TAX COURT OPINION

Case: Arnon Harari
Docket Number: 7060-11
Judge: Gustafson
Opinion Type: bench
Filed: 02/13/2012
Pages: 20

UNITED STATES TAX COURT WASHINGTON, DC 20217 RMM ARNON HARARI, Petitioner, v. COMMISSIONER OF INTERNAL REVENUE, Respondent ) ) ) ) ) Docket No. 7060-11. ) ) ) ) ORD E R Pursuant to Rule 152(b), Tax Court Rules of Practice and Procedure, it is ORDERED that the Clerk of the Court shall transmit herewith to petitioner and to respondent a copy of the pages of the transcript of the trial in the above case before Judge David Gustafson at New York, New York, on February 1, 2012, containing his oral findings of fact and opinion rendered at the conclusion of the trial. In accordance with the oral findings of fact and opinion, decision will be entered under Rule 155. (Signed) David Gustafson Judge Dated. Washington, D.C. February 13, 2012 SERVED Feb 14 2012 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 3 Bench Opinion by Judge David Gustafson Arnon Harari v. Commissloner Docket No. 7060-11 February 1,. 2012 THE COURT:( The Court has decided to render oral Findings of Fa t and. Opinion in this case . The - following represents the Court' s oral Findings of Fact and Opinion, which shall not be .relied on as precedent in any other case . This Bench Opinion is made pursuant to the authority granted by section 7459 (b) of the Internal Revenue Code of 1986, as amended, and Rule 152 of the Tax Court Rules of ractice and Procedure . . By a notic of deficiéncy datèd December 20, 2010, the Internal R venue Service (IRS) determined a deficiency in the Fe eral income tax of petitionei' Arnon Harari for the year 2007, and an accuracy- related penalty unde section 6662 (a) . The def iciency arose. from several a i ustment that -the IRS made, two of which Mr . Harari poncedes : f irs t , a cost -of -goods - sold adjustment of $2,268; and secoÊd, a $3, 921 deduction for a computer. Still in dispute, however, are f ive other adjus ments . For thé reasons explained hereafter, we ,will sústain the IRS' s adjustments in part . Trial of this case was conducted on Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 January 30, 2012, ir New York City. Mr. Harari testified. The part .es' Stipulation of Facts was admitted into evide ce, .along with its Exhibits 1-P through 7-P, and an additional Exhibit 9-P was admitted into eviderice. We find thê following facts: . FINDINGS In 2007 Mr. Harari was a self-employed computer consultant . He resided with his wife in Queens, New York, i a two-bedroom apartment for which he paid $1, 10 0 per onth (i . e . , $13, 20 0 f or the year) . In one bedroom he maintained the office for his business . That bedroom took up approximately 25 percent of the floor space of the house and was used exclusively for his business . He and his wife used the other bedroom as a bedroom, though :he also performed some of his work in that room and in the other rooms in the house (i.e., a living room and an eat-in kitchen) . H had no other office location for his business. . In 2007 Mr. Harari had 25 to 30 clients, who were in Manhattan and New Jersey. He owned two cars and used them to drive to the clients' locations in connection with his work for them. In so doing, he incurred tolls and parking expenses . For the tolls he had an EZ-Pass device in his car, by which he paid the Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 5 tolls automatically without stopping at a toll booth, and he was charged periodically with a statement that showed each toll. Ise substantiated tolls and parking expenses totaling $2,817 that he incurred in 2007. The IRS concedes that he incurred such expenses in these amounts but disputes that they were incurred in connection with his business. It appears.that some portion of those amo nts was incurred not for his business but for.personal use by his wife or himself -- a portion that we cannot determine precisely because of Mr. Harari's inadequate records. "Accordingly, based n all the facts and circumstances, but b aring h,eavily against petitioner for the inexactitude of [his:] evidence, " Concord Consumers Housing Cooperativ'e v. Commissioner, 89 T.C. 105, 125, (1987), we find that no more than 40 percent of these expenditures were personal, so that he incurred $1, 690 of p rking and tolls for his business . Mr. Harari sometimes gave a gift (such as a bottle of wine) to a client. At trial he offered bank statements to attempt to quantify such business gifts; but he was unable to show particular expenditures as to which he could sa what the gift was, who the donee was, and what the bu iness purpose was. We therefore find that he has not substantiated any business gifts Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 L to clients. At his work, Mr. Harari wore typical business attire, . usually dress slacks, a dress shirt, and a tie. In 2007 he incurred approximately $401 of dry cleaning expenses, the majority of which was for his business clothes but some portion of which (which we cannot determine recisely) was for his wife's clothes. In 2007 Mr. Harari and his wife maintained two "land line" telephones, one of which they considered his business phone, and the other of which he had insisted she bbtain because she made f requent expensive calls to B azil. He did not maintain records of the persohal land line, and the records he did maintain for the business land line showed that it was. sometimes used for calls to Brazil. His phone records (Ex. 6-P) appear to show that in 2007 he paid a total of $1,619.87 for that "business" land line. Mr. Harari. also main ained a cell phone that he used at least in part for his business . His phone records (Ex. 7-P) show that in 2007 he paid a total of $1, 515 . 