TAX COURT OPINION

Case: Anthony I. Provitola & Kathleen A. Provitola
Docket Number: 12357-16
Judge: Buch
Opinion Type: bench
Filed: 01/24/2020
Pages: 16

74 UNITED STATES TAX COURT WASHINGTON, DC 20217 ANTHONY I. PROVITOLA & KATHLEEN A. PROVITOLA, ET AL., Petitioners, v. ) ) ) ) CT ) Docket No. 12357-16, 16168-17. COMMISSIONER OF INTERNAL REVENUE, Respondent ) ) ) ORDER Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is ORDERED that the Clerk of the Court shall transmit with this order to petitioners and respondent a copy of the pages of the transcript of the trial in this case before Judge Ronald L. Buch at Jacksonville, Florida, containing his oral findings of fact and opinion rendered at the trial session at which these cases were heard. In accordance with the oral findings of fact and opinion, decision will be entered for respondent. (Signed) Ronald L. Buch Judge Dated: Washington, D.C. January 24, 2020 SERVED Jan 27 2020 3 Bench Opinion by Judge Ronald L. Buch December 18, 2019 Anthony I. Provitola & Kathleen A. Provitola v. Commissioner of Internal Revenue Docket Nos. 12357-16, 16168-17 THE COURT: The following represents the Court's oral findings of fact and opinion. These oral findings of fact and opinion may not be relied upon as precedent in any other case. This opinion is in conformity with Internal Revenue Code section 7459(b) and Rule 152(a) of the Tax Court Rules of Practice and Procedure. Any section references refer to the Internal Revenue Code or the Treasury regulations in effect during the years at issue, and Rule references are to the Tax Court Rules of 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Practice and Procedure. 16 17 The Commissioner issued notices of deficiency for 2013 and 2014 to Mr. and Mrs. Provitola. The 18 Provitolas filed a petition challenging the deficiencies. 19 We must decide whether the Provitolas may take deductions 20 for legal and professional services for 2013 and 2014 and 21 other expenses for 2014. 22 23 BACKGROUND Anthony and Kathleen Provitola are married and 24 were married at all relevant times. Mr. Provitola has a 25 B.S. in physics and a law degree. He is a practicing attorney who is admitted to the bar of the Tax Court. Early in his career, he was a personal injury attorney. Later in his career, he transitioned his area of practice 4 to patent law. He practiced law through Anthony I. Provitola, P.A. (APPA), a professional association and subchapter S corporation of which Mr. Provitola is the sole owner. In roughly 2003, Mr. Provitola stumbled on the idea for a product to enhance television viewing. Sometime thereafter, he began developing a product, and from 2005 to 2016, he was awarded seven patents in connection with the product he was developing. In 2007, the Provitolas formed Viovision 1 2 3 4 5 6 7 8 9 10 11 12 13 14 ventures LLC, a limited liability company with Kathleen 15 Provitola as the sole owner. Viovision was formed for the 16 marketing of any product that may result from Mr. 17 Provitola's original concept. From its formation through 18 2012, Viovision did not report any income or expenses. 19 That changed in 2013. 20 In January 2013, APPA billed Viovision for five 21 years of services provided by Mr. Provitola through APPA. 22 The bill listed the services provided as "Annual Retainer 23 for IP Services + Business Consult". Mr. Provitola 24 provided all management, product development, and product 25 design services to Viovision through APPA. For those . cnners services, APPA billed Viovision $12,000 per year for 2009 5 through 2013, inclusive, showing a total balance of $60,000 on the January 2013 invoice. On December 30, 2013, the Provitolas capitalized Viovision by writing a personal check to Viovision for $36,000. On that same date, Viovision wrote a check to APPA for $36,000 as partial payment of the accrued fees. That payment was to compensate APPA for Mr. Provitola's services. APPA then wrote a check to Mr. Provitola for 1 2 3 4 5 6 7 8 9 10 $36,000, also on December 30, 2013. All of those checks 11 were promptly deposited. 12 Similar payments were made in December 2014. On 13 December 29, 2014, the Provitolas wrote a check for 14 $42,500 to Viovision. In turn, Viovision wrote checks 15 Payable to APPA for $359, $16,992, and $22,000. Viovision 16 also wrote a $2,000 check to Mr. Provitola, individually. 