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KUNJLATA J. JADHAV AND JALANDAR Y. JADHAV, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent, T.C. Memo. 2023-140

Petitioner husband, Jalandar Y. Jadhav, received a Ph.D. in chemistry on a date not established by the record. At all relevant times he worked for Mobile Rosin Oil Co., Inc. (Mobile), as a salaried employee. During the years in issue Mobile paid him a yearly salary ranging between $154,000 and $159,000.

In addition to working for Mobile, petitioner husband owned and operated a sole proprietorship from 2006 to 2014. Doing business as “K J Marketing,” petitioner husband identified new markets for chemical producers and connected them with potential customers. K J Marketing earned commissions on sales to the customers petitioner husband identified. For 2006 through 2014 petitioners reported K J Marketing’s income and expenses on Schedules C, Profit or Loss from business. For reasons not explained by the record, petitioners named petitioner wife, Kunjlata Jadhav, as the owner of K J Marketing on their tax returns. Petitioner wife, who did not testify at trial, worked as a substitute teacher until 2014.

K J Marketing maintained a section 401(k) retirement plan with Oppenheimer Funds (Oppenheimer). On April 10, 2015, petitioners mailed Oppenheimer a $104,350 check payment to cover contributions to the accounts of petitioner wife and their two sons, Veerendra and Arjun Jadhav, for taxable year 2014. Petitioners instructed Oppenheimer to allocate the $104,350 payment as follows:

Petitioners viewed K J Marketing as a family business and wished to pass it on to Veerendra and Arjun. Petitioner husband started training his sons when they were in high school. While Veerendra and Arjun were in college, he assigned them research tasks and oversaw their work. Veerendra attended the University of Alabama in Birmingham, Alabama, from 2006 to 2015, and Arjun attended the University of South Alabama in Mobile, Alabama, from 2009 to 2015.

Petitioners’ Residential Properties

In 2005 petitioners purchased a residential property in Daphne, Alabama (Daphne property). Petitioners used the Daphne property as their primary residence until 2014 when they moved to Spring, Texas.

In or about 2009 petitioners purchased a residential property in Birmingham, Alabama (Birmingham property). Veerendra resided at the Birmingham property while attending the University of Alabama. In November 2015 petitioners sold the Birmingham property.

In 2010, petitioners purchased a residential property in Mobile, Alabama (Mobile property). Arjun resided at the Mobile property while attending the University of South Alabama. In November 2015, petitioners sold the Mobile property.

In 2013, petitioners purchased a residential property in Spring, Texas (Spring property). Petitioners moved to the Spring property in 2014, and it was their primary residence at the time of trial.

Income Tax Plan

By 2014, K J Marketing was generating substantial income. Around that time petitioners engaged Capital Protection Services, LLC (CPS), to evaluate their organizational structure, facilitate succession planning, and reduce their tax exposure. For $50,000 CPS provided petitioners a 183-page “Income Tax Plan” (Plan). After interviewing petitioners and reviewing their financial information, CPS estimated that petitioners’ “average tax rate” (ratio of tax to taxable income) was 37%. CPS stated that, if petitioners adopted the recommendations in the Plan, they could reduce their “average tax rate” to 9%. According to CPS, petitioners could achieve that goal by restructuring their business to facilitate greater tax deductions. CPS explained:

Marginal rates are important for measuring income tax saving from deductions. The marginal rate is the rate applied to the last Dollar earned. If a deduction can be created, that deduction will create income tax savings at the marginal rate. So, if your marginal rate is 48.40%, for each $100 of deduction created tax savings of $48 will occur.

In accordance with the above strategy, CPS advised petitioners to (1) convert K J Marketing to an S corporation and (2) rent their residential properties to the S corporation “for business purposes at a reasonable per day rate supported by independent comparable.” Under the Plan, the S corporation would rent each of petitioners’ residential properties for a maximum of 14 days and deduct that expense on its income tax return. Petitioners, in turn, would exclude their corresponding rental income pursuant to section 280A(g).

CPS included a tax saving projection in the Plan. For purposes of that projection, CPS “assumed” that one of the residential properties had a per-day rental rate of $2,500 and that each of the other three properties had a per-day rental rate of $2,000. Despite those assumptions, CPS warned petitioners that the rental rates “should be supported by independent comps [sic] within a 100 mile radius.” CPS also suggested that petitioners retain a professional appraiser to value the rental rate every three years.

