Court Opinion

ID: 4526361
Source: CourtListenerOpinion
Date Created: 2020-04-17 05:01:33.062668+00
Date Added: 2024-06-11T08:43:31.079048
License: Public Domain

T.C. Memo. 2020-48

                        UNITED STATES TAX COURT

        HENRY C. WILLIAMS AND SONJA L. JOHNSON, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

      Docket Nos. 22528-14, 8947-15,              Filed April 16, 2020.
                  23676-16.

      Joseph M. Bray, Sandeep Singh, and Clifford A. Capdevielle, for

petitioners.

      Jeffery D. Rice and Janice B. Geier, for respondent.
                                        -2-

[*2]        MEMORANDUM FINDINGS OF FACT AND OPINION

       VASQUEZ, Judge: In these consolidated cases respondent determined

deficiencies in petitioners’ Federal income tax and section 6662(a)1 accuracy-

related penalties as follows:

                                                                  Penalty
           Year                     Deficiency                  sec. 6662(a)

           2010                       $62,050                     $12,410
           2011                        29,583                        ---
           2013                       142,004                      28,401
           2014                       166,778                      33,356

       1
         All section references are to the Internal Revenue Code in effect for the
years at issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure.
                                          -3-

[*3] After concessions,2 the issues for decision are whether petitioners:

(1) failed to report $5,936 of short-term capital gain income for 2014, (2) are

entitled to deductions claimed on Schedules C, Profit or Loss From Business, for

the years at issue, and (3) are liable for the 10% additional tax on early

distributions from qualified retirement plans for 2010 and 2011.

                                FINDINGS OF FACT

      Some of the facts have been stipulated and are so found. We incorporate

the first stipulation of facts, first supplemental stipulation of facts, and

      2
          These cases were tried in San Francisco, California. A substantial amount
of trial time pertained to respondent’s disallowance of petitioners’ rental real
estate losses for the years at issue. Respondent has since conceded that petitioners
are entitled to deduct $47,944, $49,994, $66,411, and $74,270 as nonpassive
losses for 2010, 2011, 2013, and 2014, respectively. Respondent’s concession for
2010 is $50 less than the amount disallowed in the deficiency notice. Because this
discrepancy is not addressed in respondent’s simultaneous opening brief, we
conclude this is an error and that respondent concedes $47,994 for 2010.
        Respondent also concedes on brief that petitioners: (i) did not have
unreported capital gain income for 2013, (ii) did not fail to report short-term
capital gain income of $63,566, (iii) did not fail to report $131 of taxable qualified
dividends for 2010 and $10 of taxable interest from the State of California for
2011, and (iv) are not liable for sec. 6662(a) accuracy-related penalties for 2010,
2013, and 2014. Petitioners concede that they received taxable retirement income
of $71,625 and $42,858 in 2010 and 2011, respectively.
        For some of the issues that remain in dispute, the parties have made partial
concessions, which we address in the body of this opinion. Other adjustments are
computational and will be resolved under Rule 155.
                                          -4-

[*4] accompanying exhibits by this reference. Petitioners resided in California

when they timely filed their petitions.

Petitioner Husband’s Background

      Petitioner husband started working for Washington Mutual Insurance Co.

(Washington Mutual) in 2003. As regional manager he oversaw the sales of

insurance and commercial banking products. In 2008 Washington Mutual merged

into J.P. Morgan Chase Bank (J.P. Morgan), which retained petitioner husband as

part of a transition team to integrate the two businesses. J.P. Morgan relieved

petitioner husband of his responsibilities in January 2010. Although his official

termination date was June 2010, petitioner husband did not perform services for

J.P. Morgan after January 2010.

GSE Financial

      In 2007 petitioner husband formed GSE Financial (GSE) as a sole

proprietorship. Petitioner husband intended for GSE to operate as a holding

company for insurance businesses he hoped to acquire. In 2010 petitioner

husband’s sole focus with respect to GSE was expansion. Petitioner husband

spent his GSE-related time pursuing deals with several potential targets. In late

December 2010 petitioner husband purchased an interest in one of those targets,

insurance brokerage firm Bernall & Jones. Thereafter, beginning in January 2011,
                                       -5-

[*5] GSE provided business development, marketing, and other support to the

newly acquired firm.

      In 2010, 2011, and 2013 GSE engaged law firms Donahue, Gallagher &

Woods and Michelman & Robinson. These firms provided legal advice and

counsel pertaining to licensing, State insurance requirements, acquisitions, and

business planning.

      GSE leased office space in Oakland, California, during the years at issue.

During 2014 petitioner husband paid $677 for that office space.

      In 2013 petitioner husband paid $4,465 for GSE-related taxes and licensing

fees, postage, bank charges, printing, telephone, and internet. Petitioner husband

also paid $390 for supplies used in connection with his GSE-related activities. In

2014 petitioner husband paid $289 for GSE-related online marketing efforts.

      Petitioners reported GSE’s expenses on Schedules C for 2010 and 2011.

For 2013 and 2014 they reported GSE’s expenses on Schedules C2. GSE’s

reported expenses are summarized below:
                                         -6-

[*6]              Expense                2010      2011        2013        2014
       Meals and entertainment          $1,531    $1,161       $563        $346
       Rent/lease--Other business
        property                          4,140    7,500        533         ---
       Depreciation                       1,600      ---     33,875         ---
       Other                              1,707    5,262       4,945        ---
       Car and truck                      3,600    5,327       5,506        ---
       Legal and professional           12,204     1,000        850         ---
       Travel                           14,785     8,489       3,465        401
       Supplies                           ---        ---        390         ---
       Interest                           ---        ---       4,532        ---
       Office                             ---        ---         ---        677
       Advertising                        ---        ---         ---        289

         In the notices of deficiency respondent disallowed some of the above-listed

deductions for 2011 and all of the deductions for 2010, 2013, and 2014. We set

forth infra p. 24 the specific deductions (or portions thereof) that respondent

disallowed for 2011.

