t c memo united_states tax_court bruno and francesca tabbi petitioners v commissioner of internal revenue respondent docket no filed date gerald j carnago for petitioners dennis g driscoll for respondent memorandum findings_of_fact and opinion colvin judge respondent determined deficiencies in petitioners' federal_income_tax and additions to tax as follows additions to tax sec sec sec sec year deficiency a a a a b dollar_figure dollar_figure dollar_figure dollar_figure big_number -- -- big_number big_number big_number -- -- -- sec sec sec sec sec year b a b b b dollar_figure -- -- -- -- -- dollar_figure -- -- -- -- -- dollar_figure dollar_figure fifty percent of the interest due on dollar_figure sec_6653 for fifty percent of the interest due on dollar_figure after concessions the issues for decision are whether petitioners had unreported income of dollar_figure for dollar_figure for and dollar_figure for we hold that they did except as discussed below whether petitioners' unreported income is subject_to self-employment_tax for and we hold that it is except as conceded by respondent whether petitioners had unreported income of dollar_figure from the sale of their residence in we hold that they did whether petitioners' gains and losses from the sale of real_property in and were capital or ordinary we hold that they were ordinary whether petitioners had unreported capital_gains of dollar_figure from the sale of their interest in bagnasco-tabbi funeral home we hold that they did whether petitioners had unreported interest_income of dollar_figure for dollar_figure for and dollar_figure for we hold that they did whether petitioners may deduct advertising rent office expenses utilities and telephone commissions supplies licenses and fees dues rental maintenance and insurance expenses in excess of the amounts allowed by respondent we hold that they may not except as discussed below whether petitioners may carry forward a net_operating_loss of dollar_figure for we hold that they may not whether petitioner bruno tabbi is liable for the addition_to_tax for fraud under sec_6653 for and the fraud_penalty under sec_6663 for we hold that he is not whether petitioners are liable for additions to tax for a negligence under sec_6653 for and in the alternative to fraud for and the negligence_penalty under sec_6662 for b substantial_understatement_of_income_tax under sec_6661 for and and c late filing under sec_6651 for and in the alternative to fraud for we hold that they are liable for the additions to tax for negligence and substantial_understatement of tax for and the negligence_penalty for and the addition_to_tax for late filing for but that they are not liable for the addition_to_tax for late filing for whether petitioner francesca tabbi qualifies as an innocent spouse under sec_6013 we hold that she does not respondent concedes that petitioners are not liable for the addition_to_tax for fraud for and that petitioner francesca tabbi is not liable for the addition_to_tax for fraud for and references to petitioner husband are to bruno tabbi references to petitioner wife are to francesca or frances p tabbi section references are to the internal_revenue_code in effect for the years in issue rule references are to the tax_court rules_of_practice and procedure findings_of_fact some of the facts have been stipulated and are so found petitioners petitioners resided in clinton township michigan when they filed the petition petitioner wife worked as a secretary for her father salvatore lochirco lochirco at oliver homes inc oliver homes from to she did not work in petitioner husband's office and was not involved in his real_estate business petitioners had two children born before petitioners' son antonino was born in date with severe heart problems that led to his death in date petitioner wife spent most of the time after antonino was born caring for him and petitioners' two older children antonino was in the hospital frequently from date to date he had heart surgery in date and was hospitalized until late july petitioners were at the hospital with him continuously during these months antonino died days after he was discharged from the hospital petitioner husband's real_estate activities petitioner husband was a real_estate broker from to petitioners owned rental properties and investment real_estate in and petitioner husband was also in the business of buying and selling homes through his company americana investment corp americana because of changes in the detroit real_estate market in and petitioner husband could not sell as many houses in the years in issue as he had previously petitioner husband rented the houses until he could sell them and made repairs that were necessary to keep the houses in saleable condition petitioner husband conducted his real_estate activities through several business entities his business operations were disorganized he did not keep good records he intermingled assets and funds between his many business and personal bank accounts and he was thinly capitalized and overextended in credit because of his disorganization and lack of records he did not know and could not accurately reconstruct his income for the years in issue a in petitioner husband owned and was president of americana a michigan corporation that used investments to buy certificates of deposit cd's and then borrow against them he used the loan proceeds to buy sell and manage residential real_estate for investors many of americana's investors were friends and relatives of petitioner husband's family americana promised its investors a high rate ie percent of return it reported gross_sales of homes of dollar_figure and a dollar_figure loss for americana went out of business in in petitioner husband was a real_estate broker and operated rental properties for b r tabbi inc d b a earl kiem realty bell shores realty inc a michigan corporation brt mortgage co brt and canta building co canta petitioner husband was president of earl kiem realty he sold dollar_figure of real_property in b petitioner husband was a real_estate broker and operated rental properties for canta in he sold dollar_figure of real_property in c petitioner husband was a real_estate broker and operated rental properties in for canta premiere financial services premiere homeowners direct co homeowners and la terra real_estate la terra d b a soldi real_estate co soldi la terra was a michigan corporation owned by petitioner husband anthony duronio and joseph ancona petitioner husband owned one-third of la terra's stock la terra's shareholders and nonshareholder employees earned commissions from real_estate sales each salesperson contributed his or her share of expenses to la terra laterra's shareholders did not share equally in la terra's income and were not paid for being shareholders or officers la terra leased an office pincite0 van dyke sterling heights michigan on date petitioner husband incorporated premiere in nevada petitioner husband was the president of premiere on date petitioner husband incorporated canta in delaware petitioner husband was the president and petitioner wife was the secretary of canta petitioner husband sold dollar_figure of real_property in petitioner husband's bankruptcy on date petitioner husband filed for bankruptcy under chapter of the u s bankruptcy code in the u s bankruptcy court for the eastern district of michigan petitioner husband was granted a discharge under chapter on date petitioner husband's creditors pressed him for payment both before and after his discharge_in_bankruptcy americana before and during the years in issue petitioner husband transferred real_estate without consideration from petitioners to americana and from americana to petitioners during the years in issue petitioner husband deposited rental and installment_sales income from real_estate owned by americana to the earl kiem bell shores escrow account which petitioner husband