Court Opinion

ID: 9324377
Source: CourtListenerOpinion
Date Created: 2022-12-12 00:02:15.55501+00
Date Added: 2024-06-11T17:14:54.790385
License: Public Domain

United States Tax Court

                         T.C. Memo. 2022-119

                          PALMARINI INC.,
                             Petitioner

                                   v.

           COMMISSIONER OF INTERNAL REVENUE,
                       Respondent

     BENITO PALMARINI AND BERNADETTE PALMARINI,
                      Petitioners

                                   v.

           COMMISSIONER OF INTERNAL REVENUE,
                       Respondent

                                —————

Docket Nos. 1719-17, 1723-17.                   Filed December 7, 2022.

                                —————

             In the years at issue, P Corp. was engaged in the
      business of online marketing and construction contracting.
      P–H, an individual, is the president of P Corp. Neither
      P Corp. nor P–H maintained books or records to determine
      their tax liabilities for 2013 and 2014, and the reporting of
      P Corp.’s income and expenses was split between P Corp.’s
      returns and P–H’s Schedules C, “Profit or Loss From
      Business”, attached to the returns he filed jointly with
      P–W.

             R performed a bank deposits analysis of accounts
      owned by P Corp. and P–H and determined that P Corp.
      paid for certain personal expenses of P–H, including
      medical care, vacation, and maintenance of residential
      rental properties that he owned personally.

           By a statutory notice of deficiency (“NOD”) issued in
      November 2016, R determined that P Corp. underreported

                           Served 12/07/22
                                                   2

[*2]     its income and that certain deductions it claimed should be
         disallowed.    R also determined that P–H received
         constructive dividends from P Corp. and that certain
         deductions he claimed should be disallowed. R further
         determined that P Corp. and P–H are liable for accuracy-
         related penalties for 2013 and 2014.

               Held: P–H’s Schedules C are disregarded, all
         business income and expenses must be reported on
         P Corp.’s returns, and P Corp.’s payments of P–H’s
         personal expenses were constructive dividends to P–H.

               Held, further, with few exceptions, Ps failed to
         substantiate deductions beyond amounts R concedes.

               Held, further, P Corp., P–H, and P–W are liable for
         accuracy-related penalties for 2013 and 2014.

                                            —————

Benito Palmarini (an officer), for petitioner in Docket No. 1719-17.

Benito Palmarini and Bernadette Palmarini, for themselves in
Docket No. 1723-17.

Kristina L. Rico, for respondent.

                                  TABLE OF CONTENTS

MEMORANDUM FINDINGS OF FACT AND OPINION ..................... 4

FINDINGS OF FACT .............................................................................. 5

       Palmarini Inc. and its ownership..................................................... 5
       Palmarini Inc.’s business activity .................................................... 5
       Palmarini Inc.’s place of business .................................................... 6
       Palmarini Inc.’s 2013 and 2014 returns .......................................... 6
       Examination of Palmarini Inc.’s returns ....................................... 14
       Benito and Bernadette Palmarini.................................................. 15
       Rental properties ............................................................................ 15
       The Palmarinis’ 2013 and 2014 returns ........................................ 16
       Examination of the Palmarinis’ returns ....................................... 18
       NODs to Palmarini Inc. and to the Palmarinis ............................. 19
                                                     3

[*3] Petition to Tax Court ...................................................................... 19
     Settled and conceded issues ........................................................... 20

OPINION ................................................................................................ 24

I.    Burden of proof ............................................................................... 24
II.   Palmarini Inc.’s corporate income tax returns .............................. 25

      A.     Status as a corporation ........................................................... 25
      B.     Business activity ..................................................................... 25
      C.     Gross receipts .......................................................................... 27
      D.     Deductions ............................................................................... 28

             1.     Officer compensation, salaries, and wages ..................... 28
             2.     Repairs and maintenance................................................ 30
             3.     Bad debt ........................................................................... 31
             4.     Rent .................................................................................. 33
             5.     Depreciation ..................................................................... 33
             6.     Advertising....................................................................... 34
             7.     Other deductions ............................................................. 35

      E.     Constructive dividends ........................................................... 36

             1.     Paid out of earnings and profits ...................................... 36
             2.     Two-part test.................................................................... 37
             3.     Analysis............................................................................ 38

      F.     Section 6662 accuracy-related penalties ................................ 41

III. The Palmarinis’ individual income tax returns ............................ 42

      A.     Income ..................................................................................... 42

             1.     Wages, salaries, tips, etc. ................................................ 42
             2.     Constructive dividends from Palmarini Inc. .................. 42
             3.     Other income.................................................................... 43

      B.     Schedule A casualty loss deduction for 2014 ......................... 43
      C.     Schedule C ............................................................................... 44
      D.     Schedule E rental properties .................................................. 45
      E.     Section 6662 accuracy-related penalties ................................ 46

IV. Conclusion ....................................................................................... 47
                                           4

[*4]     MEMORANDUM FINDINGS OF FACT AND OPINION

       GUSTAFSON, Judge: Pursuant to section 6212, 1 the Internal
Revenue Service (“IRS”) issued statutory notices of deficiency (“NOD”)
to petitioners Palmarini Inc. and Benito and Bernadette Palmarini on
November 14, 2016, determining the following deficiencies in federal
income tax and accuracy-related penalties under section 6662(a) for the
years 2013 and 2014:

                                                                         Penalty
       Petitioner                Year              Deficiency          sec. 6662(a)
    Palmarini Inc.               2013                $219,364              $43,873
                                 2014                  175,221              35,044

       Benito and                2013                  118,955              23,791
       Bernadette
       Palmarini
                                 2014                  106,550              21,310

       Palmarini Inc. and the Palmarinis filed timely petitions under
section 6213(a) for redetermination of the deficiencies and penalties.
After the parties’ concessions, there are eight remaining issues for
decision in these consolidated cases. As to the corporation: (1) the
amount of Palmarini Inc.’s gross receipts in 2013 and 2014; (2) whether
Palmarini Inc. is entitled to certain income tax deductions claimed for
2013 and 2014; (3) whether Palmarini Inc. constructively issued
dividends to Mr. Palmarini in 2013 and 2014; and (4) whether Palmarini
Inc. is liable for the section 6662 accuracy-related penalties. As to the
Palmarinis as individuals: (5) the amount of the Palmarinis’ income for
2013 and 2014; (6) the Palmarinis’ entitlement to certain income tax
deductions claimed for 2013 and 2014; (7) whether Mr. Palmarini may
report his advertising business on Schedule C, “Profit or Loss From
Business”; and (8) whether the Palmarinis are liable for the section 6662
accuracy-related penalties.       To the extent not conceded by the
Commissioner, we will uphold the IRS’s adjustments in large part, and

        1 Unless otherwise indicated, statutory references are to the Internal Revenue

Code (Title 26 of the United States Code) as in effect at the relevant times; references
to regulations are to Title 26 of the Code of Federal Regulations (“Treas. Reg.”) as in
effect at the relevant times; and references to Rules are to the Tax Court Rules of
Practice and Procedure. Some dollar amounts are rounded.
                                          5

[*5] we will hold petitioners liable for the section 6662 accuracy-related
penalties.

       On the evidence before us, and using the burden-of-proof
principles explained below, we find the following facts.

                             FINDINGS OF FACT

       Palmarini Inc. is a Pennsylvania corporation with its principal
place of business in Pennsylvania, and Benito and Bernadette Palmarini
resided in Pennsylvania, 2 when they filed their petitions in these
consolidated cases. (Benito and other members of the Palmarini family
are mentioned below with their first names, but references to
“Mr. Palmarini” in this opinion are to petitioner Benito Palmarini.)

Palmarini Inc. and its ownership

       Before the incorporation of Palmarini Inc., its cement business
was a sole proprietorship operated by Francesco Palmarini (Benito’s
father). Palmarini Inc. was incorporated in 1983, and its original
shareholders were Benito (49.75%), his brother Pacifico Palmarini
(49.75%), and Don Hurley (0.5%). Shortly after its incorporation, Benito
transferred approximately two-thirds of his ownership interest in
Palmarini Inc. to his father Francesco and his brother Manuel, and the
shareholders of Palmarini Inc. thus became Pacifico (49.75%), Benito
(16.58%), Francesco (16.58%), Manuel (16.58%), and Don Hurley (0.5%).
In 2007 Francesco Palmarini transferred his interest in Palmarini Inc.
back to Benito. Thereafter, the three brothers’ interests in the
corporation were Pacifico’s 49.75%, Benito’s 33.16%, and Manuel’s
16.58%.

      Benito, Pacifico, and Manuel Palmarini each served as officers of
Palmarini Inc.; however, Pacifico did not actively engage in the
corporation’s business operations. During 2013 and 2014, Benito was
the president of Palmarini Inc. and managed its operations.

Palmarini Inc.’s business activity

      After its incorporation in 1983, Palmarini Inc. was primarily
operated as a cement construction business. However, in 2013 and 2014,

       2 Absent stipulation otherwise, venue for an appeal in these cases would lie in

the U.S. Court of Appeals for the Third Circuit. See § 7482(b).
                                          6

[*6] revenues from affiliated online marketing 3 activity undertaken by
Benito and Manuel (and not Pacifico) were deposited into Palmarini
Inc.’s corporate bank accounts, and associated advertising expenses
were paid from its corporate bank accounts. Palmarini Inc. did not
receive any revenues from cement construction work in 2013 or 2014,
and Palmarini Inc. did not own any rental property as part of its
business activity. On Schedule K, “Other Information”, of its original
and amended 2013 and 2014 Forms 1120, “U.S. Corporation Income Tax
Return”, Palmarini Inc.’s business activity is reported as “affiliate
marketing”, except that on its latest-filed amended return for 2014, it is
reported as “affiliate marketing (mainly) & cement work”.

      We find that in 2013 and 2014 Palmarini Inc.’s cement
construction business was virtually dormant because its only
construction work in the years at issue was uncompensated work on one
of Mr. Palmarini’s personal rental properties, and we find that
Mr.Palmarini conducted the marketing activity through Palmarini Inc.
and not through his limited liability company (“LLC”). See infra p. 15
and Part II.B.

Palmarini Inc.’s place of business

       Palmarini Inc. maintained its principal place of business at a
garage on Halstead Street in Philadelphia. 4 Manuel Palmarini owned
the Halstead Street property and received rental payments from
Palmarini Inc. for its use of the Halstead Street garage until March
2014, after which it became property of Palmarini Inc. Palmarini Inc.
continued improving the Halstead Street garage until it was placed into
service as corporate property in August 2014.

Palmarini Inc.’s 2013 and 2014 returns

       1.      Palmarini Inc.’s record keeping

      Palmarini Inc. did not maintain any books or records, a general
ledger, or profit and loss statement, nor did it engage the services of an
accountant or bookkeeper or use any accounting software in 2013 and
2014. Instead, Mr. Palmarini manually reviewed the corporation’s bank

       3   Affiliated online marketing is a business activity in which an intermediary
(“the affiliate”) hosts a link for a third party on a website and receives a commission
when the affiliate’s link generates business for the third party.
        4 The Halstead Street property is a double lot: A residential home stands on

one lot and a stand-alone garage on the other.
                                      7

[*7] and credit card statements to identify and distinguish corporate
business expenses from personal expenses, then aggregated totals for
reporting on Palmarini Inc.’s returns.

      2.     Preparation and filing of original and amended returns

      Palmarini Inc. did not hire a return preparer to complete its 2013
and 2014 returns. Mr. Palmarini prepared all original and amended
returns for Palmarini Inc. for 2013 and 2014.

      Palmarini Inc. timely filed its Form 1120 for 2013 on March 10,
2014. Palmarini Inc. timely filed its Form 1120 for 2014 on March 6,
2015.

       Starting within six days after filing the original 2014 return and
over the next three months, Palmarini Inc. filed a series of amended
returns for both years, on one occasion signing two amended returns for
the same year (2013) on the same day (May 1, 2015), and on several
occasions filing amended returns (for 2013) only days apart. The
signature dates of the original and amended returns were as follows:

                        2013                       2014
              March 10, 2014 (original)
                                          March 6, 2015 (original)
              March 12, 2015
              April 4, 2015
                                          April 7, 2015
              April 25, 2015
              April 28, 2015
              May 1, 2015
              May 1, 2015
                                          May 5, 2015
              June 25, 2015
                                          June 27, 2015
                                   8

[*8] The IRS accepted and processed Palmarini Inc.’s amended return
for 2013 dated June 25, 2015, but it did not process any of the amended
returns for 2014.

