Higbee v. Commissioner, 116 T.C. No. 28 | June 6, 2001 | Vasquez, J. | Docket No. 14035-99

Short Summary:

For the tax year 1996, the Commissioner of Internal Revenue (Commissioner) determined a deficiency of $10,796 in, and an addition to tax under IRC § 6651(a)(1) of $2,669 on, Petitioners' 1996 federal income taxes. For the tax year 1997, the Commissioner determined a deficiency of $12,443 in, and an accuracy-related penalty under IRC § 6662(a) of $2,488.60 on, Petitioners'1997 federal income taxes.

Petitioners contested the Commissioner's determinations with regard to both tax years 1996 and 1997. At trial, and after concessions, the only issue that remained was whether Petitioners were entitled to a $1,920 Schedule C deduction reported on their 1996 tax return and disallowed by the Commissioner. However, at trial, Petitioners raised new issues by claiming additional deductions that were not claimed on their returns and that were not raised in the original notice of deficiency.

Key Issues:

Issue 1: Disallowed Deductions

Whether Petitioners are entitled to deductions for a casualty loss, charitable contributions, unreimbursed employee expenses, amounts paid on account of a failed business as part of a chapter 13 bankruptcy proceeding, and various expenses related to two rental properties?

Issue 2: Addition to Tax and Accuracy-Related Penalty

Whether Petitioners are liable for an addition to tax under IRC § 6651(a)(1) and an accuracy-related penalty under IRC § 6662(a)?

Primary Holding:

Issue 1: Disallowed Deductions

The Court rejected Petitioners' claimed casualty loss deduction. Petitioners failed to provide credible evidence of a casualty loss as required by IRC § 7491(a). As a result, the burden of proof as to this issue was not placed on the Commissioner. Further, Petitioners did not meet their burden of proof.

The Court concluded that Petitioners were not entitled to a deduction for charitable contributions in excess of the $1,500 the Commissioner had already allowed. Petitioners failed to introduce credible evidence to substantiate the actual items contributed and their fair market values as required by IRC § 7491(a). Consequently, the burden of proof as to this issue was not placed on the Commissioner. For the same reasons, Petitioners did not meet their burden of proof.

The Court rejected all of Petitioner's contentions as to the unreimbursed employee expenses, amounts paid on account of a failed business as part of a chapter 13 bankruptcy proceeding, and various expenses related to two rental properties. Petitioners failed to introduce credible evidence to meet the substantiation and record-keeping requirements of IRC § 7491(a). As a result, the burden of proof as to this issue was not placed on the Commissioner, and for the same reasons, Petitioners failed to meet their burden of proof.

Issue 2: Addition to Tax and Accuracy-Related Penalty

The Court sustained an addition to tax of 25% of the amount required to be shown as tax on the return under IRC § 6651(a)(1). The Commissioner produced sufficient evidence that the addition to tax was appropriate. Petitioners failed to provide any evidence that indicated their failure to timely file was due to reasonable cause.

The Court sustained the Commissioner's determination that Petitioners were liable for the accuracy-related penalty on the underpayment associated with the disallowed itemized deductions conceded by Petitioners. The Commissioner was able to show that Petitioners failed to keep adequate books and records to substantiate properly the items in question – such evidence shows negligence on the part of Petitioners. Thus, the Commissioner met his burden of production as to this specific determination. As for Petitioners, they failed to meet their burden of proving that they acted with reasonable cause and in good faith.

Key Points of Law:

Issue 1: Disallowed Deductions

  • Deductions are a matter of legislative grace, and a taxpayer bears the burden of proving that he is entitled to the deductions claimed. SeeINDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934).
    • Taxpayers are required to maintain records sufficient to allow the Commissioner to determine the proper tax liability. IRC § 6001; Treas. Reg. § 1.6001-1(a).
    • Further, taxpayers bear the burden of substantiating the amount and purpose of the claimed deductions. SeeHradesky v. Commissioner, 65 T.C. 87, 90 (1975), aff'd per curiam, 540 F.2d 821 (5th Cir. 1976).
  • IRC § 7491(a)(1) states that if, in any court proceeding, a taxpayer introduces credible evidence with respect to factual issues relevant to ascertaining the proper liability of the taxpayer, the burden of proof as to those issues will be placed on the Commissioner.
    • For IRC § 7491(a)(1) to apply, taxpayers are required to comply with record-keeping and substantiation obligations contained within the IRC, and to cooperate with reasonable requests made by the Commissioner. See IRC §§ 7491(a)(2)(A), (B).
    • To shift the burden of proof to the Commissioner, taxpayers must provide sufficient credible evidence. See IRC § 7491(a).
  • IRC § 165(a) allows for the deduction of any uncompensated loss.1
    • When property is damaged, as opposed to completely destroyed, the proper measure of the loss incurred is the difference in the fair market value right before, and right after, the property was damaged, not to exceed the property's adjusted basis. Treas. Reg. § 1.165-7(b)(1). Generally, the fair market value must be provided by competent appraisal. See Reg. § 1.165-7(a)(2)(i).
    • Alternatively, if the taxpayer has repaired the damage, the taxpayer may use the cost of repairs to prove the casualty loss. See Reg. § 1.165-7(a)(2)(ii).
  • IRC § 170(a)(1) allows for the deduction of any charitable contribution made, only if it is verified in accordance with Treasury Regulations.
    • For charitable contributions of money, a taxpayer shall maintain a cancelled check, a receipt from the donee charitable organization with information such as the donee's name, the date of the contribution, and the amount of the contribution. See Reg. § 1.170A-13(a).
    • For charitable contributions of property, a taxpayer shall maintain a receipt from the donee with the name of the donee, the date and location of the contribution, and a description of the property in detail reasonably sufficient under the circumstances. See Reg. § 1.170A-13(b).
    • In either instance, if it is impractical to obtain a receipt, reliable written records with the above state information are sufficient.

Issue 2: Addition to Tax and Accuracy-Related Penalty

  • The Commissioner bears the burden ofproduction with respect to any penalty assessed against a taxpayer. See IRC § 7491(c).
    • To meet his burden of production, the Commissioner must come forward with sufficient evidence indicating that it is appropriate to impose the relevant penalty.2
  • Once the Commissioner meets his burden, the taxpayer bears the burden of proving the Commissioner's determination is incorrect. Thus, the taxpayer must introduce evidence related to reasonable cause, substantial authority, or similar provisions.
  • IRC § 6651(a)(1) imposes an addition to tax for a taxpayer's failure to timely file a required return.
    • However, the addition to tax is not applicable if the taxpayer's failure to timely file was due to reasonable cause and was not due to willful neglect. The Commissioner does not bear the burden of proof regarding the reasonable cause exception.
  • Under IRC § 6662(a), a taxpayer may be liable for a penalty equal to 20% of any portion of an underpayment of tax that is attributable to a substantial understatement of tax or due to negligence or disregard of rules or regulations.
    • An understatement is “substantial” if it exceeds the greater of 10% of the tax required to be shown on the return for the taxable year or $5,000. See IRC § 6662(d)(1)(A).
    • “Negligence” includes any failure to make a reasonable attempt to comply with the provisions of the IRC; “disregard” includes any careless, reckless, or intentional disregard. See IRC § 6662(c).
  • The accuracy-related penalty is not imposed if the taxpayer is able to prove they acted with reasonable cause and in good faith. See IRC § 6664(c)(1).
    • Such a determination is based upon an analysis of the relevant facts and circumstances. See Reg. § 1.6664-4(b)(1).
    • An honest misunderstanding of fact or law that is reasonable in light of the experience, knowledge, and education of the taxpayer may indicate reasonable cause and good faith. SeeRemy v. Commissioner, 73 T.C.M. (CCH) 1976 (1997).

Insight:

This opinion by the Tax Court is a great example of the headache that may be caused by new (and likely-to-be-disputed) issues being brought up at the eleventh hour – in this case, right as the final dispute was set to be resolved – and lacking the requisite substantiating evidence. Throughout the entire opinion, the importance of accurate and detailed documentation substantiating claimed deductions is repeatedly stated. Failure to provide such credible evidence prevents the burden of proof from shifting from the taxpayer to the Commissioner.

Additionally, with respect to penalties assessed against a taxpayer, the Higbee opinion provides an explanation of the Commissioner's burden of production. Congress' use of burden of production, as opposed to burden of proof, lowers the burden of the Commissioner, and requires only that the Commissioner present sufficient evidence that the penalty assessed against a taxpayer is appropriate. And once the Commissioner has met his burden of production, it is the taxpayer's responsibility to meet the burden of proof necessary to assert a defense to an assessment of penalties by the IRS.

Footnotes

1. Deductions under IRC § 165(a) shall be limited to (1) losses incurred in a trade or business; (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business; and (3) except as provided in IRC § 165(h), losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft.

2. The Code does not define "burden of production." The Court bases its conclusion as to Congress's intent as to the meaning of the phrase on the legislative history of IRC § 7491(c). See H.R. Rep. No. 105-599 (1998) (Conf. Rep.).

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