controlled in petitioner husband transferred dollar_figure to americana's account petitioner husband liquidated americana in at that time he distributed its assets including financial investments and real_estate to himself and assumed its liabilities in petitioners paid various expenses relating to real_estate owned by petitioners and or americana from to petitioner husband obtained second mortgages on and rented real properties owned by petitioners and or americana at the same time he sold parcels of real_estate that were owned by petitioners and or americana in and he sold five houses in three in and two in also in those years petitioner husband used funds invested in americana to buy real_estate for americana petitioners earned interest of dollar_figure in dollar_figure in and dollar_figure in petitioners' bank accounts and investments a overview petitioner husband used the following personal and corporate bank accounts in the years at issue account bank frances p tabbi comerica x x frances p tabbi comerica x x frances p tabbi comerica x frances p tabbi or comerica x bruno tabbi itf bruno tabbi jr frances tabbi itf bruno tabbi jr paulette m tabbi comerica x bruno tabbi first state bank x canta manufacturers x x x canta wilmington trust x a delaware bank earl kiem realty first state bank x escrow brt first state bank x americana first state bank x premiere first interstate x a nevada bank homeowners manufacturers x b petitioner husband signed the signature card for the brt account he was listed as president and petitioner wife was listed as secretary of americana on its account petitioner husband signed petitioner wife's name on the signature card for the americana account petitioner husband used his social_security_number on the brt and canta business accounts for the years in issue petitioner husband deposited the following amounts in account type of income amount petitioner wife commissions dollar_figure petitioner wife other dollar_figure brt commissions dollar_figure brt refunds dollar_figure brt other dollar_figure canta commissions dollar_figure canta refunds dollar_figure canta other dollar_figure americana other1 dollar_figure petitioner husband had dollar_figure of commissions dollar_figure of refund income and dollar_figure of other income in petitioners reported income of dollar_figure from petitioner husband's real_estate activities for petitioner husband deposited the following amounts in the earl kiem bell shores escrow account in americana deposited in its checking account dollar_figure reflecting the net_proceeds from cashing cd's of dollar_figure and replacing them with cd's of dollar_figure petitioner husband deposited dollar_figure in commissions however we subtracted dollar_figure of land_contract payments and dollar_figure of transfers between bank accounts in figuring his commission income for petitioner husband received refunds of certain business_expenses such as insurance and utilities that he deposited in his various accounts amount dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure total dollar_figure source of funds americana sale of real_estate owned by petitioners and or americana petitioner husband's income installment income from sale of real_estate schedule e rental income petitioners' bank accounts petitioner husband used dollar_figure from the escrow account in to pay petitioners' personal expenses and expenses relating to various real properties owned by petitioners and or americana petitioner husband made several deposits of currency of more than dollar_figure in petitioner husband deposited income he earned in and in bank accounts in petitioner wife's name she used these bank accounts to pay personal and household expenses c petitioner husband earned commissions of dollar_figure in from the sale of two residences in rochester michigan petitioner husband cashed the two commission checks at the east side market and deposited the cash petitioner husband made several other large ie more than dollar_figure deposits of currency in petitioner husband deposited the following amounts in account type of income amount petitioner wife commissions petitioner wife other dollar_figure canta commissions dollar_figure canta refunds dollar_figure dollar_figure canta other dollar_figure unknown commissions dollar_figure petitioner husband had real_estate commissions of dollar_figure refunds of dollar_figure and other income of dollar_figure in petitioners reported income of dollar_figure from petitioner husband's real_estate activities for d petitioner husband deposited his real_estate commissions in the bank accounts of canta premiere and homeowners he routinely transferred funds between the canta and premiere corporate accounts and the canta and homeowners noncorporate accounts in petitioner husband routinely used funds from the canta and premiere corporate accounts to pay petitioners' personal living_expenses petitioner husband deposited dollar_figure of soldi's commission checks from various title companies in accounts which he controlled soldi had not recorded those payments on its books petitioner husband deposited the following amounts in account type of income amount canta commissions dollar_figure4 canta other dollar_figure premiere commissions big_number this includes dollar_figure of soldi's funds petitioner husband deposited in canta's manufacturers account this includes dollar_figure of soldi's funds petitioner husband deposited in the premiere account canta ii commissions big_number canta ii refunds dollar_figure homeowners commissions dollar_figure petitioner husband deposited no commission checks in petitioner wife's accounts in however he or one of the other soldi shareholders wrote checks to petitioner wife on soldi's bank account totaling dollar_figure in petitioner husband had real_estate commissions of dollar_figure including dollar_figure of soldi's funds which petitioner husband deposited in accounts which he controlled refunds of dollar_figure and other income of dollar_figure in petitioners reported that they had income of dollar_figure from petitioner husband's real_estate activities for petitioner husband's payments to clients and investors on date petitioner husband was the agent for christoforo and jacqueline mazzola at a real_estate closing on jo-ed sterling heights michigan as their agent he received dollar_figure at the closing petitioner husband deposited the dollar_figure in americana's bank account in petitioner husband borrowed dollar_figure from his parents richard and elvera tabbi to pay the mazzolas he paid the mazzolas or olympia homes on the mazzolas' behalf dollar_figure from the earl kiem realty bell shores escrow account in and dollar_figure from canta in this includes dollar_figure of soldi's funds petitioner husband deposited in canta's wilmington trust account petitioner husband reimbursed investors in americana for their investments in and he paid them dollar_figure in dollar_figure in and dollar_figure in petitioners refunded a deposit of dollar_figure to two former clients robert and charlene graham which they paid for the sale of a home pincite1 lincoln east detroit michigan on date petitioner husband borrowed dollar_figure from comerica bank to pay investors and business_expenses in date petitioner husband borrowed dollar_figure from his parents to pay investors and business_expenses the bagnasco-tabbi funeral home petitioner husband owned an interest in the madison funeral home corp which operated the bagnasco-tabbi funeral home in he sold his interest in for funeral certificates worth about dollar_figure each and months of health insurance worth dollar_figure petitioners' residence oliver homes a michigan corporation wholly owned by lochirco bought a lot pincite tanglewood rochester hills michigan for dollar_figure from biltmore properties on date on date oliver homes conveyed the lot to petitioner wife petitioner wife did not pay for