BJW Insurance LLC

         Founded by Rob Jones and Chris Bernall in 1992, Bernall & Jones was a

surplus line commercial insurance brokerage firm that provided commercial

property liability, general liability, errors and omissions, and other commercial

lines of insurance. Petitioner husband was interested in acquiring the firm because
                                         -7-

[*7] it had an established staff capable of handling its daily operation. Bernall &

Jones’ staff had extensive knowledge of the customer base, the accounts, and other

aspects of the business.

      Petitioner husband paid $320,000 for an ownership interest in Bernall &

Jones in late December 2010. After the sale Bernall & Jones was renamed BJW

Insurance LLC (BJW). Mr. Jones and Mr. Bernall remained partners in the firm

during the 2011 tax year. In 2012 petitioner husband became the sole owner of

BJW, which continued to operate as a single-member limited liability company.

      During 2013 and 2014 BJW employed as its office manager Kendra

Thompson, who assisted existing customers and handled office duties including

sales, billing, accounting, and all portfolio work for the company. In 2013 BJW

also employed Gregory Wessel, who assisted customers and solicited sales. The

following year BJW employed Michael Johnson, who assisted Ms. Thompson with

customer relations, marketing, and various administrative duties. During 2014

petitioner husband paid wages of $58,000 and $7,209 to Kendra Thompson and

Michael Johnson, respectively.

      During 2013 petitioner husband (on behalf of BJW) paid $12,723 for

individual sales licenses, California and other local taxes, and entity licensing fees.

During 2014 petitioner husband (on behalf of BJW) paid legal and professional
                                        -8-

[*8] fees of $2,979. That year BJW lost several accounts, forcing petitioner

husband to take out several short-term, high-interest loans to keep the company

afloat. As a result, petitioner husband (on behalf of BJW) paid interest of

$28,181.

      For 2011 BJW filed a partnership return, and petitioners reported a

nonpassive loss from BJW on a Schedule E, Supplemental Income and Loss, for

that year. Petitioners reported BJW’s income and expenses on Schedules C1 for

tax years 2013 and 2014.3 BJW’s reported Schedule C1 expenses are summarized

below:

      3
         With respect to these tax years, respondent does not dispute that BJW was
a disregarded entity under secs. 301.7701-2(c)(2)(i) and 301.7701-3(b)(1)(ii),
Proced. & Admin. Regs. The income and expenses of a disregarded entity are
usually reflected on a Schedule C.
                                       -9-

[*9]                      Expense              2013        2014
             Other                            $7,020        ---
             Wages                            55,984     $68,686
             Meals and entertainment             270       2,489
             Travel                            1,410       2,456
             Taxes and licenses               12,723      15,317
             Rent/lease                       20,097      21,135
             Legal and professional            2,234       2,979
             Interest                          3,109      28,181
             Insurance                        10,634      17,070
             Commissions and fees            112,432     125,952
             Utilities                           ---        5,239
             Office                              ---       3,060
             Depreciation                        ---      36,179
             Car and truck                       ---         756
             Repairs and maintenance             ---              71
             Advertising                         ---         435

Respondent disallowed all of the above-listed deductions in the notice of

deficiency for 2013 and 2014.

Withdrawals From Retirement Accounts

       In 2010 and 2011 petitioners withdrew $71,625 and $42,858, respectively,

from their retirement accounts. On their 2010 return petitioners reported that they
                                         - 10 -

[*10] received $50,275 in pension and annuity distributions but asserted the

distributions were nontaxable because they were “used to fund their children’s

qualified higher education expenses”. Petitioners reported $49,259 in pension and

annuity distributions on their 2011 return but treated the distributions as

nontaxable for the same reason as for 2010.

      Respondent determined that petitioners had taxable retirement income of

$71,625 and $42,858 for 2010 and 2011, respectively. For 2010 respondent

determined an additional tax of $7,162 under section 72(t). Respondent

determined a section 72(t) additional tax of $1,702 for 2011 after subtracting

amounts petitioners used for higher education expenses. Petitioners concede that

their retirement distributions were taxable but contest their liability for the

additional tax under section 72(t).

Stock Options

      During 2013 and 2014 petitioner wife was an employee of TW Telecom

Holdings (TW Telecom). Her compensation included salary, commission income,

and stock options that she exercised in 2013 and 2014.

      TW Telecom provided petitioner wife Forms W-2, Wage and Tax

Statement, reporting wages of $236,970 and $353,365 for 2013 and 2014,

respectively. For 2014 her Form W-2 wages comprised, among other forms of
                                        - 11 -

[*11] compensation, $63,566 for the exercise of the stock options that year.

Petitioners reported petitioner wife’s Form W-2 income on their 2014 income tax

return. Petitioner wife received $69,502 in gross proceeds from the sale of

securities in 2014. E Trade Clearing LLC (E Trade) issued several Forms 1099-B,

Proceeds From Broker and Barter Exchange Transactions, for 2014 reporting that

petitioner wife received those gross proceeds and stating that she had a basis of

zero in the securities sold. In the notice of deficiency for 2014, respondent relied

on the Forms 1099-B to determine that petitioners had unreported short-term

capital gain income of $69,502.4 As discussed below, respondent now alleges that

petitioners failed to report only $5,936 of that amount.

                                     OPINION

I.    Short-Term Capital Gain Adjustment

      We first address whether petitioners had, as respondent now alleges,

unreported short-term capital gain income of $5,936 for 2014. As a general rule,

the Commissioner’s determination of a taxpayer’s liability in a notice of

deficiency is presumed correct, and the taxpayer bears the burden of proving that

      4
         Respondent also determined that petitioners had unreported short-term
capital gain income of $25,833 on the basis of a 2013 Form 1099-B issued by E
Trade. On brief respondent concedes this adjustment.
                                       - 12 -

[*12] the determination is incorrect.5 Rule 142(a); Welch v. Helvering, 290 U.S.