      3.     Accounting method

       On line 1 of Schedule K of both its original 2013 return and its
original 2014 return, Palmarini Inc. responded to the prompt “Check
accounting method” by checking the box for the “Cash” method of
accounting (not “Accrual”). Several of its amended returns (including
the first 2013 amended return, filed after the original 2014 return)
included a Schedule K, and on those schedules the “Accrual” box was
checked; but petitioners made no showing that the reporting of income
and expenses on the amended returns was actually revised from the
“Cash” method originals to reflect accrual of income and expenses.

       Petitioners did not offer into evidence the corporation’s returns
for any years before 2013, nor any company books reflecting an accrual
method; and the only evidence that those earlier returns might have
used an accrual method is the trial testimony of Mr. Palmarini, which
we did not find credible on the point. His description of his preparation
of the returns (viewing bank and credit card statements and tallying
expenses reported there, see infra p. 26) gave no indication of accruing
expenses rather than deducting them when paid. Petitioners made no
contention as to, and offered no evidence showing, Palmarini Inc.’s
requesting the IRS’s consent to a change of accounting method, in
compliance with section 446(e). We find that in fact Palmarini Inc. used
the cash method of accounting and did not request consent to a change
to the accrual method. See infra Part II.D.3.

      4.     Gross receipts

       Palmarini Inc.’s gross receipts in 2013 and 2014 were entirely
from affiliated online marketing, and not from Palmarini Inc.’s former
cement activity. Consistent with the IRS’s bank deposits analysis
(“BDA”) (described below at pages 14–15), we find that Palmarini Inc.
received gross receipts of $959,248 in 2013 and $937,532 in 2014.

       These were not amounts that Palmarini Inc. reported. Rather, on
its original return for 2013, Palmarini. Inc. reported gross receipts of
$812,629; but on its amended return filed March 12, 2015 (and also on
those filed April 4 and April 25, 2015), it reported $894,963. On line 1
of Part I of its amended return filed April 28, 2015, it reported in
column (b) a reduction of $27,927 and in column (c) a “Correct amount”
                                     9

[*9] of $866,986 as its gross receipts. Column (b) requires “explain in
Part II”, but Part II gives no explanation for this reduction. Palmarini
carried over this lower amount to its subsequent amended returns, and
the IRS apparently used it as its starting point in the notice of deficiency
for 2013, discussed below.

       On its original return for 2014, which was the apparent starting
point of the IRS’s examination of Palmarini Inc.’s 2014 return, discussed
below, Palmarini Inc. reported gross receipts of $659,799. However, the
IRS apparently overlooked the fact that Palmarini Inc. admitted that
this amount was an error. Palmarini Inc. reported $943,281 in Part I of
its amended return filed April 7, 2015, and admitted in Part II a
“miscalculation of total income”. (It also reported the larger amount on
its subsequent amended returns for 2014.)

        Entities that paid Palmarini Inc. issued to it (and filed with the
Government) Forms 1099–MISC, “Miscellaneous Income”, showing
payments that totaled $628,149 for 2013 and $672,362 for 2014.
Palmarini Inc. agrees that it received gross receipts of those amounts;
but the Commissioner contends (and we find, as stated above and
explained in Part II.B below) that these amounts were not the sum total
of its gross receipts.

      5.     Officer compensation and salaries and wages

       We find that Palmarini Inc. paid officer compensation of zero for
2013 and 2014, and salaries and wages of $58,100 in 2013 and $76,500
in 2014. See infra Part II.D.1. Benito and Manuel Palmarini were the
only persons who performed work for Palmarini Inc. in 2013 and 2014,
and they did so not only in their capacities as officers but also as laborers
for their work on one of Mr. Palmarini’s personal rental properties. On
its 2013 return Palmarini Inc. claimed deductions of $92,400 on line 12
for “Compensation of officers” and $15,000 on line 13 for “Salaries and
wages”; but on its 2014 return it did not claim any such deductions.
During 2013 and 2014 Palmarini Inc. did not report to the IRS on a
Form W-2 any wages paid to anyone, nor did it file any associated
employment tax returns (Form 940, “Employer’s Annual Federal
Unemployment (FUTA) Tax Return”, and Form 941, “Employer’s
Quarterly Federal Tax Return”) or pay any employment taxes. After the
IRS selected Palmarini Inc.’s 2013 and 2014 returns for examination,
the corporation filed with the IRS two Forms 1099 reporting non-
employee compensation to two officers, Benito and Manuel Palmarini,
for 2014 (but not for 2013). In anticipation of trial in these cases, Benito
                                   10

[*10] Palmarini created invoices from himself to Palmarini Inc. to
substantiate the Form 1099 issued to him by Palmarini Inc.

      6.     Repairs and maintenance

       Palmarini Inc. incurred no expenses to repair or maintain its own
property in 2013 and 2014, see infra Part II.D.2, but the corporation did
expend money in 2013 and 2014 to repair and maintain residential
properties owned personally by Mr. Palmarini. Palmarini Inc. claimed
a $114,719 deduction for repairs and maintenance on its 2013 return
and did not claim any deduction for repairs and maintenance on its 2014
return. This 2013 deduction is related to Palmarini Inc.’s use of Benito
and Manuel Palmarini’s personally owned residential properties for
storage of its machinery and equipment used in its (inactive)
construction business. Palmarini Inc. also stored its machinery and
equipment at the Halstead Street garage (which also served as its
principal place of business), the lower level of a building on Chandler
Street, and at a building on Knorr Street. See infra pp. 15–16.

      7.     Bad debt deductions

       On line 15 of its original return for 2013, filed in March 2014,
Palmarini Inc. claimed a deduction for “Bad debts” of $80,541. On line
15 of its original return for 2014, filed in March 2015, Palmarini Inc.
claimed a deduction for “Bad debts” of $81,900. Both those amounts
were revised on amended returns:

       Six days later, on March 12, 2015, Palmarini Inc. increased its
2013 bad debt deduction to $123,429. On April 7, 2015, it reduced the
2014 bad debt deduction from $81,900 to zero, explaining: “Line 15 error
on original return. Miscalculation as bad debt was taken as a deduction
on ‘2013’ return.” The later amended returns for 2014 likewise reported
no bad debt deduction. But for 2013 the amendments continued:

       On April 25, 2015, Palmarini increased the 2013 bad debt
deduction from $123,429 to $204,056, explaining: “Total deductions
increased by $80,630.06 due to underreporting bad debt loss”. Three
days later, on April 28, 2015, the bad debt deduction was increased
again, this time by about $33,000 to $237,458. We find on that amended
return no legible explanation for the increase.

      These bad debt deductions are based on an alleged unpaid
balance of approximately $240,000 owed to Palmarini Inc. by Epic Media
Group for affiliated online advertising services in 2011. At trial
                                          11

[*11] Mr. Palmarini alleged that in 2011 Epic Media Group had
reported, on Form 1099, payments made to Palmarini Inc. of $205,000
and that he had reported that income on Palmarini Inc.’s 2011 return.
(Neither that return nor a Form 1099 was offered in evidence.) The
unpaid balance for advertising services was later (on an unspecified
date) allegedly negotiated down to $83,000; however, Epic Media Group
failed to pay even this discounted amount and instead paid only $5,000
to Palmarini Inc. Mr. Palmarini alleges that he determined the debt to
be worthless in 2013. (Although the precise amounts are difficult to
understand, it seems that he first claimed on the original 2013 return
an amount ($80,630) that roughly corresponded to the negotiated (but
unpaid) lower amount ($83,000), and that he eventually claimed on
amended returns an amount ($237,458) that roughly corresponded to
the gross debt ($240,000)). If this is true, it is impossible to explain the
intermediate amounts reported on some of the amended returns.
Petitioners presented no documentary evidence to substantiate the
accrual of the receivable (and the reporting of the accrued income) in
2011 (or any other year) or the write-off of the unpaid debt in 2013. 5 We
find that the receivable was neither accrued nor written off as alleged
and that no bad debt deduction is allowable. See infra Part II.D.3.

       8.        Rents

      We find that Palmarini Inc. made recurring payments to Manuel
Palmarini totaling $12,187 in 2013 and $13,387 in 2014 as rent, for the
corporation’s use of the Halstead Street garage as its principal place of
business. Palmarini Inc. claimed no rent deduction on its original 2013
return but claimed a rent deduction of $18,129 on its first amended 2013
return. 6 The corporation did not claim any deduction for rents for 2014
but proved at trial that rent payments were made until March 2014.

       5   The Court engaged in this colloquy with Mr. Palmarini:
       THE COURT: . . . Did you make any entry on your books to write off that debt
in 2013?
       THE WITNESS: Yes.
       THE COURT: Does—do you want to show me that?
       THE WITNESS: It was on my income tax return. I put it down.
       THE COURT: I’m talking about the company books.
       THE WITNESS: No. I don’t have the company books here.
       6 The explanation on the amended return states: “On previous return—$18,129

payable for rents on line 16 not included”.
                                  12

[*12] This expense consisted of regular payments made by Palmarini
Inc. to Manuel Palmarini in his capacity as owner of the Halstead Street
garage, for Palmarini Inc.’s use of the garage as its principal place of
business and for storage of its machinery and equipment.

      9.     Depreciation

       Palmarini Inc. claimed a $6,035 deduction for depreciation on its
2013 return and did not claim a deduction for depreciation for 2014. The
2013 depreciation was claimed for a 2013 Ford F-150 pickup truck that
was used in Palmarini Inc.’s cement construction business but owned by
Mr. Palmarini personally. Palmarini Inc. maintains its entitlement to
depreciate the cost of the truck, but because there is no evidence from
which we can determine any business use percentage of the truck, we
find that its business ownership and use are not substantiated. See
infra Part II.D.5. We further find that Palmarini Inc. is entitled to
depreciate the cost of the Halstead Street garage after it became the
corporation’s property and was placed in service in August 2014, and the
Commissioner has conceded a depreciation deduction of $1,671 for 2014.

      10.    Advertising

        Palmarini Inc. reported deductions for advertising expenses of
$345,433 for 2013 and $577,156 for 2014. We find, consistent with the
Commissioner’s contention, that Palmarini Inc. paid $386,628 for
advertising in 2013 and $452,390 for advertising in 2014 as part of its
affiliated online marketing business. The 2013 amount is larger than
Palmarini Inc. reported, so it is undisputed. The amount we allow for
2014 is smaller because we find that two alleged expenditures are not
substantiated. See infra Part II.D.6.

      11.    Other deductions

       Palmarini Inc. reported no line 26 “Other deductions” on its
original returns for 2013 and 2014; and although it now claims such
deductions for each year, we find that it has substantiated none. See
infra Part II.D.7. The evolution of its reporting of “Other deductions”
was as follows.
                                  13

[*13]       a.     2013

      Palmarini Inc.’s original Form 1120 for 2013, and the first
amended return filed March 12, 2015, claimed no “Other deductions” on
line 26. Rather, such deductions were claimed only on the amended
returns and in amounts that changed substantially over three months:

      The second amended return filed April 4, 2015, claimed $18,129
and explained in Part II, “Explanation of Changes to Items in Part I”:
“On previous return—$18,129 payable for rents on line 16 not included”.

       The fourth amended return filed April 28, 2015, claimed $16,511,
(not zero or $18,129, as on previous returns). A statement attached to
the fourth amended return, entitled “2013 Other Deductions”, presents
almost illegible entries totaling that amount, apparently from various
sources (including “Cardpayments”, “Amex”, “Visa card”, and “Paid
cash”).

       The sixth amended return, dated May 1, 2015, claimed a further
reduced amount—$14,826—that was itemized in an attached statement
entitled “1120 Line 26 Other Deduction 2013”, which presents entries
totaling that amount that are stated to be derived from, inter alia,
“Amex card ending 51007”, “BOA card ending 9744”, “Visa card ending
2031”, and “Cash to wife”.

       The seventh amended return for 2013, filed June 25, 2015,
claimed a much larger amount—$38,290. The explanation in Part II
states: “More deductions found in Line 26—Form 1120.” An attached
statement entitled “Form 1120—Line 26—Other Deductions” presents
entries totaling $38,290 derived from, inter alia, “Amex card ending
51007”, “Bank of America card ending 9141”, “Credit card end 3031”,
“Card ending 7732”, and “Card ending C68-640”.

            b.     2014

       Palmarini Inc.’s original Form 1120 for 2014, and the first and
second amended returns filed for that year, claimed no “Other
deductions” on line 26. Rather such deductions were claimed only on
the final amended return, filed June 27, 2015, which claimed $57,337.
                                    14

[*14] The explanation states: “More deductions taken for Line 26 missed
in earlier return.”

