Court Opinion

ID: 4341029
Source: CourtListenerOpinion
Date Created: 2018-11-14 08:53:48.36096+00
Date Added: 2024-06-11T14:48:51.005464
License: Public Domain

T.C. Memo. 2018-53

                        UNITED STATES TAX COURT

    JOHN E. ROGERS AND FRANCES L. ROGERS, ET AL.,1 Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent

      Docket Nos. 30586-09, 1052-12,             Filed April 17, 2018.
                  15682-13, 30482-13,
                  20910-14.

      John E. Rogers, for petitioners.

      Craig Connell, Bernard J. Audet, Jr., Thomas A. Deamus, Frederick Petrino,

Mayah Solh-Cade, and Briseyda Villalpando, for respondent in docket Nos.

30586-09, 1052-12, 15682-13, 30482-13, and 20910-14.

      Elizabeth A. Carlson, for respondent in docket No. 20910-14.

      1
       Cases of the following petitioners are consolidated herewith: John E.
Rogers and Frances L. Rogers, docket Nos. 1052-12, 15682-13, and 30482-13;
and Frances L. Rogers, docket No. 20910-14.
                                          -2-

[*2]          MEMORANDUM FINDINGS OF FACT AND OPINION

       GOEKE, Judge: Respondent issued notices of deficiency to petitioners

determining income tax deficiencies and accuracy-related penalties as follows

(deficiency years):2

                                     Penalty          Penalty           Penalty
           Year   Deficiency       sec. 6662(a)     sec. 6662(h)      sec. 6662A
           2005   $2,287,696        $139,449          $633,623         $34,033
           2006    4,188,051         694,266           286,688              210
           2007        403,465        80,693             -0-              -0-
           2009    1,014,065         202,813             -0-              -0-

       For 2006 respondent determined a 75% fraud penalty under section 6663

against petitioner John Rogers; the above-listed accuracy-related penalties for

2006 are respondent’s alternative position. In his answer for 2009 respondent

asserted that petitioners are liable for an addition to tax for failure to timely file a

return under section 6651(a).

       Petitioner Frances Rogers seeks relief from joint and several liability under

section 6015 for 2003 and the above deficiency years. For 2003 petitioners

       2
        Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect at all relevant times, and all Rule references are to the Tax
Court Rules of Practice and Procedure. All amounts are rounded to the nearest
dollar.
                                        -3-

[*3] litigated their income tax liability in Rogers v. Commissioner (Rogers 2003),

T.C. Memo. 2011-277, aff’d, 728 F.3d 673 (7th Cir. 2013). The Court determined

that petitioners had unreported income from Mr. Rogers’ business activities and

disallowed certain business expense deductions related to both petitioners’

business activities. Petitioners were assessed with income tax and a penalty for

2003 as a result of our decision in Superior Trading, LLC v. Commissioner, 137

T.C. 70 (2011), supplemented by T.C. Memo. 2012-110, aff’d, 728 F.3d 676 (7th

Cir. 2013). In November 2013 the Commissioner issued a notice of intent to levy

with respect to 2003, and petitioners requested a collection due process (CDP)

hearing. Respondent did not make a determination regarding Mrs. Rogers’ request

for innocent spouse relief in a CDP hearing.

      Petitioners litigated their 2004 tax liability in Rogers v. Commissioner

(Rogers 2004), T.C. Memo. 2014-141, which determined that petitioners had

unreported income and disallowed business expense deductions related to their

business entities. We denied Mrs. Rogers relief from joint and several liability for

2004 in Rogers v. Commissioner, T.C. Memo. 2017-130, appeal filed (7th Cir.

Nov. 16, 2017). On January 23, 2018, petitioners filed a motion for partial

summary judgment with respect to the penalties against them in these consolidated
                                         -4-

[*4] cases on the basis of our decision in Graev v. Commissioner, 149 T.C. ___

(Dec. 20, 2017), supplementing 147 T.C. ___ (Nov. 30, 2016).

      After concessions, the issues for consideration are: (1) whether petitioners

have unreported income from the following sources: trustee fees relating to Mr.

Rogers’ implementation of distressed debt transactions in 2006, unreported

income from Mr. Rogers’ business, Portfolio Properties, Inc. (PPI), for 2005 and

2006, and unreported income for 2005 and 2006 relating to the tax consequences

of Mrs. Rogers’ transfer of real property to her wholly owned S corporation,

Sterling Ridge, Inc. (SRI); we hold that they do; (2) whether petitioners and their

wholly owned entities are entitled to the following deductions: a charitable

contribution deduction in 2005 for the transfer of real property, a worthless debt

deduction relating to Reddy Lab (described infra) or a worthless debt or stock

deduction relating to Portfolio Technologies, Inc. (PTI), certain business expenses

for 2005, 2006, 2007, and 2009, certain itemized deductions for 2006, and a

$5,355 long-term capital loss deduction for 2005; with a few limited exceptions;

we hold that they are not; (3) whether Mrs. Rogers is entitled to relief from joint

and several liability under section 6015; we hold that she is not; (4) whether

petitioners are liable for penalties and an addition to tax as follows: (a) Mr.

Rogers, a section 6663 fraud penalty for 2006; we hold that he is not;
                                         -5-

[*5] (b) petitioners, accuracy-related penalties under section 6662(a) or (h) or

section 6662A for 2005 and 2006 and under section 6662(a) for 2007 and 2009;

we reserve this issue for subsequent disposition; (c) petitioners, an addition to tax

under section 6651(a)(1) for their failure to timely file an income tax return for

2009; we hold that they are not.

                               FINDINGS OF FACT

I.    Background

      At the time the petitions were filed, petitioners resided in Illinois.3 They

were married during the years at issue, filed a joint income tax return for each

year, and remained married at the time of trial. Mr. Rogers is a tax attorney with

over 40 years of experience. He has a juris doctor degree (J.D.) from Harvard

University and a master of business administration degree (M.B.A.) from the

University of Chicago. From January 1998 to June 2003 he was a partner at the

law firm Altheimer & Gray. From July 2003 to May 2008 he was a tax partner at

Seyfarth Shaw, LLP (Seyfarth Shaw). In 2008 he formed Rogers & Associates as

a sole proprietorship. He is also a certified public accountant. Petitioners also

owned a number of business entities. Most of the adjustments in dispute here

      3
       The stipulation of facts and the accompanying exhibits are incorporated
therein by this reference.
                                         -6-

[*6] relate to income and deductions from these businesses and Mr. Rogers’

activities as an attorney. Mr. Rogers used some of these entities to promote a tax-

avoidance transaction involving Brazilian consumer distressed debt (distressed

debt transactions) that has been the subject of previous Court Opinions. Kenna

Trading, LLC v. Commissioner, 143 T.C. 322 (2014); Superior Trading, LLC v.

Commissioner, 137 T.C. 70. Petitioners were assessed additional tax as a result of

these partnership-level proceedings.

      Mrs. Rogers has a bachelor’s degree in chemistry, a master’s degree in

biochemistry, an M.B.A, a doctorate in educational administration, and a J.D. She

worked as a high school chemistry and computer science teacher and an associate

principal for over 20 years, retiring in 2005. She also has been a licensed real

estate broker since 1967 and a licensed attorney since 1991. In 2009 she began

representing clients in property tax appeals, which she taught herself to perform.

II.   Petitioners’ Business Activities

      A.     Tax Shelter Promotion Activities

      Mr. Rogers implemented and promoted the distressed debt transactions that

give rise to respondent’s adjustments through three business entities: (1) PPI,

(2) Sugarloaf Fund, LLC (Sugarloaf), and (3) Jetstream Business Ltd. (Jetstream).

Mr. Rogers formed PPI as its sole shareholder and caused it to elect S corporation
                                        -7-

[*7] status in 1992.4 He formed Sugarloaf and treated it as a partnership for

Federal income tax purposes. He formed Jetstream, a British Virgin Islands

limited company, with PPI as its sole shareholder to act as Sugarloaf’s sole

manager and its tax matters partner. Jetstream is a disregarded entity for Federal

tax purposes. Mr. Rogers was Jetstream’s sole director and manager. Mr. Rogers

indirectly owned no more than 1% of Sugarloaf through Jetstream and PPI.

However, he controlled PPI, Jetstream, and Sugarloaf during the deficiency years.

      Mr. Rogers used Sugarloaf to promote the distressed debt transactions

(Sugarloaf transactions) involved in Kenna Trading LLC v. Commissioner, 143

T.C. 322.5 Sugarloaf acquired distressed consumer receivables (distressed debt)

from Brazilian retailers in exchange for a purported ownership interest in

Sugarloaf, and Sugarloaf then transferred interests in the distressed debt to

individual investors in the Sugarloaf tax shelter through either a partnership or

trust structure. In 2004 Mr. Rogers used a partnership structure involving trading

      4
       As Mr. Rogers is PPI’s sole shareholder, we must determine PPI’s income
and business expense deductions to determine petitioners’ income tax liability.
Where a notice of deficiency includes adjustments for S corporation items with
other adjustments, we have jurisdiction to determine the correctness of all
adjustments. See Winter v. Commissioner, 135 T.C. 238 (2010).
      5
       The case at docket No. 30586-09 at issue here was one of the consolidated
cases of Kenna Trading, LLC v. Commissioner, 143 T.C. 322 (2014).
                                         -8-

[*8] and holding companies for the individual investors to hold the distressed

debt. Beginning in 2005 and continuing through 2007 Mr. Rogers used a trust

structure for the tax shelters in response to legislative changes in 2004 to the

subchapter K partnership rules that prevented the tax shelter loss-shifting benefits

in his trading and holding company structure.6 Id. at 324, 328. Under the trust

structure, Sugarloaf would form a new trust for each individual who invested in

the tax shelter (main trust), and then Sugarloaf would contribute distressed debt to

the main trust. The individual investors would have each main trust form a

subtrust, and the main trust would assign the debt to the subtrust. The investor

would contribute cash to the main trust, typically equal to approximately 6% of the

face value of the distressed debt held by the main trust. In exchange, the investor

would receive an interest in the main trust and the entire beneficial interest in the

subtrust. Mr. Rogers was the trustee of both the main trust and the subtrust

formed for each investor; Sugarloaf was the beneficiary. For each investor,

Sugarloaf, the main trust, and the subtrust treated the distressed debt as having a

carryover basis from the Brazilian retailer that was based on the face value of the

      6
        The American Jobs Creation Act of 2004, Pub. L. No. 108-357, sec. 833,
118 Stat. at 1589, changed the rules governing the allocation of built-in loss on
property contributed to a partnership, providing that the built-in loss may be taken
into account only by the contributing partner. Sec. 704. The change prevented the
shifting of the built-in loss on the distressed debt to the investor.
                                        -9-

[*9] debt. The investor would have the subtrust claim a worthless debt deduction

that was based on partial worthlessness of the distressed debt, typically equal to

97% of the face value of the distressed debt, and the investor (as the purported

grantor of the subtrust) would pass the worthless debt deduction through to his

personal tax return.

      In Kenna Trading, LLC v. Commissioner, 143 T.C. at 324-325, 359-360,

the Court held that the tax shelter investors were not entitled to worthless debt

deductions for the Sugarloaf transactions for 2004 and 2005. The Court held that

Sugarloaf was a sham and not a valid partnership for 2004, and the purported

trusts were shams and not trusts for Federal tax purposes for 2005. Id. at 351-353,

362-365. The purported contribution of the distressed debt to Sugarloaf was in

substance a sale, and Sugarloaf received a cost basis in the distressed debt, not a

carryover basis as claimed. Id. at 353-358. Also Sugarloaf overstated its cost of

goods sold for 2004 and had unreported income for 2004 and 2005 and was not

entitled to certain deductions for 2004 and 2005. Sugarloaf Fund, LLC v.

Commissioner, docket No. 671-10 (Oct. 11, 2017).

      Mr. Rogers deducted multiple expenses relating to his Sugarloaf activities,

including travel expenses, legal fees, and miscellaneous expenses connected to his

promotion and operation of the tax shelter. He advanced funds to Sugarloaf to
                                       - 10 -

[*10] finance its expenses. He also paid these expenses through his wholly owned

entity PPI, and PPI deducted the expenses, including amounts paid to or on behalf

of two loan management companies, Multicred Investment, Ltd., and Multicred

Investimentos Limitada (collectively Multicred), and a PPI employee, Brad Todd.7

See infra Appendix E. In 2009 Brad Todd worked on issues relating to distressed

debt, including engaging a new agency to replace Multicred and finding additional

distressed debt portfolios to purchase. Petitioners incurred expenses as result of a

number of disputes that arose in connection with the Sugarloaf transactions,

including allegations of mismanagement and theft by individuals connected with

Multicred and legal actions by individuals who invested in the tax shelter.

Petitioners also deducted expenses incurred in connection with Mr. Rogers’

Sugarloaf activities on Schedules C, Profit or Loss from Business, filed with

respect to Mr. Rogers’ business activities (Schedule C-1). See infra Appendix A.

             1.    Petitioners’ Investments in Sugarloaf Transactions

      In addition to Mr. Rogers’ promotion of the Sugarloaf tax shelter,

petitioners also invested in two Sugarloaf transactions themselves to obtain tax-

shelter benefits. In 2005 SRI, Mrs. Rogers’ wholly owned corporation invested in

      7
       For practical purposes, the two companies are the same, and we refer to
them interchangeably as Multicred.
                                        - 11 -

[*11] a Sugarloaf transaction through the trust structure described above that

petitioners used to offset their income from SRI. The business activities of SRI

are described further infra. In 2006 Mr. Rogers invested in a Sugarloaf transaction

through the trust structure. In Kenna Trading, LLC v. Commissioner, 143 T.C. at

359-364, we disallowed the worthless debt deductions claimed by investors in the

Sugarloaf transactions for 2004 and 2005. In that case, we disallowed the

worthless debt deduction claimed by SRI. Id. at 364. Kenna Trading did not

address the Sugarloaf transactions implemented in 2006 and accordingly did not

address deductions relating to Mr. Rogers’ 2006 Sugarloaf transaction.

Respondent filed a motion for partial summary judgment to disallow petitioners’

worthless debt deduction for 2006 of approximately $1.94 million, plus nominal

legal and fiduciary expenses, relating to Mr. Rogers’ 2006 Sugarloaf transaction

(Sugarloaf deductions).8 To accomplish Mr. Rogers’ investment in the Sugarloaf

transaction, Sugarloaf formed a trust and transferred distressed debt to it, using the

structure described above. Mr. Rogers contributed $40,000 to the trust, i.e., the

Rogers trust. Sugarloaf and Mr. Rogers created a subtrust (Rogers Subtrust) and

allocated the Rogers trust’s distressed assets to it. The Rogers Trust and the

      8
       Respondent disallowed two additional deductions relating to the Sugarloaf
transaction on Schedule C-1 for 2006: $1,000 in legal fees and $1,000 in fiduciary
expenses. See infra Appendix A.
                                         - 12 -

[*12] Rogers Subtrust claimed a carryover basis in the distressed debt of

approximately $2 million. We granted respondent partial summary judgment and

held that Mr. Rogers is not entitled to the Sugarloaf deductions for 2006.

      In Notice 2008-34, 2008-1 C.B. 645, the Internal Revenue Service (IRS)

identified as a listed transaction a distressed debt asset trust transaction in which a

U.S. taxpayer acquires an interest in a trust, or a series of trusts and subtrusts,

holding distressed assets to obtain built-in tax losses. Mr. Rogers did not submit a

Form 8886, Reportable Transaction Disclosure Statement, for 2006 in connection

with his Sugarloaf transaction. Nor did SRI file Form 8886 for its 2005 Sugarloaf

transaction.

               2.   Fees From the Sugarloaf Transactions

      Before 2005 Mr. Rogers used his law firm Seyfarth Shaw to implement the

Sugarloaf transactions. Sugarloaf paid a portion of the investors’ cash

contributions to Seyfarth Shaw as legal fees. In 2006 Seyfarth Shaw told Mr.

Rogers to stop implementing the Sugarloaf transactions because of the IRS’

inquiries into the transactions. Unbeknownst to Seyfarth Shaw, Mr. Rogers began

implementing the Sugarloaf transactions through PPI. Seyfarth Shaw asked Mr.

Rogers to resign in May 2008 when it learned that he was still promoting the

Sugarloaf transaction.
                                        - 13 -

[*13] For the Sugarloaf transactions in 2006, Mr. Rogers was the trustee for each

main trust and was entitled to trustee fees under the main trust agreements. Each

main trust had a bank account that Mr. Rogers controlled (trust bank account).

The investors contributed approximately 6% of the face value of the distressed

debt held by their main trust, which were deposited into the trust bank accounts for

their respective main trusts. The funds held in the trust bank accounts were paid

over to Sugarloaf and Mr. Rogers. Mr. Rogers typically received approximately

one-third of the investor’s cash contributions; this is approximately the same

amount that Seyfarth Shaw had received as legal fees. During 2006 Mr. Rogers

received $1,165,500 from the trust bank accounts that he deposited into

petitioners’ personal bank accounts. Petitioners did not report the deposits as

income on their 2006 joint return. Mr. Rogers’ accountant altered the copies of

the checks he received from the trusts (trust checks) to delete references in their

memorandum lines to “trustee fee”, “fee”, or “hunter fee” before submitting the

checks to the IRS during the examination.

      B.     PPI’s Income and Deductions

      As described above, Mr. Rogers used PPI to implement the Sugarloaf

transactions. Petitioners also used PPI in their real estate development activities

including the development of real estate that Mrs. Rogers had inherited from her
                                           - 14 -

[*14] father, discussed further infra, known as Sterling Ridge. During 2006 PPI

received at least $1,484,366 in gross income as follows: (1) $710,366 in

consulting fees from petitioners’ real estate development business, SRI,

(2) $240,000 from the Sterling Ridge Trust, (3) $465,000 from Sugarloaf, and

(4) $69,000 from Laurence Builders.9 SRI deducted the consulting fees paid to

PPI; Sugarloaf deducted $100,000 of the $465,000 that it paid to PPI as a

management fee and amortized the remainder as startup expenses. PPI reported

gross receipts of $790,201 for 2006, understating its gross receipts by $694,165.

For 2005, 2006, and 2009, PPI claimed business expense deductions that

respondent disallowed in the deficiency notices and that remain in dispute to the

extent stated infra Appendix E.

III.   Real Estate Development Activities

       A.        Sterling Ridge Subdivision

       Mrs. Rogers owned an approximately 31-acre parcel of undeveloped real

property in Orland Park, Illinois (Orland Park), that she had inherited from her

father.10 When she inherited the property, its fair market value was approximately

       9
       PPI did not report these amounts in their entirety on its 2006 tax return; the
IRS discovered them during its examination using a bank deposits analysis.
       10
            Mrs. Rogers is also the beneficiary of a land trust that owns 81 acres of
                                                                           (continued...)
                                       - 15 -

[*15] $15,000. During 2004 petitioners partnered with the owner of an adjacent

8.7-acre parcel of land to develop Orland Park into a residential subdivision called

Sterling Ridge (Sterling Ridge subdivision). On January 30, 2004, Mrs. Rogers

organized SRI as a wholly owned S corporation with an initial capital contribution

of $50,000. Mr. Rogers was its president. On that same date Mrs. Rogers entered

into a contract to sell Orland Park to SRI for $7 million (Rogers loan), with

$50,000 to be paid upon the execution of the sale contract and the remaining

balance to be paid by an installment note or by wire transfer at closing. SRI did

not transfer the $50,000 upon the contract’s execution and did not transfer any

money to Mrs. Rogers at closing. SRI did not have any other assets at the time of

the transfer. The parties did not execute an installment note for the unpaid balance

of the sale price. They did not set a repayment schedule, a maturity date, or an

interest charge and did not provide security for a loan. The deed recording the

transfer from Mrs. Rogers to SRI was dated January 24, 2005, approximately one

year after the date of the sale contract, and was recorded on February 10, 2005.

      10
        (...continued)
farmland referred to as Oake Pointe that she received from her parents as a gift.
Beginning in 2003 petitioners attempted to develop the land into a multiuse retail
and residential center, without success. Mrs. Rogers handled issues relating to the
land including zoning, repairs, and a cell tower.
                                        - 16 -

[*16] They were required to record the deed as a condition to obtain a third-party

construction loan, described below. The deed listed that the consideration was

$10 and other good and valuable consideration.

      In February 2005 the local municipality approved the Sterling Ridge

subdivision and entered into an annexation agreement with SRI and its partner for

the subdivision. As a condition of the approval, SRI agreed to convey a portion of

Orland Park to the municipality for a park and other public uses. See Village of

Orland Park Land Development Code art. 5, sec. 5-112 (requiring a contribution

of land or a monetary payment in lieu of a land contribution). The joint property

was subdivided into 82 lots for residential construction, with 65 lots owned by SRI

and 17 lots owned by SRI’s partner, and 3 additional lots dedicated to public use,

including a park and detention ponds, with 2 of the lots attributable to SRI’s land

and one to its partner’s. SRI transferred 4.89 acres of Orland Park to the local

municipality for public use; the deed evidencing the transfer was recorded in 2012.

Petitioners did not claim a charitable contribution deduction for the land transfer

to the municipality on their 2005 joint return.

      In March 2005 SRI obtained a $2.65 million construction loan (construction

loan) from a third-party lender with a maturity date of September 10, 2006. The

lender required Mr. Rogers to guarantee the loan. The lender’s records do not
                                        - 17 -

[*17] reflect the existence of a $7 million liability to Mrs. Rogers. The lender

required SRI to repay the construction loan with $135,000 from the proceeds on

the sale of each lot. SRI repaid the construction loan in its entirety in 2005.