111, 115 (1933).

      In the Court of Appeals for the Ninth Circuit, to which an appeal of these

cases presumably would lie absent a stipulation to the contrary, see sec.

7482(b)(1)(A), (2), the presumption of correctness does not attach in cases

involving unreported income unless the Commissioner first establishes an

evidentiary foundation linking the taxpayer to the alleged income-producing

activity, see Weimerskirch v. Commissioner, 596 F.2d 358, 361-362 (9th Cir.

1979), rev’g 67 T.C. 672 (1977). The requisite evidentiary foundation is minimal

and need not include direct evidence. See Rapp v. Commissioner, 774 F.2d 932,

935 (9th Cir. 1985); Banister v. Commissioner, T.C. Memo. 2008-201, aff’d, 418

F. App’x 637 (9th Cir. 2011).

      Respondent established the requisite evidentiary foundation linking

petitioners to an income-producing activity. Petitioners stipulated that petitioner

      5
         Sec. 7491(a) provides that if, in any court proceeding, a taxpayer
introduces credible evidence with respect to any factual issue relevant to
ascertaining the liability of the taxpayer for any tax imposed by subtit. A or B and
meets other prerequisites, the Commissioner shall have the burden of proof with
respect to that issue. See Higbee v. Commissioner, 116 T.C. 438, 440-441 (2001).
Because we resolve these cases on the preponderance of the evidence and without
regard to the burden of proof, we do not decide whether sec. 7491(a) applies here.
                                        - 13 -

[*13] wife received $69,502 in gross proceeds from the sale of securities in 2014.

This amount matches the amount reported by E Trade on the Forms 1099-B.6

      Petitioners contend that the proceeds reported on the Forms 1099-B were

included in petitioner wife’s reported Form W-2 income. Respondent now

concedes this issue to the extent of $63,566. This concession leaves in dispute

$5,936, which is the difference between the amount reported on the Forms 1099-B

($69,502) and the amount respondent conceded ($63,566).

      Petitioners stipulated that petitioner wife received the $5,936, and the record

does not show that this amount was reported on the return as an amount

attributable to the exercise of petitioner wife’s stock options.7 The record,

      6
         Under sec. 6201(d), if a taxpayer asserts a reasonable dispute with respect
to an item of income reported on an information return filed by a third party and
the taxpayer meets certain other requirements, the Commissioner bears the burden
of producing reasonable and probative evidence, in addition to the information
return, concerning the deficiency attributable to the income item. Assuming
arguendo that respondent bears the burden of production under sec. 6201(d), we
find that respondent has satisfied it.
      7
         We understand the parties to agree that the stock options at issue were
nonqualified stock options. If a nonqualified stock option does not have a readily
ascertainable fair market value at the time of the grant, the exercise of the option
gives rise to gross income at the time of the exercise, equal to the amount by
which the fair market value of the stock at the exercise date exceeds the option
price. Sec. 83(a); Tanner v. Commissioner, 117 T.C. 237, 246 (2001), aff’d, 65 F.
App’x 508 (5th Cir. 2003); Svoboda v. Commissioner, T.C. Memo. 2006-235, slip
op. at 8; sec. 1.83-7(a), Income Tax Regs. The stock received upon the exercise of
                                                                         (continued...)
                                        - 14 -

[*14] therefore, does not support our finding, and we decline to find, that the

exercise of the stock options resulted in a basis sufficient to offset the disputed

gross proceeds of the same amount. Nor does the record show that the $5,936 is

not taxable for another reason. We therefore hold that petitioners have unreported

short-term capital gain income of $5,936 for 2014.

II.   Deductions

      Deductions are a matter of legislative grace, and taxpayers generally bear

the burden of proving that they have met all requirements to be entitled to any

deductions claimed. See 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).

Taxpayers generally must maintain sufficient records to enable the Commissioner

to determine their correct tax liability. Sec. 6001.

      Section 162 generally allows a deduction for ordinary and necessary

expenses paid or incurred during the taxable year in carrying on a trade or

business. Such expenses must be directly connected with or pertain to the

taxpayer’s trade or business. Sec. 1.162-1(a), Income Tax Regs. Generally, no

      7
        (...continued)
the option generally has an adjusted basis equal to the option price plus any
amount includible in gross income as a result of the option exercise, and any gain
or loss computed on the sale of that stock takes that basis into account. See
Svoboda v. Commissioner, slip op. at 9.
                                        - 15 -

[*15] deduction is allowed for personal, living, or family expenses, nor is a

deduction proper for expenditures that are properly categorized as capital

expenditures. See secs. 262 and 263. The determination of whether an

expenditure satisfies the requirements of section 162 is a question of fact.

Commissioner v. Heininger, 320 U.S. 467, 475 (1943).

      When a taxpayer establishes that he incurred deductible expenses but is

unable to substantiate the exact amounts, we can estimate the deductible amounts,

but only if the taxpayer presents sufficient evidence to establish a rational basis for

making the estimate. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir.

1930); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). In estimating the

amount allowable, we bear heavily against the taxpayer whose inexactitude is of

his own making. See Cohan v. Commissioner, 39 F.2d at 544.

      Section 274(d) imposes strict substantiation requirements for travel,

entertainment, gift, and listed property (including passenger automobiles)

expenses. Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d per curiam,

412 F.2d 201 (2d Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax Regs., 50

Fed. Reg. 46014 (Nov. 6, 1985). Under section 274(d), the taxpayer generally

must substantiate either by adequate records or by sufficient evidence

corroborating the taxpayer’s own statement: (1) the amount of the expense; (2) the
                                        - 16 -

[*16] 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 the property. See sec. 1.274-5T(b)(6)(i)(B), Temporary Income

Tax Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985).