17 With the exception of the check to Mr. Provitola, those 18 19 20 21 22 checks were deposited into APPA's account along with $10,000 cash on December 29, 2014. And also on December 29, 2014, APPA wrote a check to Mr. Provitola for $49,000. For 2013, the $36,000 payments were reported by the Provitolas on various returns and schedules. The 23 Provitolas' Form 1040, U.S. Individual Income Tax Return, 24 included a Schedule C, Profit or Loss From Business, for 25 Viovision. That Schedule C reported a $36,000 expense for 6 legal and professional services. The result was a net loss that the Provitolas carried onto the face page of the Form 1040. As for APPA, it reported the $36,000 as gross receipts. Those gross receipts were largely offset by expenses, netting $495 of business income. The Provitolas reported the $495 on Schedule E, Supplemental Income and Loss, where it was more than offset by other nonpassive losses. For 2014, the payments were again reported on 1 2 3 4 5 6 7 8 9 10 various returns and schedules. The payments from 11 Viovision to APPA were broken out on three different lines 12 on the Schedule C; legal and professional fees of $22,000, 13 other expenses of $20,327, and taxes and licenses of $139. 14 15 Those amounts do not correspond directly to the reporting by APPA, which reported $32,000 of gross receipts. That 16 income was largely offset by expenses, yielding net income 17 of $341. The Provitolas reported that $341 on Schedule E 18 where, like 2013, it was more than offset by nonpassive 19 losses. 20 21 The Provitolas jointly prepared and jointly filed their returns for 2013 and 2014. They were also 22 both involved in the preparation of the APPA returns. 23 As of 2015, indeed, as of the time of trial, 24 Viovision had not attempted to sell any products and has 25 not generated any revenue or any profit. Approximately cnners 1,000 product units were manufactured after the years in 7 issue, but there has been no attempt to sell them. Viovision never had any employees, never had an office apart from the Provitolas' home, and never did any advertising or marketing. Viovision has developed a website, but that website has not been made public. The Commissioner examined the Provitolas' 2013 and 2014 returns, issuing separate notices of deficiency for each year. 1 2 3 4 5 6 7 8 9 10 The Commissioner issued a notice of deficiency 11 with respect to 2013 on March 7, 2016. In that notice, 12 the Commissioner disallowed the $36,000 expense reported 13 on the Viovision Schedule C that was included with the 14 Provitolas' Form 1040. The notice explained that the 15 expense was disallowed because the Provitolas had not 16 established that the expense was paid or incurred in 2013 17 or that the expense was ordinary or necessary. The notice 18 also determined computational adjustments resulting from 19 the $36,000 disallowance. Lastly, the notice included an 20 accuracy-related penalty under section 6662. Although the 21 notice listed in the alternative several bases for 22 determining an accuracy-related penalty, only the 23 substantial understatement penalty received supervisory 24 25 approval, which occurred on November 20, 2015. The Commissioner issued a notice of deficiency with respect to 2014 on May 1, 2017. In that notice, the Commissioner disallowed $42,236 of expenses ($22,000 legal and professional fees and $20,236 other expenses) reported 8 on the Viovision Schedule C that was included with the Provitolas' Form 1040. The notice explained that the expenses were disallowed because the Provitolas had not established that the expenses were paid or incurred in 2014 or that the expenses were ordinary or necessary. The notice also determined computational adjustments resulting from the $42,236 disallowance. Lastly, the notice included an accuracy-related penalty under section 6662. 1 2 3 4 5 6 7 8 9 10 11 12 Although the notice listed in the alternative several 13 bases for determining an accuracy-related penalty, only 14 15 16 the substantial understatement penalty received supervisory approval, which occurred on February 27, 2017. While residing in Florida, the Provitolas filed 17 timely petitions challenging each notice of deficiency. 