Separate from the construction loan, the local municipality required SRI to

maintain a letter of credit to guarantee funding for the development. The terms of

the letter of credit required annual renewal. SRI deducted a $23,935 fee for a

letter of credit in 2005; respondent disallowed the deduction.

      Mrs. Rogers was actively involved in the development of the subdivision.

She met with SRI’s partner to discuss her vision for the development. She

participated in the design and layout of the residential lots, the park, and the ponds

and in the design of a model home. She inspected the installation of the park and

the ponds to ensure they met her instructions. She assisted with setting the sale

terms and the price of the lots. SRI incurred approximately $2.3 million in

improvement costs for Orland Park from 2004 through 2006. It sold most of its

lots to builders during 2005 and 2006 for $260,000 per lot. In 2005 SRI sold 22

lots and received $282,0000 in deposits on future sales; it reported gross sales of

approximately $4.9 million and cost of goods sold of $2.4 million. It reported a

net loss for 2005 on the basis of its investment in the Sugarloaf transaction. In

2006 SRI sold 20 lots and reported gross sales of $5,191,467 and cost of goods
                                        - 18 -

[*18] sold of $4,290,605. SRI determined the gain on the sale of the lots using a

cost basis of $7 million from its purported purchase of Orland Park. SRI did not

sell any lots in 2007 or 2009. As of the end of 2013, SRI had sold 58 of its 65 lots

for total sale proceeds of over $13 million.

      On their 2005 joint tax return, petitioners reported that Mrs. Rogers received

a $1.7 million payment from SRI on the $7 million Rogers loan, including $1.35

million of principal and $350,000 of interest. On its 2005 corporation tax return,

SRI reported repayment of shareholder loans of $2.5 million. On their 2006 joint

tax return, petitioners reported a $2 million payment from SRI on the Rogers loan,

including $1,825,000 of principal and $175,000 of interest.11 On its 2006

corporation tax return, SRI did not report any repayment of a shareholder loan.

SRI reported dividends of over $1.4 million. In total petitioners received

approximately $4.15 million from SRI in 2006. Petitioners did not report any

repayments on the Rogers loan from 2007 to 2013. Since the origination of the

Rogers loan, they have reported approximately $3.2 million in repayment of the

loan, plus interest of $525,000.

      11
         Respondent concedes that if the Court finds that SRI is not entitled to the
interest deduction, petitioners were not required to report the interest income.
                                       - 19 -

[*19] PPI constructed homes within the Sterling Ridge subdivision. In 2005 PPI

engaged an architect for a fee of $6,340 to design a model home for the

subdivision. The architect billed its fee to PPI, but SRI deducted the fee.

Respondent also disallowed SRI’s deduction of the architect’s fee as well as other

business expense deductions claimed by SRI relating to the subdivision. See infra

Appendix D. PPI did not sell any homes during 2009. However, it reported cost

of goods sold of $1,435,711 on the basis of a decline in real property values of the

unsold lots in the subdivision. Petitioners concede the cost of goods sold except

to the extent of $141,781.

      B.     Renovation Projects

      Mrs. Rogers purchased two residential properties with the intention of

renovating and reselling them for a profit. She purchased a house on Manitou

Road in Homer Glen, Illinois (Manitou house), directly and purchased a second

house on Sterling Road in Kenilworth, Illinois (Sterling Road house), through

SRI.12 During 2005 through 2007 petitioners’ adult son lived in the Manitou

house with his family. He supervised the contractors who renovated the house and

provided manual labor. In 2006 SRI paid and deducted $60,000 in rent to Mrs.

      12
        The Sterling Road house is unrelated to the Sterling Ridge subdivision and
is approximately 50 miles from it.
                                       - 20 -

[*20] Rogers for the Manitou house on the son’s behalf. See infra Appendixes C

and D. Petitioners reported the rent as income on Mrs. Rogers’ Schedule C for her

real estate activities (Schedule C-2). The son was an employee of PPI but did not

have an employment contract. He was the only employee of PPI who was

provided housing. PPI is not an owner of either house. The reasoning for SRI to

pay and deduct the rent for a PPI employee is unclear from the record except that

PPI was involved in the development of the Sterling Ridge subdivision. Mrs.

Rogers sold the Manitou house in 2007, reporting a capital gain. During 2009 the

son lived in the Sterling Road house with his family. As of the date of trial SRI

still owned the Sterling Road house. Petitioners deducted numerous expenses

relating to the Manitou house for 2005, 2006, and 2007, in addition to the 2006

rent, and the Sterling Road house for 2009, including interest, repairs, taxes and

licenses, utilities, bank service charges, and insurance, on their Schedules C-2 or

on SRI’s and PPI’s corporation tax returns. See infra Appendix C.

IV.   Reddy Labs and Portfolio Technologies, Inc. (PTI)

      In 1991 Mr. Rogers began working for a startup medical device company as

its president and chief operating officer. He created a holding company structure

for the medical device company, collectively Reddy Lab, to hold the patent on the

medical device and to manufacture and distribute the device. Mr. Rogers worked
                                       - 21 -

[*21] to obtain financing for the company. Beginning in late 1991 Mr. Rogers

lent money to Reddy Lab personally and through his wholly owned S corporation,

Lucas & Rogers, Inc. (L&R). L&R is a real estate brokerage firm. Mr. Rogers

resigned from Reddy Lab in July 1993. From 1992 through 1995, entities within

the Reddy Lab structure were involved in multiple bankruptcies. Its creditors,

including Mr. Rogers, filed an involuntary bankruptcy in May 1995 (1995

bankruptcy). The trustee in the 1995 bankruptcy found that Mr. Rogers and his

related entities (L&R and a trust in Mrs. Rogers’ name) had general unsecured

claims of over $3.3 million, including unpaid interest that arose from advances to

Reddy Lab and payments on personal guaranties of Reddy Lab’s debts.

Approximately $500,000 was owed to Mr. Rogers, including principal and

interest; the remainder was owed to his related entities. The Reddy Lab entity

involved in the 1995 bankruptcy also owed over $1.5 million in secured claims to

entities unrelated to Mr. Rogers. In 1995 Mr. Rogers initiated a lawsuit against

the inventor of the medical device, separate from the involuntary bankruptcy,

alleging fraud. Petitioners wrote down the value of the debt owed by Reddy Lab

to $400,000 in 1995 and reported that they were worthless on their balance sheet,

dated July 1, 1996. The IRS allowed petitioners a $915,000 worthless debt

deduction for 1998 with respect to Reddy Lab.
                                        - 22 -

[*22] In 1997 Mr. Rogers organized PTI, as its president. In 1998 PTI purchased

the patent rights to the medical device from Reddy Lab in a sale approved in the

1995 bankruptcy. The asset purchase agreement required PTI to pay a 10%

royalty on its sale proceeds from the medical device and a portion of any licensing

fees for the patent to the bankruptcy trustee. In 1998 L&R assigned its

approximately $2 million bankruptcy claim, including approximately $1.3 million

of principal plus unpaid interest, to PTI in exchange for stock. L&R owned at

least 20% of PTI. Although Mr. Rogers was a shareholder of PTI, his exact

ownership percentage was not established at trial.

      After PTI acquired the patent rights, it attempted to bring the device to

market. See Rogers 2004, at *11-*12. However, it faced serious obstacles to

marketing the product, including competition from the inventor of the medical

device and Reddy Lab’s original owner. Mr. Rogers contracted with Global

Protection Corp. (Global Protection) to provide management services for PTI and

to market the medical device. Global Protection became a shareholder of PTI.

Mr. Rogers lent money to PTI and paid its expenses to maintain an inventory. PTI

recorded on its books and records an initial liability of $45,000 and a liability of

$363,000 from 2004 owed to Mr. Rogers from his payment of expenses for

inventory and supplies. PTI did not issue any notes evidencing the liabilities.
                                       - 23 -

[*23] During this time PTI did not pay amounts owed to the bankruptcy trustee

under the sale agreement.

      In 2005 PTI initiated a patent infringement lawsuit, which was decided

against PTI in U.S. District Court in October 2007 and affirmed in the Court of

Appeals for the Federal Circuit in June 2008. Mr. Rogers kept PTI in existence to

pursue the patent infringement case. He understood that PTI needed to continue to

market the medical device to establish that a domestic market existed for the

product for purposes of the infringement case. He believed that the only way that

he would receive money from PTI was through a judgment in the patent

infringement case, not through sales of the product. In 2007, after PTI received a

favorable ruling by an administrative law judge and before it ultimately lost the

infringement case in District Court, Mr. Rogers paid the bankruptcy trustee

$400,000 for the trustee’s relinquishing any right to unpaid royalties and to future

payments under the asset purchase agreement. PTI recorded a $400,000 liability

payable to Mr. Rogers from this payment. In total PTI recorded liabilities to Mr.

Rogers of $808,000. PTI dissolved in 2010 and wrote off the $808,000 debt to

Mr. Rogers. PTI’s liabilities exceeded its assets on its books and records

beginning in 2000 and including the time of Mr. Rogers’ advances. Over the

course of the infringement case, Mr. Rogers had PPI pay expenses on PTI’s behalf
                                        - 24 -

[*24] because PTI did not have sufficient funds to meet its operational needs. The

record contains no evidence that PPI had an ownership interest in PTI. PPI

deducted a “PTI subsidy” and legal expenses that it paid on PTI’s behalf.13 See

infra Appendix E. Petitioners seek worthless debt deductions for liabilities owed

by Reddy Lab or PTI or worthless stock deductions for PTI.

V.    Deductions and Losses

      Petitioners filed two Schedules C for each deficiency year reporting their

business activities. Mr. Rogers reported his business activity as an attorney on

Schedule C-1; Mrs. Rogers reported her business activity as a realtor on Schedule

C-2. See infra Appendixes A and B. Mr. Rogers also filed a Schedule C for 2003,

at issue for Mrs. Rogers’ section 6015 relief. During the deficiency years

petitioners reported numerous personal expenses as business expenses on their

joint income tax returns or on the corporation tax returns for their business

entities, including expenses relating to their personal residence such as alarm

services, utilities, insurance, taxes, repairs, automobile expenses, and club dues.

See infra Appendix A. In many instances they deducted 100% of the expenses

incurred for their personal residence. However, they used at most one room

      13
        PPI deducted $908,474 in legal expenses for 2005, including $579,730
paid on PTI’s behalf. It paid the remaining the legal expenses with respect to the
Sterling Ridge subdivision or Sugarloaf.
                                        - 25 -

[*25] exclusively for business purposes and failed to establish the relative size of

the room compared to the entire home. Most of their business use for the

remainder of their residence consisted of storage. During 2005 through 2007 Mr.

Rogers maintained an office at Seyfarth Shaw. During 2009 he maintained an

office at Rogers & Associates. During 2005 and 2006 Mrs. Rogers had an office

at SRI. During 2009 she represented clients seeking property tax abatement and

assisted her husband at Rogers & Associates where she maintained an office.

Petitioners also deducted personal living expenses for their son and his family,

who were living at the Manitou and Sterling Road houses, including utilities,

landscaping, and insurance. They traveled frequently and deducted substantial

travel expenses on their Schedules C-1 and the corporation tax returns for L&R

and PPI. See infra Appendixes A and E. For 2005, 2006, and 2007 they deducted

travel expenses for Mr. Rogers’ work at Seyfarth Shaw. Seyfarth Shaw had a

policy that would have reimbursed him for his travel, including travel for client

services, certain partnership issues, continuing legal education, and $3,000 for

promotional travel. Mrs. Rogers frequently accompanied her husband on his

business trips. For 2009 Mr. Rogers provided legal services through Rogers &

Associates and reported his income and expenses from his legal services on

Schedule C-1. He was unable to collect approximately $1.4 million of the legal
                                       - 26 -

[*26] fees that he recorded as billed to clients for 2009 and deducted the

uncollected fees as returns and allowances. See infra Appendix A.

      Petitioners presented QuickBooks records, canceled checks, and credit card

statements to substantiate the reported expenses. At times they provided receipts

and invoices. Often the canceled checks, receipts, invoices, and QuickBooks

records do not reconcile with each other and with the amounts deducted on their

returns. Petitioners used their credit cards for both personal and business reasons

and did not make any adequate effort at trial to distinguish between personal and

business expenses. In many instances they did not provide sufficient information

and documentation to establish that they are entitled to deduct the expenses

respondent disallowed except to the extent indicated in the Appendixes. They also

incorrectly reported numerous transactions between their businesses where the

payor entity deducted the payment but the payee entity did not report the payment

as income. They also claimed a long-term capital loss for 2005 of $53,550. They

concede $48,195, and $5,355 remains in dispute. But they failed to provide any

evidence regarding the capital loss. Respondent has also disallowed amounts that

petitioners deducted for taxes, interest, and other expenses of $11,745, $4,659, and

$1,770, respectively, on their 2006 Schedule A, Itemized Deductions, that remain

in dispute.
                                        - 27 -

[*27] A.     L&R’s Deductions

      L&R deducted travel expenses of $50,543 and $39,741 for 2005 and 2006,

respectively, and respondent disallowed these deductions in their entirety. Mrs.

Rogers was a real estate agent and broker at L&R. There is minimal information

relating to the activities of L&R in the record. The deducted travel expenses relate

to Mr. Rogers’ activities with Sugarloaf, PTI, and his legal work as a partner at

Seyfarth Shaw. At times Mrs. Rogers accompanied Mr. Rogers on his travel, and

L&R deducted her travel expenses.

      B.     PPI’s Deductions

      PPI deducted numerous business expenses for 2005, 2006, and 2009;

respondent disallowed the deductions. See infra Appendix E. PPI deducted

expenses that were related to Mr. Rogers’ Sugarloaf tax shelter activities,

including a “Multicred fee” for 2005, legal fees for 2005, 2006, and 2009, and

payments and rent relating to Brad Todd, who worked on issues relating to

Sugarloaf, discussed above. PPI also deducted travel, meal, and automobile

expenses under multiple categories including meals, taxi, airfare, hotel, gasoline,

repairs, parking, and travel, that respondent has disallowed in their entirety. It also

deducted expenses relating to PTI’s patent infringement lawsuit and its business

activities, including a PTI subsidy and legal fees, as discussed supra part IV. PPI
                                       - 28 -

[*28] did not have an ownership interest in PTI but paid these expenses because of

Mr. Rogers’ ownership of both companies. PPI also deducted personal expenses

for repairs for the Manitou house and medical expenses for their adult son and his

family when PPI did not have a health insurance plan for its employees. During

2005 PPI purchased an employee benefits program and deducted its costs for

subsequent years.

VI.   Tax Returns

      Petitioners timely filed their joint tax returns for 2005, 2006, and 2007

under extensions. Respondent received petitioners’ 2009 joint return on October

20, 2010. The 2009 return had a postmark date of October 14, 2010. Petitioners

did not file a request for an extension for 2009, and respondent has no record of

granting an extension. For 2006, 2007, and 2009, petitioners reported income tax

liability of zero and reported a nominal amount of income tax due for 2005. Mr.

Rogers reported income from Seyfarth Shaw in excess of $500,000 for 2005,

2006, and 2007. Mr. Rogers prepared the joint income tax returns for each year at

issue, the entity income tax returns for PPI, SRI, L&R, and Sugarloaf, and the

returns for various trusts.
                                         - 29 -

[*29] VII.   Innocent Spouse Relief

      Mrs. Rogers has requested section 6015 relief from joint and several

liability for 2003 through 2012. We have previously denied her request for relief

for 2004. See Rogers v. Commissioner, T.C. Memo. 2017-130. We now consider

her request for relief for 2003, 2005, 2006, 2007, and 2009. Throughout their

marriage petitioners filed joint income tax returns prepared by Mr. Rogers,

including returns for the years at issue. In 2003 Mrs. Rogers earned a salary as an

associate principal, retiring in 2005. She organized SRI in 2004 and participated

in its business activities. Petitioners had a routine for preparing their joint returns

that they followed every year. Mrs. Rogers would provide the necessary

documents relating to her income to her husband, and he would prepare the returns

and review them with her. She asked questions when she did not understand

something and asked whether the returns were accurate and complete. She had

access to the documents used to prepare the returns but did not review them. She

was concerned with the amount of their income tax and would discuss with her

husband whether any tax payment was due with the filing of the return and

whether they had any losses. She understood that any losses would reduce their

taxable income. She was aware that they paid little or no income tax during the

years at issue. She also understood that the distressed debt transactions promoted
                                        - 30 -

[*30] by her husband produced large tax benefits for a relatively small investment.

She knew that SRI’s participation in the Sugarloaf transaction reduced her income

tax from SRI’s sale of the subdivision lots. Mrs. Rogers also reviewed SRI’s

corporation tax returns before they were filed. She understood that SRI’s income

or loss would pass through to her on petitioners’ joint income tax return.

      Mrs. Rogers was an active participant in petitioners’ financial affairs and

businesses activities. Throughout the years at issue, petitioners maintained joint

bank accounts and credit cards, and Mrs. Rogers maintained accounts in her own

name. She had at least 41 accounts at 15 financial institutions. She had complete

access to petitioners’ financial records, joint bank accounts, and credit card

statements. She was involved in household finances, paid bills, made purchases

from their joint bank accounts, and made deposits. She endorsed checks from the

joint accounts for both personal and business expenses. She joined her husband

on extensive travel and maintained a high standard of living. She purchased real

estate and luxury automobiles, including some for her adult son. She assisted her

husband in his legal work, including preparing documents to set up corporations

for his clients. In 2008 she assisted with the client invoices, bank deposits, and

bill payment and endorsed checks on behalf of Rogers & Associates. She is a

licensed attorney and represented clients in property tax abatements. In April
                                       - 31 -

[*31] 2009 Mr. Rogers was hospitalized for an extended period relating to his

alcohol addiction, during which time there was no means of communication

between petitioners. Mrs. Rogers became more involved at Rogers & Associates.

She fired the office manager and took over that position herself.

      On August 24, 2007, respondent issued a notice of deficiency to petitioners

for 2003, determining a deficiency of over $1.3 million, plus an accuracy-related

penalty and interest. The deficiency resulted from Mr. Rogers’ income from PPI

and certain deductions claimed in connection with PPI. Petitioners timely filed a

joint petition in this Court (2003 deficiency case). They were represented by

counsel, and Mrs. Rogers sat at the table reserved for petitioners and their counsel

during the trial. See Rogers 2003. She did not raise a claim for innocent spouse

relief at any stage of the 2003 deficiency case. Id. The Court sustained

respondent’s determinations in part and entered a decision. Id. Petitioners paid

the 2003 deficiency, penalty, and interest, and Mrs. Rogers now seeks a refund.

She has filed three different Forms 8857, Request For Innocent Spouse Relief. On

the third form, she answered for the first time that she had experienced abuse from

her husband. She reported assets of over $8.1 million. She did not provide a

Form 433-A, Collection Information Statement. Petitioners continued to file joint

income tax returns for years as recent as 2014.
                                        - 32 -

[*32]                                 OPINION

        Generally, the Commissioner’s determinations in a notice of deficiency are

presumed correct, and the taxpayer has the burden of proving that those

determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111,

115 (1933); Gold Emporium, Inc. v. Commissioner, 910 F.2d 1374, 1378 (7th Cir.

1990), aff’g T.C. Memo. 1988-559. However, the Commissioner bears the burden

of proof “in respect of any new matter, increases in deficiency, and affirmative

defenses, pleaded in the answer”. Rule 142(a)(1). In these cases, respondent has

raised new matters relating to the characterization of the transfer of Orland Park to

SRI and a late-filing penalty for 2009 and has the burden of proof on those issues,

as discussed further infra. Generally, taxpayers have the burden of proof with

respect to their entitlement to any deduction. Rule 142(a); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992); Welch v. Helvering, 290 U.S. at 115.

Taxpayers are required to maintain sufficient records to substantiate their gross

income, deductions, credits, and tax attributes. Sec. 6001; INDOPCO, Inc. v.

Commissioner, 503 U.S. at 84; see sec. 1.6001-1(a), Income Tax Regs.

        The Court of Appeals for the Seventh Circuit has stated that the

presumption of correctness does not apply and the burden of proof will shift to the

Commissioner where the Commissioner’s deficiency determination does not have
                                        - 33 -

[*33] a rational foundation or is arbitrary and excessive. Pittman v.

Commissioner, 100 F.3d 1308, 1313 (7th Cir. 1996) (citing Ruth v. United States,

823 F.2d 1091, 1094 (7th Cir. 1987)), aff’g T.C. Memo. 1995-243. For the

presumption of correctness to attach to the notice of deficiency in unreported

income cases, the Commissioner must make an evidentiary showing that connects

the taxpayer with the alleged unreported income. Pittman v. Commissioner, 100

F.3d at 1313. As discussed further infra, we find that the Commissioner has made

an evidentiary showing to connect petitioners with the unreported income from

PPI and Sugarloaf, see infra part I.A. and B., and petitioners have the burden of

proof with respect to these issues.

      Petitioners made factual assertions in their briefs that are not supported by

evidence in the record and referred to exhibits that were not admitted into the

record. Statements on brief are not evidence and cannot supplement the record.

See Rule 143(c); Niedringhaus v. Commissioner, 99 T.C. 202, 214 n.7 (1992);

Kronish v. Commissioner, 90 T.C. 684 (1988). Petitioner’s opening brief failed to

propose findings of fact as required by Rule 151. Their brief contains factual

assertions in narrative form combined with legal arguments and lacks citations of

the record to support a substantial portion of the factual assertions. In their reply

brief they objected to respondent’s proposed findings of fact but, in substantial
                                        - 34 -

[*34] part, did not provide supporting references to the record for their objections.

The record consists of a 1,262-page transcript for an 8-day trial and 25 sets of

stipulations of fact and accompanying exhibits, and petitioners failed to adequately

assist the Court with the voluminous record. See Beane v. Commissioner, T.C.