Examination of Palmarini Inc.’s returns

      Palmarini Inc.’s 2013 and 2014 returns were selected by the IRS
for examination and assigned to Revenue Agent Christine Berntsen.
The starting point for the IRS’s examination was the last-filed amended
return for 2013 (dated June 25, 2015) and the original return for 2014
(dated March 6, 2015).

       During the examination Palmarini Inc. did not provide any books
or records reflecting its calculations of its gross income for 2013 or 2014.
Accordingly, Agent Berntsen performed a BDA, whereby the IRS issued
summonses to all banks at which Palmarini Inc. held accounts and sent
letters to third parties to verify the type of income reflected by the
deposits into the corporate accounts. Agent Berntsen determined that
Palmarini Inc. received gross receipts of $959,248 in 2013 and $937,532
in 2014 (amounts greater than those reported on its returns). Agent
Berntsen’s 2013 gross income amount was greater by about $65,000
than the largest amount that Palmarini Inc. had reported on a 2013
return (i.e., $894,963 on amended returns); but her 2014 amount was
about $6,000 less than the amount Palmarini Inc. reported on its
amended return filed April 7, 2015 (i.e., $943,281). As is stated above
at page 9 and is explained below in Part II.B, we find Agent Berntsen’s
analysis reliable and convincing.

       Agent Berntsen then performed a disbursement analysis using
Palmarini Inc.’s bank and credit card statements. Those statements
listed both business expenses of the corporation and personal expenses
of Mr. Palmarini. To distinguish between business and personal
expenses, Agent Berntsen surveyed each line item on Palmarini Inc.’s
bank and credit card statements, as well as check stub descriptions
when available, and allowed deductions for all expenses that she
determined were reasonably related to Palmarini Inc.’s business
activities, which (on the basis of the income and expenses reflected on
the corporate bank statements) she determined to be affiliated online
marketing. In her analysis she did not allow Palmarini Inc. deductions
for either personal expenses or for those which had no ascertainable
business purpose, and all personal expenses borne by Palmarini Inc.
were recharacterized as a constructive dividend to Mr. Palmarini in his
capacity as shareholder.
                                  15

[*15] On the basis of her BDA of 2013 and 2014, Agent Berntsen
determined to increase Palmarini Inc.’s income for underreported gross
receipts and disallowed deductions. Agent Berntsen also determined a
constructive dividend to Mr. Palmarini as president and shareholder,
and she determined that Palmarini Inc. is liable for accuracy-related
penalties under section 6662.

Benito and Bernadette Palmarini

       During 2013 and 2014, petitioner Bernadette Palmarini worked
as a procurement analyst for the U.S. Department of Defense. She
received wages of $78,049 in 2013 and $81,333 in 2014. Mr. Palmarini
has worked as a cement contractor for Palmarini Inc. (an activity
virtually dormant in the years at issue) and was paid wages of $58,100
in 2013 and $76,500 in 2014 by Palmarini Inc. for his work building the
Neshaminy Street garage. Mr. Palmarini also received constructive
dividends from Palmarini Inc. of $116,741 in 2013 and $62,798 in 2014.
See infra Part II.E. Mr. Palmarini is also the owner of Affiliated
Marketing Online, LLC (“AMOLLC”), a single-member LLC engaged in
the business of affiliated online marketing. However, Mr. Palmarini
viewed all accounts of Palmarini Inc. and AMOLLC as his own and used
them as needed for both business and personal purposes; and as is
stated above, we find that Mr. Palmarini operated the affiliated online
marketing business not through AMOLLC but through Palmarini Inc.

Rental properties

       Mr. Palmarini owned the following residential properties. He
hired professional real estate management companies to manage the
renting of these properties to tenants, and some of them were used both
for paying tenants and for storage of equipment for Palmarini Inc. Mr.
Palmarini is responsible for paying the utility costs associated with
Palmarini Inc.’s use of these properties for storage of its equipment.
(The parties have come to agreement about the income and some of the
expenses from these properties, but some expenses remain in dispute.
See infra Part III.D.)

      1.    Chandler Street

      The Chandler Street property is a duplex: the upstairs unit is a
residence rented to tenants, and the downstairs unit is used by
Palmarini Inc. as a business office. Palmarini Inc. did not pay rent to
Mr. Palmarini for its use of the Chandler Street property. In March
2014 Benito Palmarini conveyed the Chandler Street property plus
                                    16

[*16] $30,000 (paid by Palmarini Inc.) to Manuel Palmarini in exchange
for the Halstead Street property. After that transaction, Manuel
Palmarini held title to the Chandler Street property.

      2.     Knorr Street

       The Knorr Street property is a double duplex: one common floor
leads to two residential units on the right and two on the left (for a total
of four residential units); and a separate, lower level was used by
Palmarini Inc. for storage of its machinery and equipment. Palmarini
Inc. did not pay rent to Mr. Palmarini for its use of the Knorr Street
property.

      3.     Neshaminy Street

       The Neshaminy Street property is a single-family home.
Mr. Palmarini purchased the Neshaminy Street property in 2007 with
Michael Smyth (each owning a one-half undivided interest). In 2009
Mr. Palmarini acquired full ownership of the Neshaminy Street
property from Michael Smyth. Thereafter, Mr. Palmarini began a series
of extensive renovations continuing from 2009 until 2011. He eventually
attempted to sell the property but was unsuccessful (in part) because
the property did not have a garage. He decided to build a garage for the
Neshaminy Street property using the construction assets of Palmarini
Inc. During 2013 and 2014, Palmarini Inc. was building a garage for the
Neshaminy Street property, and the labor was performed by Benito and
Manuel Palmarini.

      4.     Gypsy Lane

        The Gypsy Lane property is a single-family home.          The
Palmarinis purchased the property on April 11, 2008, for $145,000 and
sold it at a loss on April 12, 2013, for $105,000.

The Palmarinis’ 2013 and 2014 returns

       The Palmarinis filed their original return for 2013 on March 4,
2014. They then filed three amended returns for 2013, the first of which
was filed April 1, 2015, and the last two of which were not accepted by
the IRS.

        The Palmarinis filed their original return for 2014 on
February 24, 2015. They then filed two amended returns for 2014, the
first of which was filed on April 8, 2015, and the second of which was not
                                      17

[*17] accepted by the IRS. The Palmarinis did not use a paid return
preparer for their 2013 and 2014 federal income tax returns. Mr.
Palmarini prepared all their original and amended returns for 2013 and
2014.

       1.     Casualty loss deduction

      In July 2014 a series of severe storms caused trees at the
Palmarinis’ personal residence to fall on their fence, destroying
approximately 20 feet of the fence (two sections with a post in the
middle). The Palmarinis reported the damage to their insurance
company, which determined the value of the damage to be
approximately $3,360 and issued to the Palmarinis a check for $860 (the
remainder after their $2,500 deductible) in settlement of their claim.

       The Palmarinis received an estimate of $16,950 to remove and
replace the damaged portions of the fence. However, the manufacturer
of the original fence was no longer in business, and the replacement
sections would not have matched the original fence. Mr. Palmarini
sought an estimate to replace the entire fence (22 sections) and was
quoted $62,850. The Palmarinis spent $1,000 on repairs and then
claimed a $44,511 7 deduction for casualty loss on their 2014 return, on
the basis that the fair market value of their home declined due to having
a mismatched fence. We find that the insurance company’s valuation of
the damage was reasonable, and that the proper amount of the casualty
loss would be the $2,500 “deductible” not paid by the insurance
company, subject to the limitation on itemized deductions discussed
below in Part III.B.

       2.     Schedule C for Affiliated Marketing Online LLC

       Included with the Palmarinis’ 2013 and 2014 returns were
Schedules C for AMOLLC. The Schedule C for each year reported only
gross receipts and advertising expenses, and each one reflects a net loss.
(Because the gross receipts, the expenses, and the business activity itself
are properly allocated to Palmarini Inc., as we found above at page 6,

        7 The amount of the casualty loss the Palmarinis reported on Form 4684,

“Casualties and Thefts”, is $54,400, and the amount of the deduction claimed (as
limited by section 165(h)(1) and (2)) is $44,511.
                                    18

[*18] we find that AMOLLC has no gross receipts, no deductions, and
no losses for 2013 and 2014.)

      3.     Schedule E rental properties

       The Palmarinis did not include with their 2013 return a
Schedule E, “Supplemental Income and Loss”, reporting their income
and expenses from their rental properties, but they did include a
Schedule E with their 2014 return reporting a net loss for the year and
a corresponding $25,000 deduction pursuant to section 469(i).

Examination of the Palmarinis’ returns

      The IRS selected the Palmarinis’ 2013 and 2014 returns for
examination and assigned them to Agent Berntsen. The starting point
for the examination of the Palmarinis’ 2013 return was their first
amended return filed on April 1, 2015; and the starting point for the
examination of their 2014 return was their first amended return filed
on April 8, 2015.

       During the examination the Palmarinis did not provide any
original books or records showing how they calculated gross receipts for
AMOLLC in 2013 and 2014. Accordingly, Agent Berntsen performed a
BDA for AMOLLC and the Palmarinis individually. Agent Berntsen
determined to reduce the Palmarinis’ “other” income to an amount less
than they reported on their 2013 and 2014 returns and to increase their
qualified dividend income because of her determination that
Mr. Palmarini received constructive dividends from Palmarini Inc. for
2013 and 2014.

      Agent Berntsen further determined to disallow all deductions
claimed on Schedules A, “Itemized Deductions”, for lack of
substantiation. (Before trial the parties agreed on the itemized
deductions except for the casualty loss.)

       As to the Schedules C for AMOLLC, the agent determined to
reduce gross receipts for 2013, to increase gross receipts for 2014, and to
disallow all deductions for advertising for both years because the
expenses were paid from Palmarini Inc.’s (rather than AMOLLC’s) bank
accounts. (The IRS later disallowed the Schedule C deductions in their
entirety for both years, moving all income to elsewhere on the
Palmarinis’ returns or attributing it to Palmarini Inc.’s Forms 1120.)
                                         19

[*19] Agent Berntsen also determined to include Schedules D, “Capital
Gains and Losses”, to report the gain and loss from sales of stock and
the sale of the Gypsy Street property. (The parties agreed before trial
that the Palmarinis were entitled to a $3,000 loss deduction for each
year.)

       And as to the Schedule E rental properties, Agent Berntsen
determined to increase rents received, to disallow all deductions claimed
for 2013 and 2014, 8 and to suspend the amount of the Palmarinis’
passive loss in excess of their passive income. (The parties later agreed
as to the amounts of rental income the Palmarinis received in 2013 and
2014 as well as the amounts of substantiated Schedule E deductions,
but the Palmarinis maintain their entitlement to additional amounts of
certain Schedule E deductions as specified below.)

NODs to Palmarini Inc. and to the Palmarinis

       The IRS issued to Palmarini Inc. and to the Palmarinis
concurrent NODs for 2013 and 2014 on November 14, 2016, determining
deficiencies in federal income tax and accuracy-related penalties under
section 6662 for both years. Attached to each NOD were Letters 950,
which proposed penalties and informed the Palmarinis of their appeal
rights. The Letters 950 were signed by Mary Unger (Group Manager),
Agent Berntsen’s immediate supervisor during the examination of
Palmarini Inc.’s and the Palmarinis’ 2013 and 2014 returns.

Petition to Tax Court

      Palmarini Inc. timely filed its petition in the Tax Court on
January 23, 2017. The Palmarinis timely filed their petition in the Tax
Court on January 23, 2017. These cases were consolidated for trial and
were tried in Philadelphia, Pennsylvania.

        8 As we noted, the Palmarinis did not attach a Schedule E reporting income

and expenses from their rental properties to their original 2013 return, but they did
attach a Schedule E to their amended 2013 return filed April 23, 2015. Agent Berntsen
treated the Palmarinis as having claimed for 2013 the amounts reported on the
Schedule E attached to their amended return.
                                    20

[*20] Settled and conceded issues

       During the pendency of these cases, the Palmarinis provided
documentation supporting some of their reported expenses. Agent
Berntsen reviewed the documents and issued a revised examination
report for both Palmarini Inc. and the Palmarinis, which the
Commissioner adopts as his position in these cases. The revised report
for Palmarini Inc. made the following changes: (1) advertising expense
deductions previously disallowed on Schedule C were allowed to
Palmarini Inc. because the corporation paid AMOLLC’s credit card bill;
(2) Palmarini Inc. was allowed deductions for rent of the Halstead
property while it was owned by Manuel Palmarini; (3) Palmarini Inc.
was allowed a deduction for 2014 for depreciation of improvements to
the Halstead property after Palmarini Inc. placed it in service as
corporate property in August 2014.