68 f or the us of that cell phone . He alleged that he had a second cell phone, but his recollection seemed vague and his testimony was not convincing. Mr. Harari thus substantiated telephone Heritage .eporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12. 13 14 15 16 17 18 19 20 21 22 23 24 25 7 expenses. totaling $ ,135..55 for his "business" land line and his cell phone, and it is clear that his business did involve substantial phone contact with his clients . Howev r, his inadequate records make us unable to qua fy w th precision the actual breakdown of bus ine s s and personal use .or expense . - " [B] earing heavily against petitioner", we conclude that 50 percent of this expense (i . e . , $1, 567 . 78) was f airly attributable to Mr. Harari's business. Petitioner' s tax return and IRS adjustments Mr. Harari timely filed his 2007 Federal income tax return, and the IRS examined that return and disallowed some of the deductions he had taken on Schedul.e C, Profit or Loss from Business. Mr. Harari reportèd a "Rent" déduction of $13,200, which the IRS disallowed entirely He reported a parking and tolls deduction of $2, 817, but the IRS disallowed .$2, 257 of it. and allowed only $560. He reported a deduction of $1,426 for business gifts, but the IRS disallowed it entirely. He repor ed a deduction of $401 for laundry and cleaning, but the IRS disallowed it entirely. He deducted $4, 043 for telephone expense, but the IRS disallowed 75 percerit of that amount .($3, 033) and allowed only $1, 010 Based on these adjustments (and the ones Mr . Harari concedes) , the IRS determined that Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 8 Mr. Harari owed an ncome tax deficiency of $7,101 for 2007, plus an accur cy-related penalty of $1,420.20. On December 20, 2010, the IRS issued the notice of deficiency. Mr. Harari timely mailed his petition to this Codrt on March 21, 2011. At that time he resided in the State of New York. t OPINION The IRS's etermination is presumed correct, and the taxpayer generally bears the burden to prove his entitlement to any deductions he claims. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Deductions are strictly a matter of legislative grace, and taxpayers must s tisfy the specific requirements for any deduction claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Furthermore, taxpayers are required to maintain records sufficient to substantiate theik claimed deductions. See sec. 6001; 26 C.F.R. sec. 1.6001-1(a) Proced. & Admin. Regs. I. Home offic expense Section 280A(1) (A) allows a taxpayer to deduct expenses for he business use of his residence, but only to the exteht the expenses are allocable to a portion of the resid nce which is exclusively used on a regular basis as the principal place of business for Herïtage Reporting Corporation (202) 628-4888 1 2 3. 4 5. 6 7 8 9 10 11 12 13 a trade or business of the taxpayer. Mr. Harari did regularly use his home office as the principal place of business for his computer consulting business . As a result, he is entitled to the home office deduction for the portion of 1 is home that was exclusively used as the principal pldce .of his business. We find that his home office exclusively used for his business constituted approximately 25 percent of the floo space of the apartment, and that he is therefore entitled to deduct 25 percent of the related expenses. ' he only expense in dispute is his rental payments that totaled $13,200 fof.the year. He is therefore entitled to a rent reduction of 25 14. . percent of that amo nt, or $3, 300 (i . e . , not the zero 15 16 17 18 19 20 21 22 23 24 25 that the IRS allowed, and not the $13,200 he claimed.) II. Parking an tolls expense In general, the cost of daily commuting to and from work is a ondeductible personal expense, see Commissioner v. Flowers, 326 U.S. 465, 473 474 (1946); 26 C.F.R. sec 1.162 2(e) Income Tax Regs., but this prohibition does not apply to the expenses incurred traveling between a taxpayer' s residence and a place of business if the residence. is the taxpayer's principal place of ] 1siness; see Curphev .v. Commissioner, 73 T.C. 766, 777-778 (1980); Rev. Rul. Heritage Reporting Corporation 202) 628-4.888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 10 99-7, 1999-1 C.B. 3 1, 362. If an office in the taxpayer's residence satisfies the princ pal place of business requirements of section 280A (c) (1) (A) , then the residence is considered a business location. In these circumstances, the daily transportation expenses incurred in going b tween the residence and other work locations in the sane trade or business are ordinary and necessary business expenses deductible under section 162 (a) . See Curphey, 73 T . C. .at 777 -778 . Since Mr. Harari's home office is his principal place of business, the toll expenses he incurs on the way to his clients and the parking expenses he incurs at their locations are potentially deductible. . However, c rtain business expenses described in section 274 (d) are subject to strict substantiation rules. Sanford v. Commissioner, 50 T.C. 823, 827-828 (1968), affd. 412 F.2d 201 .