the lot on date petitioner wife conveyed the lot for no charge to oliver homes and oliver homes built a house on the lot oliver homes then sold the house to petitioner wife for dollar_figure petitioners lived in the tanglewood home in and petitioners spent dollar_figure to improve that home while petitioner wife owned it on date petitioner wife sold it for dollar_figure petitioner wife had sales expenses of dollar_figure her cost_basis in the house was dollar_figure on date petitioner wife bought a lot pincite1 alden clinton township michigan for dollar_figure canta built a residence on this lot in petitioner wife bought the residence on date for dollar_figure petitioners' returns h_r block prepared petitioners' and returns petitioner husband gave h_r block various documents to prepare those returns for the schedule c he gave h_r block only his real_estate commission receipts totaling dollar_figure as shown on a form_1099 he did not give them records of commission checks that he cashed before depositing records of corporate payment of petitioners' personal expenses or records of commissions petitioner husband received that were payable to another entity petitioners did not review the returns before signing them they did not claim all of their exemptions for gerald carnago of carnago neddermeyer bringard prepared petitioners' return petitioners filed their returns for on date for on date and for on date petitioner husband did not keep books_and_records other than checks for his businesses from to he used accountants to keep his books balance his checking accounts and prepare returns from to he could not afford to use accountants after because his business declined petitioners reported on their and returns that they owned several real properties that americana formerly owned nashville mayfield and whittier respondent's examination respondent's revenue agents reconstructed petitioners' income for and using the bank_deposits plus expenditures method revenue_agent martin interviewed petitioner husband on may and date and on date petitioner husband cooperated with revenue_agent martin and revenue_agent andrews' investigation he gave the agents his checks which were his only records of the transactions he did not make misleading statements to or give misleading documents to respondent's agents the revenue agents identified all bank accounts for which petitioners had signatory authority during the years in issue and obtained signature cards monthly statements canceled checks deposits slips and deposit items for these accounts the agents analyzed the deposits made to these accounts and excluded all deposits that the agents believed were nontaxable including transfers between accounts the agents also obtained other documents such as real_estate closing statements to identify income from real_estate commissions rents refunds and other sources the agents concluded that petitioners had income in from petitioner husband's use of the earl kiem bell shores escrow account to pay petitioners' personal living_expenses petitioners' unreported income petitioners had unreported income of dollar_figure in dollar_figure in and dollar_figure in petitioners had gains from real_estate sales of dollar_figure for and losses of dollar_figure for and dollar_figure for they had net gains of dollar_figure for and net losses of dollar_figure for and dollar_figure for petitioners underreported their capital_loss by dollar_figure in and overreported capital_gain by dollar_figure in they had a net_loss of dollar_figure in and a net gain of dollar_figure in excluding capital_gain from the sale of their interests in the bagnasco-tabbi funeral home and americana opinion respondent's use of the bank_deposits method respondent used the bank_deposits plus expenditures method to determine petitioner's income for the years in issue if a respondent determined petitioners' income from the escrow account by computing disbursements as income less any funds petitioner husband deposited in the account taxpayer does not maintain adequate books_and_records respondent may reconstruct a taxpayer's income by any reasonable method which clearly reflects income sec_446 348_us_121 the bank_deposits method has long been approved by the courts as a method for computing income 64_tc_651 affd 566_f2d_2 6th cir bank_deposits are prima facie evidence of income 87_tc_74 estate of mason v commissioner supra pincite respondent's determination is presumed to be correct and petitioners bear the burden of proving otherwise rule a 290_us_111 petitioners must overcome the presumption as to each item of unreported income in respondent's deficiency determination 391_f2d_727 4th cir affg in part revg in part on other grounds tcmemo_1965_246 petitioners argue that respondent erred in including in their income for dollar_figure from americana's bank account dollar_figure from petitioner husband's use of the earl kiem escrow respondent concedes that petitioners are not liable for tax on other income items of dollar_figure for and dollar_figure for respondent calculated that petitioners had taxable_income of dollar_figure from their personal_use of funds in the earl kiem escrow account as follows continued account dollar_figure of refunds received by petitioner husband and dollar_figure of other income petitioners contend that respondent improperly reallocated income from americana to petitioners in disregard of sec_482 by claiming that americana was the alter ego of petitioner husband similarly petitioners argue that respondent improperly continued checks written on escrow account checks for personal expenses and real_estate checks to for benefit of mazzolas checks to charlene graham total checks petitioners' basis in account americana funds americana funds deposited to account payments to for mazzolas petitioners' funds installment income from real_estate sales rental income deposited to account transfers income from real_estate sales funds from other sources dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure total dollar_figure funds for petitioners' benefit rental income deposited to account checks written for petitioners' benefit total taxable_income from account funds for petitioners' benefit petitioners' basis in account dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure dollar_figure reallocated income from the earl kiem escrow account to petitioners under sec_482 however respondent did not reallocate income to petitioners from americana or the earl kiem escrow account under sec_482 respondent argues that petitioners are taxable on americana's income because petitioner husband improperly converted americana's assets to his control and intermingled his financial affairs with those of americana such that americana became his alter ego we disagree respondent cited no authority for us to apply the alter ego theory in these circumstances we do not apply an alter ego theory to reallocate income from americana to petitioners because americana engaged in bona_fide business activities and was a separate taxable entity 233_f2d_289 2d cir affg 24_tc_1 150_f2d_334 2d cir income from property taxed to stockholders rather than the corporation only if the corporation is a dummy or sham or is used for tax_avoidance purposes as discussed below infra par petitioner husband did not fraudulently divert corporate funds from americana cf 476_f2d_502 10th cir affg in part and revg and remanding in part tcmemo_1971_194 moore v commissioner tcmemo_1977_275 affd 619_f2d_619 6th cir corporation's dominant shareholder fraudulently diverted corporate funds for personal_use and so controlled the corporation that the corporate entity was destroyed and the corporation became the individual's alter ego thus we do not include dollar_figure from americana's account in petitioners' income for petitioners contend that respondent must establish that americana and the earl kiem escrow account had sufficient