Court Opinion

ID: 9384708
Source: CourtListenerOpinion
Date Created: 2023-04-04 19:01:40.513527+00
Date Added: 2024-06-11T17:17:55.838835
License: Public Domain

United States Tax Court

                        T.C. Summary Opinion 2023-14

         NOAH SCHMERLING AND SUSANA SCHMERLING,
                        Petitioners

                                           v.

               COMMISSIONER OF INTERNAL REVENUE,
                           Respondent

                                     —————

Docket No. 342-18S.                                             Filed April 4, 2023.

                                     —————

Noah Schmerling and Susana Schmerling, pro se.

Daniel C. Chavez and Michael R. Park, for respondent.

                              SUMMARY OPINION

       CARLUZZO, Chief Special Trial Judge: This case was heard
pursuant to the provisions of section 7463 of the Internal Revenue Code
in effect when the Petition was filed. 1 Pursuant to section 7463(b), the
decision to be entered is not reviewable by any other court, and this
Opinion shall not be treated as precedent for any other case.

      In a notice of deficiency dated October 23, 2017 (notice),
respondent determined a deficiency in petitioners’ federal income tax for
2014 (year in issue) and a section 6662(a) accuracy-related penalty.
Respondent has now conceded the section 6662(a) penalty.

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

Revenue Code, Title 26 U.S.C., in effect at all relevant times, all regulation references
are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant
times, and all Rule references are to the Tax Court Rules of Practice and Procedure.
Monetary amounts are rounded to the nearest dollar unless indicated otherwise.

                                 Served 04/04/23
                                    2

       The issues for decision are whether (1) Mr. Schmerling
(petitioner) was engaged in the trade or business of auto sales other than
as an employee of McKenna Motors BMW (McKenna) and (2) petitioners
are entitled to deduct various expenses related to petitioner’s
employment with McKenna, and if so, how those deductions must be
claimed.

                              Background

      Some of the facts have been stipulated and are so found. When
the Petition was filed, petitioners resided in California.

      Petitioner was hired as an automobile salesman in 2008 by
McKenna. McKenna operated under a franchise from BMW of North
America, LLC (BMW), for selling BMW automobiles. Between 2008 and
the year in issue, petitioner was promoted to corporate/VIP sales
manager for McKenna, and his duties expanded to include managing
the used car fleet.

      As the used car fleet manager, petitioner had various duties,
including purchasing used cars at auctions for resale at McKenna. He
personally attended used car auctions, estimated the value of a car
presented for auction, and decided whether and how much to bid on it.
McKenna provided the funds to purchase the used cars. The used cars
purchased at auction were resold by McKenna, not petitioner, and the
company profited or suffered a loss from each resale of a car purchased
at auction.

       The Form W–2, Wage and Tax Statement, McKenna issued to
petitioner for 2014 shows $206,506 in wages and commissions that
petitioner earned during that year. In addition to the income reported
on the Form W–2, petitioner was compensated by others in connection
with his position at McKenna. The sources of petitioner’s additional
income and the circumstances that generated that income are
summarized in the following paragraphs.

      BMW offered a performance bonus program (program) for sales
managers. The program provided cash awards to eligible individuals
who met or exceeded various goals set by BMW. Petitioner was eligible
for and participated in the program. The program also provided for
severe sanctions if a participant abused its benefits. According to the
program rules,
                                   3

      [i]f it is determined that a payment was made based on
      fraudulent reporting, the Center will be charged back
      through their parts account the entire amount awarded to
      all of its employees under the Performance Bonus Program.
      In addition, those individuals involved in the fraudulent
      reporting will not be eligible to participate in future
      Performance Bonus programs.

      The references to “Center” and “its” are to McKenna. Apparently,
if any one participant violated the program rules, all of the bonus
payments to all participants were recoverable. Petitioner received
compensation through the program, and he was issued Form 1099–
MISC, Miscellaneous Income, from BMW reporting $37,234 in
miscellaneous other income for the year in issue. Neither party takes
the position that petitioner was an employee of BMW with respect to the
amounts he earned under the program.