      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. Sec. 1.274-5(c)(2)(iii), Income Tax

Regs.; sec. 1.274-5T(c)(2), Temporary Income Tax Regs., 50 Fed. Reg. 46017

(Nov. 6, 1985). Substantiation by other sufficient evidence requires the

production of corroborative evidence in support of the taxpayer’s statement

specifically detailing the required elements. Sec. 1.274-5T(c)(3), Temporary

Income Tax Regs., 50 Fed. Reg. 46020 (Nov. 6, 1985).

      A.     GSE

      For 2010 and 2011 respondent argues that petitioners’ GSE-related

expenditures are nondeductible startup expenses under section 195. Respondent

also contends that petitioners failed to substantiate many of GSE’s reported
                                        - 17 -

[*17] expenses. With respect to 2013 and 2014, the parties agree that GSE was an

active trade or business. However, respondent contends that petitioners failed to

substantiate many of GSE’s reported expenses.

             1.     Startup Expenses

      We first consider whether GSE’s 2010 and 2011 expenditures should be

classified as nondeductible startup expenses under section 195.

      To qualify for deduction under section 162 or 212, expenses must be

associated with a trade or business or other income-producing activity that is

functioning as a going concern. See Woody v. Commissioner, T.C. Memo.

2009-93, aff’d, 403 F. App’x 519 (D.C. Cir. 2010); Glotov v. Commissioner, T.C.

Memo. 2007-147; Walsh v. Commissioner, T.C. Memo. 1988-242, aff’d without

published opinion, 884 F.2d 1393 (6th Cir. 1989). Although a taxpayer may be

committed to entering into a business and invest considerable time and money in

preparing to do so, the activity does not constitute a trade or business for section

162(a) purposes until the business is actually functioning and performing the

activities for which it was organized. Richmond Television Corp. v. United

States, 345 F.2d 901, 907 (4th Cir. 1965), vacated and remanded on other grounds,

382 U.S. 68 (1965); see also Glotov v. Commissioner, T.C. Memo. 2007-147.

Business operations with respect to the activity must have actually commenced.
                                        - 18 -

[*18] See McKelvey v. Commissioner, T.C. Memo. 2002-63, aff’d, 76 F. App’x

806 (9th Cir. 2003). “Until that time, expenses related to that activity are not

‘ordinary and necessary’ expenses currently deductible under section 162 (nor are

they deductible under section 212) but rather are ‘start-up’ or ‘pre-opening’

expenses.” Woody v. Commissioner, slip op. at 9-10.

      Section 195(a) provides the general rule that no current deduction shall be

allowed for startup expenditures. Section 195(c)(1) defines a “start-up

expenditure” as:

             (1) * * * any amount--

                   (A) paid or incurred in connection with--

                          (i) investigating the creation or acquisition of an
                   active trade or business, or

                          (ii) creating an active trade or business, or

                          (iii) any activity engaged in for profit and for the
                   production of income before the day on which the active
                   trade or business begins, in anticipation of such activity
                   becoming an active trade or business, and

                    (B) which, if paid or incurred in connection with the
             operation of an existing active trade or business (in the same field
             as the trade or business referred to in subparagraph (A)), would be
             allowable as a deduction for the taxable year in which paid or
             incurred.
                                        - 19 -

[*19] However, under section 195(b)(1)(A), a taxpayer may elect to deduct for the

taxable year in which the active trade or business begins up to $5,000 of startup

expenditures, reduced by the amount by which those expenditures exceed $50,000.

The remainder is allowable as a deduction ratably over the 180-month period

beginning with the month in which the active trade or business begins. Sec.

195(b)(1)(B). This election must be made no later than the time prescribed for

filing the return for the taxable year in which the trade or business begins. Sec.

195(d)(1). Section 1.195-1(b), Income Tax Regs., provides that a “taxpayer is

deemed to have made an election under section 195(b) to amortize start-up

expenditures as defined in section 195(c)(1) for the taxable year in which the

active trade or business to which the expenditures relate begins.”8 A taxpayer may

forgo this deemed election by affirmatively electing to capitalize startup

expenditures on a timely filed return for that year. Sec. 1.195-1(b), Income Tax

Regs.

        8
         This regulation applies to startup expenditures paid or incurred after
August 16, 2011. Sec. 1.195-1(d), Income Tax Regs. Taxpayers may apply the
final regulation to expenses paid or incurred after October 22, 2004, provided the
applicable limitations period has not expired for the year the sec. 195 election is
deemed made. Sec. 1.195-1(d), Income Tax Regs. A nearly identical temporary
regulation applies to expenditures paid or incurred after September 8, 2008. See
sec. 1.195-1T(b), (d), Temporary Income Tax Regs., 73 Fed. Reg. 38913 (July 8,
2008).
                                        - 20 -

[*20] Respondent contends that section 195 applies because GSE’s only activity

during 2010 and 2011 was pursuing target companies it did not actually purchase.

Respondent also asserts that GSE did not report income until 2013 when it shifted

its business purpose from acquiring target companies to providing support to

BJW. Petitioners counter that GSE was operational in 2010 and 2011, performing

its trade or business of providing support to BJW.

      At trial petitioner husband credibly testified that his GSE-related activities

in 2010 involved the pursuit of three target entities. He recalled at trial: “[W]e

were meeting with our lawyers. We were meeting with business people. Fully

engaged with seeking to acquire established companies to merge the operations.”

Because GSE’s only activity in 2010 was the pursuit of potential targets,

petitioners’ GSE-related expenditures were paid in connection with “investigating

the creation or acquisition of an active trade or business”. See sec. 195(c)(1).