earnings_and_profits before respondent attributes income ie constructive dividends to petitioners we disagree petitioner husband controlled the deposits in the earl kiem escrow account and used those funds to pay petitioners' personal expenses and petitioners' real_property expenses when a corporation pays a nondeductible personal_expense of its sole shareholder or permits a shareholder to use corporate property for a personal purpose the shareholder receives a constructive_dividend to the extent the corporation's earnings_and_profits provide personal benefit to the shareholder sec_301 sec_316 85_tc_332 60_tc_728 petitioners bear the burden of proving that americana and the earl kiem escrow account had insufficient earnings_and_profits to support the constructive_dividend treatment 958_f2d_684 ndollar_figure 6th cir affg and remanding tcmemo_1987_594 524_f2d_1076 2d cir 89_tc_1280 petitioners have not carried their burden petitioners argue that for respondent erred in reconstructing their income and in including in income refunds of dollar_figure and other income of dollar_figure for petitioners argue that respondent erred in including in income refunds from lucido insurance agency of dollar_figure and as other income a check from michael larco for dollar_figure because it was a loan repayment petitioners have failed to prove that the disputed items for and were nontaxable refunds petitioner husband received are includable in petitioners' income because they were refunds for various items such as insurance and utilities that petitioner husband deducted as business_expenses petitioners have not proved that cash deposits they made several of which exceeded dollar_figure were from a nontaxable source petitioners did not show that the payment from larco was repayment of a loan petitioners have failed to prove that respondent erred by including in income for petitioners' use of the earl kiem escrow account to pay personal expenses and their real_property expenses of dollar_figure sec_301 falsetti v commissioner supra henry schwartz corp v commissioner supra however as stated above we do not treat funds deposited to americana's account as income taxable to petitioners we sustain respondent's calculation of petitioners' unreported income for and except for the inclusion of the americana funds in petitioners incorrectly omitted installment_sales of dollar_figure from their calculation of their income for self-employment taxes respondent determined that petitioners are liable for self- employment_taxes under sec_1401 for and sec_1401 imposes a tax on a taxpayer's self-employment_income self-employment_income includes the net_earnings_from_self-employment derived by an individual during the taxable_year sec_1402 net_earnings_from_self-employment income means gross_income less certain deductions derived by an individual from any trade_or_business carried on by such individual sec_1402 respondent concedes that petitioners are not liable for self-employment_tax for on dollar_figure attributed to them from their personal_use of earl kiem bell shores escrow account funds and dollar_figure from americana's bank account petitioners bear the burden of proving that they are not liable for the taxes imposed by sec_1401 rule a petitioners concede that they are liable for self-employment_tax on their real_estate income less business deductions they argue however that they are not liable for self-employment_tax on other_amounts on the theory that they did not receive those amounts or if received that those amounts were nontaxable gifts or loan repayments petitioners also argue that petitioner husband is not liable for self-employment_tax on the income he earned as a real_estate dealer selling and renting houses he held_for_sale primarily to customers sec_1402 we held above that petitioners failed to prove that they did not have unreported income in the amounts asserted by respondent they have not proven that they did not receive that income nor have they proven that it is not subject_to self-employment_tax petitioner husband received refunds for items such as insurance and utilities that he deducted as business_expenses the refunds are includable in petitioners' income and are subject_to self-employment_tax an individual who is engaged in the business of selling real_estate to customers may be classified as a real_estate dealer sec_1_1402_a_-4 income_tax regs rentals from real_estate and the related deductions are excluded from net_earnings subject_to self-employment_tax unless the rentals are received in the course of a taxpayer's trade_or_business as a real_estate dealer sec_1402 94_tc_542 sec_1_1402_a_-4 income_tax regs whether property is held by a taxpayer for investment or for sale to customers in the ordinary_course_of_his_trade_or_business is a question of fact 89_tc_467 78_tc_623 as discussed below we hold that petitioner husband was a dealer in real_estate thus the rentals are subject_to self-employment_tax sec_1402 512_f2d_882 9th cir petitioners have failed to prove that they are not liable for self-employment_tax except as conceded by respondent unreported income from the sale of petitioners' residence the parties dispute the basis of the lot oliver homes gave to petitioner wife respondent contends that the lot has a zero basis petitioners contend that the basis of the lot is dollar_figure which was the cost of the lot to oliver homes taxpayers bear the burden of proving their basis in the lot rule a a taxpayer who acquires property by gift takes a basis in the property equal to the lesser_of the donor's basis or the fair_market_value sec_1015 respondent argues that petitioner wife had no basis in the lot because her father lochirco misappropriated it from oliver homes respondent argues that because transactions within a family group are subject_to special scrutiny 19_tc_78 and because lochirco was petitioner wife's father his failure to pay oliver homes for the lot before oliver homes conveyed it to his daughter should be treated as a constructive_dividend to him followed by a gift of the lot from him to her respondent asserts that petitioners did not show that lochirco recognized a constructive_dividend on the transfer of the lot and that therefore he had no basis in the lot when oliver homes conveyed it to petitioner wife 82_f2d_141 10th cir 68_f2d_640 1st cir affg 27_bta_360 respondent contends that under sec_1015 petitioner wife had no basis in the lot petitioners argue that under sec_301 a distribution to lochirco was taxable to him at the lot's fair_market_value revenue_agent rizzardi used dollar_figure as lochirco's basis for the lot and concluded that lochirco realized a constructive_dividend because oliver homes built petitioners' home on the lot petitioners contend that petitioner wife's basis in the lot was the amount oliver homes paid for it namely dollar_figure or in the alternative the amount accepted by agent rizzardi in his audit of the lochircos dollar_figure petitioners argue that their gain on the sale of their home should be reduced accordingly petitioners have not proven that lochirco realized a constructive_dividend when oliver homes distributed the lot to him see 577_f2d_1206 5th cir 298_f2d_562 9th cir affg tcmemo_1960_276 88_tc_63 affd per curiam 894_f2d_1072 9th cir also petitioners have not established the fair_market_value of the lot when oliver homes distributed it to lochirco sec_301 we hold that petitioner wife's basis in the lot was zero capital or ordinary_income and loss petitioners argue that the character of the gains and losses from petitioner husband's sale of real_estate in the years at issue was ordinary and not capital because he held the real_estate primarily_for_sale_to_customers in the ordinary course of business sec_1221 615_f2d_171 5th cir 526_f2d_409 5th cir sec_1221 excludes from capital_asset classification-- stock_in_trade of the taxpayer or