       In connection with the sale of new and used automobiles,
petitioner also earned commissions on the sale of extended warranty
service contracts underwritten by Devex, Inc. (Devex).          Those
commissions, which totaled $2,560, are shown on a Form 1099–MISC
that Devex issued to petitioner. Neither party takes the position that
petitioner was an employee of Devex with respect to the commissions
that he received from Devex.

       Petitioner leased a BMW X3 that he used to travel to meet with
McKenna’s customers and to attend used car auctions during 2014.
Petitioner also leased another vehicle that was used exclusively for
personal purposes. During the examination of petitioners’ return,
petitioner prepared and provided respondent with a 2014 calendar in
which he recorded each day’s mileage and a destination (mileage log).
According to the mileage log, petitioner drove 13,844 miles in 2014 to
deliver cars to McKenna’s customers and attend used car auctions. The
mileage log does not identify a beginning destination for any entry, nor
does it show a beginning or ending odometer reading. However,
McKenna’s commission list records corroborate some of the information
shown on the mileage log.

      In preparation for trial petitioners prepared spreadsheets
categorizing expenses shown on credit card and bank statements for
2014. Some of the spreadsheets include a date, the location of the
expenditure, the account from which the expense was paid, and an
                                         4

amount for each entry, while other spreadsheets show only a date or
range of dates, an account number, and an amount.

       Petitioners’ timely filed 2014 Form 1040, U.S. Individual Income
Tax Return, was prepared by a certified public accountant (CPA).
Petitioner’s occupation is shown as “used car salesman.” The $206,506
compensation that petitioner received from McKenna is reported as
wages on the return. The return includes a Schedule C, Profit or Loss
From Business, identifying petitioner as the sole proprietor of an “auto
sales, used cars” business. The Schedule C shows income of $39,795 (the
sum of the amounts shown on the Forms 1099–MISC issued by BMW
and Devex), expenses of $27,307, and a net profit of $12,488. 2

       In the notice respondent determined that the activities described
on petitioners’ Schedule C (that is, petitioner’s participation in the BMW
bonus program and his sale of extended warranty service contracts for
Devex) did not constitute a trade or business separate and apart from
his employment with McKenna. The gross receipts reported on the
Schedule C were recharacterized as “other income,” and the deductions
for expenses reported on the Schedule C were disallowed. Respondent
also imposed a section 6662(a) accuracy-related penalty on various
grounds.

                                    Discussion

      As a general rule, the Commissioner’s determination of a
taxpayer’s federal income tax liability in a notice of deficiency is
presumed correct, and the taxpayer bears the burden of proving that the

       2  Petitioners also submitted to respondent a Form 1040X, Amended U.S.
Individual Income Tax Return (amended return), dated June 9, 2016, prepared by a
different paid income tax return preparer from the CPA who prepared their original
return. The amended return included an amended Schedule C on which petitioners
increased gross receipts by $60,000 and inexplicably subtracted that amount in the
computation of adjusted gross income shown on the amended return. Although what
petitioners did is less than clear, they also appear to have treated a portion of
petitioner’s wage and commission income from McKenna as Schedule C income. The
Schedule C included with the amended return shows cost of goods sold of $38,320 and
expense deductions totaling $46,600. As a result of these changes, the amended return
reports no income tax liability, a $15,597 overpayment of income tax, and a refund
claim for that amount. Respondent treated the amended return as a claim for refund
and apparently denied it. We consider petitioners’ claimed deductions, as addressed
by the parties, without taking into account how, or on which return, each deduction
was claimed.
                                         5

determination is erroneous. Rule 142(a); Welch v. Helvering, 290 U.S.
111, 115 (1933).

I.     Treatment of petitioners’ income and expenses

      We first turn our attention to the manner in which income and
expenses in dispute must be treated for federal income tax purposes.

       According to petitioners, petitioner’s activities with respect to his
participation in the BMW bonus program and the sale of Devex extended
warranty service contracts constitute a trade or business separate and
apart from his status as an employee of McKenna. As petitioners view
the matter, the income and expenses related to these activities are
properly reported on a Schedule C because the activities, taken together
and in and of themselves, constitute a trade or business. 3

       Respondent disagrees. According to respondent, petitioner must
treat the amounts received from BMW and Devex as “other income”
related to his employment as a car salesman/manager, and any
deduction for expenses associated with those earnings must be deducted
on Schedule A, Itemized Deductions, as a miscellaneous itemized
deduction. See § 212(1).