Another component of the Plan was the creation of a C corporation, which would provide “marketing” services to the S corporation. Under the Plan, the S corporation would pay the C corporation a yearly marketing fee, which “should not exceed more than 10%” of the S corporation’s gross income. The C corporation, in turn, would pay and deduct on its income tax returns the following expenses: (1) deferred compensation plan payments, (2) tuition for petitioners’ sons, (3) medical expenses and disability plans for petitioners’ family, (4) overtime and weekend meals for the employees, (5) meals for petitioners’ family “for the convenience of the employer,” and (6) salaries to petitioners’ children. As for the nature of the marketing services, the Plan states: “The C Corporation should pay for marketing expenses for the benefit of the Operating Entity [the S corporation]. These expenses may be for items such as promotional materials and little league sponsorships showing that this company is very active.”

The Plan also includes an unsigned legal opinion from attorney T. Walton Dallas, stating: “We have determined that in the event that the taxpayer is challenged by the IRS, it is more likely than not that the taxpayer will be entitled to the income tax benefits described” in the Plan. That conclusion, however, had several caveats. For one, Mr. Dallas gave “no opinion as to the fair market value of any item for any deduction or credit taken.” Mr. Dallas also made “no representation as to the reasonableness of any item” and “assumed there is a substantial and proper business purpose for each component of the tax plan, the structure of any entities, and the participation of any persons.”

KJJJ Marketing, Inc.

In December 2014 petitioners organized KJJJ Marketing, Inc. (KJJJ), under the laws of Texas. Petitioners used KJJJ to conduct the business they had previously done as K J Marketing. Petitioner wife was the sole owner of KJJJ, which elected to be treated as an S corporation for income tax purposes. During 2015, 2016, and 2017, Veerendra and Arjun were employees of KJJJ.

Before engaging CPS, petitioner husband used hotels and restaurants to conduct business meetings for K J Marketing. In 2014 petitioners moved those meetings to the Daphne, Birmingham, Mobile, and Spring Properties. After KJJJ’s incorporation, petitioners began charging rent to the S corporation for the use of those properties. Pursuant to the Plan, KJJJ rented each of their residential properties for a maximum of 14 days.

Petitioners did not obtain any appraisals of their properties for purposes of valuing the above-described daily rental rates. Instead, they used the rates CPS had assumed for purposes of making a tax saving projection in the Plan.

JYJ Marketing, Inc.

In November 2014 petitioners incorporated their new “marketing” company, JYJ Marketing, Inc. (JYJ), pursuant to the Plan. Organized as a C corporation under the laws of Texas, JYJ issued 4 shares of stock to petitioner husband, 48 shares to an unrelated individual, and 48 shares to another unrelated individual. Petitioners, Veerendra, and Arjun (collectively, Jadhav family) were appointed directors and part-time employees of JYJ. At the initial meeting of shareholders and directors, the Jadhav family in their capacity as directors adopted several plans for the benefit of JYJ’s employees, including plans for (1) medical expense reimbursement, (2) overtime and weekend meal reimbursement, (3) meals furnished for the convenience of the employer, (4) mileage, (5) dwelling unit leasing, (6) tuition, and (7) fitness and country club expenses.

With respect to JYJ’s marketing activities, the minutes from the initial board meeting state:

A new Marketing Company has been formed and marketing activities are allocated by written agreement to the new Marketing Company. The Marketing Company conducts marketing events at the house of the Employee. Also, employee meetings are now being held at the house of the Employee.

As the marketing activities are being conducted by a separate legal entity, the Operating Company is not liable for those activities. This allows more marketing events to be conducted as the Operating Company will be free from liqueur liability and slip and fall liability.

While all marketing decisions were made at the Operating Company level, now those decisions are being made at the Marketing Company level.

During the years in issue, KJJJ made yearly payments to JYJ for purported marketing services. The marketing fees were JYJ’s only source of income. KJJJ paid JYJ as follows:

JYJ used the marketing fees to pay several personal expenses of the Jadhav family. It did not use any portion of the funds to pay KJJJ’s marketing expenses. Nor did it host marketing or promotional events on KJJJ’s behalf, as the minutes of the initial board meeting had envisioned.

Tax Reporting

Kenneth Walker, a certified public accountant (CPA), prepared petitioners’ joint Forms 1040, U.S. Individual Income Tax Return, for the years in issue. Petitioners’ 2014 Form 1040 includes a Schedule C for K J Marketing. On that Schedule C petitioners claimed as a pension and profit sharing deduction their $46,850 contribution to their sons’ section 401(k) accounts. They also claimed a deduction of $68,063 for travel expenses.