       The revised report for the Palmarinis made the following changes:
(1) the Schedule C deductions were disallowed entirely, the advertising
items were moved to Palmarini Inc.’s corporate returns, and the
remaining items of income were moved to “other” income on the
Palmarinis’ returns; (2) the Palmarinis were allowed deductions on
Schedule A for substantiated expenses; (3) the Palmarinis were allowed
deductions for their Schedule E rental properties; and (4) the
constructive dividend determination was reduced by excluding expenses
to be reported by Palmarini Inc. We will order the parties to recompute
petitioners’ liabilities pursuant to Rule 155; and when they do so, they
will take into account both the foregoing agreed items and our
resolutions of the following disputed items.

      The items listed below remain in dispute for Palmarini Inc., and
we find for the reasons stated above and explained below that the
amounts in the right-hand column were income actually received and
expenses actually paid for deductible business purposes:
                                             21

[*21]
 2013
                                                  Revised            Amount              Amount
        Item          Return        NOD            report           in dispute           allowed
 Gross receipts     $866,986       $959,248       $963,248          $335,099 9           $959,248
 Advertising         (345,433)     (314,190)      (386,628)            -0-               (386,628)
 Bad debt            (237,458)       -0-            -0-              (237,458)             -0-
 Officer
                      (92,400)       -0-            -0-               (92,400)             -0-
 compensation
 Salaries and
                      (15,000)       -0-            -0-               (15,000)            (58,100)
 wages
 Repairs and
                     (114,719)       -0-            -0-              (114,719)             -0-
 maintenance
 Rent expense         (18,229)       -0-          (12,187)             -0- 10             (12,187)
 Depreciation          (6,035)       -0-            -0-                (6,035)             -0-
 Other
                      (38,290)       -0-            -0-                (38,290)            -0-
 deductions

 2014
                                                     Revised           Amount             Amount
        Item          Return          NOD             report          in dispute          allowed
 Gross receipts       $659,799       $937,532       $937,532          $265,1709          $937,532
 Advertising           (577,157)      (421,901)      (452,390)          (87,146) 11       (452,390)
 Bad debt               (81,900)       -0-                -0-           (81,900)            -0-
 Salaries and
                                                                                           (76,500)
 wages
 Rent expense           -0-            -0-            (13,387)               (5,191)10     (13,387)
 Depreciation           -0-            -0-                (1,671)         -0-               (1,671)
 Other
                                       -0-                -0-                               -0-
 deductions

        Palmarini Inc. admits that it received gross receipts of $628,149 in 2013 and
        9

$672,362 in 2014 (the total amounts on Forms 1099 issued to it for each year).
        10Palmarini Inc. agrees to accept the Commissioner’s revised determination of
rents paid in 2013 but alleges it is entitled to an $18,578 deduction for rents paid in
2014.
                                             22

[*22] The items listed below remain in dispute for Mr. and Mrs.
Palmarini, and we find for the reasons stated above and explained below
that the amounts in the right-hand column were income actually
received and expenses actually paid for deductible purposes:

 2013
                                                  Revised      Amount          Amount
        Item          Return          NOD          report     in dispute       allowed
 Wages, salaries,
                        $78,048        n/a          n/a          n/a           $136,148
 tips, etc.
 Other income           129,400       $60,000     $13,750        -0-             13,750
 Qualified
                        -0-           328,931     261,716     $261,716          116,741
 dividends
 Sch. C–
  Gross receipts        135,037        13,750       -0-         135,037         -0-
  Advertising           (194,090)      -0-          -0-        (194,090)        -0-
  Business use
                         (61,660)      -0-          -0-         (61,660)        -0-
  of home
 Sch. E–
  Chandler St.
                         (18,845)      -0-          -0-         (18,845)        -0-
  repairs
  Chandler St.
                              (985)    -0-            90 12        1075               90
  insurance
  Chandler St.
                                0      n/a         n/a          n/a                   376
  depreciation
  Knorr St.
                         (29,450)      -0-          -0-         (29,450)        -0-
  other
  Gypsy Ln.
                              (404)    -0-          -0-                (404)    -0-
  utilities
  Gypsy Ln.
                          (3,810)      -0-          -0-           (3,810)       -0-
  repairs
  Gypsy Ln.
                              (330)    -0-          -0-                (330)    -0-
  insurance

        11Palmarini Inc. alleges it is entitled to a $539,536 deduction for advertising
expenses in 2014.
        12 The Commissioner’s revised determination, based on documents provided by

the Palmarinis, asserts that in 2013 the Palmarinis received insurance proceeds, $922,
in excess of their insurance expense, $832, for Chandler St. in 2013 and that the net
proceeds of $90 be included in their income. This determination is sustained for the
reasons explained below in Part III.D.
                                         23

[*23]
2014
                                              Revised      Amount          Amount
        Item       Return         NOD          report     in dispute       allowed
Wages, salaries,
                    $81,333        n/a          n/a          n/a           $157,833
tips, etc.
Other income         71,200        $1,200       $9,108       -0-              9,108
Qualified
                    -0-           386,054     226,794      $226,794          62,798
dividends
Sch. A–
                    (54,400)       -0-          -0-          (54,400)         (2,500)
 Casualty loss
Sch. C–
  Gross receipts     (2,200)       (9,108)      -0-           (2,200)       -0-
  Advertising       (30,238)       -0-          -0-          (30,238)       -0-
  Other              (3,657)       -0-          -0-           (3,657)       -0-
Sch. E–
  Knorr St.
                          (740)    -0-          -0-                (740)    -0-
  other
  Knorr St.
                     (6,706)       -0-          (4,729)       (1,977)         (4,729)
  utilities
  Knorr St.
                     (9,820)       -0-            (732)       (9,188)             (732)
  depreciation
  Halstead St.
                     (2,783)       -0-          -0-           (2,783)       -0-
  taxes
  Halstead St.
                     (8,288)       -0-          -0-           (8,288)       -0-
  depreciation
  Halstead St.
  cleaning and       (1,134)       -0-          -0-           (1,134)       -0-
  maintenance
  Halstead St.
                     (2,570)       -0-          -0-           (2,570)       -0-
  insurance
  Neshaminy St.
                    (14,182)       -0-          -0-          (14,182)       -0-
  depreciation
  Neshaminy St.
  cleaning and       (2,800)       -0-          (1,220)       (1,580)         (1,220)
  maintenance
                                     24

[*24]                            OPINION

I.      Burden of proof

       Generally, the Commissioner’s determination of a deficiency is
presumed correct, and the taxpayer has the burden of proving it wrong.
Welch v. Helvering, 290 U.S. 111, 115 (1933); see also Rule 142(a)(1).
However, where the Commissioner alleges that a taxpayer
underreported income, he must “provide some predicate evidence
connecting the taxpayer to the charged activity” before the presumption
of correctness attaches to his determination. Gerardo v. Commissioner,
552 F.2d 549, 554 (3d Cir. 1977), aff’g in part, rev’g in part T.C. Memo.
1975-341. Determinations of constructive dividends (as in these cases)
are determinations of underreported income. And to support such
determinations, the Commissioner must establish a sufficient
connection between the income and the taxpayer before the presumption
of correctness attaches to his determination of a constructive dividend.
See, e.g., Austin Otology Assocs. v. Commissioner, T.C. Memo. 2013-293,
at *23; D’Errico v. Commissioner, T.C. Memo. 2012-149, 103 T.C.M.
(CCH) 1802, 1809. Once the Commissioner connects the taxpayer with
the unreported income, the taxpayer then bears the burden of proving
that he did not receive the income and that the Commissioner’s
determination of a deficiency is incorrect. See Walker v. Commissioner,
757 F.2d 36, 38 (3d Cir. 1985), rev’g and remanding T.C. Memo. 1983-
538; see also Rule 142(a).

       Important for such proof are the taxpayer’s records. The
taxpayer’s record-keeping requirements for the income tax are set forth
in section 6001, which requires that—

        Every person liable for any tax imposed by this title, or for
        the collection thereof, shall keep such records, render such
        statements, make such returns, and comply with such
        rules and regulations as the Secretary may from time to
        time prescribe. [Emphasis added.]

Those rules and regulations that the Secretary has prescribed are found
in Treasury Regulation section 1.6001-1; and as is relevant here, they
require a taxpayer to “keep such permanent books of account or records
. . . as are sufficient to establish the amount of gross income, deductions,
credits, or other matters required to be shown by such person in any
return of such tax or information”, id. § 1.6001-1(a), and to retain such
books or records “for inspection by authorized internal revenue officers
                                   25

[*25] or employees . . . so long as the contents thereof may become
material in the administration of any internal revenue law”,
id. § 1.6001-1(e).

II.   Palmarini Inc.’s corporate income tax returns

      A.     Status as a corporation

       As a C corporation (as defined in sections 7701(a)(3) and
1361(a)(2)), Palmarini Inc. is a separate federal income tax-paying
entity, distinct from its shareholders. As the Supreme Court explained
in Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438–39 (1943)
(footnotes omitted):

             The doctrine of corporate entity fills a useful purpose
      in business life. Whether the purpose be to gain an
      advantage under the law of the state of incorporation or to
      avoid or to comply with the demands of creditors or to serve
      the creator’s personal or undisclosed convenience, so long
      as that purpose is the equivalent of business activity or is
      followed by the carrying on of business by the corporation,
      the corporation remains a separate taxable entity.

By choosing to incorporate, Palmarini Inc.’s shareholders assumed both
the benefits and burdens of the corporate form, and they may not
disregard its separate status if they find it is disadvantageous for tax
purposes. See Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co.,
417 U.S. 134, 149 (1974) (“[W]hile a taxpayer is free to organize his
affairs as he chooses, nevertheless, once having done so, he must accept
the tax consequences of his choice, whether contemplated or not, and
may not enjoy the benefit of some other route he might have chosen to
follow but did not.” (citations omitted)). Accordingly, in these cases we
must determine the proper tax consequences to Palmarini Inc. and to
the Palmarinis of the income and expenses shared between them and
allocated amongst their tax returns.

      B.     Business activity

      A taxpayer’s gross income includes “all income from whatever
source derived”. § 61(a). If a taxpayer fails to keep adequate records,
                                          26

[*26] the Commissioner may determine the existence and amount of the
taxpayer’s income by any method that clearly reflects income. § 446(b).

        Because Palmarini Inc. did not maintain adequate records, the
Commissioner used the bank deposits method of proof to reconstruct
Palmarini Inc.’s taxable income for 2013 and 2014 according to the cash
receipts and disbursements method of accounting. 13 See § 446(c)(1). Use
of a BDA to determine unreported income is well-recognized, and it
begins by assuming that all bank deposits are taxable income 14 unless
the taxpayer can show otherwise. Estate of Mason v. Commissioner,
64 T.C. 651, 656–57 (1975), aff’d, 566 F.2d 2 (6th Cir. 1977). We see no
flaw 15 in the Commissioner’s BDA here, and we point out that
Mr. Palmarini’s method of using his bank and credit card statements to
distinguish business and personal expenses, categorizing those
expenses, and calculating the totals is substantially the same.
Furthermore, there is no evidence from which to determine Palmarini
Inc.’s taxable income in 2013 and 2014 other than its bank and credit
card statements.

