TAX COURT OPINION

Case: Sandy Lee Rowe & Sylvia Marie Rowe
Docket Number: 7592-20
Judge: Buch
Opinion Type: bench
Filed: 06/23/2021
Pages: 14

SANDY LEE ROWE & SYLVIA MARIE ROWE, Petitioners v. Commissioner of Internal Revenue, Respondent United States Tax Court Washington, DC 20217 Docket Nos. 6432-20 7592-20. ) ) ) ) ) ) ) ) ) ) ) O R D 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 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 Las Vegas, Nevada, containing his oral findings of fact and opinion rendered at the remote trial session at which the case was heard. In accordance with the oral findings of fact and opinion, decisions will be entered for respondent as to the tax for 2017 and 2018, and for the petitioners as to the penalty for 2017. (Signed) Ronald L. Buch Judge Served 06/23/21 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 Ronald L. Buch May 21, 2021 Sandy Lee Rowe & Sylvia Marie Rowe v. Commissioner Docket Nos. 6432-20;7592-20 THE COURT: The following represents the Court's oral findings of fact and opinion. The 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 Practice and Procedure. Mr. and Mrs. Rowe claimed a significant loss from a travel business on their 2017 return. For 2018, the Rowes made a reporting error, but they intended to report a loss for that year, as well. The Commissioner disallowed a portion of the 2017 expenses that gave rise to the loss and disallowed the entire 2018 loss, both for lack of substantiation. At trial, the Rowes did not substantiate the 2018 expenses that gave rise to their loss, and they provided inadequate substantiation to support their claimed deductions for 2017. Accordingly, we will sustain the Commissioner's determinations for both 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 years. BACKGROUND 4 Until the late 1990s, Mr. and Mrs. Rowe both had careers in Los Angeles, California. While attending to their full-time careers, the Rowes took a course at Los Angeles Trade Tech on how to open a travel agency. Mr. Rowe began working for a travel agency until an earthquake destroyed the building that housed the agency in 1994. After the earthquake the Rowes operated their own business specializing in cruise travel. Mr. Rowe retired from his full-time job in 1999. But the Rowes have continued to run their travel business, which currently operates as Cruise Cruise Cruise Cruise (which we will simply refer to as Cruise). They work as independent agents through an office that services independent agents like them. The office receives a 10% commission for every cruise the Rowes sell; Cruise receives 30% of that amount (in effect, a 3% commission). When describing the size of his business, Mr. Rowe usually tells people that his business sells between $300,000 and $500,000 annually. Applying the commission rate Mr. Rowe described would result in revenue to the Rowes of $9,000 to $15,000 annually. The business generally runs at a loss. As Mr. Rowe described, "The income was secondary to us, because 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 we like to see people travel, family and other 5 acquaintances." He continued, "So it's not to make money; it's for the pleasure of inspiring people to travel." The Rowe's 2017 Tax Return and Substantiation On their 2017 individual tax return, the Rowes claimed a $58,058 loss on their Schedule C, Profit or Loss from Business. They listed a variety of expenses, but the bulk of the loss stemmed from a $53,738 deduction for travel expenses and a $2,480 deduction for meal and entertainment expenses. The Commissioner audited the Rowes' 2017 return and requested information to substantiate the claimed business expenses. In response, the Rowes provided a seven-page document. Each page lists one or two events for a total of nine entries, and the document appears to be an expense log. An example of one entry reads: "Cruise Seminar Embassy Suites Washington, DC October 7, 2017 to October 8, 2017 Airfare $630.40 Hotel $330.40 139 people attended Room rental entertainment and food $8,799.69 Open Bar $3,690.20 1 2 3 4 5 6 7 8 9 10 11 12 13 6 Meals $375.90 Dinner meet with clientts [sic]" Some of those entries are undated, and the Rowes did not provide receipts to support any of the listed expenses. When combined, four of the entries included room rental, entertainment, food, and open bar costs totaling over $43,000. Along with the expense log, the Rowes also provided the Commissioner with partial copies of documents haphazardly pieced together. Most of the pages include partial credit card statements, nearly all of which lack line entries showing purchases. To the extent the copies show purchases, the pieced together information is 14 incomplete. 15 16 Only one of the credit card entries roughly corresponds to an entry in the seven-page expense log. It 17 reads: 18 "Oct 9 Oct 9 Embassy Suites CNV CTR Washington 19 DC 640.60" 20 21 22 23 24 25 But this entry does not match the date listed as the Washington, DC trip on the expense log, nor does it correspond to any costs listed for that trip. A different credit card statement shows credit card charges on October 9, 10, and 12 from New Orleans, raising questions about the October 9 expenses in Washington, DC. This evidence 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 is unreliable. 