       Whether an activity is a trade or business is a question of fact
that takes into account a taxpayer’s intent and all other relevant facts
and circumstances surrounding the activity. See Commissioner v.
Groetzinger, 480 U.S. 23, 35–36 (1987). Petitioner does not claim that
he earned any income from either BMW or Devex independently from
his employment with McKenna. The income that petitioner earned from
BMW and Devex is inextricably intertwined with and connected to his
status as an employee of McKenna. Using common sense as a guide, as
Groetzinger suggests, we are not persuaded that petitioner’s
relationships to BMW and Devex provided him with the opportunity to
earn a living separate and apart from his status as an employee of
McKenna. See id. Petitioner “earned his living” during 2014 as a result
of his “trade or business” of being an employee of McKenna, not as the
proprietor of a separate trade or business independent from his
employment with McKenna. That being so, petitioners must treat

       3 As described above, as an employee of McKenna, petitioner attended used car

auctions to acquire cars to be resold by McKenna. To the extent that petitioners
suggest that the activity constitutes a trade or business separate from petitioner’s
employment with McKenna, their suggestion is rejected without further comment.
                                         6

petitioner’s compensation from BMW and Devex as “other income,” as
respondent argues. 4

II.    Petitioners’ claimed deductions

       Next we consider how the expenses attributable to petitioner’s
employment with McKenna and the expenses attributable to the “other
income” are treated. As we view the matter, some of the amounts
claimed as deductions on the Schedule C should be reported as
unreimbursed employee business expenses, see § 162(a), and some
should be treated as deductions for expenses incurred for the production
of income, see § 212(1). Actually, for purposes here, the distinction
makes no difference, as the expense deductions are treated in the same
manner, and it is unnecessary to allocate the deductions to any of the
income-generating activities for purposes of section 67 or otherwise. 5
Consequently, we proceed as though any otherwise allowable deduction
is allowed as an unreimbursed employee business expense, recognizing
that petitioner is not an employee of either BMW or Devex.

       Regardless of how the expenses are categorized, as we have
observed in countless opinions, deductions are a matter of legislative
grace, and the taxpayer bears the burden of proving entitlement to any
claimed deduction. Rule 142(a); INDOPCO, Inc. v. Commissioner, 503
U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440
(1934). This burden requires the taxpayer to substantiate expenses
underlying deductions claimed by keeping and producing adequate
records that enable the Commissioner to determine the taxpayer’s
correct tax liability. § 6001; Hradesky v. Commissioner, 65 T.C. 87,
89–90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976); Meneguzzo
v. Commissioner, 43 T.C. 824, 831–32 (1965). A taxpayer claiming a
deduction on a federal income tax return must demonstrate that the
deduction is allowable pursuant to some statutory provision and must
further substantiate that the expense to which the deduction relates has
been paid or incurred. See § 6001; Hradesky, 65 T.C. at 89–90; Treas.
Reg. § 1.6001-1(a).

       4  The notice does not treat the income petitioner earned and received from
BMW or Devex as net earnings from self-employment subject to the tax imposed by
section 1402, and respondent does not argue for that treatment here.
        5 The year in issue, 2014, precedes changes to section 67. The Tax Cuts and

Jobs Act of 2017, Pub. L. No. 115-97, § 11045, 131 Stat. 2054, 2088, amended section
67 by suspending miscellaneous itemized deductions for any taxable year beginning
after December 31, 2017, and before January 1, 2026.
                                    7

       Taxpayers may deduct “ordinary and necessary” expenses paid in
connection with operating a trade or business. § 162(a); Boyd v.
Commissioner, 122 T.C. 305, 313 (2004). Performing services as an
employee may constitute a “trade or business.” See Primuth v.
Commissioner, 54 T.C. 374, 377 (1970). Whether an expenditure is
“ordinary and necessary” is generally a question of fact. Commissioner
v. Heininger, 320 U.S. 467, 475 (1943). To be “ordinary,” the expense
must be a common or frequent occurrence for the taxpayer’s type of
business. Deputy v. du Pont, 308 U.S. 488, 495 (1940). An expenditure
is “necessary” if it is “appropriate and helpful” to the taxpayer’s
business, Welch v. Helvering, 290 U.S. at 113, but it must also be
“directly connected with or pertaining to the taxpayer’s trade or
business,” Treas. Reg. § 1.162-1(a). On the other hand, section 262(a)
generally disallows a deduction for personal, living, or family expenses.