Memo. 2009-152, slip op. at 7 (citing Stringer v. Commissioner, 84 T.C. 693, 703-

705 (1985), aff’d without published opinion, 789 F.2d 917 (4th Cir. 1986));

Lenihan v. Commissioner, T.C. Memo. 2006-259, slip op. at 4 n.3.

I.    Unreported Income

      Respondent determined that petitioners had unreported income from three

sources: trustee’s fees relating to Mr. Rogers’ implementation of the Sugarloaf

transactions, unreported income from PPI, and unreported income on the basis of

respondent’s recharacterization of Mrs. Rogers’ purported sale of Orland Park to

SRI as a capital contribution.

      A.     Trustee’s Fees

      Respondent determined that petitioners failed to report income of

$1,165,000 for 2006 that Mr. Rogers received as trustee’s fees for his role in

implementing the Sugarloaf transactions. During 2006 investors implemented the

Sugarloaf transactions through a tiered trust structure. The investors entered into

trust agreements that named Mr. Rogers as trustee and compensated him with
                                        - 35 -

[*35] trustee’s fees. Each main trust had its own bank account, but all accounts

were at the same bank. Each investor contributed cash to the main trust that was

deposited into the trust’s bank account. During 2006 Mr. Rogers issued checks

totaling $1,165,000 from the trusts’ bank accounts to himself, endorsed them, and

deposited them into his personal bank account. The checks contained notations in

the memo line, at times written by Mr. Rogers, of “trust fee”, “fee”, “trustee” or

“hunter fee”. Mr. Rogers generally received one-third of the investors’ cash

contributions, and a portion of the investors’ contributions was paid to Sugarloaf.

      Petitioners argue that the $1,165,000 was not taxable income; they do not

dispute that they received the money. They argue that the deposits were

nontaxable reimbursements of advances or nontaxable returns of capital on the

basis that Mr. Rogers made payments to, or on behalf of, Sugarloaf from 2003

through 2006 that increased his basis in Sugarloaf. They argue that the disallowed

deductions for prior years were capital expenditures that increased Mr. Rogers’

basis in Sugarloaf, referring to his entitlement to “capitalized contemporaneous

conduit deductions” to offset the income from the trustee’s fees.14 To further

      14
        In addition to the capitalized contemporaneous conduit deductions,
petitioners also argue that they experienced a theft loss of $1 million in 2005 that
increased their basis in Sugarloaf. We previously found that petitioners failed to
prove a theft occurred. Kenna Trading, LLC v. Commissioner, Dkt. No. 671-10
                                                                         (continued...)
                                        - 36 -

[*36] support this argument, petitioners contend that they reported the trustee’s

fees received during 2007 as income because the 2006 receipts eliminated the

basis in Sugarloaf. However, at times, petitioners argue that 2007 distributions

from Sugarloaf are nontaxable to the extent of Mr. Rogers’ basis in Sugarloaf.

They initially included the trustee’s fees as income on a draft of their 2006 joint

income tax return but changed their reporting position after receiving a notice of

deficiency for 2003, taking the position that the 2006 payments were not income.

At the outset we note that the 2003 case did not involve Sugarloaf.15 See Rogers

2003. In 2003 Mr. Rogers implemented the Sugarloaf transactions through

      14
        (...continued)
(order denying in relevant part petitioners’ motion for a new trial dated Aug. 22,
2016, at 7-8). Likewise, in these consolidated cases petitioners have not
established that a theft occurred.
      15
         Petitioners misrepresent the findings of the 2003 case. Rogers v.
Commissioner, T.C. Memo. 2011-277. During 2003 PPI received approximately
$2.4 million related to distressed debt transactions implemented through Warwick
Trading, LLC. PPI transferred approximately $1.2 million to Multicred and
retained approximately $1.2 million. Id., slip op. at 7. On its return PPI deducted
the $1.2 million transferred to Multicred. The Court held that PPI was not
required to report as income the amount transferred to Multicred and thus was not
entitled to deduct the transferred amount. Id. PPI was taxed only on the retained
$1.2 million. Id. The Court rejected PPI’s argument that it held the retained
amount in trust or as a conduit for Warwick Trading or Jetstream as it found no
evidence to support that position. Id. at 7-8. The Commissioner initially
disallowed PPI’s deduction for legal fees in the notice of deficiency but conceded
the deduction. Id. at 9.
                                         - 37 -

[*37] Warwick Trading, LLC (Warwick Trading), not Sugarloaf. Petitioners

appear to abandon any arguments relating to 2003 but continue to advance

multiple arguments that attempt to relitigate prior years’ tax liabilities to offset the

adjustments to income in these cases.16 Kenna Trading, LLC v. Commissioner,

143 T.C. at 365, did not hold that Mr. Rogers may treat the expenses relating to

the promotion of an abusive tax shelter as capital expenditures. Rather, it denied

section 162 business expense deductions on the basis that expenses relating to the

Sugarloaf transactions were incurred to obtain abusive tax shelter benefits. Id.

      We find that petitioners received unreported income of $1,165,000 from the

trustee’s fees during 2006. Under the terms of the trust agreements, Mr. Rogers

had the right to payment of the trustee’s fees, and he received those fees.

Sugarloaf did not have any right to the trustee’s fees. The trusts paid the fees, not

Sugarloaf. Mr. Rogers received similar amounts as legal fees for implementing

distressed debt transactions in prior years through Seyfarth Shaw. Seyfarth Shaw

directed Mr. Rogers to terminate the transactions in 2006. Instead he began to

implement the transactions through PPI. Respondent argues that Mr. Rogers

      16
         Petitioners argue that we should reject respondent’s determinations with
respect to the Sugarloaf transactions because he failed to audit the returns of the
subtrusts that engaged in the Sugarloaf transactions. We have previously found
that this argument is without merit. See Kenna Trading, LLC v. Commissioner,
143 T.C. at 374 n.41.
                                        - 38 -

[*38] structured the Sugarloaf transactions to receive trustee’s fees instead of legal

fees to avoid Seyfarth Shaw’s policy that required him to pay over any legal fees

that he earned to the firm. The amounts of trustee’s fees are consistent with his

past income from implementing distressed debt transactions.

      Petitioners have not established that Mr. Rogers had an ownership interest

in Sugarloaf and thus do not have a capital account for purposes of a basis

determination. Mr. Rogers previously represented that he did not have a direct

ownership interest in Sugarloaf and indirectly owned no more than 1% through

Jetstream. See id. at 352 (stating that documents show that the Brazil retailers

owned 215% of Sugarloaf). Nor have they established a loan arrangement

between Mr. Rogers and Sugarloaf although they presented canceled checks and

wire transfers as evidence of advances to Sugarloaf. Petitioners assert that Mr.

Rogers advanced money to Sugarloaf for startup expenses. They made a similar

argument in their 2004 case, unsuccessfully arguing that a payment from

Sugarloaf to Mr. Rogers was a nontaxable repayment of a loan. See Rogers 2004.

They would not be entitled to treat expenses paid on Sugarloaf’s behalf as capital

expenditures simply because they were denied ordinary and necessary business

expense deductions for the expenses.
                                       - 39 -

[*39] B.    PPI’s Unreported Income

      Respondent determined that petitioners had unreported income from PPI for

2005 and 2006. After concessions respondent alleges that PPI received $30,000

from SRI in 2005 that it failed to report. SRI deducted the $30,000 payment.

Petitioners did not present any evidence to dispute respondent’s position that the

$30,000 is income. Accordingly, we find that PPI had unreported income of

$30,000 for 2005.17 For 2006 respondent determined, using a bank deposits

analysis, that PPI understated its gross receipts by $694,165. Bank deposits are

prima facie evidence of income. DiLeo v. Commissioner, 96 T.C. 858, 868

(1991), aff’d, 959 F.2d 16 (2d Cir. 1992). Respondent’s bank deposits analysis is

supported by the record. During 2006 PPI deposited the following amounts into

its bank account: (1) $710,366 in consulting fees from SRI, (2) $240,000 from the

Sterling Ridge Trust, (3) $465,000 from Sugarloaf, and (4) $469,000 from

Laurence Builders. PPI transferred $400,000 of the $469,000 received from

Laurence Builders to SRI; SRI reported it as income, and it is not includable in

      17
        Respondent also argues for the first time on brief that Mr. Rogers received
$100,000 of the Multicred fee paid by PPI in 2005 and seeks to characterize it as a
shareholder distribution taxable to the extent provided by application of the S
corporation rules. The taxation of the $100,000 distribution is a new issue not
properly raised before trial, and we will not consider it here. Dirico v.
Commissioner, 139 T.C. 396, 416 (2012).
                                         - 40 -

[*40] PPI’s 2006 gross receipts. PPI retained the remaining $69,000. On the basis

of these deposits PPI had gross receipts of $1,484,366 for 2006. It reported gross

receipts of $790,201, understating its gross receipts by $694,165. Petitioners did

not offer any explanation for treating the deposits from the Sterling Ridge Trust

and Laurence Builders as nontaxable income.

      With respect to the SRI deposit, SRI deducted the $710,366 as consulting

fees.18 See infra Appendix D. Although SRI deducted this payment as a business

expense, petitioners argue that PPI is entitled to treat $350,000 as repayment of a

loan that PPI made to SRI in 2005. The record establishes a $350,000 transfer to

SRI. However, SRI’s corporate records did not treat the transfer as a loan, and

petitioners have failed to establish the existence of a debt. We find that the

deposit from SRI is income to PPI in accordance with SRI’s treatment of the item.

Similarly, petitioners argue that PPI is entitled to treat the Sugarloaf deposits as a

loan repayment. Petitioners have provided a minimal amount of evidence of

purported transfers from PPI to Sugarloaf or on Sugarloaf’s behalf to support their

argument that the deposits were loan repayments. However, Sugarloaf, an entity

that Mr. Rogers controlled, did not treat the deposits as loan repayments. It

      18
        Respondent concedes that if the payment is includable in PPI’s gross
receipts, SRI is entitled to deduct the fee.
                                         - 41 -

[*41] deducted $100,000 as a management fee to PPI and amortized the remainder

as startup expenses. In the alternative, they argue that PPI is entitled to treat its

2006 deposits as a nontaxable distribution to the extent of its basis in Sugarloaf

and to increase its basis by any disallowed business expense deductions, including

the Multicred fee in 2005. See infra Appendix E. However, there is no indication

that PPI held such an equity interest in Sugarloaf. Moreover, as discussed further

infra, they have not substantiated the payment of the Multicred fee or any other

expense paid in connection with Sugarloaf. Nor have they established the

business purpose of the expenditure that would allow PPI to treat the payments as

capital expenditures or to increase PPI’s basis in Sugarloaf if PPI in fact did have

an ownership interest in Sugarloaf.

      Petitioners appear to make a third argument; their brief is convoluted and

confusing. They argue that PPI paid over the Sugarloaf deposits to individuals

involved in the Sugarloaf transactions but have provided no proof of such

payments. Petitioners make a series of arguments about overstatements of revenue

and double taxation in past years and among different entities. They repeatedly

cite incorrect tax years or misstate the facts from the prior years as set forth in the

Court’s prior opinions. They attempt to relitigate their 2004 case, where they

sought to decrease the amount of gross receipts reported on PPI’s return, arguing
                                        - 42 -

[*42] that PPI included the amount in its gross receipts by mistake and that PPI

was holding the money in trust. We rejected these arguments. See Rogers 2004.

Petitioners also argue that both Sugarloaf and PPI reported the income from the

Sugarloaf transactions, resulting in double taxation. The evidence does not

establish inappropriate double taxation. Petitioners have not established that any

of the four sources of deposits is nontaxable. Accordingly, we find that PPI

understated its gross receipts for 2006 by $694,165.

      C.     Transfer of Orland Park to SRI

      Mrs. Rogers entered into a contract to sell Orland Park to her wholly owned

S corporation, SRI, for $7 million, i.e., the Rogers loan. SRI determined its gain

on the sales of the subdivision lots of Orland Park during 2005 and 2006 by

including the $7 million in its basis. Petitioners contend that the Rogers loan

included imputed interest. Respondent argues that the land transfer should be

recharacterized as a capital contribution to SRI (rather than a sale), and SRI’s basis

in Orland Park is not increased by the purported $7 million sale price.19

According to respondent’s argument, SRI underreported its income on the sale of

      19
        Respondent concedes that the recharacterization of Mrs. Rogers’ transfer
of Orland Park to SRI as a capital contribution is a new matter for 2005, shifting
the burden of proof to him. See Rule 142(a). Respondent did not challenge the
property’s basis in the 2005 notice of deficiency. Respondent did challenge SRI’s
basis in Orland Park in the 2006 notice of deficiency.
                                         - 43 -

[*43] the subdivision lots for 2005 and 2006 by overstating its basis. As an

alternative argument, respondent argues that petitioners underreported their

income from the installment sale of Orland Park under section 453(a) or (e) for

2005 and 2006.

      The characterization of a shareholder’s transfer to a closely held corporation

as either a sale that creates a bona fide debt or a capital contribution is determined

by all the surrounding facts and circumstances. Dixie Dairies Corp. v.

Commissioner, 74 T.C. 476, 493 (1980). The Court of Appeals for the Seventh

Circuit has considered the following eight factors for determining whether to treat

a transfer between a shareholder and his corporation as debt or equity:

(1) testimony regarding the intent to repay, (2) the extent of the shareholder’s

control of the corporation; (3) the retained earnings and dividend history of the

corporation; (4) the size of the transfer, (5) the presence of conventional indicia of

debt, such as a promissory note, collateral, and interest charges; (6) treatment of

advances in corporate records; (7) the history of repayment; and (8) the taxpayer’s

use of the funds. Busch v. Commissioner, 728 F.2d 945, 948-949 (7th Cir. 1984)

(considering whether a shareholder’s withdrawal was a loan or a dividend), aff’g

T.C. Memo. 1983-98. The Court of Appeals for the Seventh Circuit treats these

objective factors as indications of the parties’ intent. Id. at 948.
                                          - 44 -

[*44] We have identified a nonexclusive list of 13 factors to consider when

determining the nature of transfers to closely held corporations: (1) the names or

labels given to the transfer by the parties and the instruments evidencing the

transfer and indebtedness; (2) the presence or absence of a fixed maturity date;

(3) the source of payments; (4) the right to enforce payments; (5) participation in

management as a result of the advances; (6) the status of the advances in relation

to regular corporate creditors; (7) the intent of the parties; (8) the identity of

interest between the creditor and the shareholder; (9) “thinness” of the capital

structure in relation to the debt, i.e., the debt-to-equity ratio; (10) the ability of the

corporation to obtain credit from outside sources; (11) the use to which advances

were put, i.e., to purchase capital assets or to pay operating expenses; (12) the

failure of the debtor to repay; and (13) the risk involved in making the advances.

Calumet Indus., Inc. v. Commissioner, 95 T.C. 257, 285 (1990); Dixie Dairies

Corp. v. Commissioner, 74 T.C. at 493. No single factor is controlling, and not all

factors may apply to each case. John Kelley Co. v. Commissioner, 326 U.S. 521,

530 (1946); Dixie Dairies Corp. v. Commissioner, 74 T.C. at 493-494. A

shareholder’s transaction with a closely held corporation is subject to close

scrutiny but does not preclude the existence of a bona fide debt. Fin Hay Realty

Co. v. Commissioner, 398 F.2d 694, 697 (3d Cir. 1968); C.M. Gooch Lumber
                                        - 45 -

[*45] Sales Co. v. Commissioner, 49 T.C. 649, 656 (1968); Am. Underwriters, Inc.

v. Commissioner, T.C. Memo. 1996-548. The enumerated factors are aids in

evaluating the transaction; the ultimate question is: “Was there a genuine

intention to create a debt, with a reasonable expectation of repayment, and did that

intention comport with the economic reality of creating a debtor-creditor

relationship?” Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973).

      Mrs. Rogers entered into a sale agreement for Orland Park in exchange for a

$7 million loan with a $50,000 deposit.20 She entered into the sale agreement on

the same date that she incorporated SRI with a $50,000 capital contribution. SRI

did not make any payment at closing or pay the $50,000 deposit as required by the

sale contract. While SRI reported the transfer as creating a liability in its books

and records and on its tax returns, including interest payments in 2005 and 2006,

petitioners failed to observe the formalities of a debt. They did not issue a note or

a debt instrument. They did not record a mortgage or a lien on the property. They

did not execute or record a deed for the transfer of Orland Park for nearly one year

      20
         Petitioners argue that respondent is barred by claim preclusion or laches
from contesting the treatment of the transaction as a sale because the sale occurred
in 2004 and respondent failed to raise the issue in the notice of deficiency or in the
trial for 2004. We find that this argument is without merit. It is well established
that each tax year stands on its own. See United States v. Skelly Oil Co., 394 U.S.
678, 684 (1969).
                                        - 46 -

[*46] after entering the sale contract and executed and recorded the deed at that

time because they were required to do so to obtain a construction loan from a

third-party lender. There was no repayment schedule or fixed maturity date, and a

portion of the alleged loan remained outstanding at the time of trial, 11 years after

its origination despite SRI’s earning over $13 million from the sale of the

subdivision lots. Petitioners had complete control over SRI, with Mrs. Rogers as

its sole shareholder and Mr. Rogers as its president. SRI paid $6 million of its $13

million sale proceeds to Mrs. Rogers, and petitioners reported approximately $3.2

million of the $6 million as repayment on the loan principal. They characterized

over $2 million as a nontaxable return of capital. Mr. Rogers testified that SRI

had no obligation to repay the unpaid balance of the loan at any specific date.

There was no collateral or guaranty.21 SRI was newly incorporated and held no

other assets, except for an initial capital contribution of $50,000. It used the

alleged debt to acquire the essential asset of the corporation. It was thinly

capitalized. In contrast SRI obtained a $2.65 million construction loan from a

third-party lender that required collateral and Mr. Rogers’ personal guaranty. The

construction loan had a fixed maturity date within 18 months of its origination and

      21
       On brief petitioners argues that SRI paid dividends to Mrs. Rogers in
2006. However, there were no corporate records of a dividend.
                                        - 47 -

[*47] a repayment schedule that required SRI to pay $135,000 from the sale

proceeds of each lot, representing over 50% of the $260,000 sale price per lot. It

repaid the construction loan in full by the end of 2005, before its maturity date,

indicating payment to Mrs. Rogers was subordinate to the third-party creditor or a

preference to repay the third-party creditor. Respondent suggests that petitioners

did not disclose the $7 million debt to the lender because its records did not

contain any information regarding the alleged liability.

      The source of the payments to Mrs. Rogers was SRI’s earnings from the sale

of the subdivision lots, and payment depended on the successful sale of the lots.

Mrs. Rogers continued to bear the risk of loss and the risk that Orland Park’s

market value would decrease. SRI made only two payments against the principal

in 2005 and 2006 when it sold most of the subdivision lots for nearly $11 million.

She did not receive any payments after 2006 despite the continued sale of the lots.

At the time of the trial SRI still owed approximately $3.8 million on the purported

loan, without considering interest. The sale of the remaining four unsold lots

would not likely generate sufficient funds to repay the loan. Moreover, appraisals

of Orland Park suggest that SRI would not have been able to repay the $7 million

sale price at the time of the land transfer. The third-party lender on the

construction loan appraised the land for approximately $4.6 million to $6.1
                                        - 48 -

[*48] million. Petitioners obtained an appraisal in 2014 that valued Orland Park at

$6.28 million as of May 26, 2005. Both appraisals included the land conveyed to

the municipality for public use that would not have generated revenue to pay the

$7 million sale price.

      We find that Mrs. Rogers did not intend to create a bona fide debtor-creditor

relationship. An unrelated lender would not have extended credit to SRI on

similar terms. On review of the enumerated factors, we find that Mrs. Rogers and

SRI did not create a bona fide debt upon the transfer of Orland Park. Rather, Mrs.

Rogers made a capital contribution of the property to SRI, and SRI had a carryover

basis in Orland Park. See sec. 362. By including the $7 million debt in its basis

for Orland Park, SRI underreported its income on the sale of the subdivision lots

for 2005 and 2006.

      Petitioners argue that if we recharacterize the land transfer as a capital

contribution, the income resulting from the sale of the subdivision lots should be

taxed as capital gain under section 1237. The character of the income is a new

issue raised for the first time on brief. The Court afforded the parties an

opportunity to amend their pleadings before the trial and instructed the parties to

request leave to amend their pleadings by July 15, 2015. Petitioners timely filed a

request with a proposed amended petition. They did not raise the issue of the
                                        - 49 -

[*49] capital gain treatment for the subdivision lots or include any reference to

section 1237. Nor did they raise this issue in the pretrial memorandum or at trial.

Throughout their posttrial briefs, petitioners repeatedly raise new issues not in the

pleadings. We will not consider this issue as doing so would be prejudicial to

respondent. Dirico v. Commissioner, 139 T.C. at 415-417. SRI reported the

revenues from the sale of the lots as ordinary income on its corporation tax

returns. SRI included the costs of improvements to the basis of the lots, contrary

to the rules of section 1237(b)(3)(C). Petitioners entered into a business venture to

develop Orland Park with a business partner, borrowed significant amounts of

money to improve the land for purposes of its subdivision, and constructed homes

on the lots, including a model home. See sec. 1237(b)(3)(A); sec. 1.1237-1(c)(4),

Income Tax Regs. They received at least one unsolicited offer for Orland Park for

$5 million in 2003. Petitioners rely on caselaw that is distinguishable from the

limited facts that have been developed here that are relevant to a determination of

whether section 1237 applies. See Bauschard v. Commissioner, 279 F.2d 115 (6th

Cir. 1960), aff’g 31 T.C. 910 (1959); Riedel v. Commissioner, 261 F.2d 371 (5th

Cir. 1958), rev’g T.C. Memo. 1957-210.22

      22
       Riedel v. Commissioner, 261 F.2d 371 (5th Cir. 1958), rev’g T.C. Memo.
1957-210, predates the enactment of sec. 1237 as do at least two of the three years
                                                                      (continued...)
                                          - 50 -

[*50] SRI treated its acquisition of Orland Park as a purchase costing $7 million,

and as a result overstated its costs of goods sold for 2005 and 2006. For 2005 SRI

sold 22 lots and reported the cost of goods sold of $2.4 million.23 For 2006 it sold

20 lots and reported the cost of goods sold of $4,209,605. Respondent concedes

that SRI incurred costs of improvements of $103,418, $1,891,853, and $307,105

in 2004, 2005, and 2006, respectively. See sec. 263(a); W.C. & A.N. Miller Dev.