Accordingly, for 2010 petitioners are not entitled to deductions for their GSE-

related expenses. See sec. 195(a).

      With respect to 2011, petitioner husband credibly testified that he purchased

an interest in a brokerage firm called Bernall & Jones in late December 2010. He

also credibly testified that he had always intended for GSE to provide support and

services to his other companies. GSE provided business development, marketing,
                                        - 21 -

[*21] and other support to the acquired firm after the December 2010 purchase.

Because GSE started performing services for which it was intended after

December 2010, we find that GSE’s active trade or business began in January

2011. See Richmond Television Corp., 345 F.2d at 907. Therefore, section

195(a) does not prohibit petitioners from deducting GSE-related expenditures for

2011.

        On their 2011 return petitioners did not make an affirmative election to

capitalize their startup expenditures. Accordingly, pursuant to section 1.195-1(b),

Income Tax Regs., petitioners are deemed to have made the election to amortize

startup expenditures under section 195(b) for 2011.

              2.    2010 Expenses

        Because petitioners are deemed to have made the election to amortize

startup expenses under section 195(b), we must determine the amount of

petitioners’ GSE-related startup expenses for 2010. In the table below, we

summarize the expenses reported on petitioners’ 2010 Schedule C, the amounts

disallowed in the deficiency notice, the amounts respondent concedes on brief, and

the amounts still at issue.
                                            - 22 -

[*22]          Item                 Reported         Disallowed   Conceded   At issue

 Meals and entertainment              $1,531          $1,531         ---     $1,531
 Rent/lease                            4,140           4,140       $3,372       768
 Depreciation                          1,600           1,600         ---      1,600
 Other expenses                        1,707           1,707        1,707       ---
 Car and truck                         3,600           3,600         ---      3,600
 Legal and professional               12,204          12,201       12,201       ---
 Travel                               14,785          14,785       14,785       ---

                      i.     Meals and Entertainment

        The strict substantiation requirements of section 274(d) apply to this

expense. Petitioners provided no document that qualifies as an adequate record

within the meaning of section 274(d) and no other corroborative evidence

sufficient to satisfy the requirements of that section. We therefore hold that

petitioners failed to substantiate GSE’s reported meal and entertainment expenses.

                      ii.    Rent/Lease

        The record does not establish that GSE had rental expenses in excess of the

amount respondent has conceded. On the basis of respondent’s concession, we

hold that petitioners substantiated rent/lease expenses of $3,372.

                      iii.   Depreciation

        Petitioner husband credibly testified that GSE’s deduction for depreciation

comprised amounts paid for office equipment and a 1996 Jetta. The latter is a

passenger automobile that falls within the definition of listed property under
                                         - 23 -

[*23] section 280F(d)(4) and (5). Therefore, petitioners’ depreciation deduction

for this vehicle is subject to the strict substantiation requirements of section

274(d).

      Petitioners provided no document that qualifies as an adequate record

within the meaning of section 274(d) and no other corroborative evidence

sufficient to satisfy the requirements of that section. Furthermore, because we do

not know how much of the depreciation deduction is attributable to the

automobile, we have no basis to make an estimate with respect to the office

equipment.

      Consequently, although we found petitioners’ testimony credible, we have

no choice but to hold that they failed to substantiate GSE’s reported depreciation

expenses.9

                    iv.    Car and Truck

      For the reasons explained supra part II(A)(2)(iii), we hold that petitioners

failed to substantiate GSE’s reported car and truck expenses.

      9
        We decide this issue as framed by the parties. Given our holding, the
Court need not decide the interplay (if any) between secs. 167 and 195.
                                        - 24 -

[*24]                 v.   Conclusion

        On the basis of respondent’s concessions and our review of the record, we

find that petitioners substantiated GSE-related startup expenses of $32,065.

Petitioners are entitled to a deduction of $5,000 for 2011 and may amortize the

remaining balance of $27,065. See sec. 195(b)(1). This balance is deductible

ratably over the 180-month period beginning with January 2011, which was the

month in which GSE’s active trade or business began, absent an earlier complete

disposition of GSE’s business. See sec. 195(b)(1) and (2).

              3.      2011 Schedule C Deductions

        The table below summarizes the expenses reported on petitioners’ 2011

Schedule C,10 the amounts disallowed in the deficiency notice, the amounts

respondent concedes on brief, and the amounts still at issue. Respondent contends

petitioners have not substantiated the amounts listed below:

               Item                Reported      Disallowed    Conceded   At issue

 Legal and professional             $1,000          $407          ---        $407
 Travel                              8,489          1,054         ---        1,054

        10
         Petitioners claimed several other Schedule C deductions that respondent
did not adjust in the deficiency notice. We do not include those items.
                                         - 25 -

[*25]                i.    Legal and Professional Services

        At trial petitioner husband credibly testified that GSE hired several

attorneys throughout the years at issue. Those attorneys provided legal advice and

counsel pertaining to licensing, State insurance requirements, acquisitions, and

business planning. Petitioner husband also credibly testified that the amount

reported on the Schedule C for 2011 was correct as to the portion of the legal fees

that related to GSE’s business.