other_property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable_year or property held by the taxpayer primarily_for_sale_to_customers in the ordinary_course_of_his_trade_or_business the function of sec_1221 is to differentiate between 'profits and losses arising from the everyday operation of a business' and 'the realization of appreciation in value accrued over a substantial period of time' 383_us_569 primarily means principally or of first importance malat v riddell supra whether property is held by a taxpayer primarily_for_sale_to_customers in the ordinary course of business is a question of fact 78_tc_234 courts consider numerous factors in deciding this issue and no one factor is controlling biedenharn realty co v united_states supra pincite petitioner bears the burden of proving that his property was not so held rule a 290_us_111 the following factors indicate that petitioner husband held the houses primarily_for_sale_to_customers in the ordinary course of business a the frequency and regularity of sales b the substantiality of sales c the nature and extent of the taxpayer's business d the purpose for which the taxpayer acquired and held the property before sale e the extent of the taxpayer's sales efforts by advertising or otherwise and f the extent of improvements to the property made by the taxpayer 705_f2d_1418 5th cir 417_f2d_905 5th cir 227_f2d_265 5th cir revg tcmemo_1954_177 223_f2d_709 5th cir revg 22_tc_533 97_tc_308 affd without published opinion 21_f3d_427 6th cir before the years at issue petitioner husband sold properties regularly and frequently for example he sold of the properties he acquired personally or from americana in earlier years petitioner husband actively advertised the houses for sale and made substantial efforts to sell them see norris v commissioner tcmemo_1986_151 taxpayer's extensive solicitation and advertising efforts and use of time and energy for real_estate pursuits show that real_estate was not held for investment petitioner husband made necessary repairs to keep the houses in saleable condition see norris v commissioner supra these factors suggest that petitioner husband held these houses for sale to customers because of the downturn in the detroit residential real_estate market in petitioner husband did not sell as many houses he sold five houses for dollar_figure in three for dollar_figure in and two for dollar_figure in to cut costs he rented properties that he did not sell immediately the rents paid his carrying costs such as mortgage payments utilities and property taxes cf baris v commissioner tcmemo_1965_ gain on sale of rental property_held_for_sale to customers taxed as ordinary_income rental income deemed incidental under these circumstances we do not believe the infrequency of petitioner husband's sales shows that he held the property for investment rather than for sale suburban realty co v united_states supra pincite biedenharn realty co v united_states supra pincite united_states v winthrop supra pincite we hold that petitioner husband held the houses for sale to customers petitioners' gains and losses from other investments petitioners underreported their capital_loss by dollar_figure for a net_loss of dollar_figure in and overreported capital_gain by dollar_figure for a net gain of dollar_figure in excluding capital_gain from the sale of their interests in the bagnasco-tabbi funeral home and americana petitioners concede that they had capital_gain of dollar_figure in on their receipt of months of medical insurance coverage for their interest in bagnasco-tabbi funeral home petitioners argue that they had a dollar_figure ordinary_loss and a dollar_figure capital_loss in from their investment in americana in the alternative they argue that they had a dollar_figure capital_loss in gain_or_loss upon the disposition of an asset is computed by comparing the amount received with the taxpayer's basis in the asset sec_1001 sec_1011 petitioners failed to prove their basis in americana petitioners contend that their total investment in americana was dollar_figure dollar_figure that petitioner husband deposited in americana's account plus dollar_figure paid for capital stock dollar_figure loaned to americana and dollar_figure for amounts petitioner husband paid the mazzolas minus dollar_figure credited by respondent for petitioners' basis in americana for a net investment of dollar_figure there is no evidence to support petitioners' position eg no canceled checks their only evidence of their investment in the corporation was a listing of dollar_figure in capital stock and loans from stockholders of dollar_figure on americana's return and dollar_figure on its return this evidence is not sufficient to substantiate their basis in americana cf 71_tc_633 7_tc_245 affd 175_f2d_500 2d cir petitioners claim that they may deduct business_interest of dollar_figure for payments to the mazzolas and americana's net_operating_loss of dollar_figure for they claim dollar_figure as a capital_loss in we disagree petitioners are not entitled to basis in americana for petitioner husband's deposit of dollar_figure into its account because petitioner husband did not prove that this was a true investment of funds in americana instead it was an instance of petitioner husband's moving funds between accounts petitioners did not offer any evidence showing that the dollar_figure petitioner husband paid to the mazzolas was interest also petitioners have not established the value of the assets they received from americana when it liquidated petitioners have not proven the amount of their basis in americana or that they may deduct the business_interest or net_operating_loss in the amounts claimed thus petitioners may not deduct a capital or ordinary_loss upon americana's liquidation unreported interest_income gross_income means all income from whatever source derived including dividends and interest sec_61 petitioners argue that respondent erred in attributing interest_income from americana's bank account in and to petitioners they contend that interest earned on americana's account went directly into the account and was not used by petitioners petitioners argue that a withdrawal of funds from a closely_held_corporation is a dividend to the recipient-shareholder to the extent of the corporation's earnings see halpern v commissioner tcmemo_1982_31 controlling shareholder who diverts income from corporation receives taxable dividend to the extent of the corporate earnings_and_profits petitioners argue that americana had no earnings or retained earnings in or and that therefore the interest is not income to them petitioners' contention that respondent must show that americana had sufficient earnings_and_profits to reallocate interest_income to petitioners is erroneous petitioner husband acquired ownership of americana's assets when it liquidated and went out of business in the interest earned during and on assets in the bank account that formerly belonged to americana is therefore taxable to petitioner husband we sustain respondent's determination deductions a taxpayer may deduct ordinary and necessary expenses paid_or_incurred during the taxable_year in carrying_on_a_trade_or_business sec_162 personal living_expenses generally are not deductible sec_262 deductions are a matter of legislative grace and taxpayers bear the burden of proving that they are entitled to any deductions claimed on their returns rule a 308_us_488 292_us_435 290_us_111 petitioners claimed schedules a c and e deductions for each of the years in issue respondent disallowed some of these deductions because the earl kiem bell shores escrow account rather than petitioners paid the expenses respondent disallowed others because petitioners failed to substantiate that the expenses had a business purposedollar_figure petitioners argue that they substantiated their business deductions with canceled checks and through petitioner husband's testimony about the