       Deductions for expenses attributable to travel (“including meals
and lodging while away from home”), entertainment, gifts, and the use
of “listed property” (as defined in section 280F(d)(4) and including
passenger automobiles), if otherwise allowable, are subject to strict rules
of substantiation. See § 274(d); Sanford v. Commissioner, 50 T.C. 823,
827 (1968), aff’d per curiam, 412 F.2d 201 (2d Cir. 1969); Temp. Treas.
Reg. § 1.274-5T(a). With respect to deductions for these types of
expenses, section 274(d) requires that the taxpayer substantiate either
by adequate records or by sufficient evidence corroborating the
taxpayer’s own statement (1) the amount of the expense, (2) the time
and place the expense was incurred, (3) the business purpose of the
expense, and (4) in the case of an entertainment or gift expense, the
business relationship to the taxpayer of each expense incurred. For
“listed property” expenses, the taxpayer must establish the amount of
business use and the amount of total use for such property. See Temp.
Treas. Reg. § 1.274-5T(b)(6)(i)(B).

       Substantiation by adequate records requires the taxpayer to
maintain an account book, a diary, a log, a statement of expense, trip
sheets, or a similar record prepared contemporaneously with the
expenditure and documentary evidence (e.g., receipts or bills) of certain
expenditures. Treas. Reg. § 1.274-5(c)(2)(iii); Temp. Treas. Reg. § 1.274-
5T(c)(2). Substantiation by other sufficient evidence requires the
production of corroborative evidence in support of the taxpayer’s
statement specifically detailing the required elements. Temp. Treas.
Reg. § 1.274-5T(c)(3).
                                    8

      A.     Tips and other payments to various individuals

       According to petitioners, they are entitled to deductions for
payments petitioner made to other McKenna employees, large volume
buyers, and assistant used car auctioneers. It would seem that some of
the payments would have violated the BMW program, and we question
whether petitioner would have made those payments, considering the
consequences that could have resulted.         As to other payments,
petitioners have failed to substantiate some of the amounts they now
claim or otherwise to establish that the expenses related to petitioner’s
employment with McKenna or to the income petitioner received from
BMW or Devex. However, under the circumstances, we find that
petitioner paid tips to certain McKenna employees and used car
auctioneers and that the tips were ordinary and necessary business
expenses. After a careful review of the evidence, and as best we can
estimate from what has been submitted, we find that petitioners are
entitled to deduct $2,840 for tips and similar payments. See Cohan v.
Commissioner, 39 F.2d 540, 543–44 (2d Cir. 1930).

      B.     Advertising, taxes and licenses, and legal and professional
             services expenses

       Petitioners claim deductions of $4,233, $398, and $1,257 for
advertising, taxes and licenses, and legal and professional services
expenses, respectively. Other than petitioner’s generalized testimony
that he incurred expenses for advertising, there is nothing in the record
connecting advertising expenses with any of the substantiating
documents (e.g., credit card and bank statements) petitioners provided.
Petitioners offered no explanation for the deductions for taxes and
licenses and legal and professional services expenses.

       Petitioners have failed to either substantiate these deductions or
offer sufficient specific testimony to allow for deductions. Accordingly,
petitioners are not entitled to deduct advertising, taxes and licenses, and
legal and professional services expenses.

      C.     Expenses for travel, car and truck, and rent or lease of other
             business property

       Petitioners claim deductions of $82 for travel expenses, $5,320 for
car and truck expenses, and $2,311 for rent or lease of other business
property. These deductions relate to the use of petitioner’s BMW X3 in
his employment as a corporate/VIP sales manager for McKenna.
Petitioners did not explain, and it is not otherwise clear, how the
                                   9

deductions were calculated, i.e., whether by actual expenses or the
standard mileage rate. As best we can determine, the deductions
include the costs of mileage, car insurance, gas, and the lease.