        On the basis of petitioner husband’s credible testimony, we hold that

petitioners are entitled to a Schedule C deduction of $1,000 for legal and

professional services.

                     ii.   Travel

        The strict substantiation requirements of section 274(d) apply to travel

expenses. To substantiate $1,054 of travel expenses disallowed by respondent,

petitioners submitted airline itineraries and a construction risk management

conference schedule. These documents do not do not state the amounts petitioners

expended and therefore fail to satisfy section 274(d). Accordingly, we sustain

respondent’s determination with respect to this issue.
                                       - 26 -

[*26]         4.      2013 Schedule C2 Deductions

        The table below summarizes the expenses reported on petitioners’ 2013

Schedule C2, the amounts disallowed in the deficiency notice, the amounts

respondent concedes on brief, and the amounts still at issue. Respondent contends

that petitioners have not substantiated the amounts listed below:

               Item                Reported     Disallowed   Conceded     At issue

 Other expenses                     $4,945       $4,945         ---        $4,945
 Meals and entertainment               563          563         ---           563
 Travel                              3,465        3,465         ---         3,465
 Supplies                              390          390         ---           390
 Rent/lease                            533          533         ---           533
 Legal and professional                850          850         ---           850
 Interest                            4,532        4,532         ---         4,532
 Depreciation                       33,875       33,875         ---        33,875
 Car and truck                       5,506        5,506          ---        5,506

                      i.   Other Expenses

        We have found that in 2013 petitioner husband, on behalf of GSE, paid

$4,465 for taxes and licensing fees, postage, bank charges, printing, telephone,
                                        - 27 -

[*27] and internet.11 Accordingly, we hold that petitioners are entitled to a

deduction of $4,465 for other expenses.

                   ii.    Meals and Entertainment

      For the reasons explained supra part II(A)(2)(i), petitioners failed to satisfy

the substantiation requirements of section 274(d). Accordingly, they are not

entitled to a deduction for meals and entertainment.

                   iii.   Travel

      To substantiate $3,465 of travel expenses disallowed by respondent,

petitioners submitted airline itineraries. These documents do not substantiate the

amounts or business purposes of the reported expenses. Because petitioners have

failed to satisfy the substantiation requirements of section 274(d), we sustain

respondent’s disallowance of this deduction.

                   iv.    Supplies

      Petitioner husband credibly testified that this deduction comprised expenses

for office and computer supplies. We find petitioner husband’s testimony to be

credible evidence that petitioners paid $390 for GSE-related office and computer

      11
         The difference between the amount reported and the amount we allow is
$480. This amount pertains to a charitable donation that petitioners failed to
substantiate. See sec. 170(f)(8)(A) (requiring the donor to obtain a
contemporaneous written acknowledgment of the donation from the donee for
contributions of cash or property over $250).
                                         - 28 -

[*28] supplies. Accordingly, we hold that petitioners are entitled to a deduction of

$390 for supplies.

                     v.     Rent/Lease

      Petitioner husband testified that this reported expense was for

“miscellaneous equipment”. However, he did not specify how this expense

pertained to GSE’s trade or business. We therefore sustain respondent’s

disallowance of this deduction.

                     vi.    Legal and Professional

      For the reasons explained supra part II(A)(3)(i), we hold that petitioners are

entitled to a deduction of $850 for legal and professional services.

                     vii.   Interest

      Petitioner husband testified that the reported interest expense was erroneous

and should have been reported on their Schedule C1 for BJW. However, on their

Schedule C1 for BJW, petitioners claimed an interest deduction of $3,109, which

respondent concedes on brief. Petitioners did not present any testimony or other

evidence to substantiate additional interest expenses. We therefore sustain

respondent’s disallowance of this deduction.
                                         - 29 -

[*29]               viii. Depreciation

        At trial petitioner husband explained that the placement of this deduction on

the Schedule C2 for GSE was in error because the deduction pertains to BJW.

According to petitioners, the reported depreciation expense represents the

amortization of goodwill from the purchase of Bernall & Jones for $320,000 at the

end of December 2010.

        Section 167(a) provides for depreciation of property used in a trade or

business or held for the production of income. Under section 1.167(a)-3(a),

Income Tax Regs., “[n]o deduction for depreciation is allowable with respect to

goodwill.” However, section 197 provides for the amortization of the acquisition

cost of certain intangibles, including goodwill, over a fixed 15-year period. Sec.

197(a), (d)(1)(A). An amortizable section 197 intangible includes any section 197

intangible acquired by a taxpayer after August 10, 1993, and held in connection

with the conduct of a trade or business. Sec. 197(c)(1). For purposes of

depreciation and amortization, a taxpayer’s basis in purchased property is the cost,

including any valid liabilities incurred in acquiring the property. Crane v.

Commissioner, 331 U.S. 1, 9-11 (1947).

        Respondent’s sole argument with respect to this deduction is that petitioners

failed to substantiate the purchase price and the amount allocable to goodwill.
                                       - 30 -

[*30] However, petitioner husband credibly testified that the purchase price was

$320,000. He also credibly testified that Bernall & Jones (which was renamed

BJW) did not have any tangible assets of value when he purchased it. Instead the

insurance firm had an established staff with extensive knowledge of the customer

base, the accounts, and other aspects of the business.

      On the basis of petitioner husband’s credible testimony, we find that the

$320,000 purchase price was wholly allocable to the insurance firm’s workforce in

place, information base, and goodwill, all of which are amortizable section 197

intangibles.12 See sec. 197(c) and (d). However, the amortization deduction that

petitioners claimed is miscalculated. We find that the proper amortization

deduction is $21,333 (petitioner husband’s cost basis of $320,000, divided by 15).

Accordingly, petitioners are entitled to an amortization deduction of $21,333 for

2013.13

      12
         Sec. 197 intangibles do not include an interest in a partnership. Sec.
1.197-2(c)(1), Income Tax Regs. Thus, amortization under sec. 197 is generally
not available for the cost of acquiring a partnership interest. Id. Respondent did
not contend in the deficiency notice or at any point in this proceeding that
petitioner husband purchased a nonamortizable partnership interest in Bernall &
Jones. We deem the argument waived.
      13
         Respondent does not dispute petitioners’ contention that this deduction,
if allowed, belongs on the Schedule C1 for BJW rather than the Schedule C2 for
GSE. We expect the parties to treat the deduction as BJW’s in the Rule 155
                                                                      (continued...)
                                          - 31 -

[*31]                  ix.   Car and Truck

        For the reasons explained supra part II(A)(2)(iii), we hold that petitioners

failed to substantiate GSE’s reported car and truck expenses. We therefore sustain

respondent’s disallowance of this deduction.