Petitioners selected Mr. Walker on a friend’s recommendation. They provided their new CPA information about the Plan and the organizational changes to their business. After telling petitioner husband that he understood the Plan, Mr. Walker prepared income tax returns for KJJJ and JYJ.

KJJJ filed Forms 1120S, U.S. Income Tax Return for an S Corporation, for the years in issue. For each year in issue, KJJJ deducted the rent petitioners had invoiced.

After deducting its reported expenses, KJJJ reported ordinary business income of $10,945, $247,592, $104,944, and $268,563 for 2014, 2015, 2016, and 2017, respectively. Petitioners reported those amounts on their Schedules E, Supplemental Income and Loss, for the years in issue. Petitioners also reported their rental income from KJJJ on their Schedules E but treated those amounts as excludable pursuant to section 280A(g).

JYJ reported the marketing fees it had received from KJJJ on Forms 1120, U.S. Corporation Income Tax Return, for its taxable years ending November 30, 2015, 2016, 2017, and 2018. ¹¹ Besides the marketing fees from KJJJ, JYJ did not report any income. It did not claim any deductions for officer compensation or wages but deducted several personal expenses of the Jadhav family including (1) out-of-pocket medical bills, (2) meals and entertainment, (3) petitioner husband’s mileage, (4) portions of Arjun’s and Veerendra’s tuition, (5) petitioners’ health club membership, and (6) lawn care.

Examination

In 2017, the Internal Revenue Service selected petitioners’ KJJJ’s, and JYJ’s returns for examination. KJJJ’s Form 1120S rent deductions for the years in issue and “Other” deductions were disallowed. Of those items, only KJJJ’s reported marketing fees and travel expenses remain at issue. KJJJ’s 2014 deduction for application fees and its 2015 and 2016 deductions for payroll processing fees were allowed. In the Stipulation of Settled Issues, respondent conceded that KJJJ may deduct its reported insurance expenses for the years in issue. Meanwhile, petitioners conceded that KJJJ is not entitled to deductions for conference expenses, contract labor, gifts, mileage reimbursement, office supplies, product development, and professional fees. The IRS, because of clerical errors, however, issued a Statutory Notice of Deficiency (SNOD) understating KJJJ’s passthrough income for 2015, 2016, and 2017.

Respondent also made adjustments to petitioners’ 2014 Schedule C in the SNOD for that year. Therein respondent disallowed petitioners’ Schedule C deductions for travel and pension and profit sharing expenses.

With respect to JYJ, respondent did not determine any deficiencies against the corporation. Instead, respondent treated JYJ’s 2015, 2016, and 2017 Forms 1120 as “sham” returns. IRS refunded the amounts JYJ had paid as tax for those years.

2014 Schedule C

Pension and profit-sharing expense

On their 2014 Schedule C petitioners deducted as a pension and profit-sharing expense their $46,850 contribution to Arjun’s and Veerendra’s section 401(k) accounts. Disputing the deduction, respondent contends that neither Arjun nor Veerendra was an employee of petitioners in 2014.

At trial petitioner husband credibly testified that he viewed K J Marketing (which later became KJJJ) as a family business. He also credibly testified that he wished to pass his business on to Veerendra and Arjun. The record establishes that petitioners pursued that goal. Although Veerendra and Arjun were in college in 2014, petitioner husband credibly recounted assigning them research tasks and overseeing their work while they were in school. Upon KJJJ’s incorporation, Veerendra and Arjun became employees of the S corporation, which issued them Forms W–2, Wage and Tax Statement, for 2015, 2016, and 2017. Veerendra was a full-time employee of KJJJ at the time of trial. These facts support a finding of an employment relationship, as they demonstrate petitioner husband’s control over his sons’ work, his investment in the business, a lengthy employment relationship, and an intention to create an employer-employee relationship.

Respondent does not appear to dispute the classification of Veerendra and Arjun as employees—at least not for 2015, 2016, and 2017. Rather, respondent disputes the timing of their employment, asserting that it did not commence in 2014. In support of his contention, respondent cites petitioners’ failure to file Forms W–2 for 2014. To be sure, the failure to file information returns may undermine the assertion of a bona fide employer-employee relationship. The Plan, which was prepared in 2014, states: “You [petitioner husband] have 2 children. The children work in the business.” Thus, under the particular circumstances of this case, we find it more likely than not that Arjun and Veerendra were petitioners’ employees in 2014.