7 In addition to their expense log and partial credit card statements and at the Commissioner's request, the Rowes prepared a Form 886-A, Schedule C-4--General Questionnaire and detailed their travel expenses on Form 886-A, Schedule C-7--Travel, Meals and Entertainment Expenses. The Schedule C-4 calls into question Mr. Rowe's testimony about how long he has been in the travel business. The Rowes' Schedule C-4 states that their travel business was established in 2010, long after the date he stated in his testimony. The Rowes reported deductions for travel, meal, and entertainment expenses incurred during nine trips on their Schedule C-7. For example, they reported $3,763 of lodging expenses and $690 of airfare costs for "Allure of the Seas, Ft. Lauderdale, FL." Mr. Rowe's description of the purpose of the trip is "escort group training." While this trip might be plausible, the Schedule C-7 raises more questions. The handwritten schedule lists this trip as occurring from July 24 through August 2, 2017. But the log shows that trip with the date of August 30, 2017. If we try to backup either of these entries with the pieced- together credit card statements, we find a July 30 entry for Allure of the Seas, but because of the manner that 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 this document was pieced together, no dollar amount is 8 shown. On March 5, 2020, the Commissioner issued a notice of deficiency to Mr. and Mrs. Rowe for 2017. In the notice, the Commissioner disallowed $2,480 of meal and entertainment expenses and $53,738 of travel expenses. The Commissioner also determined a section 6662 accuracy related penalty, however he conceded that penalty at trial. The Rowes' 2018 Tax Return On their 2018 individual income tax return, Mr. and Mrs. Rowe reported $126,753 of wage income and claimed a qualified business income deduction of $80,322. The record includes a draft Schedule C for 2018 that the Commissioner never accepted. That Schedule C shows income and expenses amounting to the $80,322 loss that the Rowes reported as the qualified business deduction on their 18 return. 19 20 21 22 23 24 25 The parties agree that the Rowes' original return contained reporting errors. The parties also agree that the Rowes wage income was in fact IRA distributions and that they should have reported their qualified business income deduction as a Schedule C loss. But the Commissioner disputes that they are entitled to that loss. On February 25, 2020, the Commissioner issued a 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 notice of deficiency to Mr. and Mrs. Rowe for 2018. In 9 that notice, the Commissioner recharacterized the wage income as IRA distributions. He also disallowed the qualified business income deduction. At trial, the parties stipulated to the documents the Rowes provided to the Commissioner during the exam. For 2017, this included the log, partial credit card statements, and the Schedules C-4 and C-7. For 2018, the record includes no such information. DISCUSSION As a general matter, the Commissioner's determinations in a notice of deficiency are presumed to be correct, and the taxpayer bears the burden of proving an error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Because deductions are a matter of legislative grace, the taxpayer bears the burden of proving his right to any claimed deductions. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992), Higbee v. Commissioner, 116 T.C. 438, 440 (2001). Whether an expenditure satisfies the requirements for deductibility is a question of fact. Cloud v. Commissioner, 97 T.C. 22 613, 618 (1991). 23 24 25 A taxpayer may shift the burden of proving the facts to the Commissioner by introducing credible evidence concerning their liability. Sec. 7491(a)(1). However, 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 the ability to shift the burden is conditioned on the 10 taxpayer's compliance with applicable substantiation and record-keeping requirements and his cooperation with reasonable requests by the Commissioner for "witnesses, information, documents, meetings, and interviews." Sec. 7491(a)(2)(A), (B). The Rowes do not allege, nor does the record support, that they are entitled to a shifting of the burden of proof. Section 162 permits taxpayers to deduct expenses paid or incurred during the taxable year in carrying on any trade or business. Sec. 162(a). For an expense to qualify for this deduction, a taxpayer must show that the expense was ordinary and necessary. Sec. 162(a). Ordinary means "normal, usual, or customary." Deputy v. du Pont, 308 U.S. 488, 495 (1940). Necessary means "appropriate and helpful." Welch v. Helvering, 290 U.S. 111, 113 (1933). For an expense to be necessary, it "must be reasonable in relation to its purpose. To the extent that an expense is unreasonable, it is not necessary." Boser v. Commissioner, 77 T.C. 1124, 1133 (1981). The Rowes failed to meet their burden to show that these expenses, if incurred, were reasonable in relation to their purpose. If we accept Mr. Rowe's revenue estimates for his business, the room rental, entertainment, food, and open bar costs from the 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 Washington, DC trip alone would eclipse the total annual 11 revenue in all but the best years of the business. These costs are not reasonable in relation