              5.       2014 Schedule C2 Deductions

        The table below summarizes the expenses reported on petitioners’ 2014

Schedule C2, the amounts disallowed in the deficiency notice, the amounts

respondent concedes on brief, and the amounts still at issue. Respondent contends

that petitioners have not substantiated the amounts listed below:

                Item                 Reported      Disallowed   Conceded      At issue

 Meals and entertainment                $346          $346          ---         $346
 Travel                                  401           401          ---          401
 Office expenses                         677           677          ---          677
 Advertising                             289           289          ---          289
                       i.    Meals and Entertainment

        For the reasons explained supra part II(A)(2)(i), petitioners failed to satisfy

the substantiation requirements of section 274(d). Accordingly, they are not

entitled to a deduction for meals and entertainment.

        13
      (...continued)
computation to the extent this correction has any effect thereon.
                                          - 32 -

[*32]                ii.    Travel

        Petitioners rely on petitioner husband’s testimony to substantiate travel

expenses of $401. Having failed to submit adequate records or other sufficient

evidence corroborating the amount, time, and business purpose of petitioner

husband’s reported travel expenses, petitioners have not satisfied the requirements

of section 274(d). We sustain respondent’s disallowance of this deduction.

                     iii.   Office Expenses

        We have found that petitioner husband, on behalf of GSE, paid $677 in

2014 to lease part-time office space at the Oakland location. We hold that

petitioners are entitled to a deduction of $677 for office expenses.

                     iv.    Advertising

        We have found that petitioner husband paid $289 for GSE-related online

marketing efforts in 2014. We hold that petitioners are entitled to a deduction of

$289 for advertising.

        B.    BJW

        For 2013 and 2014 petitioners reported BJW’s income and expenses on

Schedules C1. Respondent disallowed petitioners’ Schedule C1 deductions for

both years.
                                        - 33 -

[*33]         1.      2013

        The table below summarizes the expenses reported on petitioners’ 2013

Schedule C1, the amounts disallowed in the deficiency notice, the amounts

respondent concedes on brief, and the amounts still at issue. Respondent contends

that petitioners failed to substantiate the expenses listed below that have not been

conceded:

               Item                 Reported     Disallowed   Conceded     At issue

 Other expenses                      $7,020        $7,020      $6,850        $170
 Wages                               55,984        55,984      55,984          ---
 Meals and entertainment                270           270        ---           270
 Travel                               1,410         1,410        ---         1,410
 Taxes and licenses                  12,723        12,723      11,458        1,265
 Rent/lease                          20,097        20,097      20,097           ---
 Legal and professional               2,234         2,234       2,234           ---
 Interest                             3,109         3,109       3,109           ---
 Insurance                           10,634        10,634      10,634           ---
 Commissions and fees               112,432       112,432     112,432           ---

                      i.     Other Expenses

        On brief respondent concedes that petitioners have substantiated all but

$170 of this reported expense. After careful review of the record, we find that

petitioners substantiated the remaining $170 of other expenses. We therefore hold

that petitioners are entitled to a deduction of $7,020.
                                          - 34 -

[*34]                ii.    Meals and Entertainment

        For the reasons explained supra part II(A)(2)(i), petitioners failed to satisfy

the substantiation requirements of section 274(d). Accordingly, they are not

entitled to a deduction for meals and entertainment.

                     iii.   Travel

        To substantiate petitioner husband’s BJW-related travel expenses,

petitioners rely on petitioner husband’s testimony, along with canceled checks, a

summary travel log, and an Expedia itinerary. Because none of these documents

establishes the business purposes of the reported expenditures, petitioners have

failed to satisfy the substantiation requirements of section 274(d). Accordingly,

we sustain respondent’s disallowance of this deduction.

                     iv.    Taxes and Licenses

        Petitioners reported tax and licensing expenses of $12,723. On brief

respondent concedes that petitioners have substantiated all but $1,265 of these

expenses. The $12,723 deduction comprised expenses for individual sales

licenses, California and other local taxes, and entity licensing fees. As we have

found that petitioner husband paid the remaining $1,265 on behalf of BJW, we

hold that petitioners are entitled to a deduction of $12,723 for tax and licensing

expenses.
                                         - 35 -

[*35]         2.      2014

        The table below summarizes the expenses reported on petitioners’ 2014

Schedule C1, the amounts disallowed in the deficiency notice, the amounts

respondent concedes on brief, and the amounts still at issue. Respondent contends

that petitioners failed to substantiate the expenses listed below that have not been

conceded:

               Item                  Reported     Disallowed   Conceded    At issue

 Wages                               $68,686       $68,686     $65,208      $3,478
 Meals and entertainment               2,489         2,489        ---        2,489
 Travel                                2,456         2,456        ---        2,456
 Taxes and licenses                   15,317        15,317      15,317         ---
 Rent/lease                           21,135        21,135      21,135         ---
 Legal and professional                2,979         2,979       2,700         279
 Interest                             28,181        28,181       5,965      22,216
 Insurance                            17,070        17,070      12,351       4,719
 Commissions and fees                125,952       125,952     125,952         ---
 Utilities                             5,239         5,239       5,239         ---
 Office expenses                       3,060         3,060       3,060         ---
 Depreciation/sec. 179 expense        36,179        36,179         ---      36,179
 Car and truck expenses                  756           756         ---        756
 Advertising                             435           435          435        ---
 Repairs and maintenance                  71            71            71        ---

                      i.     Wages

        On brief respondent concedes that petitioners have substantiated BJW-

related wages of $65,208, leaving the remaining $3,478 at issue. The record

establishes (and we have found) that petitioner husband paid wages of $58,000
                                        - 36 -

[*36] and $7,209 to Kendra Thompson and Michael Johnson, respectively. The

record does not establish that BJW paid wages in excess of the sum of those

amounts, $65,209. Accordingly, petitioners are entitled to a deduction of $65,209.

                    ii.    Meals and Entertainment

      For the reasons explained supra part II(A)(2)(i), petitioners failed to satisfy

the substantiation requirements of section 274(d). Accordingly, they are not

entitled to a deduction for meals and entertainment.

                    iii.   Travel

      To substantiate petitioners’ BJW-related travel expenses, petitioners rely on

petitioner husband’s testimony and a Southwest airlines travel itinerary. The

travel itinerary does not establish the business purpose of the reported expenses.