purpose of the checks petitioners contend that the legal and professional fees they paid in are deductible on schedule c not schedule a as determined by respondent petitioner husband spent dollar_figure in legal fees relating to his bankruptcy resulting from his and americana's business failure petitioners argue that the legal fees are a schedule c deduction under the origin of the claim doctrine 372_us_39 68_tc_294 in dowd v commissioner supra we relied on the origin of the claim doctrine in deciding that business_expenses of a bankrupt taxpayer were deductible under sec_162 since respondent concedes that petitioners may deduct for advertising expenses of dollar_figure office expenses of dollar_figure licenses and fees of dollar_figure dues of dollar_figure rental maintenance of dollar_figure and insurance expenses of dollar_figure for office expenses of dollar_figure rental maintenance of dollar_figure rental insurance of dollar_figure and schedule c rental expenses of dollar_figure and for advertising of dollar_figure and rental insurance of dollar_figure respondent also concedes that petitioners may deduct a charitable_contribution of dollar_figure to the salvation army for petitioner husband's business failure with americana caused his bankruptcy legal fees paid to file his bankruptcy petition originated with his business we hold that petitioners may deduct on schedule c legal fees of dollar_figure caused by his business failure dowd v commissioner supra pincite petitioners argue that their payments to americana investors of dollar_figure in dollar_figure in and dollar_figure in are deductible on schedule c as ordinary and necessary business_expenses respondent argues that the payments to the americana investors are deductible on schedule a because americana's activities were not a trade_or_business of petitioner husband many of the investors were friends of petitioner husband's family respondent argues that petitioner husband's claim that he paid investors to protect his own business reputation are self-serving respondent argues that no evidence suggests that petitioner husband's financial problems with these investors would affect his reputation as a real_estate broker we disagree we find that he carried his burden_of_proof in this respect petitioners may deduct on schedule c the payments to the americana investors petitioners paid income_tax return preparers' fees of dollar_figure to h_r block in petitioner husband argues that since he was a sole_proprietor he may deduct the return preparation fees on schedule c not on schedule a we disagree tax preparation fees generally are deductible as a schedule a expense sec_212 sec_1_212-1 income_tax regs sec_1 1t a iii b temporary income_tax regs fed reg date petitioners have not provided evidence that would enable us to find or estimate any portion of the fees that is allocable to petitioner husband's business we conclude that petitioners failed to prove that they may deduct advertising rent office expenses utilities and telephone commissions supplies licenses and fees dues rental maintenance and insurance expenses in excess of the amounts allowed by respondent petitioners' evidence that they could deduct these expenses consisted of the canceled checks and petitioner husband's testimony petitioner husband did not explain the nature or necessity of some of the advertising and rental property repairs expenses or the business_purpose for these expenses he did not show that some insurance expenses had a business rather than a personal purpose many of the disputed checks were payable to cash or to payees related to petitioners he did not show whether some of the license fees rental maintenance and insurance expenses related to schedule c or schedule e activities petitioners also failed to meet the sec_274 substantiation requirements for his club_dues for club terrasini and the italian american cultural society and for promotional expenses for watches bearing the soldi logo except as stated in this opinion petitioners have failed to convince us that they may deduct any of the expenses in excess of those allowed by respondent net_operating_loss carryforward sec_172 allows a taxpayer to deduct net operating losses respondent determined that petitioners did not have a net_operating_loss carryforward from to because respondent's adjustments to petitioner husband's schedule c activity eliminated the claimed net_operating_loss petitioners attached to their brief appendix c entitled loss carry forward which purports to be petitioners' calculation of their net_operating_loss for they did not include references to the record as required by rule e due to our conclusions about petitioners' unreported income business_expenses rent expenses and additional business deductions for we are not convinced that petitioners had a net_operating_loss for we sustain respondent's determination on this issue additions to tax for fraud under sec_6653 and penalty under sec_6663 a background respondent determined that petitioner husband but not petitioner wife is liable for the addition_to_tax for fraud under sec_6653 for and the fraud_penalty under sec_6663 for a taxpayer is liable for an addition_to_tax or penalty for fraud equal to percent of the part of the underpayment which is attributable to fraud sec_6653 sec_6663 respondent has the burden of proving fraud by clear_and_convincing evidence sec_7454 rule b first respondent must prove the existence of an underpayment 94_tc_654 respondent may not rely on petitioners' failure to carry the burden_of_proof as to the underlying deficiency id pincite 92_tc_661 second respondent must show that petitioner husband intended to evade taxes he believed to be owing by conduct intended to conceal mislead or otherwise prevent tax collection 398_f2d_1002 3d cir parks v commissioner supra pincite 80_tc_1111 b underpayment we conclude that respondent has clearly and convincingly proven that petitioner husband underreported tax for and c fraudulent intent respondent must prove by clear_and_convincing evidence that petitioner husband had fraudulent intent parks v commissioner supra pincite for purposes of sec_6653 fraud means actual intentional wrongdoing 118_f2d_308 5th cir revg 40_bta_424 ie the intentional commission of an act for the specific purpose of evading a tax believed to be owing 394_f2d_366 5th cir affg tcmemo_1966_81 fraud may be proven by circumstantial evidence because direct evidence of the taxpayer's intent is rarely available 79_tc_995 affd 748_f2d_331 6th cir respondent argues that the following badges_of_fraud are present in this case a pattern of unreported income failure to keep books_and_records concealment of income and false statements to revenue agents we disagree that the evidence is sufficient to clearly and convincingly show that petitioner husband fraudulently underreported income in and we recognize that he could not accurately reconstruct income for those years from his books_and_records but we are not persuaded that he underreported his income due to fraud rather than carelessness or negligence respondent alleges that petitioner husband did not have a bank account in his name respondent's allegation is not entirely correct petitioner husband had an account in his name at first state bank in also respondent points out that petitioner husband deposited his income in canta's and petitioner wife's bank accounts that in he cashed two commission checks totaling dollar_figure and that he gave his return preparer only the commission income documented by forms however we do not believe petitioner husband's use of those bank accounts was fraudulent he deposited all of his receipts including the two commission checks he cashed in in bank accounts several of which bore his social_security_number we do not think that he was trying to hide his income or ownership of the accounts respondent points out that petitioner husband did not keep