to their purpose. Even if the costs were reasonable, they would not be allowable for 2017 and 2018, because the Rowes failed to adequately substantiate them. The taxpayer bears the burden of substantiating a claimed deduction. See Hradesky v. Commissioner, 65 T.C. 87, 89 (1975), aff'd per curiam 540 F.2d 821 (5th Cir. 1976). To meet this burden, the taxpayer must maintain sufficient records to establish the amount and purpose of the deduction. See sec. 6001; also sec. 1.6001-1(a), Income Tax Regs. The substantiation requirements are more stringent for certain categories of expenditures, such as travel, entertainment, and meal expenses. Sec. 274(d)(1); sec. 1.274-2(b)(1), Income Tax Regs. To substantiate these expenditures, the taxpayer must provide "adequate records" to determine: 1) the amount of the expense, 2) the time and place it was incurred, 3) the business purpose of the expense, and 4) the business relationship to the taxpayer of the person receiving the benefit. Sec. 274(d) (flush language). To meet this requirement the taxpayer must maintain an "account book, diary, log, statement of expense, trip sheets, or similar record" and 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 "documentary evidence, such as receipts, paid bills, or 12 similar evidence." Sec. 1.274-5T(c)(2)(i), Temporary Income Tax Regs.; sec. 1.274-5(c)(2)(iii), Income Tax Regs. If the Commissioner requests adequate records to substantiate an expense, the taxpayer must produce them. Martin v. Commissioner, T.C. Memo. 2016-189, at *10-11. As an alternative to meeting these stringent documentation standards, a taxpayer may substantiate expenses by providing other corroborating evidence, including the taxpayer's own statements. Sec. 274(d); sec. 1.274-5T(c)(3), Temporary Income Tax Regs. The Rowes did not provide sufficient documentation to substantiate their expenses. For 2017, their records are inconsistent and contradictory. For 2018, the Rowes did not provide any evidence to substantiate the expenses they deducted. Accordingly, we cannot sustain their deductions for either year. 18 Hobby Loss 19 20 21 22 23 24 25 During trial, Mr. Rowe testified that he runs his travel business for reasons other than profit. Losses resulting from activities undertaken for purposes other than generating profit, such as recreational activities and hobbies, are not deductible. Secs. 183(a), 67(b); sec. 1.183-2(a), Income Tax Regs. Mr. Rowe's statements suggest that the business losses may be non-deductible 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 hobby losses. However, the Commissioner did not raise 13 this issue in the notice of deficiency, pleadings, or pre- trial memorandum. In his closing, the Commissioner mentioned the nondeductibility of hobby losses in an apparent invitation for the Court to disallow the losses on those grounds. We will decline the Commissioner's invitation. Our Rules are designed to give the parties fair notice of the matters in controversy. Rule 31(a). To that end, the Commissioner is required to "advise the petitioner * * * fully of the nature of the defense" and provide a "specific admission or denial of each material allegation in the petition." Rule 36(b). The Commissioner may raise a new matter provided the taxpayer receives fair warning. See Pagel, Inc. v. Commissioner, 91 T.C. 200, 211-212 (1988), aff'd, 905 F.2d 1190 (8th Cir. 1990). If a previously unraised issue is tried "by express or implied consent" of the parties, we will treat it as though it had been raised in the pleadings. Rule 41(b)(1). To determine whether it is appropriate to apply the principle of implied consent, we consider whether sustaining the issue would result in unfair surprise or prejudice to the opposing party and limit the evidence that party might have otherwise introduced if the issue had been timely raised. See, e.g. 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 WB Acquisition, Inc. & Subs. v. Commissioner, T.C. Memo. 14 2011-36; Krist v. Commissioner, T.C. Memo. 2001-140; McGee v. Commissioner, T.C. Memo. 2000-308. Allowing the Commissioner to raise this issue for the first time post trial would constitute unfair surprise for the Rowes, particularly as pro se litigants. For Mr. Rowe to establish that his business is not subject to hobby loss rules would require different evidence than substantiating specific deductions. For example, determining whether an activity is a trade or business or a recreational pursuit might require evidence relating to profitability of years not before the Court. Sec. 1.183- 2(b)(6), Income Tax Regs. We also note that if we were to apply the hobby loss rule, it would result in an increased deficiency for 2017 and perhaps 2018. CONCLUSION To be deductible, business expenses must be ordinary and necessary and the taxpayer must substantiate the purpose and amount of each expense. The Rowes failed to establish that their meals and entertainment expenses were ordinary and necessary, and they failed to provide sufficient records to establish the deductibility of those expenses. Accordingly, decision will be entered for the Commissioner as to the tax for 2017 and 2018, and for the petitioners as to the penalty for 2017. 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 (Whereupon, at 11:20 a.m., the above-entitled 15 matter was concluded.)