Co. v. Commissioner, 81 T.C. 619, 632 (1983). Petitioners have not substantiated

improvement costs in excess of respondent’s concessions; however, petitioners are

entitled to treat the letter of credit fee and the architect’s fee as capital

expenditures as explained infra in section II.D.1 and 2.24

       22
         (...continued)
at issue in Bauschard v. Commissioner, 279 F.2d 115 (6th Cir. 1960), aff’g 31
T.C. 910 (1959).
       23
       Respondent concedes that $282,000 of the gross receipts reported for 2005
was deposits made for sales that occurred in 2006.
       24
        Petitioners contend that SRI had a $150,000 basis in each lot in the
Sterling Ridge subdivision, which would result in a 2005 cost of goods sold for
SRI of $3.3 million. The $150,000 basis per lot depends on the inclusion of the $7
million purported purchase price. SRI sold 22 lots in 2005 (22 x $150,000 = $3.3
million). However, SRI reported the cost of goods sold of $2.4 million on its 2005
tax return. Petitioners also argue that SRI omitted from its cost of goods sold for
2005 the cost of six lots that it sold to its business partner in a bargain sale for
$450,000. Both of these positions depend on including the $7 million purported
loan in SRI’s basis for Orland Park. As we have found that SRI cannot include the
                                                                           (continued...)
                                        - 51 -

[*51] For 2006 SRI reported a cost of goods sold of over $4.2 million. However,

petitioners’ position, to use a basis of $150,000 per lot, does not support the cost

of goods sold in excess of $3 million. They have not adequately provided support

for the excess of approximately $1.2 million in the cost of goods sold reported for

2006. They suggest that it could have included a markdown in the value of SRI’s

unsold lots at the end of 2006 to $100,000 per lot. They have not cited any legal

authority to support a markdown in the unsold lots and did not obtain an appraisal

to support the markdown. During 2006 SRI sold the lots for $260,000 each, and it

is inconsistent to discount the unsold lots to $100,000 in the same year without

further evidence. Accordingly, we hold that in determining its taxable income SRI

overstated its cost of goods sold for 2006.

II.   Deductions

      A.     Charitable Contribution Status of SRI’s Land
             Transfer to Municipality

      Petitioners argue that they are entitled to a $1 million charitable

contribution deduction for the transfer of 4.89 acres of Orland Park to the

municipality for 2005. They did not claim this deduction on their 2005 joint tax

      24
        (...continued)
$7 million purported purchase price in its basis, both of petitioners’ arguments
fail.
                                        - 52 -

[*52] return or SRI’s 2005 corporation tax return.25 We note that the deed

conveying the land to the municipality was dated March 2012. Respondent argues

that petitioners are not entitled to the charitable contribution deduction because

they were required to transfer the land to the municipality to obtain approval for

the subdivision. Section 170(a) allows taxpayers to deduct charitable

contributions. The phrase “charitable contribution” has generally been defined as

synonymous with the term “gift”. Elrod v. Commissioner, 87 T.C. 1046, 1075

(1986); DeJong v. Commissioner, 36 T.C. 896, 899 (1961), aff’d, 309 F.2d 373

(9th Cir. 1962). A gift is generally defined as a voluntary transfer of property

without adequate consideration. Osborne v. Commissioner, 87 T.C. 575, 581

(1986). A gift is made with detached and disinterested generosity. Commissioner

v. LoBue, 351 U.S. 243, 246 (1956). A taxpayer may not deduct a payment as a

charitable contribution if the taxpayer received a substantial benefit in return.

United States v. Am. Bar Endowment, 477 U.S. 105, 116-117 (1986). A payment

that is part of a quid pro quo arrangement is not a deductible charitable

      25
         Petitioners also seek a $260,000 charitable contribution deduction on the
basis that SRI transferred land to its business partner to reimburse it for its land
contribution to the municipality. They did not raise the $260,000 deduction in
their pleadings or pretrial memorandum or during trial. Accordingly, we will not
consider this new issue and disallow the $260,000 deduction. See Dirico v.
Commissioner, 139 T.C. at 416.
                                        - 53 -

[*53] contribution. Hernandez v. Commissioner, 490 U.S. 680, 701-702 (1989);

United States v. Am. Bar Endowment, 477 U.S. at 117-118. A taxpayer is not

entitled to a charitable contribution deduction for a land transfer where she obtains

a “direct or indirect benefit in the form of enhancement in the value or utility of

the taxpayer’s remaining land or otherwise to benefit the taxpayer.” Elrod v.

Commissioner, 87 T.C. at 1075 (quoting Sutton v. Commissioner, 57 T.C. 239,

243 (1971)). A taxpayer’s legal obligation to convey the property also negates a

donative intent. Pettit v. Commissioner, 61 T.C. 634, 640-641 (1974).

      Petitioners are not entitled to a charitable contribution deduction for the

land transfer to the municipality because SRI conveyed the land to obtain approval

for the subdivision, and thus petitioners lacked donative intent. See id.

(disallowing charitable contribution deduction where taxpayer granted rights of

way to obtain approval for subdivision); Perlmutter v. Commissioner, 45 T.C. 311

(1965) (disallowing charitable contribution deduction where taxpayer conveyed

property for school and recreational uses to obtain approval for subdivision). The

municipality required petitioners to convey a portion of Orland Park as a condition

for approval of the subdivision. This requirement was stated in the agreement that

SRI entered into with the municipality for the annexation of the subdivision and

was required by the municipality land development code. See Village of Orland
                                        - 54 -

[*54] Park Land Development Code art. 5, sec. 5-112 (requiring a contribution of

land or a monetary payment in lieu of a land contribution). The transfer was a

quid pro quo exchange. The subdivision of Orland Park increased its value,

providing a substantial benefit to petitioners.26 See Elrod v. Commissioner, 87

T.C. at 1075-1079.

      Petitioners argue that they are entitled to the charitable contribution

deduction because the parks and detention ponds that they developed for Orland

Park and contributed to the municipality were superior to parks and ponds in the

neighboring subdivisions and exceeded the specifications required by the

municipality. For example, they argue that SRI provided for a larger detention

pond and a larger setback area than required by law. Where a taxpayer receives

consideration for a charitable contribution, he may still deduct as a charitable

contribution the fair market value of the property that the taxpayer transferred less

the fair market value of the goods that the grantee organization provided in

      26
        We further note that petitioners failed to obtain a contemporaneous written
acknowledgment for the land transfer from the municipality or a qualified
appraisal of the land at the time of the transfer as required for a charitable
contribution deduction. See sec. 170(f)(8)(A), (11). Petitioners argue that they
substantially complied with the substantiation requirements and had reasonable
cause for their failure to substantiate the contribution because of a
misunderstanding of the law. We do not address this issue as we have found that
petitioners lacked the requisite donative intent.
                                       - 55 -

[*55] exchange for the contribution. Rolfs v. Commissioner, 135 T.C. 471, 486-

487 (2010), aff’d, 668 F.3d 888 (7th Cir. 2012); sec. 1.170A-1(h)(1) and (2),

Income Tax Regs. The burden is on the taxpayer to make this showing. Sec.

1.170A-1(h)(1), Income Tax Regs. Petitioners have not established the value of

the enhancements to the park and ponds above the specifications required by law.

      B.    Reddy Lab and PTI Deductions

      Petitioners seek worthless debt or worthless stock deductions with respect to

their activities with Reddy Lab and PTI. Their arguments are inconsistent and

confusing. They appear to argue for: (1) a $1.3 million worthless debt deduction

for amounts owed by Reddy Lab, (2) an $808,000 worthless debt deduction for

amounts owed by PTI, (3) a worthless stock deduction for Mr. Rogers’ PTI stock,

and (4) an approximately $2 million worthless debt deduction for L&R’s claims

against Reddy Lab or a worthless stock deduction for its PTI stock. L&R is not

entitled to deduct $2 million in claims against Reddy Lab as a worthless debt.

Pursuant to an agreement dated October 8, 1998, L&R assigned its $2 million

claim to PTI in exchange for stock. L&R has not established any other debt owed

by Reddy Lab.

      Petitioners raise the issues relating to the worthless stock deductions for PTI

stock owned by Mr. Rogers and L&R for the first time on brief. These issues are
                                         - 56 -

[*56] not properly before the Court. See Dirico v. Commissioner, 139 T.C. at

415-417. Accordingly, they are not entitled to the worthless stock deductions.

             1.     Reddy Lab Worthless Debt Deduction

      Petitioners seek a $1.3 million worthless debt deduction in connection with

alleged liabilities owed by companies within the Reddy Lab structure (Reddy

notes) for 2005 or, in the alternative, any deficiency year. Following an audit for

1992 through 1998, the IRS allowed petitioners a $915,000 worthless debt

deduction for 1998 in connection with amounts owed to them by companies within

the Reddy Lab structure. Petitioners argue that the 1998 worthless debt deduction

did not involve debt by the Reddy Lab entity involved in the 1995 bankruptcy and

instead involved debt owed by separate entities involved in early bankruptcies.

Petitioners failed to provide evidence of any liabilities except for the liabilities in

the 1995 bankruptcy, and we do not find Mr. Rogers’ testimony that the 1998

deduction related to separate liabilities to be credible. The bankruptcy trustee

found that petitioners and their related businesses had over $3.3 million in

unsecured general claims; however, most of the claims were held by L&R and a

trust, not petitioners. The debt to Mr. Rogers individually was approximately

$500,000, and the IRS allowed a $915,000 deduction. The remainder of the debt

was owed to L&R and a trust in Mrs. Rogers’ name.
                                       - 57 -

[*57] We find that petitioners are not entitled to a worthless debt deduction with

respect to any advances that Mr. Rogers made to entities with the Reddy Lab

structure for 2005 or any year at issue because Mr. Rogers failed to establish a

debt in excess of the amount previously deducted. For a section 166 worthless

debt deduction, taxpayers must show: (1) the transfer created a valid debt and was

not equity contributions, (2) the debt became worthless during the year, and (3) the

debt was incurred in connection with a trade or business. Sensenig v.

Commissioner, T.C. Memo. 2017-1, at *17-*18; sec. 1.166-1(c), Income Tax

Regs. A worthless nonbusiness debt is deductible as a short-term capital loss.

Sec. 166(d)(1); sec. 1.166-5(a)(2), Income Tax Regs. It is likely that the Reddy

notes were worthless long before the years at issue as evidenced by the 1995

bankruptcy. For a section 166 deduction, the debt must become worthless during

the tax year, i.e., it must have value at the beginning of the year and became

worthless during that year. Milenbach v. Commissioner, 106 T.C. 184, 204

(1996), aff’d in part, rev’d in part on other grounds, 318 F.3d 924 (9th Cir. 2003).

The determination of when a debt becomes worthless depends upon the particular

facts and circumstances of each case. Id. A taxpayer must generally show that

identifiable events occurred to render the debt worthless during the year for which

the taxpayer claimed the deduction. Am. Offshore, Inc. v. Commissioner, 97 T.C.
                                        - 58 -

[*58] 579, 593 (1991). Some objective factors considered by the Court in

determining worthlessness include the value of property securing the debt, the

debtor’s earning capacity, events of default, the debtor’s refusal to pay, actions to

collect the debt, any subsequent dealings between the parties, and the debtor’s lack

of assets. Id. at 594-595. No single factor is conclusive. Id. at 595. Debts

become worthless when the taxpayer has no reasonable expectation of repayment.

Crown v. Commissioner, 77 T.C. 582, 598 (1981). Bankruptcy is an indication of

the worthlessness of an unsecured debt. Sec. 1.166-2(c), Income Tax Regs. Mr.

Rogers’ claims were subordinate to secured claims of over $1.5 million, and the

bankrupt estate held no assets and had a right to receive 10% of PTI’s sales, which

ranged between approximately $300,000 and $600,000 annually. Petitioners

wrote down the Reddy notes to $400,000 in 1995 and reported them as completely

worthless on their personal balance sheet, dated July 1, 1996. They have not

established that the Reddy notes had any value at the beginning of 2005. They are

not entitled to a worthless debt deduction for any deficiency year with respect to

debt owed by any entity within the Reddy Lab structure. They also have not

established the other two requirements for section 166, that the debt was a bona

fide debt rather than a capital contribution to Reddy Lab or was incurred in a trade

or business.
                                        - 59 -

[*59]         2.    PTI Worthless Debt Deduction

        Petitioners also seek an $808,000 worthless debt deduction for amounts that

Mr. Rogers advanced to PTI, including the $363,000 in payments to finance PTI’s

inventory in 2004 and the $400,000 payment to the bankruptcy trustee in 2007.

Respondent objects to the worthless debt deduction relating to PTI as a new issue.

Petitioners raised this issue at trial and presented evidence relating to the Mr.

Rogers’ transfer to PTI. Nevertheless, we find that petitioners failed to establish

that a valid debtor-creditor relationship existed between PTI and Mr. Rogers, and

we deny the deduction. For a section 166 deduction, the debt must arise from a

debtor-creditor relationship based upon a valid and enforceable obligation to pay

fixed or determinable sum of money. Kean v. Commissioner, 91 T.C. 575, 594

(1988); sec. 1.166-1(c), Income Tax Regs. The evidence shows that Mr. Rogers

entered into a business relationship with PTI to make a profit on the sale of the

medical device. He did not advance funds for the purpose of earning interest

income. He believed that PTI had the potential to become a multimillion-dollar

company. He was concerned with profits as a shareholder of PTI. After an initial

victory (later reversed) in the patent case, Mr. Rogers paid $400,000 to release PTI

from its obligations to pay the bankruptcy trustee. Mr. Rogers made this payment

in 2007, following years in which PTI had reported its insolvency on its books and
                                        - 60 -

[*60] records and had failed to pay its debts to unrelated persons. His main

concern was profits as a business owner. He believed that PTI could potentially

recover over $1 million in damages in the patent litigation.

      We have previously held that Mr. Rogers made the payments to fund the

continued operation of PTI to protect his investment in the company and the

payments were nondeductible capital contributions to PTI. Rogers 2004, at *12-

*13, *56. We further held that PPI could not deduct the payments. Id. at *56.

Mr. Rogers wanted to make a profit from the sale of the medical device and to

recover damages from the alleged infringement of PTI’s patent rights. Id. at *12-

*13, *56. Likewise, we find that petitioners are not entitled to a worthless debt

deduction for any amounts paid on PTI’s behalf in these cases because Mr. Rogers

made the payments to protect his investment in PTI. Mr. Rogers’ payments were

capital contributions to PTI. Moreover, petitioners failed to address the traditional

factors that the Court considers to determine whether a shareholder’s advance to

his corporation is a valid debt or a capital contribution. See Dixie Dairies Corp. v.

Commissioner, 74 T.C. at 493-494. PTI entered the $808,000 debt on its books

and records but did not issue a debt instrument, did not set an interest charge,

maturity date, or payment schedule, and did not provide any collateral. It did not

have the capacity to repay the advances when they were made. Mr. Rogers kept
                                         - 61 -

[*61] PTI alive, by his own admission, solely to enable the patent litigation to

proceed. Petitioners did not state a year for which they seek a deduction. The

debt must have value at the beginning of the year of the deduction and become

worthless during the year. Milenbach v. Commissioner, 106 T.C. at 204; sec.

1.166-1(c), Income Tax Regs. The debt was arguably worthless when the transfer

was made. Approximately half of the PTI deduction ($363,000) arose to pay for

production costs in 2004, and Mr. Rogers lent another $400,000 in 2007 without

any payment of the prior debt. Petitioners are not entitled to a worthless debt

deduction for any of the $808,000 advanced to PTI for any deficiency year.

      C.     Business Expense Deductions

      Petitioners filed two Schedules C with their joint tax returns for the

deficiency years, Schedule C-1 for Mr. Rogers’ business activities as an attorney

and Schedule C-2 for Mrs. Rogers’ business activities as a realtor. They deducted

expenses relating to their personal residence, including mortgage interest,

insurance, utilities, repairs, and alarm services, on the basis that they used their

residence as a home office. See infra Appendix A. They also deducted personal

expenses relating to their automobiles and substantial amounts of personal travel.

See infra Appendix A. They deducted expenses relating to the personal residence

of their adult son who lived at the Manitou house with his family, including
                                        - 62 -

[*62] depreciation, mortgage interest, repairs, taxes, and utilities. See infra

Appendixes A, B, and C. They also deducted expenses relating to the Manitou

house on PPI’s 2005 corporation tax return and SRI’s 2006 corporation tax return.

See infra Appendixes C and D. Petitioners provided QuickBooks records,

canceled checks, and credit card statements to substantiate their business

expenses. They provided invoices or receipts for only a limited number of the

expenses. Often the amounts deducted do not correspond to the QuickBooks

records, checks, and credit card statements. The QuickBooks entries often do not

correspond to the canceled checks and credit card statements. They used the credit

cards for both personal and business expenses, failed to adequately distinguish the

expenses as personal verus business, and deducted personal expenses. They

lacked adequate business records for a substantial portion of the disputed

deductions. See sec. 6001.

      Section 162(a) permits taxpayers to deduct ordinary and necessary expenses

paid or incurred in carrying on a trade or business. See Commissioner v. Lincoln

Sav. & Loan Ass’n, 403 U.S. 345, 352 (1971). Taxpayers may also deduct

expenses incurred for the production of income. Sec. 212. Section 262(a)

disallows deductions for personal, living, or family expenses. See also sec. 1.162-

17(a), Income Tax Regs. Generally, the taxpayers have the burden to prove to
                                       - 63 -

[*63] their entitlement to any deduction and must maintain adequate records to

substantiate their deductions. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503

U.S. at 84; Welch v. Helvering, 290 U.S. at 115. When a taxpayer establishes that

he paid or incurred a deductible expense but does not establish the amount of the

expense, we may estimate the amount allowable in some circumstances (the Cohan

rule). Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). There must

be sufficient evidence in the record on which we can base an estimate. See

Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957); Vanicek v.

Commissioner, 85 T.C. 731, 742-743 (1985). In estimating the deductible amount,

we bear heavily upon the taxpayer who failed to maintain the required records.

Cohan v. Commissioner, 39 F.2d at 544.

      Strict substantiation rules apply to travel, meal, and entertainment expenses

and expenses relating to passenger vehicles, including parking, and preclude the

use of the Cohan rule. Secs. 274(d), 280F(d)(4); sec. 1.274-5T(a), Temporary

Income Tax Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985); see Sanford v.

Commissioner, 50 T.C. 823, 827 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir.

1969). When the strict substantiation rules apply, the taxpayer must substantiate

by adequate records or sufficient evidence corroborating his own statement:

(1) the amount of the expense, (2) the time and the place of the expense, (3) the
                                        - 64 -

[*64] business purpose of the expense, and (4) his business relationship to the

person benefited by the expense. Sec. 274(d); see Shea v. Commissioner, 112

T.C. 183, 187 (1999). The taxpayer must maintain adequate records to establish

each of the above elements of the expenditure. Sec. 1.274–5T(c)(1) and (2),

Temporary Income Tax Regs., 50 Fed. Reg. 46016-46017 (Nov. 6, 1985).

Taxpayers may rely on a contemporaneous log, other records, such as a diary or

account book, that they maintained at or near the time they incurred the expense,

or other sufficient evidence that includes a detailed personal statement

corroborated by other evidence that has “a high degree of probative value to

elevate such statement” to the level of credibility of a contemporaneous record.

Id. subparas. (1) through (3). A taxpayer’s testimony without corroborative

evidence is not sufficient substantiation. Wolfgram v. Commissioner, T.C. Memo.

2010-69, slip op. at 24.

             1.     Home Office Deduction

      Petitioners contend that they used 50% of their personal residence as a home

office and seek to deduct expenses relating to their personal residence, including

mortgage interest, insurance, utilities, taxes, alarm services, and repairs.27 See

      27
        Petitioners deducted repairs of $3,145 and utilities of $3,109 relating to
their personal residence on their 2007 Schedule C-1 and their 2005 Schedule C-2,
                                                                        (continued...)
                                        - 65 -

[*65] infra Appendixes A and B. However, for certain expenses they deducted

100% of the incurred expense. Section 280A(a) disallows deductions with respect

to a taxpayer’s residence with an exception for a home office. Sec. 280A(c)(1).

Home office expenses are deductible if a portion of the dwelling unit is used

exclusively and regularly for business purposes. Hamacher v. Commissioner, 94

T.C. 348, 353-354 (1990). A taxpayer may deduct expenses allocable to the

portion of the residence used as a home office. Sec. 280A(c)(1); see Stricker v.

Commissioner, T.C. Memo. 1995-530. Petitioners must establish that they used a

portion of their residence regularly for business purposes and that they used the

identifiable portion of their residence exclusively for business purposes.