       The Commissioner’s BDA revealed that Palmarini Inc. received
all its revenues in 2013 and 2014 from affiliated online marketing
activities and incurred substantial advertising expenses.              The
Commissioner determined Palmarini Inc.’s primary business activity in
2013 and 2014 to be affiliated online marketing, and his determination
is not inconsistent with Palmarini Inc.’s own reporting on its 2013 and
2014 returns. Palmarini Inc. reported its business activity to be affiliate
marketing and reported significant gross receipts and expenses from

       13   Under the cash receipts and disbursements method, income is recorded in
the year received and expenses are deducted in the year paid. Treas. Reg. § 1.461-
1(a)(1); see also §§ 451(a), 461(a).
       14  However, the Commissioner must take into account any nontaxable items or
deductions for which he has knowledge. DiLeo v. Commissioner, 96 T.C. 858, 868
(1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
        15 Palmarini Inc. contends that the Commissioner’s BDA method does not

clearly reflect its income for 2013 and 2014 because Palmarini Inc. may not receive
income from its affiliated online marketing business until 90–180 days after earning
its right to payment. However, the Commissioner’s use of the cash receipts and
disbursements method of accounting resolves this concern, since it measures actual
receipt of the income. Furthermore, this Court has long held that “[w]hen a taxpayer
keeps no books or records, has large bank deposits, and offers no plausible explanation
of such deposits, the Commissioner is not arbitrary or capricious in resorting to the
bank deposit method for computing income.” Estate of Mason, 64 T.C. at 657; see also
Clayton v. Commissioner, 102 T.C. 632, 645 (1994); DiLeo, 96 T.C. at 867.
                                   27

[*27] affiliated online marketing. The bad debt deduction Palmarini
Inc. claimed for 2013 and 2014 relates to unpaid advertising services.
Furthermore, Mr. Palmarini acknowledges that Palmarini Inc. did not
receive any revenues from cement construction in 2013 or 2014. The
only income-generating activity Palmarini Inc. engaged in in 2013 and
2014 was affiliated online marketing, and advertising income was
deposited into (and expenses for advertising were paid from) Palmarini
Inc.’s bank accounts. Although in preparing the returns Mr. Palmarini
ostensibly allocated income and expenses from the affiliate marketing
activity between Palmarini Inc. and AMOLLC, he made no showing of
any fact-based distinction between such activity conducted for or
through Palmarini Inc. and other such activity conducted for or through
AMOLLC. Rather, he allocated expenses to AMOLLC’s return only to
generate losses reportable on Schedule C on the Palmarinis’ individual
returns that would then offset Mrs. Palmarini’s otherwise taxable
income. For all these reasons, we agree with the Commissioner’s revised
determination that all advertising income and expenses are properly
reportable on Palmarini Inc.’s returns for 2013 and 2014.

      C.     Gross receipts

       Palmarini Inc. failed to maintain books and records that would
have facilitated the determination of its income, and it proposes instead
that its income should be deemed to consist of only the amounts that
third parties reported on Forms 1099 as having paid to it—i.e., less than
$700,000 in each year—thereby excusing itself from liability for any
income it received that the payor did not happen to report to the IRS.
This approach would let Palmarini Inc. benefit from its own failure,
which we will not do. Rather, we consider the positions it has taken on
its returns and discover that it has in fact reported gross receipts in
amounts greater than those for which it now contends: It reported gross
receipts of $894,963 on one of its amended 2013 returns and gross
receipts of $943,281 on its amended 2014 returns. It has never
explained where those numbers came from nor why they are not correct,
and we think it highly unlikely that Palmarini Inc. would have reported
more gross receipts than it received. The Commissioner’s BDA
determined that Palmarini Inc. received gross receipts of $959,248 for
2013 and gross receipts of $937,532 for 2014, and the Commissioner has
accordingly satisfied his burden to provide predicate evidence
connecting Palmarini Inc. to its underreported gross receipts. Because
Palmarini Inc. does not demonstrate any flaw in the Commissioner’s
                                           28

[*28] methodology or calculations, 16 the Commissioner’s determinations
of Palmarini Inc.’s gross receipts for 2013 and 2014 are sustained.

        D.      Deductions

       When deductions are in dispute, the taxpayer must satisfy the
specific requirements for any deduction claimed. INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992). A taxpayer must also maintain
records adequate to substantiate his income and deductions. § 6001.
Amounts reported on tax returns, even though signed under penalty of
perjury, are insufficient to substantiate the deductions claimed thereon.
Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979) (first citing Roberts
v. Commissioner, 62 T.C. 834, 837 (1974); and then citing Halle v.
Commissioner, 7 T.C. 245 (1946), aff’d, 175 F.2d 500 (2d Cir. 1949)).

      We must resolve Palmarini Inc.’s entitlement to the following
deductions.

                1.      Officer compensation, salaries, and wages

       Under section 162(a)(1), a taxpayer may deduct “a reasonable
allowance for salaries or other compensation for personal services
actually rendered” as an ordinary and necessary business expense. The
test for determining the deductibility of compensation payments is
(1) whether they are reasonable in amount and (2) whether they are in
fact payments purely for services.        Treas. Reg. § 1.162-7(a).
Furthermore, only payments intended as compensation are deductible,
and compensatory intent is a question of fact. Paula Constr. Co. v.
Commissioner, 58 T.C. 1055, 1058–59 (1972), aff’d, 474 F.2d 1345 (5th
Cir. 1973). The taxpayer bears the burden of proving compensatory

         16 Palmarini Inc. argues that the amount of gross receipts determined by the

IRS in excess of the aggregate amount reported on Forms 1099 issued to Palmarini
Inc. in 2013 and 2014 should be considered gifts to Palmarini Inc. However, whether
a transfer is a gift is a question of fact, Commissioner v. Duberstein, 363 U.S. 278, 288
(1960), and we reject this characterization (a) because Palmarini Inc. received these
payments in the ordinary course of its business, see § 61(a)(2), and alternatively
(b) because Palmarini Inc. has not carried its burden of proving any donor’s intention
to make a gift, see Commissioner v. Duberstein, 363 U.S. at 285; see also Robertson v.
United States, 343 U.S. 711, 713 (1952) (“[P]ayment for services rendered . . . is in no
sense a gift”). Similarly, all of Palmarini Inc.’s attempts to recharacterize as gifts its
payments to others fail for lack of evidence of Palmarini Inc.’s intention to make gifts.
                                   29

[*29] intent. King’s Court Mobile Home Park, Inc. v. Commissioner,
98 T.C. 511, 514 (1992).

                    a.    Officer compensation

      Palmarini Inc. claimed a $92,400 deduction for officer
compensation on its 2013 return, and no deduction for 2014. The
Commissioner disallowed Palmarini Inc.’s deduction on the basis of lack
of substantiation that the payments were made and that they were
made purely for the services of the officers. The fact that Palmarini Inc.
did not file any associated Forms W–2 or employment tax returns
(Forms 940 and 941) nor pay any associated employment taxes, see
§§ 3101, 3102, 3111, 3301, and the fact that Mr. Palmarini did not report
any wage income from Palmarini Inc. on his 2013 individual income tax
return, both weigh against its contention that such payments were
made.

        Palmarini Inc. responds that its Form 1125–E, “Compensation of
Officers”, attached to its 2013 return substantiates its deduction for
officer compensation. However, this reporting form attached to the
return does not prove that any amounts intended as compensation were
in fact paid to officers, and Palmarini Inc.’s bank records do not show
any payments that could be so interpreted. Palmarini Inc.’s deduction
for officer compensation is disallowed for lack of substantiation.

                    b.    Salaries and wages

       Palmarini Inc. also claimed a $15,000 deduction for salaries and
wages on its 2013 return and no deduction for 2014. The Commissioner
disallowed this deduction for lack of substantiation. We hold that
Palmarini Inc. is entitled to deduct the payments made to Mr. Palmarini
in return for his labor building the Neshaminy Street garage.

      Mr. Palmarini testified at trial that he and Manuel Palmarini
worked for Palmarini Inc. renovating the garage at Neshaminy Street.
He produced invoices reflecting payments made to him for his labor
which (although not contemporaneous) reference check numbers
corresponding with disbursements that the Commissioner identified as
“cash” and included in his proposed constructive dividend to
Mr. Palmarini. These payments are recurring, and they corroborate
Mr. Palmarini’s testimony that they were payments for his labor on the
Neshaminy Street garage. Palmarini Inc. is entitled to deduct $58,100
                                          30

[*30] for 2013 and $76,500 for 2014 for wages paid to Mr. Palmarini for
his labor. 17

               2.      Repairs and maintenance

       Section 263(a)(1) requires that the cost “for permanent
improvements or betterments made to increase the value of any
property” be capitalized, not immediately deducted. Only “[t]he cost of
incidental repairs which neither materially add to the value of the
property nor appreciably prolong its life, but keep it in an ordinarily
efficient operating condition, may be deducted as an expense” in the
current year. Treas. Reg. § 1.162-4 (2011); 18 see also Treas. Reg.
§ 1.263(a)-3(i)(1)(i). On the other hand, amounts paid for improvements,
see Treas. Reg. § 1.263(a)-3(d), betterments, see id. para. -3(j),
restorations, see id. para. -3(k), or adaptations, see id. para. -3(l), of real
property are considered capital expenditures.

       Palmarini Inc. claimed on its 2013 return a $114,719 deduction
for repairs and maintenance and no such deduction for 2014. Palmarini
Inc. now argues that it should be allowed a $97,990 deduction for repairs
and maintenance for 2013 and a $183,578 deduction for repairs and
maintenance for 2014 for expenses on the following properties:
(1) Halstead Street garage; (2) Halstead Street home; (3) Chandler
Street ground floor; (4) Knorr Street ground floor; and (5) Neshaminy
Street. The Commissioner disallowed Palmarini Inc.’s deduction for

        17  In an income tax deficiency case, we lack jurisdiction to determine any
employment tax consequences in the absence of a notice of determination of worker
classification issued to the petitioner. See Charlotte’s Office Boutique, Inc. v.
Commissioner, 121 T.C. 89, 103 (2003) (“It is the Commissioner’s determination of
worker classification that provides the predicate for our jurisdiction under
section 7436(a) . . . .”), supplemented by T.C. Memo. 2004-43, aff’d, 425 F.3d 1203 (9th
Cir. 2005); see also Povolny Group, Inc. v. Commissioner, T.C. Memo. 2018-37, at *7–9
(determining employment tax deficiencies in an income tax deficiency case where the
Commissioner also issued to the taxpayer a notice of determination of worker
classification). However, because it appears no employment tax returns were filed
with respect to amounts paid as wages to Mr. Palmarini, the statute of limitations for
assessment of any associated employment taxes likely remains open under
section 6501(a).
        18 Treasury Regulation section 1.162-4 (2011) (quoted above) was replaced by

Temporary Treasury Regulation section 1.162-4T (2013), see T.D. 9564, 2012-14 I.R.B.
614, which became final as of January 1, 2014, see T.D. 9636, 2013-43 I.R.B. 331.
Although this regulation was redrafted and given new organization, its underlying
policy is identical. See Treas. Reg. § 1.162-4(a) (2014) (“A taxpayer may deduct
amounts paid for repairs and maintenance to tangible property if the amounts paid
are not otherwise required to be capitalized”).
                                    31

[*31] repairs and maintenance in its entirety because the repairs were
not made to property owned by Palmarini Inc.

        We sustain the Commissioner’s determination that Palmarini
Inc.’s deductions for repairs and maintenance should be disallowed in
full for lack of substantiation. To the extent that these deductions are
substantiated and relate to Palmarini Inc.’s principal place of business
at the Halstead Street garage, they will be allowed, see infra Part II.D.5,
as depreciation after the garage became corporate property. The
remainder of Palmarini Inc.’s deductions relate to properties owned
individually by Mr. Palmarini. Palmarini Inc. cannot take a deduction
for repairs and maintenance to property it neither owned nor leased, see,
e.g., Arevalo v. Commissioner, 124 T.C. 244, 251 (2005) (“[W]hen a
taxpayer never actually owns the property in question, the taxpayer is
not allowed to claim deductions for depreciation”), aff’d, 469 F.3d 436
(5th Cir. 2006), even if it paid the expense and used these properties for
business purposes. Furthermore, to the extent that these alleged
expenditures for “repairs and maintenance” of Mr. Palmarini’s rental
properties might be capital expenditures that could be deductible to
Palmarini Inc. as depreciation of improvements to leased property, see
Treas. Reg. §§ 1.162-11(b)(1), 1.263(a)-3(f), Palmarini Inc. did not offer
sufficient evidence to enable us either to conclude that such a leasehold
arrangement existed between Mr. Palmarini and Palmarini Inc. in 2013
and 2014 or to distinguish between repairs and maintenance done to
areas used by Palmarini Inc. or areas occupied by residential tenants.

             3.     Bad debt

       Section 166(a) grants a taxpayer a deduction for any bona fide
debt that becomes wholly or partially worthless within the taxable year.
To prove entitlement to a bad debt deduction, the taxpayer must show
(1) the existence of a bona fide debt, (2) incurred in connection with a
trade or business, (3) that became worthless within the taxable year.
See § 166. “A bona fide debt is a debt which arises from a debtor-creditor
relationship based upon a valid and enforceable obligation to pay a fixed
or determinable sum of money”, Treas. Reg. § 1.166-1(c), and whether a
debtor-creditor relationship exists is a question of fact, Fisher v.
Commissioner, 54 T.C. 905, 909 (1970). Factors indicating a bona fide
debt include whether: (1) evidence of indebtedness exists; (2) any
security is requested; (3) there has been a demand for repayment; (4) the
parties’ records reflect the transaction as a loan; (5) any payments have
                                   32

[*32] been made; and (6) interest was charged.     See Sundby v.
Commissioner, T.C. Memo. 2003-204, 86 T.C.M. (CCH) 58, 61 (2003).