(2d Cir. 1969); sec. 1.274- ST (a) , Temporary Income Tax Regs . , 50 Fed . . Reg . 46014 (Nov. 6, 1985) . Section 274 (d) applies to, among other things, the use of "listed property", as defined in section 280F (d) (4) , which includes passenger automobiles. Mr. Ha ari's parking and toll expenses are . in this category Tò deduct such expenses, the taxpayer must substahtiate by adequate records or Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 sufficient evidence to corroborate the taxpayer's own testimony: (1) the amount of the expenditure or use; (2) the time and place of the travel; and (3) its business purpose . Sec . 274 (d) (f lush language) . . Mr.. Harari substantiates each of his parking and toll expenses b bank records that show the amounts and dates of his expenditures . His testimony convinces us that he regularly incurred such expenses in connection with his visits to clients, that he seldom drove out of his neighborhood into Manhattan or New Jersey except for business, and that his wife regularly used public transportation for her commuting into Manhattan. However, the defect in his. proof is that his testimony does not establish for each individual expense the precise business nature of the expenditure, leaving open the possibility that a portion of these expenses was not related to his client visits but instead to personal use by himself or his wif e . He test if ied that such personal use involving these expenses would be little or none; but "bearing heavily against petitioner", we assume in the IRS's favor that .it may have been somewhat more substantial -- perhaps as high as 40 percent of t·hese expenditures - and ye therefore find that he incurred $1,690 of parking anl tolls for his business (i.e., Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 not the $2, 817 that he reported, but not just the $560 12 that the IRS allowed. ) III. Business gifts As we noted above, certain business expenses described in section 274 (d) are subject to strict substantiation rules, and among these are "any expense for gifts", sec. 274 (d) (3), as to which the taxpayer must substantiate nqt only the amount but also the business purpose of the expense. Mr. Harari's evidence fails to make this substantiation, or.even to approximate it remotely. He was unable to point to any particular experditures as to which he could say what the gift was, who the donee was, and what the business purpose was. We therefore sustain the IRS's complete disallowance of this $1, 426 deduction. IV. Laundry and dry cleaning As a general rule, personal expenses are not deduct ible . Sec . 262 (a) . Like most. people, Mr . Harari wears, for his business, clothes . that he can also wear for non-business personal use. This means that his clothing e penses are not deductible business expenses. "{I]n order for the expenses of .work clothes to be deductible the clothes must be of a type specifically required as a condition of employment, and they must not be adaptable to general usage as Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 13 ordinary clothing" . Donnelly v. Commissioner, 262 F.2d 411, 412 (2d Cir. 1959), aff'q 28 T.C. 1278 (1957) . Because the clothing that petitioner purchased is suitable for general wear, the expenses incurred for laundering and dry-cleaning his clothing are personal expenses that, under section 262, are nondeductible. Boltinghouse v. Commissioner, T.C. Memo. 2007-324. We therefore sustain the IRS's disallowance of Mr. arari's entire deduction of $401 for laundry and cleaning. V. Telephone expense There can be no denying that a business like Mr. Harari's requires the use of a telephone;-- and the IRS. did not deny it. but rather allowed him not zero but $1,.010 . Th IRS s allowance constituted 25 percent of the $4, 04 that he originally reported . and is 32 percent of the $3,135.55 that he substantiated at trial . (Mr . Hara i did not note or explain the $907 difference betw en what he reported on the return and what he,substantiated at trial.) The reason for the only partial allbwance is that Mr. Harari did not show that this amoun was incurred exclusively for business purposes, and his substantiation showed that some of the use of the phones at issue was personal (i.e., his wife's long-distance calls to Brazil) . Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 '10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 It would npt be reasonable to treat the business character of a telephone expense as compromised when de minimis personal use of the telephone occurs. In virtually every business, some personal use of telephones occurs and is permitt ed. In order for business to be conducted at all, the humans who conduct it must occasionally pause to conduct personal matters -- whether to make a trip to the lavatory or to take a personal call to handle a child's emergency. Few businesses could survive if they failed to facil tate these personal matters, and the expenses that a business incurs to do so are truly a cost of doing busihess and are deductible . In theory, it should be no different for a business conducted from a home office, but that theory is subject to the rehlity that when the office is at home, the personal and the business may overlap so substantially that the business character of the expense becomes doub ful . While it cannot be denied that Mr. Harari's buhiness required the use of a telephone, it also c nnot be denied that most households that do n t involve any home office also require the use of a telephone for the conducting of non-business household matters, for which no deduction is allowed. See sec 262 (b) ("in the case of an Heritage Neporting Corporation (202) 628-4888 15 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 individual, any charge (including taxes thereon) for basic local telephone service with respect to the 1st teþephone line prov ded to any residence of the taxpayer shall be t eated as a personal expense") . One's household telephone expenses do not becóme deductible simply b cause one has a home office. So we must attempt (as the IRS's examiner attempted) to distinguish between the business and the personal in this blended circumstance. Mr . Hara i had two land lines, and he in effect urges that this fact suffices to make the necessary distinction -- i.e., that while his "personal" land=line expense is an admittedly nondeductible personal expense (which in fact he did not attempt to deduct), all of his e2pense for the óther land line and his cell phone is a deductible bus ine s s . expense . Hówever, he did not subs tant iate his expenditures f r the personal land line, and we therefore have no way- of confirming either that the expense t was e uivalänt to the expense he incurred for the business land line and the cell phone or that the business lines were not in fact carrying a . substantial portion of the nonibusiness household phone activity. Wit hout information on which to base a more exact alloca ion (which informatión Mr. Harari Heritage Reporting Corporation (202) 628 4888 16 was obliged to provide in bearing his burden of proof), and assuming facts in the IRS's favor, we find that a simple 50-50 split of personal and business of these substantiated expenses is most reasonable, so that Mr Harari is ehtitled to a business deduction of $1,567.78 for telephone expense (rather than the $1, 010 that the IRS allowed) . VI . Accuracy-related penalty Although M . Harari made no explicit contention as to penalty eit-her in his petition or at trial, we analyze here his liability for penalty. (cid:0)540ection6662 imposes an "accuracy-related penalty" of . 20 percent of the po tion of the underpayment of tax that is attributable to the taxpayer's negligence or disregard of rules or regu'lations or that is attributable to any substantial understatement of income tax. Here the IRS asserts both that Mr. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18. Harari's understatement was substantial and that it 19 20 21 22 23 24 25 was attributable to negligence . Under section 74.91(c), the Commissioner bears the burden of production and must roduce sufficient evidence that the imposition of the penalty is appropriate in a given case . Once the Commissioner meets this burden, the taxpayer must cone forward with persuasive evidence that the Co missioner' s determination 1s Herltage Reporting Corporation (202) .628-4888 17 incorrect . Rule 142 (a) ; Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001) . A. "Substantial understatement" By definition, an understatement of income . tax for an individual is substantial if .it exceeds the greater of $5, 000 .or 10 percent of the tax required to be shown on the return. Sec. 6662 (d) (1) . It seems clear that Mr. Harari's understatement exceeds 10 percent of the tax required to be shown. However, because we have upheld the IRS' s determinations only in part and will therefore instruct the parties to recompute the defici ncy pursuant to Rule 155, we cannot tell, until they have done so, whether Mr . Harari's understatem nt also exceeded $5,000. In its notice of defic'iency, the IRS made net adjustments totaling $23,433, which yielded a tax deficiency of $7,101. We allow today additional deductions totaling $4, 987 . 78 (i. e . , a home of f ice deduction f or . $3, 30 0 of his rent-, additional parking and toll expense of $1,130, and addition .1 phone expense of $557.78) . If these. allowances do not have the result of reducing the tax deficiency to an amount below $5,000, then Mr. Harari' return refl cted a substantial understatement", and he would owe t·he accuracy-related penalty on the entire amount (absent a showing of 1 2 3 4 5 6 7 8 9 10 11. 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Heritage Reporting Corporation (202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 reasonable cause and good faith, discussed below) . 