Accordingly, petitioners have failed to satisfy the substantiation requirements of

section 274(d), and they are not entitled to a deduction for travel.

                    iv.    Legal and Professional

      Petitioners reported legal and professional expenses of $2,979. On brief

respondent concedes that petitioners have substantiated all but $279 of these

expenses. At trial petitioner husband credibly testified that BJW had legal and

professional expenses in the amount stated on the return, and we have found that

petitioner husband paid $2,979 during 2014 for BJW’s legal and professional
                                        - 37 -

[*37] expenses. We therefore hold that petitioners are entitled to a deduction of

$2,979 for legal and professional expenses.

                   v.     Interest

       Petitioners claimed a $28,181 interest expense deduction on their Schedule

C1. On brief respondent concedes $5,965 of this amount but contends that

petitioners failed to substantiate the remaining $22,216.

       A taxpayer may deduct interest paid or incurred during the taxable year if

the interest is an ordinary and necessary expense of carrying on a trade or

business. Sec. 162(a); Robinson v. Commissioner, 119 T.C. 44, 48 (2002); see

sec. 163(a) (allowing a deduction for “all interest paid or accrued within the

taxable year on indebtedness”, with certain exceptions).

       We have found that petitioner husband paid BJW-related interest of $28,181

during 2014. Accordingly, petitioners are entitled to a deduction of $28,181 for

interest.

                   vi.    Insurance

       Petitioners claimed a $17,070 insurance expense deduction on their 2014

Schedule C1. On brief respondent concedes $12,351 of that amount but contends

that petitioners failed to substantiate the remaining $4,719.
                                          - 38 -

[*38] The record does not establish that BJW had insurance expenses in excess of

the amount respondent has conceded. On the basis of respondent’s concession and

our review of the record, we hold that petitioners are entitled to a deduction of

$12,351 for insurance.

                    vii.   Depreciation

       For the reasons explained supra part II(A)(4)(viii), petitioners are entitled to

an amortization deduction of $21,333 for 2014.

                    viii. Car and Truck

       For the reasons explained supra part II(A)(2)(iii), we hold that petitioners

failed to substantiate BJW’s reported car and truck expenses. We therefore sustain

respondent’s disallowance of this deduction.

III.   Additional Tax on Early Distribution

       Petitioners concede in their opening brief that they received from their

retirement accounts taxable income of $71,625 and $42,858 in 2010 and 2011,

respectively. However, they contend that they are not subject to the additional tax

on early distributions from qualified plans under section 72(t). Respondent argues

that portions of petitioners’ early withdrawals are subject to the additional tax.

       Where, as here, a taxpayer receives a distribution from a qualified

retirement plan, section 72(t)(1) generally provides that his tax shall be increased
                                        - 39 -

[*39] “by an amount equal to 10 percent of the portion of such amount which is

includible in gross income.” Section 72(t)(2)(A) provides several exceptions to

this rule, e.g., where the taxpayer receiving the distribution has attained the age of

59-1/2 or is disabled. See sec. 72(t)(2)(A)(i), (iii). A further exception appears in

section 72(t)(2)(E), captioned “Distributions from individual retirement plans for

higher education expenses.” It provides, with exceptions not relevant here, that an

early distribution from an individual retirement plan is not subject to the 10%

additional tax to the extent it does not exceed “the qualified higher education

expenses * * * of the taxpayer for the taxable year.”14

      Petitioners do not dispute that they were under the age of 59-1/2 when they

received the distributions at issue or that they were not disabled at those times.

Petitioners are thus liable for the 10% additional tax unless another exception in

section 72(t) applies. The only exception they have raised is the exception for

“higher education expenses.”

      Petitioners received early distributions from their retirement accounts

totaling $71,625 in 2010 and $42,858 in 2011. Petitioners submitted evidence of

      14
          The term “qualified higher education expenses” means qualified higher
education expenses (as defined in sec. 529(e)(3)) for education furnished to the
taxpayer, the taxpayer’s spouse, or any child (as defined in sec. 152(f)(1)) or
grandchild of the taxpayer or the taxpayer’s spouse, at an eligible educational
institution (as defined in sec. 529(e)(5)). Sec. 72(t)(7)(A).
                                          - 40 -

[*40] tuition payments of $30,557 for 2010, and respondent has conceded that this

amount is not subject to the additional tax. The record contains no evidence of

additional qualified education expenses paid for 2010 or any qualified education

expenses paid for 2011.15

         Accordingly, we find petitioners liable for the 10% additional tax under

section 72(t) on $41,06816 of their early retirement distribution for 2010. We also

sustain respondent’s determination of additional tax under section 72(t) for 2011.

         We have considered all other arguments made by the parties, and to the

extent not discussed above, find those arguments to be irrelevant, moot, or without

merit.

         To reflect the foregoing,

                                                   Decisions will be entered

                                          under Rule 155.

         15
         We note that respondent determined a sec. 72(t) additional tax of $1,702
for 2011 after subtracting amounts used for higher education expenses in the
notice of deficiency.
         16
              Total distributions of $71,625 minus education expenses of $30,557.