       The Commissioner disallowed Palmarini Inc.’s bad debt
deductions for 2013 and 2014 in full because they do not relate to a bona
fide debt and they lack substantiation. We agree. There was no loan
from Palmarini Inc. to Epic Media Group—rather, the relationship
between them was business-consumer and not debtor-creditor.
Palmarini Inc. is not permitted to take a bad debt deduction for 2013
and 2014 for an unpaid invoice from 2011. We agree with the
Commissioner’s determination that Palmarini Inc.’s bad debt
deductions for 2013 and 2014 must be disallowed.

       The circumstances in which a debt consisting of an unpaid
receivable may support a loss deduction are not present here. The
regulations provide that “[a] debt arising out of the receivables of an
accrual method taxpayer is deemed to be an enforceable obligation . . .
to the extent that the income such debt represents have been included
in the return of income for the year for which the deduction as a bad
debt is claimed or for a prior taxable year.” Treas. Reg. § 1.166-1(c)
(emphasis added). However, in 2013 and 2014 Palmarini Inc. was a cash
basis taxpayer. See supra Part II.B. The corporation so stated on its
original returns for the year and did not make any credible showing that
it had ever filed returns on any other basis.

       It is possible for a taxpayer to change methods of accounting, so
one can posit an accrual-method taxpayer who accrued income in 2011
as the result of a receivable that later became worthless in 2013, after
the taxpayer had become a cash-method taxpayer.               However,
section 446(e) provides: “[A] taxpayer who changes the method of
accounting on the basis of which he regularly computes his income in
keeping his books shall, before computing his taxable income under the
new method, secure the consent of the Secretary.” (Emphasis added.)
The provision is mandatory.

        There is no evidence supporting the position that the unpaid
balance from Epic Media Group was accrued as income in a prior year,
nor that Palmarini Inc. requested the IRS’s consent to change from its
supposed 2011 accrual method to the cash basis method it reported on
its original returns for the years at issue.
                                    33

[*33]        4.     Rent

      Section 162(a)(3) allows a deduction for rental expenses, provided
that the payment is made as a condition to the continued use or
possession (for the purposes of the trade or business) of property in
which the taxpayer has no title and no equity.

       Palmarini Inc. claimed a $18,229 deduction for rents paid on its
2013 return, and no deduction for 2014. In his revised report, the
Commissioner allowed Palmarini Inc. a $12,187 deduction for 2013 and
a $13,387 deduction for 2014 for rent of the Halstead Street garage while
it was owned by Manuel Palmarini. Palmarini Inc. accepts the
Commissioner’s revised determination as to 2013 but argues that it
should be allowed to deduct an additional $5,191 for rent for 2014
because $18,578 is the total amount of payments issued by Palmarini
Inc. to Manuel Palmarini in 2014. However, Manuel Palmarini owned
Halstead Street only until March 2014, after which it became property
of Palmarini Inc. Palmarini Inc. cannot deduct rent payments for
Halstead Street after the property became its own. See § 162(a)(3). We
therefore sustain the Commissioner’s revised determinations for rents
paid in 2013 and 2014.

             5.     Depreciation

       Section 167(a) allows a deduction for depreciation of property
“used in the trade or business” or “held for the production of income”. To
prove entitlement to a deduction for depreciation, a taxpayer must show
(1) the existence of a trade or business; (2) that the property in question
is used in the trade or business; and (3) a depreciable basis in the asset
by showing the cost of the property, its useful life, as well as any
previously allowable depreciation. See, e.g., Cluck v. Commissioner, 105
T.C. 324, 337 (1995).

       Palmarini Inc. claimed a $6,035 deduction for depreciation on its
2013 return, and no deduction for 2014. In his revised report the
Commissioner disallowed Palmarini Inc.’s depreciation deduction for
2013 and allowed a $1,671 deduction for depreciation of the Halstead
property after it was acquired by Palmarini Inc. and put into service in
August 2014. Palmarini Inc. does not allege that it is entitled to an
additional amount for depreciation for 2014, so that determination will
be sustained.

       Palmarini Inc. argues that, in addition, it is entitled to depreciate
the cost of its pickup truck for 2013. The Commissioner disallowed this
                                         34

[*34] deduction because the truck was not property of Palmarini Inc.
The bill of sale for the truck suggests that it is property of Mr. Palmarini
and that it has mixed business and personal use; and a taxpayer
claiming depreciation of a mixed-use asset must show the relevant
proportions of business and personal use. See §§ 274(d), 280F(b), (d)(4);
see also Finney v. Commissioner, T.C. Memo. 1980-23, 39 T.C.M. (CCH)
938, 950–51 (holding that the taxpayer has the burden to prove the
percent of business use); Treas. Reg. §§ 1.167(a)-2, 1.280F-2T(i)(1).
Because there are no adequate records to ascertain the business use
percentage of the truck, we cannot determine the proper amount of any
depreciation deduction, and the deduction must be disallowed for lack of
substantiation and failure of proof. See Rule 142(a).

               6.      Advertising

       “[A]dvertising and other selling expenses” that “pertain to the
taxpayer’s trade or business” are generally deductible under section 162
as an “ordinary and necessary” expense. See Treas. Reg. § 1.162-1(a)(1).
Here, Palmarini Inc. claimed (and the IRS allowed) advertising
expenses related to its affiliated online marketing business. 19

                       a.     2013

      Palmarini Inc. deducted $345,433 for advertising expenses on its
2013 return, and the Commissioner determined that it paid $386,628 for
advertising expenses in 2013. Because the Commissioner determined
an amount greater than what Palmarini Inc. claimed on its 2013 return,
and Palmarini Inc. does not allege it is entitled to a greater amount,
there is no additional amount in dispute, 20 and the Commissioner’s
determination is sustained.

                       b.     2014

      Palmarini Inc. deducted $577,156 for advertising expenses on its
2014 return, and the Commissioner determined that it paid $452,390 for

       19 Given the nature of affiliated online marketing—incurring expense to place
ads for customers—we think the technically correct character of this deduction for
supposed advertising expenses might instead be cost of goods sold. However,
Mr. Palmarini reported the expenses as advertising, and the IRS allowed them as such,
and we will not disturb the parties’ agreed-to characterization.
        20 The principal dispute regarding advertising expenses is whether

Mr. Palmarini should be allowed to report them on his Schedule C for AMOLLC. See
infra Part III.C.
                                    35

[*35] advertising expenses in 2014. Palmarini Inc. alleges that it is
entitled to deduct an additional $87,137 for advertising expenses for
2014, comprised of $52,252 paid to Media Traffic and $34,885 paid to an
unspecified Bank of America account.

       Regarding the $52,252 paid to Media Traffic, the report from
Media Traffic on which Palmarini Inc. relies for substantiation is in the
stipulation of facts that the Commissioner reviewed in making his
revised determination, but it is unclear whether the Commissioner
included this amount in his allowance for advertising expenses for 2014.
We assume he did not (and we therefore consider whether this might be
an additional deductible amount), but the report from Media Traffic is,
by itself, insufficient to substantiate an additional deduction, because it
neither specifies whether the amounts shown are revenues or expenses
nor shows whether the expenses (if expenses) were in fact paid by
Palmarini Inc. See § 461(a) (requiring deductions to be taken “under the
method of accounting used”); Treas. Reg. § 1.461-1(a)(1) (requiring cash-
method taxpayers to claim deductions “for the taxable year in which
paid”). And regarding the $34,885 paid to the unspecified Bank of
America account, we do not have any account statements from which to
verify the specific amounts paid, to whom payments were made, and
their business purpose. See § 162(a) (allowing deductions for expenses
“paid . . . in carrying on any trade or business”); § 6001 (requiring the
keeping of records). Accordingly, Palmarini Inc. has failed to carry its
burden of proving that it is entitled to deduct additional amounts for
advertising in excess of the Commissioner’s revised determination, and
the Commissioner’s revised determination is sustained.

             7.     Other deductions

        Palmarini Inc. deducted $38,290 for “other” expenses on its latest
amended 2013 return and deducted $57,337 on its latest amended
return for 2014 (filed June 27, 2015). Palmarini Inc. further alleges that
it is entitled to an additional $165,122 deduction for “other” expenses for
2013 from a VIST bank account ending in -2508. And Palmarini Inc.
now argues for an additional $128,550 deduction for “other” expenses for
2014 from the same bank account. The classification given to these
expenses in Palmarini Inc.’s post-trial brief is mostly advertising
expenses, expenses related to Mr. Palmarini’s rental properties, or
unspecified expenses. Mr. Palmarini also claimed at trial that he
believes there is a third American Express card issued to him personally
that the Commissioner did not consider when revising his
determinations. Mr. Palmarini provided a year-end summary sheet
                                    36

[*36] from American Express to substantiate what he alleges are
further business deductions to which he should be entitled, and he
points to Palmarini Inc.’s bank statements showing that it paid
$364,261 to American Express in 2013 and $467,369 in 2014.

       However, we find his testimony not credible and his documentary
evidence not convincing. Palmarini Inc.’s disorganized recordkeeping (if
it can be called recordkeeping) does not enable one to verify the business
purpose and specific amounts paid for “other” expenses. His documents
show a tangle of business and personal, of capital and ordinary, and of
mixed lines of potential business. His information was in such disarray
that he himself, preparing returns in the months after the close of the
years at issue, was unable to determine with reasonable certainty his
own deductible expenses, so he filed a series of amended returns
claiming deductions inexplicably “not included” in a return filed days
before, or stating “[m]ore deductions found in Line 26.”

       He now insists that he had (and that he presented to the IRS
statements from) “10 credit cards with huge charge expenses on them in
2013”; but he offers no explanation as to why he did not report the
expenses from those cards on his sixth and seventh amended returns for
2013, on which he did report expenses attributed to “Amex card ending
5107”, “BOA card ending 9744”, “Visa card ending 2031”, “Bank of
America card ending 9141”, “Credit card ending 7732”, and “Card ending
C68-640”. The years that have passed since he prepared those amended
returns in 2015 have not improved the situation, as papers scatter,
memories fade, document retention periods expire. The best time to
tally business expenses for 2013 and 2014 was when the returns were
due, in 2014 and 2015; but Mr. Palmarini now unwittingly discredits his
own contemporaneous reporting by years-late allegations of substantial
additional expenses. To the extent that Palmarini Inc. argues for
deductions greater than the Commissioner has elsewhere conceded, it
has failed to carry its burden of proof, and the Commissioner’s revised
determination is sustained.

      E.     Constructive dividends

             1.     Paid out of earnings and profits

       Section 301(c) controls the treatment of distributions of property
from a corporation to its shareholders. § 301(a). Under section 301(c)(1),
a shareholder must include in gross income any portion of the
distribution which is a dividend (i.e., it is paid out of the corporation’s
                                           37

[*37] earnings and profits, see § 316(a)). 21 On the basis of Palmarini
Inc.’s gross receipts less allowed deductions for 2013 and 2014, it did
have sufficient earnings and profits to issue dividends to Mr. Palmarini.
See § 316(a).

                2.      Two-part test

       Dividends may be formally declared or constructive.              A
constructive dividend arises “[w]here a corporation confers an economic
benefit on a shareholder without the expectation of repayment, . . . even
though neither the corporation nor the shareholder intended a
dividend.” Magnon v. Commissioner, 73 T.C. 980, 993–94 (1980); see
also C.F. Mueller Co. v. Commissioner, 479 F.2d 678, 683 (3d Cir. 1973)
(“A taxpayer who is a shareholder has been held to have received a
constructive dividend when he receives an economic benefit through a
diversion of corporate earnings and profits”), aff’g 55 T.C. 275 (1970).
“However, ‘not every corporate expenditure which incidentally confers
economic benefit on a shareholder is a constructive dividend.’ The
crucial test of the existence of a constructive dividend is whether ‘the
distribution was primarily for the benefit of the shareholder.’” Magnon,
73 T.C. at 994 (emphasis added) (quoting Loftin & Woodard, Inc. v.
United States, 577 F.2d 1206, 1214 (5th Cir. 1978)). Thus, there is a
two-part test to determine a constructive dividend: (1) the expense must
be nondeductible to the corporation, and (2) it must represent some
economic gain, benefit, or income to the shareholder. See, e.g., Dobbe v.
Commissioner, T.C. Memo. 2000-330, 80 T.C.M. (CCH) 577, 587, aff’d,
61 F. App’x 348 (9th Cir. 2003). But it should be borne in mind that
where the Commissioner has determined a constructive dividend as
unreported income, he bears the burden of production to show a
connection between that income and the taxpayer. See, e.g., Austin
Otology Assocs., T.C. Memo. 2013-293, at *23; D’Errico, 103 T.C.M.
(CCH) at 1809. Ordinarily, the Commissioner’s showing that a
corporate expenditure produced a benefit to the shareholder implicitly
satisfies his burden of production to connect the shareholder-taxpayer
with the underreported income; however, as we will show, the

         21 If the distribution exceeds the corporation’s earnings and profits, the excess

is first a return of capital to the extent of the shareholder’s adjusted basis in the
corporation’s stock, see § 301(c)(2); and any further remainder is treated as a long-term
capital gain, see § 301(c)(3).
                                   38

[*38] Commissioner’s method of determining constructive dividends is,
in some instances in these cases, problematic.