18 We consolidated the cases and held a partial trial October 19 22, 2018 and continuing on December 16, 2019. The 20 Provitolas challenge the Commissioner's disallowance of 21 Viovision's expenses, asserting that the expenses were 22 23 24 incurred and that they were ordinary and necessary. The Commissioner's position is less straightforward. Based on the evidence adduced at trial, 25 the Commissioner no longer appears to challenge whether 9 1 2 3 4 5 6 7 8 9 Payments were in fact made. We assume that he continues to challenge whether the expenses were ordinary or necessary, although this point may be subsumed in other arguments made by the Commissioner. He argues: "Viovision is not an actual business, but merely a legal fiction petitioners use to offset their income." We will characterize this as a substance over form argument. The Commissioner also argues: "a person cannot become liable to oneself, one cannot incur legal fees for themselves, 10 and there can be no deduction for legal fees." This 11 criticism of the circularity of payment appears to be a 12 mere rephrasing of the substance over form argument, so we 13 will address it within that discussion. Distinct from the 14 15 substance over form argument, the Commissioner argues: "Viovision was not actually engaged in business during the 16 2013 and 2014 tax years. At best, the transfers from 17 Viovision to the law practice could be considered start-up 18 expenses, which are not deductible for the years they were 19 made." We will characterize this as a start-up 20 expenditures argument. 21 22 23 I. Burden of Proof DISCUSSION Generally the Commissioner's determinations in a 24 notice of deficiency are presumed correct, and taxpayers 25 bear the burden of proving otherwise. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). 10 The Commissioner bears the burden of proof, however, on any new matter, increases in deficiency, or affirmative defenses pleaded in his answer. Rule 142(a); Shea v. Commissioner, 112 T.C. 183, 190 n.10 (1999). II. Substance Over Form When assessing whether a corporation will be respected as a separate taxable entity, courts often look to Moline Props., Inc. v. Commissioner, 319 U.S. 436 (1943). The Supreme Court held in Moline Props, that when a taxpayer adopts the corporate form, and "so long as that 1 2 3 4 5 6 7 8 9 10 11 12 purpose is the equivalent of business activity or is 13 14 followed by the carrying on of business by the corporation, the corporation remains a separate taxable 15 entity." Moline Props., Inc. v. Commissioner, 319 U.S. at 16 17 18 19 439 (citing New Colonial Ice Co. v. Helvering, 292 U.S. 435, 442 (1934), and Deputy v. Du Pont, 308 U.S. 488, 494 (1940)). Since Moline Props, courts have used this 20 Proposition to determine whether a taxpayer's chosen 21 entity will be recognized for Federal tax purposes. 22 Bertoli v. Commissioner, 103 T.C. 501, 511-512 (1994). 23 Court have applied a two-prong test: the entity (1) must 24 be created for a business purpose, or (2) must carry on a 25 business activity. Bertoli v. Commissioner, 103 T.C. at 73)4002250|operationseescribers.net www.escribers.net 511-512. For tax purposes, the "form may be disregarded 11 where it is a sham or unreal. In such situations the form is a bald and mischievous fiction." Moline Props., Inc. v. Commissioner, 319 U.S. at 439. Courts have used the principals in Moline Props to determine the validity of various entities. Bertoli v. Commissioner, 103 T.C. at 512; O'Neill v. Commissioner, 271 F.2d 44, 49 (9th 1959), aff'g T.C. Memo. 1957-193; Campbell County State Bank, Inc. v. Commissioner, 37 T.C. 430, 441 (1961), rev'd on other grounds 311 F.2d 374 (8th Cir. 1963). These principals apply to both Viovision and 1 2 3 4 5 6 7 8 9 10 11 12 APPA. The Commissioner argued at trial that Viovision, 13 the Provitolas' LLC, is "merely a legal fiction". 