books_and_records for his real_estate business in and however as stated above we do not believe that he intended to defraud instead we think he did not keep books_and_records other than his checks because he was disorganized and because he could not afford accountants see compton v commissioner tcmemo_1983_647 respondent points out that petitioner husband deposited checks from soldi in premiere's and canta's out-of-state bank accounts petitioner husband admitted that he routinely transferred funds between accounts he did this to create a float on these fundsdollar_figure it was not an attempt to hide his income respondent points out that petitioner husband used business bank accounts to pay personal expenses and that he deposited commission checks in the homeowners account rather than in a personal account in a float exists when checks that have been credited to the depositor's bank account have not yet been debited to the drawer's bank account this often permits the interest-free use of funds during the brief period before the checks are debited to the drawer's account black's law dictionary 6th ed respondent points out that petitioner husband deposited more than dollar_figure in checks payable to soldi in other accounts he controlled respondent argues that he tried to conceal commissions by making soldi commission checks payable to petitioner wife we disagree we do not think this was an attempt to conceal income because the soldi checks that petitioner husband wrote to petitioner wife were deposited to the local canta bank account that petitioner husband regularly used and on which he was the signator we do not believe that petitioner husband diverted checks from soldi to hide them from the government rather than depositing the checks to soldi's account he deposited commissions he had earned to accounts that he regularly used and on which he was the signator we think the fact that he left a record by depositing the checks is a factor that negates the inference that he was trying to conceal income from the government respondent argues that petitioner husband concealed information from his preparers we disagree petitioner husband did not intentionally conceal information from the return preparers he did not have records to give them to accurately prepare the returns we are not persuaded that his lack of records was due to fraud rather than negligence respondent argues that petitioner husband did not cooperate with respondent's agents and made false statements to a revenue_agent respondent claims that petitioner husband told the revenue_agent that he maintained separate bank accounts for personal and business activities we do not find that petitioner husband made false statements to a revenue_agent petitioner husband's business and banking activities were disorganized and he did not properly keep separate_accounts for business and personal activities we are persuaded that petitioner husband's statement while mistaken in part was not intentionally false or misleading respondent points out that petitioner husband wrote checks to americana investors and noted on the checks that they were commissions similarly respondent claims that petitioner husband falsified business_expenses by misrepresenting the purpose of the payments on the checks and on schedules he gave to respondent we disagree we think this is another example of petitioner husband's failure to keep records and the disorganized state of his business affairs we do not find that petitioner husband intentionally made false or misleading statements to respondent's agents or that he was uncooperative with respondent's agents respondent's counsel and petitioners' counsel worked hard to reconstruct petitioners' finances respondent contends that this shows the extent of petitioner husband's efforts to conceal his financial affairs we disagree we think it shows petitioners' belated cooperation with respondent's agents in attempting to get to the bottom of petitioner husband's finances while petitioners underreported some income and capital_loss we are not convinced that it was due to fraud it appears that the underreporting was due to careless bookkeeping and petitioners' difficult personal and financial circumstances which was negligent but not fraudulent we conclude that respondent has not proven by clear_and_convincing evidence that petitioner husband is liable for the addition_to_tax for fraud under sec_6653 for or the penalty for fraud under sec_6663 for additions to tax a late filing petitioners filed their and returns late a taxpayer is liable for an addition_to_tax of up to percent for failure to timely file a federal_income_tax return unless the taxpayer shows that the failure was due to reasonable_cause and not willful neglect sec_6651 petitioner bears the burden of proving that his failure_to_file a timely return is due to reasonable_cause and not willful neglect 469_us_241 84_tc_859 81_tc_806 affd without published opinion 767_f2d_931 9th cir to prove reasonable_cause a taxpayer must show that he exercised ordinary business care and prudence but nevertheless could not file the return when it was due 92_tc_899 sec_301_6651-1 proced admin regs petitioners argue that they had reasonable_cause for filing their return late because petitioner husband believed that he had no tax_liability for in view of his financial difficulties and bankruptcy they contend that they had reasonable_cause for filing their return late because their infant son antonino was gravely ill in was hospitalized and had heart surgery in date and died in date illness of a taxpayer or member of his or her immediate_family may be reasonable_cause for late filing if the taxpayer shows that he or she cannot file a timely return because of such illness 16_tc_893 hayes v commissioner tcmemo_1967_80 while incompetence mental illness alcoholism or other incapacity may excuse a taxpayer from late filing a taxpayer's selective inability to meet his tax obligations when he can conduct normal business activities does not excuse his late filing or failure_to_file kemmerer v commissioner tcmemo_1993_394 bloch v commissioner tcmemo_1992_1 bear v commissioner tcmemo_1992_690 affd without published opinion 19_f3d_26 9th cir fambrough v commissioner tcmemo_1990_104 petitioner husband had business and financial problems during the time petitioners should have filed their tax_return for however he continued to operate his real_estate business the fact that he actively engaged in real_estate activities throughout this period we believe shows that his financial difficulties did not prevent him from filing their tax_return on time we find that petitioners' failure to timely file the return was not due to reasonable_cause therefore we find that they are liable for the addition_to_tax under sec_6651 for respondent argues that despite petitioners' personal problems resulting from antonino's tragic illness and death petitioner husband was not ill and was able to carry on his business activities in we disagree petitioners' son had heart surgery in date around the time that their return was due to be filed he was hospitalized until late july petitioners were at the hospital with him continuously during these months petitioners' son died in date and they filed their return in date we are convinced by these facts that petitioners' late filing of their return was due to reasonable_cause and not willful neglect we hold that they are not liable for the addition_to_tax under sec_6651 for b negligence respondent determined that petitioners are liable for the addition_to_tax for negligence under sec_6653 and b for and under sec_6653 for and the negligence_penalty under sec_6662 for petitioners have the burden of proving that they were not negligent 85_tc_934 sec_6653 and sec_6653 imposes an addition_to_tax equal to percent of the underpayment_of_tax if any part of the underpayment is due to negligence or intentional disregard of rules