       The Commissioner’s initial determination of constructive
dividends to Mr. Palmarini ($328,931 in 2013 and $386,054 in 2014)
reflected the difference between Palmarini Inc.’s total disbursements
and its allowed deductible expenses for those years. That is, the
Commissioner initially assumed that any expenditure by Palmarini Inc.
that was not deductible was a dividend to Mr. Palmarini. The
Commissioner’s revised determination of constructive dividends
($261,716 in 2013 and $226,794 in 2014) acknowledged certain
additional expenditures conceded to be deductible by Palmarini Inc., but
his revised determination still calculates the constructive dividends to
Mr. Palmarini to be total disbursements less allowable deductions.
However, this shorthand method of calculating a constructive dividend
does not satisfy the Commissioner’s burden of production to connect
unreported income with Mr. Palmarini. See Ashby v. Commissioner,
50 T.C. 409, 418 (1968) (“The fact that the full amounts have been
disallowed as deductions to the corporation does not necessarily mean
that the full amounts are to be treated as dividends to the individual”).
For each expense included in the constructive dividends, the
Commissioner must first establish a connection with Mr. Palmarini and
then show that the payment was primarily for his benefit. See Gerardo
v. Commissioner, 552 F.2d at 554; Magnon, 73 T.C. at 994.

             3.    Analysis

                   a.     Payments lacking description

      The Commissioner put into evidence lead sheets showing his
revised determinations of constructive dividends to Mr. Palmarini in
2013 and 2014. The lead sheets show Palmarini Inc.’s gross receipts and
allowed deductions, categorize Palmarini Inc.’s nondeductible expenses
and give totals, and identify expenses that were removed from the
constructive dividend to arrive at the revised amounts. For certain
expenses the Commissioner included description lines specifying what
the payments were for, while for others there were no such descriptions.
The expenses lacking descriptions categorically fail to satisfy the
Commissioner’s burden to connect the payments to Mr. Palmarini, see
Gerardo v. Commissioner, 552 F.2d at 554, and likewise fail to show that
the payments were primarily for his benefit, see Magnon, 73 T.C. at 994.
All categories of expenses without accompanying descriptions must
accordingly be removed from the constructive dividend determination.
                                         39

[*39]                  b.      Payments for the benefit of relatives

       Furthermore, not every expense for which the Commissioner did
include a description shows a sufficient connection with Mr. Palmarini.
For example, there are categories labeled “Manuel Palmarini”, 22 “Dora
Pasquali bill payment”, and “Pacifico Palmarini bill payment”. The
Commissioner’s descriptions identify Dora Pasquali as Mr. Palmarini’s
mother, and the evidence shows that Manuel and Pacifico are Benito’s
brothers—but these two brothers are also shareholders and officers of
Palmarini Inc. for whose benefit the payments could well have been
made. Manuel was active in the business; and Pacifico held a greater
share of the company than Benito. Although it is not unreasonable to
speculate that Benito could have authorized these payments by
Palmarini Inc. in his capacity as an officer, such authorization does not
necessarily connect these payments to Benito Palmarini as income, nor
show that these payments were primarily for his benefit. In our view,
the most reasonable supposition is that the payments to Manuel and
Pacifico are primarily for their own benefit. The payments to their
mother are primarily for her benefit; and if we postulate that a payment
to her gives rise to an indirect benefit to her son, then that indirect
benefit flows to each son equally. The categories labeled “Manuel
Palmarini”, “Dora Pasquali bill payment”, and “Pacifico Palmarini bill
payment” must therefore be removed from the constructive dividends.
The cash category represents payments made to Mr. Palmarini for his
labor (deductible to Palmarini Inc. as wages, see supra Part II.D.1.b, and
included in Mr. Palmarini’s income as such, see infra Part III.A.1), and
those payments must also be removed from the constructive dividends.

                       c.      “No statements provided”

      The Commissioner also included the $34,885 paid to an
unspecified Bank of America account, see supra Part II.D.6.b, in his
determination of a constructive dividend for 2014, and he gives the
description “no statements provided”. This contention seems to attempt
to bypass the Commissioner’s burden of production—i.e., to show benefit
to Mr. Palmarini by showing that he failed to offer evidence disproving
a benefit. But a payment to an unspecified bank account, without more
information, proves neither a benefit to Mr. Palmarini nor income to

       22 This $10,000 expense is a distinct category from the $12,187 expense labeled

“Manuel Palmarini bill payment” that the Commissioner removed from the
constructive dividend and allowed as rent payment for Palmarini Inc.’s use of the
Halstead Street garage.
                                    40

[*40] him. Just as this expense lacks substantiation to be a deduction
to Palmarini Inc., it lacks substantiation to be deemed income to Mr.
Palmarini, and therefore should not be characterized as a constructive
dividend.

                    d.     Personal and rental expenses

       The Commissioner explicitly identified the following categories of
Palmarini Inc.’s expenditures as being for the benefit of Mr. Palmarini
personally: (1) maintenance and upkeep of his Schedule E rental
properties; (2) medical bills for himself and his family; (3) a family trip
to Italy; and (4) a personal vehicle. Checks written from Palmarini Inc.’s
account (authorized by Mr. Palmarini) do indeed bear descriptions
relating to his personal rental properties, healthcare for himself and his
family, personal travel, and his personal vehicle, and they clearly
establish a connection with him and demonstrate that the expenses
were primarily for his benefit. Furthermore, there is an expense
category labeled simply “Ben Palmarini”; it has no further description,
but it establishes a sufficient connection with Mr. Palmarini. Given the
Commissioner’s showing, the burden to prove that these expenses
should not be treated as constructive dividends therefore shifted to
Palmarini Inc. and to Mr. Palmarini. See Rule 142(a); Walker v.
Commissioner, 757 F.2d at 38. Petitioners do not meet that burden.

       Mr. Palmarini argues that Palmarini Inc. uses his personal rental
properties for the business purpose of storing its equipment, and that
therefore its payments related to these properties are deductible
business expenses of Palmarini Inc. in the nature of rent, rather than a
constructive dividend to him. Although we accept that Palmarini Inc.
may have made some use of these properties for business purposes,
there is no documented rental agreement between Palmarini Inc. and
Mr. Palmarini for the corporation’s use of the properties, nor are there
any recurring payments from which to infer that anything like a rental
arrangement existed. Furthermore, these payments by Palmarini Inc.
are to third parties, rather than to Mr. Palmarini, and the description
lines simply state the address of the property and specify neither the
work done nor its business purpose. Palmarini Inc.’s expenses for
maintenance and improvements to Mr. Palmarini’s personal rental
properties represent a constructive dividend to him, see, e.g., Magnon,
73 T.C. at 994; and, to the extent set out in the Commissioner’s revised
examination report and the parties’ stipulation of settled issues,
Mr. Palmarini may deduct the third parties’ expenditures as rental
expenses on Schedule E.
                                    41

[*41] Mr. Palmarini further asserts that Palmarini Inc.’s corporate
bylaws provide for paying the cost of medical care and of a vacation for
officers and their families. No copy of Palmarini Inc.’s corporate bylaws
was produced in these cases; but even if we assume their existence, a
corporation’s bylaws do not overrule the federal income tax
consequences of a corporation’s distributions to its shareholders.
Financial benefits to be paid to officers have their federal tax
consequences even if bylaws authorize those benefits to be paid.
Palmarini Inc.’s payment of personal expenses for Mr. Palmarini and his
family must be included in his income as a constructive dividend. See,
e.g., Dobbe, 80 T.C.M. (CCH) at 587–88.

      On the basis of these burden-of-proof principles, we hold that
Mr. Palmarini received constructive dividends from Palmarini Inc. of
$116,741 for 2013 and $62,798 for 2014. An itemization of the
constructive dividends for 2013 and 2014 is included in the Appendix.

      F.     Section 6662 accuracy-related penalties

        Section 6662(a) imposes an “accuracy-related penalty” equal to
20% of the portion of an underpayment of tax that is attributable to the
taxpayer’s negligence or disregard of rules or regulations, see
§ 6662(b)(1), or that is attributable to any substantial understatement
of income tax, see § 6662(b)(2). Section 6662(c) defines negligence to be
“any failure to make a reasonable attempt to comply with the provisions
of this title [i.e., title 26 U.S.C., the Internal Revenue Code]”; and
negligence also includes “any failure by the taxpayer to keep adequate
books and records or to substantiate items properly”. Treas. Reg.
§ 1.6662-3(b)(1). Section 6662(d)(1)(B) provides that, for corporations,
an understatement of income tax is “substantial” if it exceeds the lesser
of either 10% of the tax that should have been reported on the return
(or, if greater, $10,000) or $10 million.

        Because Palmarini Inc. is not an “individual” within the meaning
of section 7491(c), that section’s burden-shifting provisions in the case
of “any individual” do not apply, and the burden remains on Palmarini
Inc. to prove it should not be held liable for the section 6662(a) accuracy-
related penalties. Palmarini Inc. argues that it should not be held liable
for the accuracy-related penalties because the IRS examination process
lasted too long, and it cites Internal Revenue Manual 4.10.2.2.2 (Feb. 11,
2016) (establishing the agency’s goal of completing examinations of
business income tax returns within 27 months after the date the return
is filed). It would be ironic if a taxpayer who had chaotic and incomplete
                                    42

[*42] records could escape penalty because it took the IRS a long time
to puzzle out its income and deductions—but that is not the case. “It is
a well-settled principle that the Internal Revenue Manual does not have
the force of law, is not binding on the IRS, and confers no rights on
taxpayers.”     McGaughy v. Commissioner, T.C. Memo. 2010-183,
100 T.C.M. (CCH) 144, 148. The only deadline that the IRS was
required to meet in order to assess a deficiency in federal income tax was
the 3-year period of limitations established by section 6501(a). Here, the
3-year period for assessment would have expired on April 15, 2017, for
the year 2013, and on April 15, 2018, for the year 2014; and the NOD
was timely issued to Palmarini Inc. on November 14, 2016, before either
period expired. Section 6503(a)(1) provides that, upon the taxpayer’s
filing of a petition in the Tax Court, the period of limitations for
assessment shall be suspended “until the decision of the Tax Court
becomes final[], and for 60 days thereafter.” The periods for assessment
of the deficiencies in federal income tax against Palmarini Inc. for 2013
and 2014 therefore remain open during the pendency of these cases.

      We are satisfied that Palmarini Inc. is liable for section 6662
accuracy-related penalties for 2013 and 2014 under either a negligence
theory based on its failure to maintain adequate records or on a
substantial understatement theory based on the extent of its
underreported income and overstated deductions.

III.   The Palmarinis’ individual income tax returns

       A.    Income

             1.     Wages, salaries, tips, etc.

      Mr. Palmarini’s wage income includes the payments he received
from Palmarini Inc. for his labor on the Neshaminy Street garage, see
supra Part II.D.1.b: $58,100 for 2013 and $76,500 for 2014.

             2.     Constructive dividends from Palmarini Inc.

       The Palmarinis reported $1,344 of dividend income on their 2013
return, and no dividend income for 2014. The Palmarinis’ dividend
income must include the constructive dividends that Mr. Palmarini
received from Palmarini Inc., see supra Part II.E: $116,741 for 2013 and
                                    43

[*43] $62,798 for 2014, see § 301(c)(1). This makes the Palmarinis’ total
dividend income $118,085 for 2013 and $62,798 for 2014.