Petitioners argue that they used five rooms in their residence plus a portion of their

basement for business purposes but admitted that these rooms (with the possible

exception of one room that Mr. Rogers used as an office) were not used

exclusively for business purposes. They admitted that the business use of their

residence consisted primarily of the storage of business records; use of a home to

store business records does not qualify the expenses for a home office deduction.

Sec. 280A(c)(2); see Druker v. Commissioner, 697 F.2d 46 (2d Cir. 1982)

      27
        (...continued)
respectively. See infra Appendixes A and B.
                                         - 66 -

[*66] (holding that storage of legal files and business records did not qualify for

home office deduction), aff’g in part, rev’g in part 77 T.C. 867 (1981); Banatwala

v. Commissioner, T.C. Memo. 1992-483 (disallowing a home office deduction for

storage use by an insurance salesman). Mr. Rogers’ home office was not his

principal place of business as he maintained offices at his law firms during the

deficiency years. See sec. 280A(c)(1)(A).

      Petitioners did not provide sufficient evidence relating to the percentage of

the home used for business purposes, i.e., the size of the room that Mr. Rogers

allegedly used for an office in relation to the size of their home. They failed to

adequately establish the portion of their home used exclusively and regularly for

business. See sec. 280A(c)(1). Accordingly, they are not entitled to business

expense deductions for any portion of the expenses relating to their personal

residence for 2005, 2006, and 2007. We disallow the business expense deductions

relating to petitioners’ personal residence as follows: for 2005, alarm services in

full; for 2006, alarm services, utilities, and taxes in full, and interest and insurance

to the extent related to the residence; and for 2007, alarm services and utilities in

full, and repairs, taxes, interest, and insurance to the extent related to the

residence. See infra Appendix A. We address the remaining interest, repairs, and

insurance deductions not related to the personal residence below.
                                        - 67 -

[*67]         2.    Manitou House

        Petitioners also deducted expenses relating to the Manitou house as

business expense deductions. See infra Appendix C. They deducted these

expenses primarily on Schedules C-2 and deducted a limited number on Schedules

C-1 and SRI’s or PPI’s S corporation tax returns. See infra Appendix C.

Respondent argues that the expenses relating to the Manitou house were

nondeductible personal expenses. We agree. Petitioners’ son used the house as

his residence, and petitioners attempted to create a rental arrangement to deduct

his personal living expenses. The son was an employee of PPI and did not have a

written employment contract. Petitioners have not established that their son was

required to live in the homes as a condition of his employment. See sec. 119. PPI

maintained an office elsewhere. Petitioners argue that their son used a room

exclusively for business purposes. They did not provide sufficient information

relating to the size of the room allegedly used for business purposes and instead

deducted 100% of the expenses relating to the house. Although the son performed

services to renovate the homes, this alone does not make his living expenses 100%

deductible. Furthermore, they did not establish that their son used any portion of

the house regularly and exclusively as a home office. We disallow the deductions

relating to the Manitou house as set forth in Appendix C. After concessions, we
                                        - 68 -

[*68] sustain respondent’s determinations to disallow the deductions on Schedules

C-2 for 2005, 2006, and 2007 in their entirety. See infra Appendix B.

             3.    Interest

      Petitioners deducted interest expenses on their Schedules C-1 for 2005,

2006, and 2007.28 See infra Appendix A. Personal interest is generally not

deductible. Sec. 163(h)(1). Nondeductible personal interest is defined as any

interest other than six listed categories of deductible interest expenses. Sec.

163(h)(2). Taxpayers must establish that the interest is within one of the

enumerated categories. Interest that is “paid or accrued on indebtedness properly

allocable to a trade or business” is deductible. Sec. 163(h)(2)(A). Petitioners

contend that they incurred the interest expense for 2005 to finance Sugarloaf and

SRI’s development of the subdivision and for 2007 to finance the PTI litigation

and the construction of two houses on the SRI lots. They did not offer a business

purpose for the 2006 interest expense. They incurred a significant portion of the

2005 interest on loans against life insurance policies and incurred approximately

$3,000 on multiple credit cards. They have not established the amounts of the

loans against their insurance policies and have not attempted to allocate the debt

      28
        Petitioners seek to shift 50% of the home mortgage interest reported on
their 2005 Schedule A to Schedule C-1 on the basis of a home office deduction.
They are not entitled to such a deduction.
                                        - 69 -

[*69] according to its alleged use. For 2005 they provided canceled checks and

QuickBooks entries to substantiate the payments to the insurance companies.

There is no evidence establishing that the payments were for premiums, interest,

or a loan repayment. The minimal policy documentation provided lists the interest

as unpaid. With respect to the credit card interest, petitioners used the credit cards

for both personal and business expenses, and they did not attempt to allocate the

interest as personal or business. For 2006 and 2007 they did not provide any

records of payments or a business purpose. We have no way to establish the

amount of the interest paid or to estimate the deductible portion of the interest.

Vanicek v. Commissioner, 85 T.C. at 742-743. Accordingly, we find that

petitioners failed to substantiate the payment and business purpose of the interest

expense deductions, and we sustain respondent’s determinations in their entirety.

See infra Appendix A.

             4.    Insurance

      Petitioners deducted insurance expenses for automobiles that they and their

son used for personal reasons, the Manitou house, jewelry and other personal

property, and an umbrella policy. See infra Appendix A. They provided

QuickBooks records and canceled checks to substantiate the insurance expenses.

With a few exceptions, they did not provide insurance policies or billing
                                         - 70 -

[*70] statements to substantiate the business purpose or the amounts of the

insurance expenses. We find that they have failed to adequately substantiate the

amounts and/or the business purpose of the insurance expenses. See secs. 162,

212; Edgar v. Commissioner, T.C. Memo. 1979-524. Accordingly, after

concessions, we disallow the insurance deductions as set forth in Appendix A.

             5.     Business Gifts

      Taxpayers are entitled to deduct the cost of business gifts limited to $25 per

recipient per year. Sec. 274(b)(1). They must substantiate the cost and description

of the gift, the date that the gift was made, the business reason for the gift, and the

business relationship between the taxpayer and the recipient. Sec. 1.274-5T(b)(5),

Temporary Income Tax Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985). Petitioners

deducted $800 in business gifts for 2006. See infra Appendix A. We are satisfied

that they adequately substantiated four business gifts of at least $25 and are

entitled to deduct $100 in business gifts for 2006. We disallow the remaining

business gift deduction for 2006. See infra Appendix A.

             6.     Travel and Meal Expenses

      Petitioners deducted travel and meal expenses as set forth in Appendix A.

Petitioners deducted travel and meal expenses relating to Mr. Rogers’ employment

with Seyfarth Shaw and his various business activities, including PTI and
                                        - 71 -

[*71] Sugarloaf. They also deducted travel expenses for Mrs. Rogers to

accompany her husband on business trips and did not establish a business purpose

for her travel. During 2005, 2006, and 2007 Mr. Rogers’ status as a partner at

Seyfarth Shaw affects his entitlement to deduct expenses relating to his legal work

on Schedules C. For 2005, 2006, and 2007 portions of the deducted travel

expenses related to Seyfarth Shaw and, for 2006 and 2007, meal expenses. See

infra Appendix A. He also deducted car rental expenses related to his work with

his law partnership, including an expense listed as “rent” for 2005 and possibly a

portion of the expense listed as “automobile” for 2007. See infra Appendix A.

      Travel and meal expenses are subject to the strict substantiation

requirements of section 274(d) discussed above. See Shea v. Commissioner, 112

T.C. at 186-187. Section 274(n) limits the deduction for certain meal expenses to

50% of the expense. We find that petitioners have failed to substantiate the time,

the place, or the business purpose of the expenses through adequate records that

satisfy the strict substantiation requirements of section 274(d) for any of the travel,

meal, or automobile expenses deducted for 2005 through 2007 or 2009 as set forth

in Appendix A. Accordingly we disallow the expenses in their entirety. See infra

Appendix A.
                                        - 72 -

[*72] Furthermore, petitioners deducted substantial expenses for 2005 through

2007 that related to Mr. Rogers’ legal services at Seyfarth Shaw. Generally, a

partner may not directly deduct expenses of the partnership on his individual

return even if he incurred the expenses in furtherance of the partnership’s business

unless there is an agreement with the partnership or a regular routine that requires

the partner to use his own funds to pay the expenses. Cropland Chem. Corp. v.

Commissioner, 75 T.C. 288, 295 (1980), aff’d without published opinion, 665

F.2d 1050 (7th Cir. 1981); Klein v. Commissioner, 25 T.C. 1045, 1051-1052

(1956). Seyfarth Shaw’s reimbursement policy provided for reimbursement of a

substantial portion of Mr. Rogers’ travel, meal, and automobile expenses.

Petitioners have not identified any specific expenditures for which Seyfarth Shaw

denied reimbursement. They claim that he did not seek reimbursement and treated

his payment of his own travel and automobile expenses as a contribution to the

partnership. However, his right to reimbursement under the firm’s policy, not

actual reimbursement, prohibits his deducting the reimbursable travel and

automobile expenses. Where a partner has a right to an expense reimbursement

but elects not to seek reimbursement, the partner is not entitled to deduct the

expense. McLauchlan v. Commissioner, 558 F. App’x 374, 379 (5th Cir. 2014),

aff’g and remanding on another issue T.C. Memo. 2011-289. Otherwise the
                                       - 73 -

[*73] taxpayer could convert a partnership expense into a deduction for himself by

deciding not to seek reimbursement. See Orvis v. Commissioner, 788 F.2d 1406,

1408 (9th Cir. 1986) (disallowing an employee’s deduction for a reimbursable

employee expense), aff’g T.C. Memo. 1984-533. Petitioners further argue that

they included any reimbursements that Mr. Rogers received in their income but

have not offered any documentation to support their claim. Accordingly,

petitioners would not be entitled to deduct travel or automobile expenses to the

extent they relate to Mr. Rogers’ activities at Shaw Seyfarth for 2005, 2006, and

2007 if they had satisfied the section 274(d) substantiation requirements.

             7.    Automobile Use

      Petitioners deducted expenses relating to their automobiles that either they

or their adult son used for 2007 and possibly a portion of the deductions for

insurance and repairs for 2006 and 2007. See infra Appendix A. Petitioners are

not entitled to deduct any portions of these expenses because they failed to satisfy

the strict substantiation requirements of sections 274(d) and 280F(d)(4). See sec.

1.274-5T(b)(6), Temporary Income Tax Regs, supra. Petitioners failed to maintain

adequate records of their business versus personal use and did not provide

sufficient proof of: (1) the amount of each separate expense, (2) the date of each

expense, and (3) the business purpose of each expense. See id. Mr. Rogers
                                        - 74 -

[*74] admitted that he used his vehicle for commuting to Seyfarth Shaw’s office

for 2005 through 2007 and deducted commuting expenses. See sec. 1.162-2(e),

Income Tax Regs. The records provided are not reliable or complete and do not

adequately establish the business use of the vehicles. Nor do we find the

witnesses’ testimony to be credible. We disallow the deductions as set forth in

Appendix A.

             8.    Legal and Professional Fees

      Petitioners deducted legal and professional fees on their Schedules C-1 for

2006, 2007 and 2009, as set forth in Appendix A, relating to PTI’s patent

infringement issues, tax issues, Mr. Rogers’ activities to promote the Sugarloaf tax

shelter for 2006, and for subsequent years, disputes arising from his Sugarloaf

activities, including a malpractice lawsuit arising from the Sugarloaf transaction

for which Mr. Rogers received partial reimbursement. Petitioners provided

sufficient evidence to substantiate the legal fees deducted on Schedules C-1 for

2006, 2007, and 2009, to the extent shown in Appendix A. They incurred

significant legal expenses with respect to their business activities. The Court may

estimate the amount of deductible legal fees. Vanicek v. Commissioner, 85 T.C. at

742-743. Petitioners provided QuickBooks records and canceled checks. They

also provided invoices that substantiate significant portions of the legal fees. For
                                        - 75 -

[*75] 2006 and 2007 petitioners deducted legal fees that were personal or for

which they failed to establish a business purpose, including legal fees relating to a

real estate assessment on their personal residence, an estate case, a laptop fire, and

significant fees paid to Seyfarth Shaw. In addition, petitioners did not substantiate

payment of the expenses through either QuickBooks entries or canceled checks for

a portion of the invoiced expenses, and they are not entitled to deduct those

expenses. For 2006 and 2007 they paid approximately 15% and 30% of the

deducted legal fees to Seyfarth Shaw, respectively, and did not provide invoices or

other documentation to establish the business purpose for the payments. For 2006

and 2007 petitioners are entitled to deduct legal fees as set forth in Appendix A,

and we disallow the remainder for the reasons stated.

      For 2009 petitioners provided sufficient evidence to substantiate the

deduction of legal fees as recorded in their QuickBooks entries, taking into

account respondent’s argument that they received reimbursement for a portion of

their expenses relating to the malpractice lawsuit. For 2009 petitioners deducted

legal fees that exceed the amount entered into petitioners’ QuickBooks records,

and we disallow the excess amount. See infra Appendix A.
                                         - 76 -

[*76]         9.     Substantiation of Expenses

        At issue for a significant portion of the disputed deductions is the

substantiation of the payment of the expenses and their business purpose. We find

that petitioners have adequately substantiated the entire amount of the returns and

allowances deducted for 2009 that relate to the deduction of uncollected legal fees

for services rendered by Rogers & Associates. They have also sufficiently

substantiated the expenses for computer services for 2006 in full, publications of

$1,509 for 2006, and dues and subscriptions of $1,272 for 2006, and supplies of

$1,865 for 2007. See infra Appendix A. In general, petitioners presented

QuickBooks entries, credit card statements, and canceled checks to substantiate

these expenses. With a few exceptions, they did not provide invoices or receipts.

The 2006 computer services deduction included the costs of business software,

real estate software, and computer repair services. A significant portion of the

disallowed 2006 publication expenses was for newspaper and magazine

subscriptions and book store purchases, for which petitioners did not establish a

business connection. We are satisfied that the documentation provided,

petitioners’ business history, and their testimony allow us to estimate the
                                        - 77 -

[*77] deductible portion of the disputed expenses pursuant to the Cohan rule as set

forth in Appendix A.29

      After concessions, we find that petitioners failed to establish the amounts

and/or business purpose of the remainder of the publications and the dues and

subscriptions for 2006 and the supplies for 2007, and failed to establish the

expenditure and/or the business purpose of the entire amounts of the following

expenses: for 2006, repairs, office expense, depreciation, taxes and licenses, fees,

miscellaneous, and bank service charges, and for 2007, repairs. In addition, they

did not establish that the expenses were ordinary and necessary. See sec. 162.

They failed to present any evidence relating to the 2006 depreciation deduction.

For the disallowed deductions, petitioners presented QuickBooks entries, credit

card statements, and canceled checks. They used the credit cards and bank

accounts for both personal and business purposes and failed to adequately

distinguish the business versus personal uses. The bank service charges included

interest charges and late payment fees for credit cards, wire transfer fees, and

overdraft fees on their personal bank accounts. For office expenses, they relied on

QuickBooks entries for purchases at office supply stores, credit card statements,

      29
        Respondent has not argued that these expenses should be treated as
nonreimbursable partnership expenses on the basis of Mr. Rogers’ partner status at
Seyfarth Shaw.
                                        - 78 -

[*78] and canceled checks for the portion of the disallowed expenses and failed to

adequately substantiate the business purpose of the expenses.

      For 2006 petitioners deducted $1,000 as a separate entry for legal fees and

$1,000 for fiduciary expenses. Both expenses relate to Mr. Rogers’ investment in

the Sugarloaf tax shelter. See discussion supra part II.A.2 in the findings of fact

relating to the granting of respondent’s motion for partial summary judgment on

the Sugarloaf deductions. We find that petitioners are not entitled to deduct either

expense as both relate to an abusive tax shelter. See Kenna Trading, LLC v.

Commissioner, 143 T.C. at 365.

      D.     Deductions Relating to SRI’s Activities

      Respondent disallowed deductions SRI claimed for 2005 and 2006. For

2005 respondent contends that SRI is not entitled to deduct a fee for a letter of

credit and an architect’s fee related to the subdivision project but instead must

treat them as capital expenditures. For 2006 he disallowed business expenses

deductions as set forth in Appendix D because of a lack of substantiation and a

failure to establish a business purpose. Respondent concedes that SRI is entitled
                                        - 79 -

[*79] to deduct the consulting fee paid to PPI on the basis of our decision above

that PPI must include that amount in its gross receipts for 2006.30

             1.    2005 Letter of Credit Fee

      SRI deducted $23,935 in 2005 for charges relating to a letter of credit for

the development of Orland Park. It obtained the letter of credit to ensure funding

for infrastructure within the subdivision. The municipality required a guaranty

that SRI had funding for infrastructure improvements that met the municipality’s

satisfaction. Respondent argues that SRI must capitalize the letter of credit fee

because it related to improvement costs for Orland Park. See sec. 263. Petitioners

equate the letter of credit, which required an annual renewal, with a premium for

an insurance policy and argue that it is a deductible business expense. Taxpayers

are required to capitalize the costs incurred for permanent improvements or

betterments to property. Sec. 263(a)(1). In general, these costs include

expenditures that add to the value of the property, substantially prolong the life of

the property, or adapt the property to a new or different use. Sec. 1.263(a)-1(b),

      30
        On brief petitioners assert that SRI is entitled to deduct $1.11 million as
compensation to its business partner for an alleged bargain sale of six lots to the
partner. The partner paid $450,000 for the six lots with an alleged fair market
value of $1.56 million. The compensation deduction is a new issue that was not
raised before trial, and we will not consider it. Dirico v. Commissioner, 139 T.C.
at 416. Respondent contends that petitioners’ position would result in higher tax.
                                        - 80 -

[*80] Income Tax Regs.; see INDOPCO, Inc. v. Commissioner, 503 U.S. at 87-89

(requiring capitalization where the expenditure produces a significant future

benefit); Commissioner v. Lincoln Sav. & Loan Ass’n, 403 U.S. at 354 (requiring

capitalization where the expenditure creates or enhances a separate and distinct

asset). Taxpayers are required to capitalize both direct and indirect costs. Sec.

263A. We have described a letter of credit as follows:

             When a bank issues a letter of credit, the bank commits to
      provide funds when and if certain specified events occur. See Chase
      Manhattan Bank v. Equibank, 550 F.2d 882, 885 (3d Cir. 1977);
      Chapman v. United States, 527 F. Supp. 1053 (D. Minn. 1981). It is
      not a loan, but rather a commitment to make a loan. * * *

Willamette Indus., Inc. v. Commissioner, 92 T.C. 1116, 1124 (1989), aff’d, 149

F.3d 1057 (9th Cir. 1998). Generally, the cost of obtaining a loan is a capital

expenditure, and the cost is deducted over the life of the loan. Cagle v.

Commissioner, 63 T.C. 86, 97 (1974), aff’d, 539 F.2d 409 (5th Cir. 1976); Enoch

v. Commissioner, 57 T.C. 781, 794-795 (1972). An expenditure may be

deductible in one setting but may require capitalization in a different setting if

incurred in connection with a capital asset. Lychuk v. Commissioner, 116 T.C.

374, 388 (2001). SRI was required to obtain the letter of credit as part of the

subdivision’s development. SRI did not draw on the letter of credit. Nevertheless

SRI incurred the fee in connection with the construction of the Sterling Ridge
                                        - 81 -

[*81] subdivision. The letter of credit fee is a cost of construction and is a capital

expenditure.31

             2.     Architect’s Fee

      SRI deducted an architect’s fee of $6,340 in 2005 for the design of a model

home for Orland Park. Petitioners contend that SRI is entitled to a loss deduction

for the architect’s fee because it abandoned the design plan. Respondent argues

that SRI is not entitled to a loss deduction because (1) petitioners failed to

establish that SRI abandoned the plans and (2) the fee was incurred by PPI, not

SRI, and was a capital expenditure of PPI. PPI engaged the architecture firm and

was billed for its services. Petitioners did not identify the payor of the expense in

the record. Section 165(a) provides for a deduction of any loss sustained during

the tax year and not compensated for by insurance or otherwise. The loss must be

evidenced by a closed and completed transaction, fixed by identifiable events.

Sec. 1.165-1(b), Income Tax Regs. Taxpayers may deduct a loss incurred when

property is permanently discarded from use or its usefulness terminates. Sec.

1.165-2(a), Income Tax Regs. This includes the costs incurred for architecture

      31
         The parties did not address the relevant period for capitalization with
respect to the letter of credit fee. In general taxpayer must deduct the cost of
obtaining a loan over the life of the loan. Cagle v. Commissioner, 63 T.C. 86, 97
(1974), aff’d, 539 F.2d 409 (5th Cir. 1976). SRI did not draw on the letter of
credit, and the fee is not a cost of a loan.
                                       - 82 -

[*82] plans if they abandon the plans, do not use the plans, and do not modify the

plans to create a new plan. Moore v. Commissioner, 19 B.T.A. 140 (1930); see

also Haspel v. Commissioner, 62 T.C. 59 (1974) (expenses for discharged

architect’s fees not deductible where part of plan was used). To be eligible for an

abandonment loss, the taxpayer must establish an intention to abandon the asset

and an affirmative act of abandonment. Citron v. Commissioner, 97 T.C. 200,

208-209 (1991).

      Petitioners have not established that either PPI or SRI abandoned the

architecture plans as required for a section 165 loss deduction. They did not

provide a copy of the plans. PPI built three custom homes within the subdivision.

Petitioners did not establish that the plans were not used in any way in the

constructed homes. The only evidence provided was Mr. Rogers’ self-serving

testimony. In the construction industry, extra expenses due to errors or changes in

planning or design are part of the builder’s costs. FRGC Inv., LLC v.