18 This remains No be seen. B. Negligence For purposes of section 6662, the term "negligence" includ s a failure to exercise ordinary and reasonable care in the preparation of a return. Sec. 1.6662-3(b) (1), Income Tax Regs. Negligence is defined as a lack of due care or failure to do what a reasonable and ordi arilý prudent person would do under the circumstarices . Neely v. Commissioner, 85 T.C. 934 (1985) . The term "disregard" includes any careless, reckless, or intentional disregard of the rules or regulations. Sec. 6662(c).· It also "includes any failure by the taxpayer to keep adequate books and records to substantiate items properly." 26 C . F . R . sec . 1. 6662 3 (b) (1) , Income. Tax Regs . By this s t andard, we f ind Mr . Harari' s underpayment to be largely négligent . For the adjustment s he ha s conceded (i . e . , cost of goods sold and the deduct on fdr a compùter), he offered at trial no substantiation f r the position he originally claimed on his return, and his position was therefore negligent If subst n ation existed at one time and he simply was unable to produce it at trial, then his failure to keep adequate records was negligent. Heritage Reporting Corporation (202) 62844888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 19 Similarly, his wholesale failure of proof as to gifts shows that his claim for that expense was negligent . He substantiated his payment of $13, 200 rent on his apartment, but he offered no justification for his grossly excessive original claim that 100 percent of it was deductible . hs to telephone expense, he originally claimed $ ,043 but at trial proffered substantiation of only $3,135.55 (i.e., he failed to substantiate $907), so that while we disallow $2,475.22 of what he claimed, we find that $907 of the disallowed deduction was negligent . However, the remainder of the disallowed telephone deduction (i . e . , $2, 475 . 22 - $90 7 = $1,568.22) and the entire disallowed portion of the parking and t ollä expense (i . e . , $2, 817 - $1690 = $1,127) looks different to us. We have explained that these amounts should be disallowed, but we do not find them negligent. .He id have substantiation for. these disallowed amounts, and we think that his failure to allocate properly between business and personal. use did not rise to the level of negligence. Thus, unless his understatement . was ''substantial" as discussed above, he will not e aôcuracy-related penalty on the portion of his understatement that was attributable to these dïsallowed ded ctions ($1,568.22 + $1,127 = Heritage Report ing Corporation (202) 628'4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 20 $2,695.22). C. Defenses A taxpayer who is otherwise liable for the accuracy-related peralty may avoid the liability if he successfully invokee one of three other provisions. Mr. Harari made no contention as to any such defense, but we briefly consider them nonetheless: . First, section 6662(d) (2) (B) provides that an understatement may be reduced where the taxpayer had substantial autEority for its treatment of any . item giving rise to the understatement. There is no authority that woulc warrant Mr. Harari's position on any of the disallowed deductions. Second, section 6662(d) (2) (B) provides that an understatement may. be reduced where the relevant facts affecting the item s treatment were adequately disclosed on his tax return and the taxpayer had a reasonable basis for its treatment of that item. Neither of these criteria is met here. Third, section 6664 (c) (1) provides ;that, if the taxpayer shows, first, that there.was reasonable cause for a portion of an underpayment and, second, that he acted in gocd faith with respect to such portion, then no accuracy-related penalty shall be imposed with respect to that portion. Whether the Heritage Reporting Corporation '202) 628-4888 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18. 19 20 21 22 23 24 25 21 taxpayer acted with reasonable cause and in good faith depends on the pertinent facts and circumstances, including his efforts to assess his .proper tax liability, his knowledge and experience, and the extent to which he relied on the advice of a tax professional. 26 C.F.R sec. 1.6664-4(b) (1), Income Tax Regs. As a witn ss, Mr. Harari seemed candid and forthright, and we assume that he filed his return "in good faith"; but he made no showing of "reasonable cause" for the erroneous deductions that he claimed. Mr . Harari had the a sistance of a return preparer in t preparing his tax return, but alleges no reliance on any .advice. He put on no evidence as to. any attempts to comply with the tax laws and pay his proper tax. He seems instead to have claimed deductions in accord with his subjective intuitions about what might be fair. r The IRS's notice of deficiency is upheld in part, to the extent shown above. So that the liability can be recálculated decision will be entered pursuant to Rule 155. This concludes the Court's oral Findings of Fact and Öpinion in his case . (Whereupon, at 9:04 a.m., the bench op1nlon in the above-entitled matter was concluded.) Heritage Reporting Corporation (202) 628-4888