or regulations sec_6653 imposes an additional liability of percent of the interest due on the underpayment_of_tax attributable to negligence or intentional disregard of rules or regulations beginning in taxpayers are liable for a penalty equal to percent of the part of the underpayment attributable to negligence sec_6662 b negligence includes a failure to make a reasonable attempt to comply with the provisions of the internal revenue laws or to exercise ordinary and reasonable care in the preparation of a tax_return sec_6662 negligence is a lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances 731_f2d_1417 9th cir affg 79_tc_714 neely v commissioner supra petitioners argue that petitioner husband reasonably believed that he had no taxable_income in and that in fact if his personal activities are combined with americana's he had a net_operating_loss for the year petitioners contend that petitioner husband's income in was nominal since they had no taxable gain on the sale of their home until they decided whether they would buy a replacement home and roll over the gain they further contend that they had no taxable_income in after deducting itemized_deductions losses on the sale of real_estate and a loss carryforward from finally petitioners maintain that any inaccuracies on the return occurred because their child was seriously ill and had heart surgery in date when the return was due they argue that they are not liable for the accuracy related penalty for because loss carryforwards eliminate any_tax liability for we disagree we believe that petitioners' tragic difficulties with antonino excuse the lateness of the return but not its inaccuracies petitioner husband did not have books_and_records showing his sales commissions etc or other information relating to the operation of his businesses petitioners substantially underreported their income and overreported their deductions for each of the years in issue we find that petitioners' underpayments of tax in and were due to negligence because they failed to keep adequate_records 72_tc_730 c substantial_understatement the next issue for decision is whether petitioners are liable for the addition_to_tax for substantial_understatement_of_income_tax under sec_6661 for and sec_6661 provides for an addition_to_tax in the amount of percent of the amount of any underpayment attributable to a substantial_understatement_of_income_tax an understatement is the amount by which the correct_tax exceeds the tax reported on the return sec_6661 an understatement is substantial if it exceeds the greater of percent of the tax required to be shown on the return or dollar_figure sec_6661 petitioners bear the burden of proving that the addition_to_tax under sec_6661 does not apply rule a 92_tc_501 if a taxpayer has substantial_authority for the tax treatment of any item on the return the understatement is reduced by the amount attributable to it sec_6661 similarly the amount of the understatement is reduced for any item adequately disclosed either on the taxpayer's return or in a statement attached to the return sec_6661 neither of these exceptions applies here petitioners argue that they did not substantially understate their income for if all deductions and economic losses are allowed for that year they also argue that there was no substantial_understatement for because the tax_liability for is not substantial petitioners omitted large amounts of income from their and joint returns which caused substantial understatements of income_tax petitioners underreported their income by about dollar_figure in and dollar_figure in petitioners have cited no authority for their failure to report those items of income we sustain respondent's determinations that petitioners are liable for the addition_to_tax under sec_6661 for and whether petitioner qualifies as an innocent spouse a background we next decide whether petitioner wife qualifies as an innocent spouse under sec_6013 spouses who file joint tax returns generally are jointly and severally liable for tax sec_6013 petitioner argues that she is not liable for the deficiencies and addition_to_tax for substantial_understatement_of_income_tax because she is an innocent spouse under sec_6013 to qualify as an innocent spouse petitioner must prove that i she filed a joint_return for the years in issue ii there is a substantial_understatement_of_income_tax attributable to grossly_erroneous_items of the other spouse on the return iii she did not know or have reason to know of the substantial_understatement when she signed the return and iv it would be inequitable to hold her liable for the deficiency attributable to the substantial_understatement sec_6013 failure to meet any of these requirements precludes a taxpayer from qualifying as an innocent spouse sec_6013 826_f2d_470 6th cir affg 86_tc_228 780_f2d_561 6th cir affg in part and revg in part tcmemo_1984_310 the innocent spouse exception is construed in view of the congressional purpose of protecting innocent taxpayers from injustice 509_f2d_162 5th cir respondent concedes that petitioner meets all of the requirements to qualify as an innocent spouse under sec_6013 except whether she knew or had reason to know of the understatements when she signed the returns and whether it is inequitable to hold her liabledollar_figure we need not decide whether petitioner wife knew or had reason to know of the understatements because we conclude that it is not inequitable to hold her liable b inequitable to hold petitioner liable to be entitled to relief as an innocent spouse petitioner wife must show that it would be inequitable to hold her liable for the deficiencies in tax for the years in issue sec_6013 in deciding whether it is inequitable to hold a spouse liable for a deficiency we consider whether the purported innocent spouse significantly benefited beyond normal support respondent also points out that respondent disallowed some of petitioners' deductions for lack of substantiation and deductions disallowed merely for lack of substantiation are not grossly_erroneous_items either directly or indirectly from the unreported income 992_f2d_1256 2d cir affg tcmemo_1992_228 93_tc_434 purcell v commissioner t c pincite h rept part pincite sec_1 b income_tax regs normal support is determined by the circumstances of the taxpayers sanders v united_states f 2d pincite 93_tc_672 93_tc_355 petitioners argue that petitioner wife did not benefit from the substantial_understatement of income by petitioner husband or receive substantial amounts from petitioner husband in the years at issue petitioners point out that petitioner wife owned the home in which petitioners lived and she owned a home on lagrange which she sold in her net cash proceeds were dollar_figure dollar_figure of which she deposited in her household account she also received dollar_figure from the sale of her home in which she deposited in her own account petitioner wife benefited from the understatements on petitioners' and returns petitioner wife had wages of dollar_figure in dollar_figure in and none in and therefore depended on petitioner husband for her support in and petitioner husband deposited funds in her bank accounts which she used to pay household expenses in petitioner husband used the premiere and canta corporate accounts to pay many of petitioners' personal living_expenses also given petitioner wife's modest income in these years she must have used petitioner husband's unreported income to buy the tanglewood home for dollar_figure in and to build the alden home for dollar_figure in we believe that petitioner wife fully benefited from the omitted income we believe that she fully shared in the tax savings from the omitted income and that the understatements let her maintain a standard of living that she would not have enjoyed otherwise see scarafile v commissioner tcmemo_1991_512 to reflect the foregoing decision will be entered under rule