Commissioner, T.C. Memo. 2002-276, slip op. at 16, aff’d, 89 F. App’x 656 (9th

Cir. 2004). Accordingly, neither SRI nor PPI is entitled to deduct the architect’s

fee under section 162. Respondent concedes that the architect’s fee is a capital

expenditure under section 263 and PPI may capitalize the fee as part of the cost of

the homes that it sold pursuant to section 263A.
                                        - 83 -

[*83]         3.    SRI’s 2006 Business Expense Deductions

        Respondent disallowed numerous business expense deductions claimed on

SRI’s 2006 S corporation tax return. Many of the disallowed business expenses

relate to amounts paid to or on behalf of petitioners’ adult son, including rent,

utilities and other expenses for the Manitou house, automobile expenses, and

miscellaneous payments to their son to reimburse him for expenses that he

allegedly paid on SRI’s behalf. See infra Appendix D. As discussed supra part

II.C.2, SRI is not entitled to deduct rent or utilities for the Manitou house, and we

disallow the deductions in full. See infra Appendix D. Nor may SRI deduct the

$2,000 automobile expense or the depreciation deduction for three automobiles

reportedly placed in service in 2005 or 2006 because petitioners did not satisfy the

strict substantiation rules of section 274(d). See infra Appendix D; see also sec.

274(d); sec. 1.274-5T, Temporary Income Tax Regs., supra. SRI deducted interest

paid on the purported installment loan from Mrs. Rogers’ transfer of Orland Park

to SRI. As we have recharacterized the transfer as a capital contribution, SRI is

not entitled to the interest expense deduction.

        Petitioners failed to adequately substantiate the business purpose and

amounts of deductions for the bank service charges, employee bonuses and

reimbursements, insurance, telephone, parking, meals and entertainment, and
                                        - 84 -

[*84] miscellaneous expenses, which we disallow in their entirety. See infra

Appendix D. Generally they provided QuickBooks entries, canceled checks,

credit card statements, and bank statements that do not establish a business

purpose for the expenditures. They did not provide receipts, invoices, or other

documentation such as insurance policies, to substantiate the business purpose or

that the amounts were ordinary and necessary. The record indicates that some of

these amounts were personal expenses, such as commuting expenses. SRI paid the

employee bonus and a substantial portion of the reimbursements and

miscellaneous expenses to petitioners’ adult son. There is no indication that SRI

reported the bonus as income to the son. He was an employee of PPI, not SRI.

For the reimbursements paid to their son, they provided QuickBooks entries and

canceled checks written to their son without any supporting documentation and

did not adequately substantiate the business purpose for the reimbursed expenses.

SRI paid the legal fees in connection with the development of the subdivision.

Petitioners presented sufficient evidence to substantiate the legal expenses, and

SRI is entitled to deduct the legal fees in full.32 See infra Appendix D.

      32
        Respondent did not argue that SRI should be required to capitalize the
legal fees.
                                        - 85 -

[*85] E      L&R Deductions

      L&R deducted travel expenses of $50,543 and $39,741 on its S corporation

tax returns for 2005 and 2006, respectively. Petitioners did not comply with the

substantiation requirements of section 274(d). They provided QuickBooks entries,

canceled checks, credit card statements, and in some cases receipts. They made

factual assertions in their briefs to support the business purpose for some of the

travel expenses. Statements in the briefs do not constitute evidence and cannot

supplement the record. See Rule 143(c). Mr. Rogers admitted that many of these

expenses related to Sugarloaf, PTI, and his legal work as a partner at Seyfarth

Shaw. L&R was a 20% shareholder in PTI. As explained above, any travel

expenses relating to Seyfarth Shaw are nondeductible, reimbursable partnership

expenses. L&R also deducted approximately $5,000 in expenses for Mrs. Rogers’

travel, and petitioners did not establish a business purpose. Petitioners have not

substantiated the time and place of the travel, the business reason for the travel, or

the business purpose of the expenses. Mr. Rogers’ self-serving testimony and

noncontemporaneous documentation are insufficient to satisfy the rigorous

standards of section 274(d). Accordingly, we find that L&R is not entitled to

deduct the travel expenses for 2005 and 2006.
                                       - 86 -

[*86] F.     2006 Itemized Deductions

      Respondent disallowed deductions on petitioners’ 2006 Schedule A as

follows: State income tax and real estate tax of $11,745 relating to their personal

residence, home mortgage interest of $4,659, and expenses from portfolio income

of $1,770. We find that petitioners have adequately substantiated these expenses

and are entitled to the deductions.

      G.     2005 Long-Term Capital Loss

      Petitioners claimed a $53,550 long-term capital loss on their 2005 income

tax return. They concede all but $5,355, on the basis of a clerical error. They

argue that they have a $5,355 capital loss carryforward from 2004 arising from

Jetstream. Respondent argues that the loss arose in 2003 relating to the

partnership Warwick Trading at issue in Superior Trading, LLC v. Commissioner,

137 T.C. 70. Respondent argues that the loss would have passed through to

petitioners as follows: from Warwick Trading to Jetstream, from Jetstream to PPI,

and from PPI to petitioners. Respondent argues that the Court disallowed the

losses to Warwick Trading in Superior Trading, and thus petitioners are not

entitled to a passthrough loss. Id. at 81-83, 92. The Court does not have

jurisdiction over the substantive issues concerning a passthrough loss from

Warwick. See sec. 6230(a)(2)(A). The capital loss carryforward depends on the
                                        - 87 -

[*87] decision in Superior Trading, and we will permit the parties to present

evidence of that decision at a subsequent time.

      H.     PPI’s Deductions and Cost of Goods Sold

      For 2005, 2006, and 2009 PPI deducted over $3 million in business

expenses as set forth in Appendix E.33 With limited exceptions, we hold that

petitioners have not substantiated the amounts or business purpose of the deducted

expenses, and we sustain respondent’s disallowance of the deductions.

             1.    PPI’s 2009 Cost of Goods Sold

      PPI reported a cost of goods sold for 2009 of $1,435,711. Petitioners

conceded this amount and argue that PPI is entitled to an adjustment to gross

receipts for the cost of goods sold of $141,781 on the basis of a mark to market

adjustment for the unsold lots in the SRI subdivision under section 475. PPI is not

entitled to an adjustment for the cost of goods sold because it did not sell any

property during 2009. In addition, PPI is not entitled to a mark to market

adjustment for the value of unsold homes. Petitioners did not properly raise this

      33
        Petitioners argue that the 2009 notice of deficiency is invalid because
respondent failed to comply with the requirements of the Administrative
Procedure Act, 5 U.S.C. sec. 500 et seq. This argument is without merit. See
Alfieri v. Commissioner, 60 T.C. 296, 299 (1973), aff’d, 487 F.2d 1393 (2d Cir.
1973); Rintoul v. Commissioner, T.C. Memo. 1992-79, aff’d, 15 F.3d 1088 (9th
Cir. 1994).
                                        - 88 -

[*88] issue in their petition or at any time before trial and are precluded from

doing so now. See Estate of Horvath v. Commissioner, 59 T.C. 551 (1953).

Moreover, the section 475 mark to market accounting method does not apply to

residential properties, and petitioners did not provide any evidence relating to the

value of PPI’s unsold property as of 2009.

             2.    PPI’s Business Expense Deductions

      PPI’s business activities involved the Sterling Ridge subdivision and

management services to Sugarloaf. Mr. Rogers also used PPI to pay for PTI’s

expenses including inventory and legal fees. PPI was not a shareholder of PTI.

Petitioners also used PPI to pay many of their son’s personal living expenses,

including housing, automobile, and medical care. Mrs. Rogers paid expenses from

her personal bank account that PPI deducted on its 2009 S corporation tax return,

including office supplies, repairs, telephone, and licenses.

                   a.     PTI Subsidy

      In 2005 PPI paid $124,520 on PTI’s behalf to its management company and

its suppliers and deducted the payments as a business expense, labeling the

deduction “PTI subsidy”. Taxpayers are entitled to deduct expenses that are

directly connected with and pertaining to the taxpayer’s trade or business. Sec.

162; sec. 1.162-1(a), Income Tax Regs. Generally a taxpayer who pays another
                                       - 89 -

[*89] person’s expenses is not entitled to a business expense deduction as the

expenses were not incurred in the payor’s trade or business unless the payor paid

the expense to protect or promote its own business. Lohrke v. Commissioner, 48

T.C. 679, 688 (1967); Columbian Rope Co. v. Commissioner, 42 T.C. 800, 815

(1964). There is no business relationship between PPI and PTI. Expenses relating

to PTI were not directly connected with and did not pertain to PPI’s trade or

business. Rogers 2004. PPI paid these expenses on PTI’s behalf because of their

common owner, Mr. Rogers. The subsidy is not an ordinary and necessary

business expense of PPI. Mr. Rogers caused PPI to pay PTI’s expenses to protect

his investment in PTI. Accordingly, PPI is not entitled to deduct expenses that it

paid on PTI’s behalf.

      Rogers 2004 involved a similar situation. We considered two payments that

Mr. Rogers made on PTI’s behalf to ensure the manufacture and the distribution of

the medical device. Id. at *12. We held that the payments were nondeductible

capital contributions from Mr. Rogers to PTI because Mr. Rogers made the

payments to fund PTI’s continued operation to protect his investment in the

company. Id. at *56-*57. We further held that PPI could not deduct the

payments. Id. PTI experienced significant market competition from an alleged
                                        - 90 -

[*90] infringer of its patent. Mr. Rogers believed that the only way that he would

receive a payout from PTI was through the infringement case.

      b.     Legal and Professional Fees

      PPI deducted legal and professional fees for 2005, 2006, and 2009. See

infra Appendix E. Petitioners provided QuickBooks entries, canceled checks,

bank statements, and invoices to substantiate the legal fees. For 2005 Mr. Rogers

implemented the Sugarloaf tax shelter through PPI and his law firm Seyfarth

Shaw. PPI deducted substantial amounts of legal fees for 2005 relating to the

Sugarloaf tax shelter, which are not deductible as ordinary and necessary business

expenses. We estimate that approximately half of PPI’s 2005 legal fees

(approximately $447,000) relate to PTI’s patent litigation. Petitioners have

established the payment and purpose of these expenses. However we have

previously held PPI is not entitled to deduct legal fees incurred with respect to

PTI’s patent matters. See Rogers 2004, at *53-*55. A taxpayer is entitled to

deduct legal fees that are directly connected with or proximately related to its trade

or business. Sec. 1.162-1(a), Income Tax Regs. We find that PPI is not entitled to

deduct the legal fees except to the extent shown in Appendix E for 2005 and 2006

for the reasons stated above. PPI is entitled to deduct the legal fees for 2009 in
                                        - 91 -

[*91] their entirety as petitioners have substantiated that PPI incurred significant

legal fees involving tax issues. See infra Appendix E.

             c.    Multicred Fee

      PPI deducted $907,263 as “Multicred fee” for 2005. Respondent concedes

that PPI is entitled to deduct $90,000 of this amount that it paid to L&R and L&R

reported as income. Petitioners contend that PPI paid the remainder of the

Multicred fee for the benefit of Sugarloaf. However, the record shows that PPI

paid $100,000 to Mr. Rogers, and petitioners did not identify the recipients for

$400,000 of the Multicred fee. We have held that expenses relating to the

Sugarloaf transactions are not deductible business expenses under section 162 as

they relate to an abusive tax shelter. Kenna Trading, LLC v. Commissioner, 143

T.C. at 365. Accordingly, we disallow the remainder of the Multicred fee

deduction.

             d.    Medical Expenses

      PPI deducted doctor and dental expenses that it paid on behalf of

petitioners’ son in 2005. PPI did not have a health insurance plan for its

employees for the portion of 2005 that it paid the son’s medical expenses. It did

not have a written dental or health plan for 2005 that met the requirements of

section 105, which would exclude reimbursement of an employee’s medical
                                       - 92 -

[*92] expenses from the employee’s income and allows the employer to deduct the

payments. There is no evidence that the son included the 2005 reimbursements in

his income or that PPI reported the amounts on his Form W-2, Wage and Tax

Statement, as wages. Accordingly, PPI is not entitled to deduct the expenses. See

infra Appendix E.

            e.      Substantiation of Expenses

      In addition to the above expenses, PPI deducted numerous expenses in

dispute for lack of substantiation as to the amount or the business purpose. See

infra Appendix E. In general, petitioners produced QuickBooks entries, canceled

checks, and credit card statements to substantiate the expenses. The credit card

statements show both business and personal expenses, and petitioners have not

made an adequate effort to distinguish the expenses. For the most part, they have

not established the business purpose of the expenses through invoices, receipts,

insurance policy statements, or other relevant documentation or that the expenses

are ordinary and necessary. We sustain respondent’s determination as provided

below.

      For 2005 petitioners have failed to substantiate amounts or business

purposes of the deductions for gasoline in accordance with the strict substantiation

requirements of section 274(d), computer services allegedly incurred for web page
                                        - 93 -

[*93] development, real estate software and an internet service provider, and

repair expenses that relate to the Manitou house that we have held are

nondeductible supra part II.C.2. See infra Appendix E.

       For 2005 and 2006 PPI deducted travel and meal expenses under the

following categories that are subject to the strict substantiation requirements of

section 274(d): travel, taxis, meals, airfare, and hotel. See infra Appendix E.

They provide QuickBooks records, credit card statements, and canceled checks to

document the expenses. They failed to maintain contemporaneous logs or other

adequate records that satisfy the section 274(d) requirements. To the extent any of

PPI’s travel expenses relate to PTI, the expenses are not PPI’s business expenses

to deduct. PPI allegedly incurred a portion of the travel expenses in connection

with Mr. Rogers’ implementation of the Sugarloaf transactions, and petitioners

have failed to establish that the expenses were ordinary and necessary expenses

incurred in a trade or business. Accordingly we disallow the above expenses in

their entirety.

       For 2006 petitioners did not substantiate the amount or the business purpose

of the deductions for repairs that were incurred primarily for car washes and store

purchases except to the extent provided in Appendix E. With respect to the repair

deduction, petitioners did not provide receipts or invoices to establish the items
                                        - 94 -

[*94] purchased or their business purpose. For 2006 we find that petitioners have

sufficiently substantiated the deductions for insurance and employee benefits. See

infra Appendix E. While their documentation is limited to QuickBooks entries

and canceled checks, we find that they adequately substantiated the expenses in

the light of their testimony and established business activities.

      For 2009 petitioners have failed to substantiate the amount or business

purposes for the deductions for: interest (which relates to credit card charges),

taxes and licenses that appear to relate to their personal residence, bank service

charges, miscellaneous, office, printing, “Brad Todd expenses” allegedly incurred

for travel expense reimbursements, and rent paid for office space for Mr. Todd.

See infra Appendix E. Nor have they substantiated insurance in excess of the

amount that respondent conceded. We find that they have substantiated the

amount and business purpose of deductions for repairs (relating to the unsold

homes in the Sterling Ridge subdivision), a business license, parking, and

accounting (the portion incurred for PPI) to the extent indicated in Appendix E

and the employee benefit program in its entirety. See infra Appendix E. The

remainder of the accounting expense was incurred for Sugarloaf, and petitioners

have not shown that the expenses are ordinary and necessary expenses incurred in

a trade or business. PPI also seeks an additional $5,000 deduction for salary and
                                         - 95 -

[*95] wages in addition to respondent’s concession. Respondent argues that

petitioners conceded the $5,000 as part of the settlement of the salary and wage

deduction. We agree. Moreover, petitioners have not substantiated the payment

or the business purpose of the amounts paid to the recipients of the disputed

$5,000.

III.   Innocent Spouse Relief

       Generally, spouses may elect to file a joint income tax return and are then

held jointly and severally liable for the entire tax due for the tax year. Sec.

6013(d)(3). Under specific circumstances a spouse who filed a joint return may

obtain relief from joint and several liability (innocent spouse relief) under section

6015. Mrs. Rogers seeks innocent spouse relief under section 6015(b) or (f) for

2003, 2005, 2006, 2007, and 2009. Petitioners litigated their tax liability for 2003

in Rogers 2003. Mrs. Rogers filed a joint petition with her husband in that case

and did not claim innocent spouse relief. Petitioners paid the deficiency

determined in that case, and Mrs. Rogers seeks a refund. Respondent seeks

additional assessments of income tax and a penalty for 2003 arising from the

partnership-level proceeding in Superior Trading, LLC v. Commissioner, 137 T.C.
                                         - 96 -

[*96] 70.34 He asserts that Mrs. Rogers is barred from seeking innocent spouse

relief for 2003 on the basis of the doctrine of res judicata. Respondent further

asserts that with respect to the deficiency years (2005 to 2007 and 2009), Mrs.

Rogers is not entitled to innocent spouse relief.

      A.     Tax Year 2003 and Doctrine of Res Judicata

      Under the doctrine of res judicata, when a court of competent jurisdiction

enters a final decision on the merits of a cause of action, the parties to the action

are bound by every matter that was or could have been offered and received to

sustain or defeat the claim. Commissioner v. Sunnen, 333 U.S. 591, 597 (1948);

see also Gustafson v. Commissioner, 97 T.C. 85, 91 (1991). Federal income tax is

determined annually, with each year being a separate cause of action, and res

judicata is applied to bar subsequent proceedings involving the same tax year.

      34
        Mrs. Rogers argues that respondent is barred from asserting the additional
assessment for 2003 on the basis of the doctrines of estoppel, res judicata, and
laches and the statute of limitations. We find her arguments to be without merit.
The Court lacked jurisdiction in the deficiency case for 2003 to consider the
partnership items at issue in Superior Trading, LLC v. Commissioner, 137 T.C. 70
(2011). Superior Trading, LLC v. Commissioner, T.C. Memo. 2012-110; see secs.
6221 through 6231. The Court’s Opinion in the deficiency case for 2003 did not
address any of the partnership items and did not resolve any potential assessment
from Superior Trading. See Rogers 2003. The parties have stipulated that the
correctness of the additional tax assessment rising from Superior Trading is not at
issue in these cases. Moreover, petitioners have not established they were
improperly denied a collection due process hearing relating to the 2003
partnership adjustments.
                                        - 97 -

[*97] Commissioner v. Sunnen, 333 U.S. at 597-598. Common law principles of

res judicata generally bar a party to a prior proceeding for the same tax year from

seeking relief from joint and several liability regardless of whether the party raised

the claim in the prior proceeding. Vetrano v. Commissioner, 116 T.C. 272, 280

(2001), supplementing T.C. Memo. 2000-128. Section 6015(g)(2) modifies the

common law doctrine of res judicata with respect to claims for innocent spouse

relief. Under section 6015(g)(2), res judicata does not bar a taxpayer from

requesting innocent spouse relief under section 6015(b), (c), or (f) if: (1) relief

from joint and several liability under section 6015 was not an issue in the prior

proceeding and (2) the spouse seeking relief did not participate meaningfully in

the prior proceeding. Innocent spouse relief was not an issue in the deficiency

case for 2003; the first factor is satisfied. Mrs. Rogers argues that she did not have

an opportunity to meaningfully participate in the deficiency case for 2003 and

should not barred from raising innocent spouse relief for 2003 here. The taxpayer

bears the burden of proving that she did not participate meaningfully in the prior

proceeding. See Deihl v. Commissioner, 134 T.C. 156, 162 (2010).

      Meaningful participation is not defined in section 6015(g)(2) or the

accompanying regulations. Generally, we look to the totality of the facts and

circumstances to determine whether a taxpayer meaningfully participated in a prior
                                       - 98 -

[*98] proceeding. Harbin v. Commissioner, 137 T.C. 93, 98 (2011); see also

Deihl v. Commissioner, 134 T.C. at 162. Specific acts such as signing court

documents, participating in settlement negotiations, exercising control over the

handling of the prior proceeding, and having the opportunity to raise an innocent

spouse claim in the prior proceeding are indicators of meaningful participation.

Harbin v. Commissioner, 137 T.C. at 98; Monsour v. Commissioner, T.C. Memo.

2004-190, slip op. at 34-35; see also sec. 1.6015-1(e), Income Tax Regs.

However, “merely compl[ying]” with a spouse’s instructions to sign pleadings and

other documents in the prior proceeding is not conclusive of meaningful

participation. Thurner v. Commissioner, 121 T.C. 43, 53 (2003). A taxpayer does

not meaningfully participate where the totality of the evidence demonstrates that

she was not fully informed or engaged in the litigation. Deihl v. Commissioner,

134 T.C. at 165. The taxpayer’s level of education and sophistication and her

knowledge or understanding of the activities giving rise to the deficiency are

relevant factors. Cf. Harbin v. Commissioner, 137 T.C. at 98 (deficiency arose

from taxpayer’s spouse’s gambling activity, of which he had no knowledge); Deihl

v. Commissioner, 134 T.C. at 163 (taxpayer had little formal education and did not

review or sign any court documents); Monsour v. Commissioner, T.C. Memo.

2004-180 (taxpayer was an attorney and signed a stipulated decision). The fact
                                       - 99 -

[*99] that the taxpayer was represented by counsel and communicated with

counsel at the prior proceeding is an indication of meaningful participation. Deihl

v. Commissioner, 134 T.C. at 164 (taxpayer’s counsel in the prior proceeding

communicated exclusively with her spouse regarding the litigation).

      Mrs. Rogers contends that she did not meaningfully participate in the

deficiency case for 2003. She was represented by counsel and sat at the table

reserved for petitioners and their counsel throughout the trial although she was not

called as a witness. Her level of education and business experience establish that

she understood the proceedings and the implications of the Court’s decision. She

has a J.D. and an M.B.A. and has taken multiple courses in tax and accounting.