       Petitioners prepared a noncontemporaneous mileage log showing
petitioner’s use of his leased BMW X3 during 2014. Petitioners’ mileage
log does not show a beginning destination, nor does it state the business
purpose of the use of the automobile, as required under Temporary
Treasury Regulation § 1.274-5T(b)(6). Nonetheless, petitioners’ mileage
log substantially complies with the “adequate records” requirement of
the regulations; to the extent their log is deficient, they have provided
corroborative evidence sufficient to establish the required elements. See
Treas. Reg. § 1.274-5(c)(2)(iii); Temp. Treas. Reg. § 1.274-5T(c)(2).

      We have reviewed the evidence and compared the mileage log
with McKenna’s commission list records and petitioners’ credit card and
bank statements. Taking into account petitioner’s personal use of the
BMW X3 and the extent to which petitioners have properly
substantiated expenses for travel, car and truck, and rent or lease of
other business property, we find that petitioners are entitled to deduct
$12,000 attributable to actual expenses.

      D.     Home office

     Petitioners claim that they are entitled to a $241 deduction for
home office expenses in connection with petitioner’s employment with
McKenna or the income he earned from BMW or Devex.

       In general, a taxpayer is entitled to a deduction for expenses
attributable to a portion of the taxpayer’s residence if that portion is
used (1) exclusively on a regular basis as (2) the taxpayer’s principal
place of business or (3) a place for meeting with customers, clients, or
patients in the normal course of the business. See § 280A(c)(1)(A) and
(B); see also Commissioner v. Soliman, 506 U.S. 168, 172–73 (1993).
Petitioners have failed to establish that these requirements have been
satisfied in connection with petitioner’s employment with McKenna or
the income he earned from BMW or Devex. Accordingly, petitioners are
not entitled to deduct home office expenses.

      E.     Supplies

       Petitioners now claim that they are entitled to a $2,937 deduction
for supplies. Our review of petitioners’ credit card and bank statements
shows that petitioners paid $2,768 for supplies related to petitioner’s
                                   10

employment with McKenna during the year in issue.            Accordingly,
petitioners are entitled to deduct $2,768 for supplies.

      F.     Meals and entertainment

       Petitioners claim that they are entitled to a $1,019 deduction for
meals and entertainment. According to petitioners, this deduction
relates to amounts petitioner paid for meals to entertain clients and
brokers.

       With respect to meals paid to entertain clients, a taxpayer must
provide records sufficient to establish (1) the amount paid for each meal,
(2) the date of the meal, (3) the name and address of the dining
establishment, (4) the business purpose of the meal, including the
nature of any business discussion, and (5) the business relationship of
the person entertained by the taxpayer. See § 274(d); Stroff v.
Commissioner, T.C. Memo. 2011-80; Temp. Treas. Reg. § 1.274-5T(b)(3).

       Petitioners’ spreadsheet suggests, and their credit card and bank
statements confirm, that petitioner paid $6,421.64 for meals during the
year in issue. To the extent these payments were for meals with clients
or brokers, the substantiating documents do not provide a business
purpose for the expenses or a business relationship with the person
entertained. Therefore, petitioners are not entitled to deduct meals and
entertainment expenses.

      G.     Other expenses

       Petitioners claim that they are entitled to deduct $9,509 for other
expenses attributable to promotion ($2,219), accounting ($750),
telephone ($2,781), internet ($811), security ($480), and small tools
($2,468). Petitioner did not offer explanation or evidence of the
promotion, accounting, security, and small tools expenses. Petitioner
did, however, offer some evidence of telephone and internet expenses.

       Petitioner used his cell phone, home phone, and internet for both
business and personal purposes. Our review of petitioners’ credit card
and bank statements, along with statements from petitioners’ telephone
and internet providers, shows that petitioners paid $1,800.60 for cell
phone expenses, $239.88 for home phone expenses, and $599.88 for
internet expenses during the year in issue. Considering all the
circumstances, we conclude that the costs of the cell phone, home phone,
and internet were ordinary and necessary business expenses related to
petitioner’s employment with McKenna and/or the income he earned
                                   11

from BMW or Devex. We further find that 50% of services to which the
expenses relate were ordinary and necessary business expenses. As a
result, petitioners are entitled to deduct $1,320.18 for “other expenses.”
See Cohan v. Commissioner, 39 F.2d at 543–44.

      To reflect the foregoing,

      Decision will be entered under Rule 155.