14 However, we will respect Viovision's form because it is 15 engaged in activities with a business purpose. Mr. 16 Provitola is currently working on inventing and bringing 17 to market his television viewing product through 18 Viovision. He has developed the product and obtained 19 several patents in the process. Although it is unclear at 20 this time whether the product will be commercially viable, 21 approximately 1,000 units of the product have been 22 manufactured with the hope of eventual sale. A website 23 has been created for that purpose, although that website 24 is not yet public. The Provitolas treated Viovision as a 25 discrete entity; for example, Viovision maintains a a ners separate bank account. Viovision is not a "sham or unreal" nor is it "a bald and mischievous fiction." Viovision exists to develop an bring to market Mr. 12 Provitola's invention, and we will respect its existence. We note that the Commissioner's substance over form argument is inconsistent with the notice of deficiency. In the notice, the Commissioner disallowed the expenses taken by Viovision for the payment of legal and professional fees paid to APPA for lack of substantiation and because the expenses were not ordinary and necessary. Notably, the Commissioner did not make a corresponding adjustment to APPA to remove the income from 1 2 3 4 5 6 7 8 9 10 11 12 13 the legal and professional fees. If the payments made by 14 Viovision were mere circular payments without any 15 substance, then the income to APPA would be disregarded 16 along with the deduction by Viovision. This is not the 17 position set forth in the notice of deficiency and it is 18 not supported by the record. We will give due regard to 19 the separate entities. 20 21 III. Start-Up Expenses Taxpayers may deduct "ordinary and necessary 22 expenses paid or incurred during the taxable year in 23 carrying on any trade or business." Sec. 162(a). An 24 "ordinary" expense is one that commonly or frequently 25 occurs in the type of business at issue. Deputy v. du cnt >ers Pont, 308 U.S. 488, 495 (1940). 13 A "necessary" expense is an expense that is "appropriate and helpful" to the business. Heinbockel v. Commissioner, T.C. Memo. 2013- 125, at *17. Before a taxpayer may deduct trade or business expenses under section 162, there must exist a business "functioning as a going concern and performing the activities for which it was organized." Glotov v. Commissioner, T.C. Memo. 2007-147, 93 T.C.M. (CCH) 1339, 1340. Before the day a business operates as a going concern, expenses related to creating a business are not "ordinary and necessary" expenses to the business and are 1 2 3 4 5 6 7 8 9 10 11 12 13 therefore not deductible. Woody v. Commissioner, T.C. 14 Memo. 2009-93, 97 T.C.M. (CCH) 1484, 1487. To be 15 deductible as a business expense under section 162, rather 16 than amortizable as a start-up expense under section 195, 17 18 19 20 business activities must have actually commenced. Glotov v. Commissioner, T.C. Memo. 2007-147, 93 T.C.M. (CCH) 1339, 1340. The Provitolas referred the Court to Stanton v. 21 Commissioner, 399 F.2d 326 (5th Cir. 1968), for the 22 Proposition that one can be in the business of inventing. 23 But the Court of Appeals for the Fifth Circuit also 24 observed: 25 The phrase 'trade or business' presupposes an existing trade or business. 14 Thus, expenditures incurred in investigating a potential new trade or business or in preparation for the possibility of entering into a new trade or business have been held not to have been incurred in connection with a trade or business so as to be deductible in computing taxable income. Id. at 329 (internal citations omitted). Though not deductible, start-up expenditures are instead capitalized and amortized under section 195. 1 2 3 4 5 6 7 8 9 10 11 12 Start-up expenditures include any amount paid or incurred 13 in creating a trade or business, or engaging in an 14 activity to create profit or produce income prior to the 15 day the active trade or business begins. Sec. 16 195(c)(1) (A). (We make no determination at this time 17 whether these expenses may, at some future date, be 18 19 claimed by Viovision.) To determine whether expenses are deductible 20 section 162 business expenses or amortizable start-up 21 expenses, we must look to whether Viovision is still in 22 the start-up phase of its business or if it has begun an 23 active trade or business. Woody v. Commissioner, T.C. 24 Memo. 2009-93, 97 T.C.M. (CCH) 1484, 1487. 