She argues that she did not understand the issues involved in the proceedings and

does not understand financial documents. She claims that she had no knowledge

of her husband’s business activities or the tax shelter that he promoted. We do not

find her claims credible. There is nothing in the record to show that she did not

have an opportunity to consult with her counsel before and during the trial, and

she has not provided any other evidence to establish her lack of participation in the

deficiency case for 2003. We find that Mrs. Rogers meaningfully participated in
                                       - 100 -

[*100] that case and is barred by the doctrine of res judicata from raising an

innocent spouse claim for 2003.35

      B.     Innocent Spouse Relief for Deficiency Years

      For the deficiency years (2005 through 2007 and 2009), Mrs. Rogers seeks

innocent spouse relief under section 6015(b) and (f).

             1.     Section 6015(b)

      Section 6015(b) requires a taxpayer seeking innocent spouse relief to satisfy

five conditions: (1) a joint return was filed, (2) the understatement of tax is

attributable to erroneous items of the taxpayer’s spouse, (3) the requesting spouse

establishes that when signing the return, she did not know, and had no reason to

know, that there was an understatement, (4) taking into account all the facts and

circumstances, it is inequitable to hold the requesting spouse liable for the

deficiency, and (5) the taxpayer timely elects innocent spouse relief under section

6015(b). These five conditions are conjunctive; the failure to satisfy any one

      35
         A taxpayer requesting innocent spouse relief is entitled to a refund only
with respect to payments made with funds provided by the requesting spouse.
Rev. Proc. 2013-34, sec. 4.04, 2013-43 I.R.B. 397, 403; see Ordlock v.
Commissioner, 126 T.C. 47, 61 (2006) (holding an innocent spouse is not entitled
to a refund from an overpayment made from community property), aff’d, 533 F.3d
1136 (9th Cir. 2008). Mrs. Rogers argues that she paid the 2003 deficiency with
her personal funds, but she has not presented documentation relating to the source
of the payment. Accordingly, she would not be entitled to a refund irrespective of
our decision that she is barred by res judicata from raising innocent spouse relief.
                                        - 101 -

[*101] condition precludes relief under section 6015(b). Haltom v.

Commissioner, T.C. Memo. 2005-209. Respondent concedes that Mrs. Rogers

satisfies conditions (1), (2), and (5). See sec. 6015(b)(1)(A), (B), (E). He

maintains that she does not satisfy condition (3), that she did not know or have

reason to know of the understatement when she signed the returns, and condition

(4), that it would be inequitable to hold her liable for the deficiencies. See sec.

6015(b)(1)(C) and (D). Mrs. Rogers has the burden to establish that she is entitled

to section 6015(b) relief.36 See Rule 142(a)(1).

                    a.    Knowledge Requirement

      To qualify for section 6015(b) relief, a requesting spouse cannot have had

actual knowledge or a reason to know of the understatement at the time she signed

the joint return. Sec. 6015(b)(1)(C). Generally, a requesting spouse has reason to

know of the understatement if she has reason to know of the transaction that gave

rise to the understatement. Jonson v. Commissioner, 118 T.C. 106, 115 (2002),

aff’d, 353 F.3d 1181 (10th Cir. 2003). The Court of Appeals for the Seventh

Circuit, to which these cases are appealable, has adopted a more lenient approach

      36
        Throughout their briefs petitioners argue that respondent has the burden of
proof on various issues, including Mrs. Rogers’ sec. 6015 relief. They do not
provide an explanation to support a shift in the burden of proof to respondent, and
we find no reason to shift the burden of proof.
                                      - 102 -

[*102] in cases where the understatement results from improper deductions

(versus cases involving unreported income). Resser v. Commissioner, 74 F.3d

1528, 1536 (7th Cir. 1996) (quoting Price v. Commissioner, 887 F.2d 959, 963

(9th Cir. 1989)), rev’g and remanding T.C. Memo. 1994-241. According to the

Court of Appeals for the Seventh Circuit, the requesting spouse must establish that

she did not know or have reason to know that the erroneous deduction would give

rise to an understatement. Resser v. Commissioner, 74 F.3d at 1536. The Court

applies a reasonably prudent person standard to evaluate the requesting spouse’s

knowledge in cases involving both unreported income and erroneous deductions.

Hopkins v. Commissioner, 121 T.C. 73, 77-78 (2003) (regarding improper

deductions); Butler v. Commissioner, 114 T.C. 276, 283-284 (2000) (regarding

unreported income). A spouse knew or had reason to know of an understatement

if a reasonably prudent person in her position would have known that the return

contained an understatement when she signed it. Resser v. Commissioner, 74 F.3d

at 1535-1536; Butler v. Commissioner, 114 T.C. at 283. The reasonably prudent

person standard also imposes a duty of inquiry on the requesting spouse. Resser v.

Commissioner, 74 F.3d at 1541; Hopkins v. Commissioner, 121 T.C. at 77-80;

Butler v. Commissioner, 114 T.C. at 283-284. For understatements resulting from

improper deductions, the requesting spouse has reason to know if she had
                                       - 103 -

[*103] sufficient knowledge of the facts underlying the deductions such that a

reasonably prudent person in her position would question seriously whether the

deductions were erroneous. Resser v. Commissioner, 74 F.3d at 1536 (quoting

Stevens v. Commissioner, 872 F.2d 1499, 1505 (11th Cir. 1989), aff’g T.C.

Memo. 1988-63). In applying the reasonably prudent person standard, we

consider four factors: (1) the spouse’s level of education, (2) her involvement in

the financial and business activities of the family, (3) the presence of unusual or

lavish expenses beyond the family’s norm, and (4) the nonrequesting spouse’s

evasiveness or deceitfulness about the family’s finances. Resser v. Commissioner,

74 F.3d at 1536. No single factor is controlling. Each of these four factors weighs

against Mrs. Rogers.

      Mrs. Rogers is highly educated and has multiple advanced degrees,

including a J.D. and an M.B.A. She took tax law courses in law school. She was

capable of understanding complex financial, accounting, and tax concepts.

Despite her education, she claims that she has only a nominal understanding of

finance and no understanding of tax and accounting or basic financial statements

such as income and loss statements, balance sheets, or bank statements. She

further maintains that she was not involved in petitioners’ business activities and

relied on her husband to handle such matters. She claims that she had no
                                        - 104 -

[*104] knowledge of her husband’s businesses or law practice and was not

involved in SRI’s business activities. We find that her claims are not credible.

She did not lack business experience as she claims. She managed and participated

in significant business dealings, including planning and designing the Sterling

Ridge subdivision, teaching herself property tax abatements and representing

clients in abatement cases, and assisting with Rogers & Associates’ office

management. She was actively involved in the Sterling Ridge subdivision,

including the planning and the supervision of the subdivision development. She

assisted with designing the layout of the construction lots, park, and ponds and

made sure the installation satisfied her instructions. She was involved with setting

the sale terms and price for the construction lots; she has held a real estate license

since 1967. We do not believe petitioners’ claims that Mrs. Rogers was a passive

investor in SRI and that Mr. Rogers made all the business decisions. She

increased her involvement in petitioners’ businesses during Mr. Rogers’s extended

hospitalization in 2009. She fired the office manager at Rogers & Associates and

assumed the position herself. She maintained the firm’s accounting records,

endorsed and deposited checks, and paid expenses including payroll. Mrs. Rogers

was able to run petitioners’ businesses without major disruption. Furthermore, it

is clear that Mrs. Rogers had knowledge of petitioners’ finances. She actively
                                       - 105 -

[*105] participated in both household finances and business activities throughout

the years at issue. She endorsed checks and used Mr. Rogers’ signature stamp for

both personal and business reasons. She paid bills from her personal accounts,

joint accounts, and accounts belonging to Mr. Rogers. She made deposits into

petitioners’ joint and individual bank accounts and had access to financial records.

      Mrs. Rogers was aware of petitioners’ financial and tax situation. We find

her claims to the contrary are not credible. She reviewed their joint tax returns

with her husband each year and asked questions. She was aware that they paid

little or no income tax during the deficiency years despite the fact that her husband

earned substantial amounts of income from his law practice from 2005 through

2007. She understood that they used losses from their business entities to offset

their income. She knew that Mr. Rogers promoted the Sugarloaf transactions, and

she understood the basic premise of the tax shelter, i.e., that investors would

acquire large tax benefits from relatively low investments. See Rogers v.

Commissioner, at *15. Mrs. Rogers engaged in a substantial residential

development project through SRI of land that she inherited from her father and

used the distressed debt tax shelter that her husband promoted to avoid paying

income tax on a substantial portion of her income from that project. She knew or

had reason to know that SRI sold lots in the subdivision for over $5 million but
                                        - 106 -

[*106] reported losses of over $3.2 million, claiming a $4 million deduction from

the Sugarloaf tax shelter. Mrs. Rogers’ education and business experience weigh

against her claim for section 6015(b) relief. See sec. 1.6015-2(c), Income Tax

Regs.

        Petitioners maintained a high standard of living through the years at issue.

They traveled extensively to international and domestic destinations, purchased

multiple luxury automobiles for themselves and their adult son, maintained

memberships at multiple clubs, and financed many of their adult son’s expenses.

Mrs. Rogers argues that her standard of living during the years at issue was

consistent with that of prior years and were not beyond the family’s norm. She

asks us to ignore the fact that her standard of living was high. Her standard of

living does not support the granting of innocent spouse relief. Finally, there is

nothing in the record that indicates Mr. Rogers tried to deceive or hide anything

from Mrs. Rogers. He never concealed any financial dealings, bank accounts, or

business operations from her. She had complete access to information about

petitioners’ financial situation. She reviewed the tax returns each year before

signing them and asked her husband questions. She had access to their banks

accounts, credit card statements, and other financial records and attended her

husband’s business dinners and meetings. On the basis of the four enumerated
                                       - 107 -

[*107] factors, we find that Mrs. Rogers knew or had reason to know of the

understatements of tax for the deficiency years and is not entitled to relief under

section 6015(b).

                   b.     Equity Requirement

      Failing any one condition of section 6015(b) precludes the granting of

innocent spouse relief. As we have found that Mrs. Rogers has failed the

knowledge requirement, she is not entitled to section 6015(b) relief. Nevertheless,

for completeness, we briefly address the other disputed requirement in these cases,

whether it would be inequitable to hold Mrs. Rogers liable for the deficiencies.

See sec. 6015(b)(1)(D). In analyzing the equity of imposing liability, we must

consider all of the facts and circumstances including whether the requesting

spouse significantly benefited from the understatement. Sec. 1.6015-2(d), Income

Tax Regs. A significant benefit is any benefit in excess of normal support. Id.

She traveled extensively with her husband, purchased luxury automobiles, and

paid living expenses for her adult son that she improperly deducted. She

purchased two homes for the alleged purpose of renovating and reselling them for

a profit and allowed her adult son and his family to live in the homes rent free,

paid living expenses on his behalf, and claimed improper deductions for the rent

and living expenses. She made expensive purchases of clothing, jewelry, and
                                        - 108 -

[*108] household items and maintained memberships at multiple private clubs.

Mrs. Rogers was aware that petitioners earned substantial income, including

approximately $13 million from the sale of the subdivision lots and an annual

income of approximately $500,000 from Mr. Rogers’ law firm for 2005 through

2007, and paid little or no income tax. As discussed above, Mrs. Rogers had

access to financial records, reviewed the returns with her husband, and asked him

questions about the returns. There is no evidence of deceit or concealment by Mr.

Rogers that would make holding Mrs. Rogers jointly and severally liable for the

deficiencies inequitable. Accordingly, Mrs. Rogers has not satisfied the equity

requirement of section 6015(b), a second reason that she is not entitled to section

6015(b) relief.

             2.     Equitable Relief Under Section 6015(f)

      Mrs. Rogers also seeks innocent spouse relief under section 6015(f).

Section 6015(f) provides an alternative means for innocent spouse relief for a

requesting spouse who does not otherwise qualify for relief under section 6015(b)

or (c).37 Sec. 6015(f)(2). Section 6015(f) provides for relief from joint and several

liability if it is inequitable to hold the requesting spouse liable for any unpaid tax

      37
        Mrs. Rogers does not qualify for relief under sec. 6015(c) because
petitioners remain married.
                                         - 109 -

[*109] or any deficiency (or any portion thereof) after taking into account all the

facts and circumstances of the case. Sec. 6015(f)(1). Except as otherwise

provided in section 6015, the taxpayer bears the burden of proving that she is

entitled to section 6015 relief. Rule 142(a). Both the scope and standard of

review in cases requesting relief from joint and several liability are de novo.

Porter v. Commissioner, 132 T.C. 203, 210 (2009). Rev. Proc. 2013-34, 2013-43

I.R.B. 397, modifying and superseding Rev. Proc. 2003-61, 2003-2 C.B. 296, sets

forth a three-step procedure for evaluating requests for innocent spouse relief: (1)

a list of seven threshold requirements that a requesting spouse must satisfy to be

eligible for relief (threshold test),38 (2) a three-part test for a streamlined

determination to grant relief, and (3) if the taxpayer is not entitled to a streamlined

determination, a nonexclusive list of factors that the IRS will consider in

determining whether it would be inequitable to hold the spouse jointly and

       38
         The seven threshold conditions are: (1) the parties filed a joint return,
(2) relief is not otherwise available under sec. 6015, (3) the claim for relief is
timely, (4) no assets were transferred between the spouses as part of a fraudulent
scheme, (5) the nonrequesting spouse did not transfer disqualified assets to the
requesting spouse, (6) the requesting spouse did not knowingly participate in the
filing of a fraudulent joint return, and (7) absent certain exceptions, the income tax
liability is attributable, in full or in part, to an item of the nonrequesting spouse or
an underpayment resulting from the nonrequesting spouse’s income. Rev. Proc.
2013-34, sec. 4.01, 2013-43 I.R.B. 397, 399.
                                        - 110 -

[*110] severally liable.39 Mrs. Rogers does not qualify for a streamlined

determination because streamlined relief requires that the taxpayers be no longer

married. Id. sec. 4.02, 2013-43 I.R.B. at 400. Generally, the requesting spouse

bears the burden of proof. Rule 142(a).

                    a.    Threshold Test for Section 6015(f) Relief

      Three of the seven requirements of the threshold test are at issue here.

Respondent contends that since as early as 1995 petitioners have engaged in a

pattern of transferring assets into Mrs. Rogers’ name that causes her to fail two

conditions of the threshold test: (1) that there were no asset transfers as part of a

fraudulent scheme and (2) that there was no transfer of disqualified assets to Mrs.

Rogers. See Rev. Proc. 2013-34, sec. 4.01(4) and (5), 2013-43 I.R.B. at 399.

Respondent alleges that their personal residence, Rogers & Associates, and

multiple bank accounts with substantial assets are held solely in Mrs. Rogers’

name. Respondent also argues that Mrs. Rogers does not satisfy a third

requirement of the threshold test because portions of the understatements are

attributable to her activities, specifically SRI, and deductions for personal

expenses. See Rev. Proc. 2013-34, sec. 4.01(7).

      39
      Rev. Proc. 2013-34, supra, applies to all requests filed on or after
September 16, 2013, and requests pending in any Federal court on or after
September 16, 2013. Id. sec. 7, 2013-43 I.R.B. at 403.
                                        - 111 -

[*111] A threshold requirement for equitable relief is that the taxpayers not have

made a transfer of a “disqualified asset” from the nonrequesting spouse to the

requesting spouse, defined as any transfer “if the principal purpose of the transfer

was the avoidance of tax or payment of tax.” Rev. Proc. 2013-34, sec. 4.01(5); see

sec. 6015(c)(4)(B)(i). The parties have presented little evidence with respect to

the value of these assets and the timing of the alleged transfers to Mrs. Rogers,

making it difficult for the Court to determine whether Mrs. Rogers satisfies the

threshold test with respect to the underpayments that are not attributable to her.

Mrs. Rogers has not presented any rebuttable evidence to support a finding that

the transfers do not cause her to fail the threshold test. The alleged transfers are

not necessarily determinative as we also find that the equities in these cases do not

support the granting of section 6015(f) relief for the deficiency years.

                    b.    Factor Test for Section 6015(f) Relief

      Respondent argues that under the list of factors enumerated in Rev. Proc.

2013-34, sec. 4.03, 2013-43 I.R.B. at 400, it is equitable to hold Mrs. Rogers

jointly and severally liable for the tax for the deficiency years. We agree. The

nonexclusive factors include: (1) marital status, (2) economic hardship, (3) the

requesting spouse’s knowledge or reason to know, (4) a legal obligation to pay the

tax, arising from a divorce decree or other binding agreement, (5) a significant
                                          - 112 -

[*112] benefit gained by the requesting spouse, (6) the requesting spouse’s

compliance with income tax laws, and (7) her mental or physical health at the time

of filing the return or the request for relief. No single factor, or the presence or

absence of a majority of the factors, is determinative; all factors are considered

and weighted appropriately. Kellam v. Commissioner, T.C. Memo. 2013-186, at

*26. This Court may consider the IRS guidelines, but is not bound by them, in

evaluating the facts and circumstances of a case. Molinet v. Commissioner, T.C.

Memo. 2014-109, at *6; see Pullins v. Commissioner, 136 T.C. 432, 438-439

(2011). Mrs. Rogers argues that the following equitable factors weigh in her

favor: she will suffer an economic hardship if not granted relief, she did not

receive a significant benefit from the understatements, she suffers chronic health

problems, and she has experienced abuse and control by Mr. Rogers that negates

her knowledge of the understatements. The factors that we consider for relief

under section 6015(f) are similar to the factors relevant to the equity requirement

of section 6015(b)(1)(D). As discussed above, Mrs. Rogers did not satisfy the

equity requirement of section 6015(b). Likewise we find that she is not entitled to

equitable relief under section 6015(f).

      Economic hardship exists if payment of the deficiency in whole or in part

would cause the requesting spouse to be unable to pay her reasonable basic living
                                       - 113 -

[*113] expenses. Rev. Proc. 2013-34, sec. 4.03(2)(b). Whether a requesting

spouse will suffer economic hardship is determined on the basis of rules similar to

those provided in section 301.6343-1(b) (4), Proced. & Admin. Regs.

(Requirement to release levy and notice of release), including the requesting

spouse’s assets and income, age, employment status and history, ability to earn,

dependents, living expenses, medical costs, and extraordinary circumstances. Rev.

Proc. 2013-34, sec. 4.03(2)(b). The IRS compares the requesting spouse’s income

with Federal poverty guidelines and with reasonable living expenses. Id. The

determination of economic hardship does not include the maintenance of an

affluent or luxurious standard of living. Sec. 301.6343-1(b)(4), Proced. & Admin.

Regs. Mrs. Rogers has not established that she would be unable to pay her

reasonable, basic living expenses or would otherwise suffer economic hardship if

relief is not granted. In financial documents that she submitted to the IRS she

reported substantial assets with values in excess of the deficiencies sustained here.

Respondent also alleges that Mrs. Rogers has undisclosed personal assets as

evidenced by insurance policies for personal property and assets held in trust that

she did not list on her forms submitted to the IRS. She submitted multiple copies

of the same form with significant unexplained discrepancies. We find that Mrs.

Rogers will not suffer economic hardship and will not be unable to pay her
                                      - 114 -

[*114] reasonable, basic living expenses. In addition she has received a

significant benefit from the understatements. As discussed above she enjoyed a

high standard of living that included expensive vacations and luxury purchases.

For reasons discussed above relating to section 6015(b) relief, Mrs. Rogers had

knowledge of the understatements. She knew that petitioners paid little or no

income tax despite Mr. Rogers’ substantial income from his law practice for 2005,

2006, and 2007. She also knew that the sale of the subdivision lots generated a

substantial amount of revenue and that SRI reported losses. Moreover, the number

of years at issue show a pattern of noncompliance. Mrs. Rogers continued to file

joint tax returns with her husband as recently as 2014 despite her knowledge that

respondent had issued the notices of deficiency.

      Consideration of the above factors supports a decision to deny Mrs. Rogers

section 6015(f) equitable relief. However, we must consider an additional factor,

that Mrs. Rogers experienced abuse and control from her husband, preventing her

from challenging the understatements because of fear of retaliation. Rev. Proc.

2013-34, sec. 4.03. We do not find credible or plausible the argument that Mr.

Rogers had control over petitioners’ financial information or financial decisions.

The evidence shows that Mrs. Rogers was actively involved in their financial

affairs and contradicts her claims that Mr. Rogers was financially controlling. She
                                      - 115 -

[*115] handled insurance issues, obtained loans and signed loan documents, and

maintained numerous bank accounts as the sole owner. She paid household

expenses and held substantial assets in her own name. She became the office

manager of Rogers & Associates during 2009. She paid bills and endorsed checks

with her husband’s signature stamp. Furthermore, there is no evidence of Mr.

Rogers’ evasiveness or deceitfulness. He reviewed the joint tax returns with Mrs.

Rogers each year and answered her questions. She was aware that they paid little

or no income tax but thought it was because her husband was a good attorney. She

accompanied her husband on business trips and attended business meetings. She

was involved in decisionmaking for SRI’s subdivision project and was its sole

shareholder.