             3.     Other income

      The Commissioner identified deposits into AMOLLC’s bank
accounts that were not advertising income, and he proposes to reclassify
these items as “other” income on the Palmarinis’ returns. The
Palmarinis reported “other” income of $129,400 on their 2013 return and
$71,200 on their 2014 return (listing the type and amount for both years
as “1099 MISC-Gambling”). In his revised report, the Commissioner
proposes to reduce the Palmarinis’ “other” income to $13,750 for 2013
and to $9,108 for 2014. The Palmarinis agree to the Commissioner’s
determinations and there is no additional amount in dispute.

      B.     Schedule A casualty loss deduction for 2014

       Section 165 allows a taxpayer a deduction for casualty losses
incurred during the year that are not compensated by insurance or
otherwise. The amount of the deduction equals the difference between
the fair market value of the property before and after the casualty, to
the extent of the taxpayer’s adjusted basis in the property. Treas. Reg.
§ 1.165-7(b)(1)(i). Treasury Regulation section 1.165-7(a)(2)(ii) further
provides that a deduction for casualty loss may be valued as the cost of
repair where (a) the repair is necessary to restore the property to its pre-
casualty condition, (b) the cost of repair is not excessive, (c) the repairs
do not exceed the actual damage suffered, and (d) the repairs do not
increase the value of the property beyond its pre-casualty value.
However, section 165(h) limits a deduction for casualty losses in two
ways: first by allowing a deduction only for casualty losses greater than
$100, see § 165(h)(1); and second by allowing a deduction for casualty
losses only to the extent that the loss exceeds the sum of the taxpayer’s
personal casualty gain for the taxable year plus 10% of the taxpayer’s
adjusted gross income (“AGI”), see § 165(h)(2)(A).

       The Palmarinis deducted $44,511 for casualty losses on their
2014 return based on the alleged decrease in the value of their home due
to the damaged fence. The Commissioner proposes to fully disallow this
casualty loss deduction for lack of substantiation of the decrease in the
value of the property. We agree that the Palmarinis’ casualty loss
deduction should be disallowed, but for a reason different from what the
Commissioner argues. The Palmarinis claimed their deduction in the
amount of what Mr. Palmarini said would have been the cost to replace
                                    44

[*44] the entire fence, despite his having paid only about $1,000 on
repairs of the damaged portion. Assuming his replacement estimate to
be correct, that $60,000 expenditure would have given him a brand new
fence, not the used fence he owned before the damage was done. There
are no receipts reflecting the cost of restoration work actually done, only
estimates and Mr. Palmarini’s testimony that the value of his property
was reduced by having a mismatching fence. Although he put
photographs into evidence that do show the damaged fence, there is no
appraisal reflecting the extent of the decrease in value of the property
as a result of the casualty. See Treas. Reg. § 1.165-7(a)(2)(i). The best
evidence by which we can quantify the amount of the loss is not the
Palmarinis’ expenditure of $1,000 (since there is no evidence that these
limited repairs were an indication of the lost value), but is instead the
insurance company’s damage estimate of $3,360, of which the insurance
company paid $860 (after a deductible of $2,500) in settlement of the
Palmarinis’ claim. Because the Palmarinis were thus compensated by
insurance to the extent of $860, their net casualty loss for 2014 is the
$2,500 “deductible” for which they received no compensation. See
§ 165(h)(2)(A)(i). The Palmarinis are entitled to deduct only the portion
of their net casualty loss that is greater than 10% of their AGI, but any
AGI amount greater than $25,000 would require the disallowance of the
entire $2,500 net loss. The Palmarinis’ 2014 AGI (even before inclusion
of the amounts determined as income in Part III.A above) is greatly in
excess of $25,000, so their casualty loss deduction must be disallowed.
See § 165(h)(2)(A).

      C.     Schedule C

       The Palmarinis’ Schedules C for 2013 and 2014 reported gross
receipts and deducted advertising expenses in excess of those gross
receipts, showing a net loss. Although all advertising income and
expenses were deposited into and paid out of Palmarini Inc.’s corporate
bank accounts, Mr. Palmarini split the reporting of these items between
Palmarini Inc.’s returns and the Palmarinis’ Schedules C for AMOLLC.
He argues that his advertising business belongs on Schedule C because
AMOLLC is a distinct business from Palmarini Inc. and because some
Forms 1099 reporting advertising revenues were issued to him under
his personal Social Security number. Such a division of business
activities between an individual and his corporation may sometimes be
appropriate, but in this instance it is not supported by the
preponderance of the evidence. The amount of advertising income
reported on the Forms 1099 that were issued to Mr. Palmarini was
marginal compared to the amount of advertising income reported on the
                                         45

[*45] Forms 1099 that were issued to Palmarini Inc. And even taking
as true that Mr. Palmarini intended that those Forms 1099 issued to
Palmarini Inc. be issued to him under his personal Social Security
number, the income was in fact deposited into Palmarini Inc.’s corporate
accounts.

       Notably, Mr. Palmarini admitted that his primary objective in
preserving his Schedules C was to generate a loss to offset Bernadette
Palmarini’s wages and reduce the amount of individual income tax
owed. This is precisely the kind of manipulative reporting for tax
purposes prohibited by the separate entity doctrine of Moline Properties
v. Commissioner, 319 U.S. at 439 (“[B]ecause the taxpayer had adopted
the corporate form for purposes of his own[,] [t]he choice of the
advantages of incorporation to do business . . . required the acceptance
of the tax disadvantages”). We therefore agree with the Commissioner
that all advertising income and expenses must be reported on Palmarini
Inc.’s 2013 and 2014 corporate income tax returns, that miscellaneous
gross receipts reported on Schedules C must be moved to “other” income
on the Palmarinis’ 2013 and 2014 returns, and that the remainder of the
Palmarinis’ Schedule C deductions should be disallowed.

       D.      Schedule E rental properties

        The Palmarinis did not attach a Schedule E to their first amended
return for 2013 (the starting point of the IRS’s examination for that
year). 23 The Palmarinis claimed a $25,000 loss from rental real estate
on their 2014 return. The Commissioner initially proposed to limit the
Palmarinis’ losses on Schedule E to the extent of their passive income.
See § 469(a), (c), (d). However, in his revised report, the Commissioner
determined that the Palmarinis underreported rental income for 2013
and 2014, and that their rental activities produced an overall profit of
$5,784 for 2013 and $1,834 for 2014. The parties have stipulated the
amounts of rents received, as well as amounts of certain deductible
expenses, in 2013 and 2014. To the extent there remain Schedule E
deductions in dispute, we will uphold the Commissioner’s revised
determinations because the Palmarinis did not maintain adequate
records and have failed to carry their burden of proving entitlement to
deductions in excess of the amounts the Commissioner conceded.
However, we will diverge from the Commissioner’s revised

        23 The Palmarinis did report the income and expenses associated with their

rental properties on their second and third amended returns for 2013, but the IRS did
not accept them.
                                   46

[*46] determination regarding the deduction            for   repairs   and
maintenance of Chandler Street in 2013.

       Expenses for repairs and maintenance may be deducted for the
current year only to the extent they are not required to be amortized as
capital expenditures. See § 263. From the records reviewed by the
Commissioner in making his revised determination, we identify $10,340
paid for “repairs and maintenance” to Chandler Street in 2013 and zero
in 2014. These expenses were paid by Palmarini Inc. and are included
in the constructive dividend Mr. Palmarini received in 2013. To the
extent these expenses represent income to Mr. Palmarini through a
constructive dividend, we will allow him (as the Commissioner has for
other Schedule E deductions) to correspondingly deduct them on
Schedule E. However, because the Palmarinis did not maintain
adequate records, we do not know whether the work done was ordinary
“repair and maintenance” or whether instead it produced a capital
benefit to the property that will last for more than one year; nor do we
know their adjusted basis in Chandler Street as of 2013. We therefore
assume that these 2013 expenditures were capital and that the
Palmarinis’ adjusted basis in Chandler Street consisted only of these
expenditures totaling $10,340, and we will accordingly allow them a
$376 deduction for 2013 for depreciation of Chandler Street (based on
an adjusted basis of $10,340 depreciated using the straight-line method
with a recovery period of 27.5 years). See §§ 167(a), (c), 168(a), (b),
and (c).

      E.     Section 6662 accuracy-related penalties

       For an individual (as for a corporation, discussed above), the
section 6662(a) and (b)(1) and (2) accuracy-related penalty applies to the
portion of an underpayment of tax required to be shown on a return that
is attributable to either (1) the taxpayer’s negligence or disregard of
rules or regulations or (2) a substantial understatement of income tax,
defined for an individual by section 6662(d)(1)(A) as exceeding either
10% of the tax that should have been reported on the return or $5,000,
whichever is greater.

       The Commissioner bears the burden of production with respect to
the liability of an individual for any penalty. § 7491(c). To satisfy his
burden, the Commissioner must present sufficient evidence to show that
it is appropriate to impose the penalty in the absence of available
defenses. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). One
element of the Commissioner’s burden of production is to show
                                   47

[*47] compliance with section 6751(b)(1), which requires the individual
making the penalty determination to obtain written supervisory
approval of the initial determination to assert any penalty. See Graev
v. Commissioner, 149 T.C. 485, 493 (2017), supplementing and
overruling in part 147 T.C. 460 (2016). Once the Commissioner meets
his burden of production on penalties, the taxpayer must come forward
with persuasive evidence that the Commissioner’s showing is incorrect.
Higbee, 116 T.C. at 447; see also Rule 142(a). Or he may defend against
the penalty with a showing of “reasonable cause” and “good faith” under
section 6664(c)(1).

      Here the Commissioner showed that Agent Berntsen received
supervisory approval to assert the section 6662 accuracy-related penalty
before sending to the Palmarinis the 30-day letter containing her
proposed report (which was the first formal communication of the
penalty determination to the Palmarinis) and has satisfied his burden
of production to show compliance with the supervisory approval
requirements of section 6751(b)(1).

       We are satisfied (as with Palmarini Inc.) that the Palmarinis are
liable for section 6662 accuracy-related penalties for 2013 and 2014
under either a negligence theory based on their failure to maintain
adequate records or on a substantial understatement theory based on
the extent of their underreported income and overstated deductions.
Furthermore, the Palmarinis have not shown any “reasonable cause”,
see § 6664(c); Treas. Reg. § 1.6664-4, that would justify relief from the
section 6662 accuracy-related penalties.

IV.   Conclusion

       The Commissioner’s revised determinations are sustained in
part, to the extent set out above. To reflect the parties’ concessions and
the foregoing,

      Decisions will be entered under Rule 155.
                                       48

[*48]                           APPENDIX

            Constructive dividends from Palmarini Inc. to
                 Benito Palmarini in 2013 and 2014

       The following is an itemization of the amounts Benito Palmarini
received as constructive dividends from Palmarini Inc. in 2013. (The
Commissioner’s greater total is itemized on his Exhibit 79–R.)

                    Description             Amount
                Bartons Carpet
                                                     $1,558
                (renovation work)
                Ben Palmarini                         9,000
                Brener Heating &
                Air Conditioning                      4,000
                (renovation work)
                Fred Morning
                                                      4,677
                (rental mowing)
                Jerry Toscano
                                                      5,568
                (renovation work)
                Kevin Burcz
                                                      3,375
                (lawnscaping)
                Magazine Center for
                Wellness (medical                    16,075
                expenses for Benito)
                McCafferty Ford
                (personally owned                     1,848
                truck)
                Michael Russo
                (worked on rental                    58,000
                properties)
                Michael Smyth                        10,340
                Paul Weiss
                (electrician-
                                                      2,300
                Neshaminy rental
                property)
                Total                           $116,741
                                         49

[*49] The following is an itemization of the amounts Benito Palmarini
received as constructive dividends from Palmarini Inc. in 2014. (The
Commissioner’s greater total is itemized on his Exhibit 80–R.)

                     Description              Amount
                AMEX card #0-
                51007 (European                    $14,979
                cruise for family)
                Ben Palmarini                          11,874
                Jerry Toscano                           9,733
                Jessica Palmarini
                                                         110
                (daughter)
                Kevin Burcz (lawn
                maintenance for                         3,610
                properties)
                Magazine Center for
                Wellness (medical                       5,055
                expenses for Benito)
                McCafferty Ford
                (personally owned                        103
                truck)
                Michael Russo
                (worked on rental                       2,468
                properties)
                Michael Smyth                          10,000
                Reinard Agency
                (insurance company                      4,490
                for rental properties)
                VW of Langhorne
                                                         376
                (daughter’s car)
                Total                              $62,798