25 In McKelvey v. Commissioner, T.C. Memo. 2002-63, 83 T.C.M. (CCH) 1339, the petitioner decided to start a 15 tree farm. In preparation for his business, the Petitioner studied the commercial viability of land, forest health, entomology, and risk control issues. After buying the land for his tree farming business, the Petitioner paid for a forest management plan and planted pine trees as a pilot test for his farm. At the time of filing his tax return claiming deductions, the petitioner had not yet commercially harvested the trees. McKelvey v. Commissioner, T.C. Memo. 2002-63, 83 T.C.M. (CCH) 1339, 1340. This Court held that petitioner "had not actually commenced the business activity of tree farming". 1 2 3 4 5 6 7 8 9 10 11 12 13 McKelvey v. Commissioner, T.C. Memo. 2002-63, 83 T.C.M. 14 15 16 (CCH) 1339, 1341. Viovision has not yet commenced an active trade or business. Like the petitioner in McKelvey, Viovision 17 has taken significant steps to prepare for the business of 18 selling Mr. Provitola's invention. Viovision has not yet 19 attempted to market or sell a product. It has not made 20 any sales, made its website public, or attempted to market 21 a product. As in McKelvey where this Court did not 22 consider the petitioner to be engaged in a trade or 23 business before commercially harvesting his trees, 24 Viovision has not yet engaged in a trade or business 25 before attempting to market and sell a product. nrmrs Because Viovision's expenses are start-up 16 expenses, the Provitolas may not deduct those expenses under section 162. However, they may capitalize these expenses under section 165(a) in the future. Because we respect the payments made by Viovision, the payments are still income to APPA. We note that this outcome is consistent with the position set forth in the Commissioner's notice of deficiency, which disallowed the expenses claimed by 1 2 3 4 5 6 7 8 9 10 Viovision but did not adjust the income to APPA. To the 11 extent the Commissioner's start-up expenditures argument 12 is a new matter, he would bear the burden of proof. Rule 13 142(a)(1). That burden, however, is easily satisfied; it 14 15 16 17 is clear that Viovision is still in the start-up phase and not yet an active trade or business. IV. Applicable Penalties Section 6662(a) imposes a 20% accuracy-related 18 Penalty on "any portion of an underpayment of tax required 19 to be shown on a return" if the underpayment is due to 20 negligence or disregard of rules or regulations. Section 21 22 23 24 25 6662(d)(1) imposes a penalty for taxpayers who report a substantial understatement of tax. An understatement is substantial if it exceeds the greater of 10 percent of the tax required to be shown for that year or $5,000. Sec. 6662(d)(1) (A). For the Commissioner to properly impose a 1 Penalty, the penalty must be personally approved-in 2 writing-by an immediate supervisor of the person making 17 3 4 5 6 7 8 9 the initial determination to impose the penalty. Sec. 6751(b)(1). The Commissioner has the burden of production with respect to a taxpayer's liability for any penalty. sec. 7491(c). After the Commissioner has met his burden, the burden shifts to the taxpayer to prove any applicable affirmative defenses to the penalties. CNT Investors, LLC v. Commissioner, 144 T.C. 161, 220 (2015). 10 The Commissioner determined an accuracy-related 11 Penalty on various grounds for each year. However, only 12 the substantial understatement penalty received 13 14 supervisory approval as required by section 6751(b). As a result, only the substantial understatement penalty can 15 apply. The amount of the understatement satisfies the 16 threshold for a substantial understatement for each year, 17 and the Provitolas have not shown that any affirmative 18 defenses apply. Mr. Provitola is an attorney, he and Mrs. 19 Provitola jointly prepared their returns, and they offered 20 nothing in the way of substantial authority for their 21 return positions. The substantial understatement penalty 22 applies to each year. 23 24 25 Decisions will be entered for respondent. (Whereupon, at 9:02 a.m., the above-entitled matter was concluded.)