      Mrs. Rogers asks us to consider whether psychological abuse by her hus-

band makes it inequitable to find her liable.40 She argues that abuse by her hus-

band made her unable to challenge the tax returns despite her knowledge. The

Court may consider whether abuse affects our decision with respect to the other

factors we considered above for determining whether to grant equitable relief. See

Rev. Proc. 2013-34, supra. Abuse includes efforts to control, isolate, humiliate,

      40
        Mrs. Rogers submitted three Forms 8857 within less than one year and
reported that she was not the victim of abuse on the first two forms and was an
abuse victim on her third form.
                                        - 116 -

[*116] and intimidate the requesting spouse or to undermine her ability to reason

independently. Id. sec. 4.03(2)(C)(iv). Mrs. Rogers testified at trial that she did

not fear for her safety. She believed that Mr. Rogers performed well as an

attorney during a substantial portion of the deficiency years despite his alcohol use

and testified that she would have made him stop working if she believed that he

could not perform in his profession. However, his behavior humiliated her and

isolated her. We are not convinced that Mr. Rogers exercised such control over

Mrs. Rogers as would have prevented her from challenging the tax returns or make

it inequitable to hold her liable. She exercised control over financial decisions,

including those relating to SRI and Rogers & Associates. She reviewed the

returns with her husband and asked questions. The assertions of control contradict

the record. We sympathize that Mrs. Rogers has experienced her own health

problems and stress, anxiety, and depression in connection with her husband’s

illness and hospitalization in 2009. However, we do not find that it is inequitable

to hold her jointly and severally liable for the deficiencies, penalties, and interest

at issue in the light of all the facts and circumstances. She knew about the

understatements and significantly benefited from them. She will not suffer

economic hardship if relief is not granted. Accordingly, we deny her claim for

equitable relief under section 6015(f) for the deficiency years.
                                        - 117 -

[*117] IV. Penalties and Addition to Tax

      Respondent determined penalties for the deficiency years as follows. For

2005 he determined an accuracy-related penalty against petitioners under section

6662(h) for gross valuation misstatements relating to deductions claimed for the

Sugarloaf transaction and under section 6662(a) and (b)(1) and (2) for the portion

of the underpayment due to omitted income and disallowed business expense

deductions. For 2006 he determined a section 6663 fraud penalty against Mr.

Rogers and, in the alternative, he determined section 6662(a) and (h) accuracy-

related penalties against petitioners. See sec. 6662(b). For 2007 and 2009 he

determined section 6662(a) accuracy-related penalties, and for 2009 he determined

an addition to tax under section 6651(a) for the late filing of petitioners’ joint

income tax return. Finally in the alternative to the section 6662(h) penalties for

2005 and 2006, respondent determined a section 6662A penalty for

understatements attributable to an undisclosed reportable or listed transaction with

respect to petitioners’ investments in the Sugarloaf transactions. See sec.

6662A(e)(2)(B).

      After trial in these consolidated cases, on January 23, 2018, petitioners filed

a motion for partial summary judgment with respect to the above penalties on the

basis of our recent decision in Graev v. Commissioner, 149 T.C. ___ (Dec. 20,
                                        - 118 -

[*118] 2017). We will deny petitioners’ motion with respect to the section 6663

fraud penalty for 2006 and the section 6651(a) late filing addition to tax as moot

because we find that petitioners are not liable for these penalties, as described

further infra. Petitioners’ liability for the section 6662 accuracy-related penalties

and the section 6662A penalty will be addressed after the parties have an

opportunity to further address this issue and will not be addressed therein.

      A.     Fraud Penalty

      Section 6663 imposes a 75% penalty on the portion of an underpayment that

is attributable to fraud. Respondent has the burden of proving fraud by clear and

convincing evidence. Sec. 7454(a); Prof’l Servs. v. Commissioner, 79 T.C. 888,

930 (1982). The clear and convincing standard applies to both the existence of the

underpayment and the existence of fraud. Parks v. Commissioner, 94 T.C. 654,

660-661 (1990); DiRicco v. Commissioner, T.C. Memo. 2009-300. To meet this

burden, the Commissioner must show that the taxpayer intended to evade taxes

known to be owing by conduct intended to conceal, mislead, or otherwise prevent

the collection of tax. Sadler v. Commissioner, 113 T.C. 99, 102 (1999); Parks v.

Commissioner, 94 T.C. at 660-661. If the Commissioner establishes that any

portion of the understatement is due to fraud, the entire underpayment is treated as

attributable to fraud, except to the extent that the taxpayer can establish that a
                                        - 119 -

[*119] portion is not attributable to fraud. Sec. 6663(b); DelVecchio v.

Commissioner, T.C. Memo. 2001-130, slip op. at 12, aff’d, 37 F. App’x 979 (11th

Cir. 2002). Fraud is not imputed from one spouse to another; in the case of a joint

tax return, the Commissioner must prove fraud as to each spouse. See sec.

6663(c); Hicks Co. v. Commissioner, 56 T.C. 982, 1030 (1971), aff’d, 470 F.2d 87

(1st Cir. 1972). Here respondent has asserted fraud only against Mr. Rogers for

2006.

        The existence of fraud is a question of fact to be resolved from

consideration of the entire record. Gajewski v. Commissioner, 67 T.C. 181, 199

(1976), aff’d without published opinion, 578 F.2d 1383 (8th Cir. 1978). Because

fraud can rarely be established by direct proof of the taxpayer’s intention, fraud

may be proven by circumstantial evidence and reasonable inferences drawn from

the facts. Rowlee v. Commissioner, 80 T.C. 1111, 1123 (1983). Several indicia,

commonly known as “badges” of fraud, are circumstantial evidence that may give

rise to evidence of fraudulent intent. Parks v. Commissioner, 94 T.C. at 664-665.

Although no single factor is determinative to establish fraud, the existence of

several indicia may be persuasive circumstantial evidence of fraud. Solomon v.

Commissioner, 732 F.2d 1459, 1461 (6th Cir. 1984), aff’g T.C. Memo. 1982-603.

“Badges” of fraudulent intent include: (1) understating income, (2) maintaining
                                        - 120 -

[*120] inadequate records, (3) implausible or inconsistent explanations of

behavior, (4) concealment of income or assets, (5) failing to cooperate with tax

authorities, (6) engaging in illegal activities, (7) an intent to mislead which may be

inferred from a pattern of conduct, (8) lack of credibility of the taxpayer’s

testimony, (9) filing false documents, (10) failing to file tax returns, and (11)

dealing in cash. Spies v. United States, 317 U.S. 492, 499 (1943); Recklitis v.

Commissioner, 91 T.C. 874, 910 (1988). As few as one or two badges of fraud

may be sufficient to prove fraudulent intent. Bertoli v. Commissioner, 103 T.C.

501, 518 (1994). The taxpayer’s entire course of conduct can be indicative of

fraud. Stone v. Commissioner, 56 T.C. 213, 223-224 (1971).

      The evidence shows that petitioners underreported income, claimed

personal expenses as business deductions, and inconsistently reported related

company transactions. Many of these failures are due to the disorganized structure

of their business transactions among their related business entities and their failure

to maintain adequate records, resulting in their inability to substantiate a

significant portion of their claimed deductions rather than an intent to evade taxes

known to be owing. Mr. Rogers promoted and implemented the Sugarloaf tax

shelter generating millions of dollars in losses for investors and engaged in the tax

shelter in 2006 to lower petitioners’ taxable income. They failed to report over
                                       - 121 -

[*121] $1 million in income that Mr. Rogers received from his promotion of the

Sugarloaf transactions. His wholly owned corporation PPI also failed to report

gross receipts of nearly $700,000 for 2006. A substantial portion of PPI’s

underreported gross receipts arose from transactions with related entities.

      When Mr. Rogers was preparing petitioners’ 2006 joint income tax return,

he initially included the trustee’s fees that he received from Sugarloaf investors as

income in a draft of the return. However, before he submitted the return, he

received notice that respondent had determined a deficiency for 2003 relating to

distressed debt transactions that Mr. Rogers promoted and implemented through a

separate entity, Warwick Trading, LLC. See Superior Trading, LLC v.

Commissioner, 137 T.C. 70. He revised his 2006 return and took the position that

the trustee’s fees were not income because they were a return of capital from

Sugarloaf and a reimbursement of disallowed 2003 deductions. Sugarloaf was not

involved in the distressed debt transactions at issue in Superior Trading. He

advanced significant amounts of money to Sugarloaf or on its behalf in the

beginning stages of his implementation and promotion of the tax shelter. He

admits that when he received the checks from the investors in 2006, he thought

that the amounts would be taxable income and later recharacterized the checks as

an expense reimbursement. He argues that his reasoning changed when
                                        - 122 -

[*122] respondent asserted the 2003 deficiency. As a result of the above position,

petitioners did not report the trustee’s fees as income on their 2006 joint return and

underreported Mr. Rogers’ income by over $1 million. However, we do not find

that Mr. Rogers’ reporting position constitutes fraudulent intent. In connection

with this changed reporting position, petitioners submitted during the IRS

examination altered checks that deleted references to trustee’s fee on the

memorandum line of checks received from Sugarloaf investors. Mr. Rogers

claims that his assistant altered the checks in defiance of his direction not to do so.

We do not find this charge to be credible. This incident occurred in 2009 before

his hospitalization for alcoholism, and Mr. Rogers later submitted the unaltered

checks. After consideration of the badges of fraud, we find that he did not

fraudulently mislead respondent. Petitioners timely filed their joint tax returns and

the returns on their numerous entities for each year, except for the late filing for

2009. We do not believe that Mr. Rogers had a fraudulent intent to evade tax.

Although at times we have found his testimony to lack credibility, his actions do

not rise to the level of fraud. Accordingly, we hold that he is not liable for the

section 6663 fraud penalty for 2006. As we have not imposed the fraud penalty,

we must determine whether petitioners are liable for the accuracy-related penalties

under section 6662(a) and (h) for 2006.
                                        - 123 -

[*123] B.    Failure To File Addition to Tax

      Section 6651(a)(1) imposes an addition to tax for the failure to timely file a

tax return. Sec. 6651(a). The addition to tax is equal to 5% of the amount

required to be shown as tax on the return if the failure to file is for not more than 1

month, with an additional 5% for each additional month or fraction thereof during

which the failure continues, not to exceed a 25% addition. Petitioners did not

request an extension of time to file their 2009 return. It was postmarked October

14, 2010.

      Respondent asserted the failure to timely file addition to tax for the first

time in his answer; the timing affects which party bears the burden of proof in

regard to the availability of the reasonable cause exception to that penalty. As a

general rule, once the Commissioner satisfies his burden of production under

section 7491(c) establishing the appropriateness of a determined penalty, the

taxpayer bears the burden of proving that reasonable cause exists for his late filing

as a defense to the imposition of the penalty. See Higbee v. Commissioner, 116

T.C. 438, 446-447 (2001). The Commissioner bears the burden of proof “in

respect of any new matter, increases in deficiency, and affirmative defenses,

pleaded in the answer”. Rule 142(a)(1). Thus, as respondent asserted the late

filing addition in the answer, he bears the burden of proving the absence of
                                       - 124 -

[*124] reasonable cause for the Court to impose the penalty if the penalty is either

a “new matter” or an “increase[] in deficiency” within the meaning of Rule 142(a).

RERI Holdings I, LLC v. Commissioner, 149 T.C. ___, ___ (slip op. at 62-63)

(July 3, 2017); Rader v. Commissioner, 143 T.C. 376, 389 (2014), aff’d in part,

appeal dismissed in part, 616 F. App’x 391 (10th Cir. 2015).

      Reasonable cause exists for a late filing if the taxpayer exercised ordinary

care and prudence but was nevertheless unable to file on time. Sec. 301.6651-

1(c)(1), Proced. & Admin. Regs. Willful neglect is defined as an intentional

failure or reckless indifference. United States v. Boyle, 469 U.S. 241, 245 (1985).

Illness or incapacity of a taxpayer or a member of his immediate family may be

reasonable cause for late filing. See Rogers v. Commissioner, T.C. Memo. 2016-

152; Joseph v. Commissioner, T.C. Memo. 2003-19; Hobson v. Commissioner,

T.C. Memo. 1996-272; Tabbi v. Commissioner, T.C. Memo. 1995-463; Hayes v.

Commissioner, T.C. Memo. 1967-80. However, a taxpayer’s selective inability to

perform his tax obligations while performing his regular business does not excuse

the failure to file. See Watts v. Commissioner, T.C. Memo. 1999-416; Kemmerer

v. Commissioner, T.C. Memo. 1993-394. Petitioners argue that they had

reasonable cause for their late filing for 2009 because of Mr. Rogers’ extended

illness. We agree. Mr. Rogers was hospitalized for an extended time in 2009, and
                                        - 125 -

[*125] he continued to deal with his illness after his release. Mrs. Rogers was

preoccupied with her husband’s illness and took on substantial additional

responsibilities in their businesses. Her health also suffered as she dealt with her

husband’s condition. In prior years petitioners timely filed their income tax

returns under extension. However, they failed to request an extension for 2009;

their return would have been timely had they done so. Cf. Judge v. Commissioner,

88 T.C. 1175 (1987) (no reasonable cause found despite illness where taxpayer

had a long history of delinquent filing). Respondent has not established that

petitioners lacked reasonable cause. We find that petitioners had reasonable cause

for the late filing and it was not due to willful neglect. Accordingly, petitioners

are not liable for the section 6651(a) late filing addition to tax for 2009.

         In reaching our holdings herein, we have considered all arguments made,

and to the extent not mentioned, we conclude they are moot, irrelevant, or without

merit.

         To reflect the foregoing,

                                                      An appropriate order will be

                                               issued.
                                      - 126 -

[*126]                            APPENDIX1 A

                               2005 Schedule C-1

                 Expense        Per return       Allowed       Disallowed

          Interest               $50,683           -0-          $50,683
          Rent                     1,722           -0-             1,722
          Alarm services             654           -0-               654
          Travel                  25,320           -0-            25,320

      1
       For purposes of the following Appendixes A through E, “per return” is the
amount listed on the return, “petitioners’ concession” is the amount of the
expenses deducted on the return that petitioners have conceded, “stipulated” is the
amount that respondent has conceded is deductible, “allowed” is the additional
amount in excess of the stipulated amount that petitioners are entitled to deduct,
and “disallowed” is the amount of the deductions per return that the Court
disallows, not including petitioners’ concessions.
                                    - 127 -

[*127]                        2006 Schedule C-1

                           Per     Petitioners’
            Expense       return   concession     Stipulated   Allowed   Disallowed

Repairs                  $15,234       ---           ---         -0-     $15,234
Office expense            11,915       ---           ---         -0-      11,915
Legal fees               137,111       ---           ---       $62,023    75,088
Interest                  7,904        ---           ---         -0-        7,904
Insurance                 4,530     $3,094          $493         -0-         943
Depreciation              7,500        ---           ---         -0-        7,500
Utilities                 7,829        ---           ---         -0-       7,829
Meals                     5,951        ---           ---         -0-       5,951
Travel                   55,110        ---           ---         -0-      55,110
Taxes and licenses       12,029       6,001          ---         -0-       6,028
Legal                     1,000        ---           ---         -0-       1,000
Fiduciary                 1,000        ---           ---         -0-       1,000
Publications              4,686        ---           ---        1,509      3,177
Dues and subscriptions    3,200        ---           ---        1,272      1,928
Fees                     151,128 150,000             ---         -0-       1,128
Miscellaneous             1,209        ---           ---         -0-       1,209
Computer services         4,336        ---           ---        4,336       -0-
Business gifts              800        ---           ---          100        700
Bank service charges      1,435        ---           ---         -0-       1,435
Alarm services              902        ---           ---         -0-         902
                                      - 128 -

[*128]                          2007 Schedule C-1

                                Petitioners’
    Expense       Per return    concession       Stipulated    Allowed Disallowed

Repairs               $5,352      $1,743            $464         -0-      $3,145
Legal fees            120,820       ---             4,471      $71,202    45,147
Interest              43,035        ---              ---         -0-      43,035
Insurance               6,853       ---              ---         -0-        6,853
Travel                130,540       ---              ---         -0-      130,540
Meals                   7,101       ---              ---         -0-        7,101
Automobile              5,582       ---              ---         -0-        5,582
Supplies                8,336        922             ---         1,865      5,549
Taxes and              10,885       ---              ---         -0-      10,885
 licenses
Utilities              11,209       ---              ---         -0-      11,209
Alarm services          1,000       ---              ---         -0-        1,000
Rent                    5,166       ---              ---         -0-        5,166

                                2009 Schedule C-1

            Expense             Per return      Stipulated    Allowed    Disallowed

Legal and professional fees     $665,242           ---        $539,061   $126,181
Returns and allowances          1,414,898       $815,809      599,089       -0-
Travel                           130,540           ---          -0-       130,540
Meals                               7,101          ---          -0-         7,101
                                               - 129 -

[*129]                             APPENDIX B

                         Schedule C-2 Deductions Per Return

                 Expense                2005              2006      2007

                                   1
          Depreciation                 $14,848           $10,909   $10,909
                                       2                           3
          Taxes and licenses               12,997         13,065       17,380
          Repairs                              7,763       ---          ---
          Interest                     14,537              ---          ---
                                           4
          Utilities                            9,320       ---          ---
          Bank service charges                 2,089       ---          ---

      1
         Petitioners concede $3,939 of the 2005 depreciation deduction with
$10,909 remaining in dispute.
       2
         The 2005 taxes include $4,080 relating to farmland and $8,917 relating to
the Manitou house. Petitioners did not establish the deductibility of the taxes paid
with respect to the farmland. It is further unclear from the record whether
respondent has conceded the taxes relating to the farmland.
       3
         Petitioners deducted taxes and licenses of $17,380 relating to the Manitou
house. Petitioners incurred additional taxes and licenses of $2,673 for 2007 that
petitioners did not deduct on their return. Respondent concedes that they are
entitled to deduct the $2,673 on Schedule C-2 for 2007.
       4
         The source of the $9,320 of utilities is not clear from the record.
Petitioners presented evidence that $3,109 related to their personal residence and
$3,000 related to the Manitou house.
                                       - 130 -

[*130]                             APPENDIX C

            Nondeductible Expenses Relating to Manitou House on
     Schedules C-1 and C-2 and SRI’s and PPI’s S Corporation Tax Returns1

                  Expense           2005          2006        2007

           Rent                      ---         $60,000        ---
           Depreciation           $10,909         10,909     $10,909
           Interest                14,537          ---          ---
           Repairs                 33,833          ---          ---
           Taxes and licenses       8,917         13,065      17,380
           Utilities                3,000          2,169        ---
           Bank service             2,089          ---          ---
           Insurance                 ---            943         ---

      1
        SRI deducted the rent and utilities for 2006 on its S corporation tax return.
Petitioners deducted the 2006 insurance on Schedule C-1. The 2005 repairs were
deducted as follows: $7,763 on Schedule C-2 and $26,070 on PPI’s S corporation
tax return. The remainder of the expenses were deducted on Schedule C-2.
                                   - 131 -

[*131]                         APPENDIX D

                           2006 SRI Deductions

                                   Petitioners’
           Expense    Per return   concession     Stipulated   Allowed   Disallowed

Rent                  $60,000          ---           ---         -0-     $60,000
Interest              175,000          ---           ---         -0-     175,000
Depreciation           13,160          ---                       -0-       13,160
Auto and truck           2,000         ---           ---         -0-        2,000
Bank charges             5,770         ---                       -0-        5,770
Employee bonuses       21,700          ---                       -0-       21,700
 and reimbursements
Insurance                5,408         ---                       -0-        5,408
Legal and              60,243          ---           ---       $60,243      -0-
 professional fees
Meals and                2,861         ---           ---         -0-        2,861
 entertainment
Miscellaneous           51,363      $1,500           ---         -0-       49,863
Parking                  2,075                       ---         -0-        2,075
Telephone                3,740         ---           ---         -0-        3,740
Utilities                2,169         ---           ---         -0-        2,169
Consulting fee        710,366          ---        $710,366       -0-        -0-
                                    - 132 -

[*132]                            APPENDIX E

                             2005 PPI Deductions

                                   Petitioners’
         Expense     Per return    concession     Stipulated   Allowed   Disallowed

Repairs              $26,070           ---           ---         -0-     $26,070
Legal and            908,474           ---           ---       $40,245   868,229
 professional fees
Computer services      7,636           ---           ---         -0-        7,636
PTI subsidy          124,520           ---           ---         -0-     124,520
Meals                  6,997           ---           ---         -0-        6,997
Taxi                   3,286        $1,752           ---         -0-        1,534
Airfare                7,538          3,990          ---         -0-        3,548
Hotel                  9,312          8,406          ---         -0-         906
Multicred fee        907,263           ---        $90,000        -0-     817,263
Doctor                 8,207           ---           ---         -0-        8,207
Gasoline               4,175           ---           ---         -0-        4,175
Dentist                4,085           ---           ---         -0-        4,085
                                    - 133 -

[*133]                        2006 PPI Deductions

            Expense           Per return      Stipulated   Allowed   Disallowed

Salaries and wages             $240,000       $363,538       -0-        -0-
Repairs                           3,387          ---        $258       $3,129
Employee benefit programs        37,283          ---       37,283       -0-
Insurance                         3,818          ---        3,818       -0-
Legal and professional fees   1,070,771          ---       31,231    1,039,540
Travel                           32,296          ---         -0-       32,296
                                      - 134 -

[*134]                       2009 PPI Deductions

                                      Petitioners’
           Expense       Per return   concession     Stipulated   Allowed   Disallowed

Salaries and wages       $10,000          ---         $5,000        -0-      $5,000
Repairs                   15,372          ---           ---       $5,647      9,725
Rent                         560          ---           ---         -0-         560
Taxes and licenses        13,779          ---           ---           30     13,749
Interest                   1,866          ---           ---         -0-       1,866
Employee benefit         23,604           ---           ---       23,604       -0-
 program
Accounting                 8,717       $2,500           ---        1,062      5,155
Bank charges                 433          ---           ---         -0-         433
Insurance                  3,738          ---           ---         -0-        -0-
Legal and professional   132,163          ---           ---       132,163      -0-
 fees
Miscellaneous              1,171          ---           366         -0-       1,171
Office                    18,462          ---           ---         -0-      18,096
Printing                     591          ---           ---         -0-         591
Parking                      240          ---           ---          240       -0-
Brad Todd Expenses         4,846          ---                       -0-       4,846