3,694 174

 Transportation 1,218 1,200

 Legal costs & consulting 1,747 1,093

Total 40,913 28,393

Net loss (29,913) (19,393)

In the notice of deficiency, respondent disallowed all items

of expense relating to the rental activity. Respondent also

reduced petitioners' income by the $20,400 of reported rental

income for each year in issue. Respondent allowed petitioners'

home mortgage interest and tax deductions as itemized deductions

on Schedule A for each year in the identical amounts as claimed

and disallowed on Schedule E. In addition, respondent disallowed

the losses claimed on Schedules E in the amounts of $29,913 and

$19,393 for 1994 and 1995, respectively. These losses are S

corporation losses reported to petitioners on Schedules K-1 from

OMNIX.

Discussion

1. General

We begin by noting that the Commissioner's determinations

are presumed correct. See Rule 142(a); Welch v. Helvering, 290
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U.S. 111, 115 (1933). Deductions are a matter of legislative

grace, and the taxpayer bears the burden of proving that they are

entitled to the claimed deduction. See Rule 142(a); New Colonial

Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

Section 6001 requires that a taxpayer liable for any tax

shall maintain such records, render such statements, make such

returns, and comply with such regulations as the Secretary may

from time to time prescribe. To be entitled to a deduction,

therefore, a taxpayer is required to substantiate the deduction

through the maintenance of books and records. In addition,

section 262 denies a deduction for any personal, living, or

family expenses. 

2. Schedule E - Rental Income & Expense

Petitioner testified that the rental income and expenses

claimed on Schedule E relate to her business, OMNIX. She asserts

that she conducted economic research and some marketing through

OMNIX, which was conducted out of the home owned by both

petitioners. She testified OMNIX' business office consisted of

the entire area in the house with the exception of two bedrooms.

Petitioner testified that she charged OMNIX rent in the

amount of $1,500 per month ($18,000 annually) for the use of the

home. Petitioner also testified that she would write checks from

OMNIX to her husband for the rent. However, she did not write

the checks on a monthly basis, but "maybe altogether one check or
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two check". Petitioners paid total annual mortgage payments for

their home in 1994 and 1995 in the amount of $18,000. In

addition to the rental of the home, petitioner testified that she

also charged OMNIX a $200 monthly rental fee for the use of the

household car. Petitioners included the $18,000 rent for use of

the home and the $2,400 rent for use of the household car as

income on their Schedule E for the years in issue.

Petitioner provided no written records or other

substantiation for the rental income and rental expenses claimed

on Schedule E as required under section 6001. It is evident from

petitioner's testimony that the rental transactions did not

actually take place, but were "paper entries" for what petitioner

felt were "fair rental values" for the use of her car and home by

OMNIX. Petitioner has provided no records or credible testimony

to show that the transactions took place or that the expenses

were incurred. Accordingly, we conclude that petitioners did not

have rental income from OMNIX as reported on Schedules E during

1994 and 1995, nor did they incur rental expenses relating to

OMNIX, deductible on Schedules E. Respondent is sustained on

this issue.

3. Schedule E - S Corporation Losses

Petitioner testified that OMNIX received $11,000 and $9,000

in income during 1994 and 1995. Petitioner asserts that the
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source of income was her children and other individuals for whom

advice was provided by OMNIX.

Respondent asserts that OMNIX' claimed expenses are not

"ordinary and necessary" expenses incurred in the carrying on of

business. Respondent also asserts that the disputed items

claimed have not been substantiated.

Section 162 generally allows a deduction for ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on a trade or business. An ordinary and necessary

expense is one which is appropriate and helpful to the taxpayer's

business and which results from an activity which is common and

accepted practice. See Boser v. Commissioner, 77 T.C. 1124, 1132

(1981), affd. without published opinion (9th Cir. 1983); Shores

v. Commissioner, T.C. Memo. 1998-193; Irwin v. Commissioner, T.C.

Memo. 1996-490, affd. without published opinion 131 F.3d 146 (9th

Cir. 1997). Whether an expense is "ordinary and necessary" is

generally a question of fact. See Commissioner v. Heininger, 320

U.S. 467, 475 (1943); Walliser v. Commissioner, 72 T.C. 433, 437

(1979); Shores v. Commissioner, supra. 

OMNIX claimed deductions for business expenses in the

amounts of $40,913 and $28,393 in 1994 and 1995, respectively. 

Petitioner has provided no credible testimony regarding the

expenses at issue. Testimony given on the matter was both vague

and inconsistent. We cannot conclude that OMNIX conducted any
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business activity in the years in issue. Petitioner has provided

no records to show that the expenses claimed were actually

incurred, as required by section 6001, although petitioner claims

to keep adequate records with regard to her activities. We

conclude that petitioners are not entitled to the claimed

expenses pursuant to section 162 and are thus not entitled to the

net losses claimed in the amounts of $29,913 and $19,393 for 1994

and 1995, respectively. Respondent is sustained on this issue.

4. Accuracy-Related Penalty Under Section 6662(a)

Respondent determined petitioners were liable for the

accuracy-related penalty under section 6662(a) for 1994 and 1995. 

The accuracy-related penalty is equal to 20 percent of any

portion of an underpayment of tax required to be shown on the

return that is attributable to the taxpayer's negligence or

disregard of rules or regulations. See sec. 6662(a), (b)(1). 

"Negligence" consists of any failure to make a reasonable attempt

to comply with the provisions of the Internal Revenue Code. Sec.

6662(c). "Disregard" consists of any careless, reckless, or

intentional disregard. Id.

An exception applies to the accuracy-related penalty when

the taxpayer demonstrates (1) there was reasonable cause for the

underpayment, and (2) he acted in good faith with respect to such

underpayment. Sec. 6664(c). Whether the taxpayer acted with

reasonable cause and in good faith is determined by the relevant
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facts and circumstances. The most important factor is the extent

of the taxpayer's effort to assess his proper tax liability. See

Stubblefield v. Commissioner, T.C. Memo. 1996-537; sec. 1.6664-

4(b)(1), Income Tax Regs. Sec. 1.6664-4(b)(1), Income Tax Regs.,

specifically provides: "Circumstances that may indicate

reasonable cause and good faith include an honest

misunderstanding of fact or law that is reasonable in light of

the experience, knowledge and education of the taxpayer."

It is the taxpayer's responsibility to establish that he is

not liable for the accuracy-related penalty imposed by section

6662(a). Rule 142(a); Tweeddale v. Commissioner, 92 T.C. 501,

505 (1989). Petitioner did not address this issue at trial or in

any pleadings filed with the Court. Petitioners claimed expenses

and losses which they failed to explain or substantiate

adequately as required under section 6001. On the basis of the

entire record, we conclude petitioners have not established the

underpayment was due to reasonable cause and that they acted in

good faith. Accordingly, we hold petitioners are liable for the

accuracy-related penalty.

To reflect the foregoing,

Decision will be entered

for respondent.