Travel Expenses

On their 2014 Schedule C petitioners claimed a deduction of $68,063 for travel expenses. Respondent argues that petitioners have not substantiated these reported expenses. In support of their deduction for travel expenses, petitioners submitted reconstructions of purported travel logs and odometer readings. However, the record does not contain any documentary evidence or other direct or circumstantial evidence of the time, location, and business purpose of each reported travel expense. Petitioners’ failure to produce such evidence (which one would expect to be in their exclusive possession or control) creates a presumption that it would not be favorable to them.

2014–17 Forms 1120S (KJJJ)

We next consider whether respondent properly disallowed KJJJ’s deductions for marketing fees, rent, and travel expenses.

Marketing fees

For the years in issue, KJJJ claimed deductions for marketing fees in accordance with the Plan. Having fully disallowed those deductions, respondent contends that the marketing fees were not ordinary and necessary under section 162. We agree.

Having carefully reviewed the records, we are doubtful that the marketing fees were ordinary and necessary. The creation of JYJ was one of the tax reduction strategies CPS had recommended in the Plan. Pursuant thereto, KJJJ made large annual payments to JYJ, of which petitioners were shareholders and directors. JYJ did not make any marketing expenditures for KJJJ, as CPS had suggested it would in the Plan. Nor did JYJ host meetings on KJJJ’s behalf, as envisioned in JYJ’s initial board minutes. Nevertheless, KJJJ paid large yearly sums to JYJ, which, in turn, used those sums to pay the personal expenses of the Jadhav family. In the light of these facts, we find it more likely than not that JYJ did not provide ordinary and necessary marketing services to KJJJ.

Acknowledging that JYJ did not provide traditional marketing services to KJJJ, petitioners nevertheless contend that the fees were ordinary and necessary for purposes of risk mitigation. At trial petitioner husband testified that he used JYJ to develop new ideas, many of which would fail. According to petitioner husband, JYJ shielded KJJJ from the reputational risk of such failures. Petitioner husband testified that once an idea proved viable, KJJJ would market it to potential users. Although we found petitioner husband credible, he did not explain how the marketing fees were determined. It is also unclear from the record whether JYJ developed any ideas that warranted KJJJ’s payments of large annual marketing fees. The invoices in the record are vague, stating only that JYJ provided “marketing and sale promotion.”

This Court has upheld disallowances of section 162 deductions in similar circumstances. For instance, in ASAT, Inc. v. Commissioner , 108 T.C. 147, 174–75 (1997), we held that the taxpayer was not entitled to deduct consulting fees it had paid to an unrelated corporation where the taxpayer did not establish how the fees were determined, there was no written contract, the invoices provided almost no detail, and there was no evidence of the service provider’s skills that might warrant the consulting fees. See also Weekend Warrior Trailers, Inc. v. Commissioner , T.C. Memo. 2011-105 (sustaining the Commissioner’s disallowance of management fee deduction where the evidence did not adequately establish the specific services performed and who performed them). For similar reasons, we hold that JYJ is not entitled to the marketing fee deductions for the years in issue. We sustain respondent’s determination on this issue.

Rent

KJJJ claimed deductions for rent paid to petitioners for the use of their residential properties during the years in issue. Having fully disallowed those deductions, respondent contends that KJJJ’s reported rental expenses were not ordinary and necessary.

Section 162 permits a taxpayer to deduct all ordinary and necessary expenses paid during the taxable year in carrying on its trade or business, including “rentals or other payments required to be made as a condition to the continued use or possession” of property. Only the portion of an expense that is reasonable qualifies for deduction under section 162(a). Having carefully reviewed the record, we find it more likely than not that KJJJ’s payments to petitioners were unreasonable and something other than rent. Petitioners’ rental arrangement with KJJJ was another tax reduction strategy CPS had suggested in the Plan. In making that suggestion, CPS advised petitioners to use a reasonable rental rate supported by independent comparable. CPS also suggested that petitioners retain a professional appraiser to determine fair rental values for their properties. Petitioners did not follow that advice. Instead, they charged KJJJ the daily rental rates CPS had assumed in its tax saving projection. Although petitioners contend that those rates were based on independent comparable, no such comparable appear in the record.

Petitioners contend that respondent’s full disallowance of KJJJ’s rent deductions was arbitrary. According to petitioners, some portion of the rent must be deductible because the residential properties have fair rental values greater than zero. However, as explained above, the record establishes that KJJJ’s rental arrangement with petitioners was not reasonable. Petitioners have not provided any expert testimony or other evidence of their properties’ fair rental values. Accordingly, we are unable to conclude that any portion of KJJJ’s reported rent was reasonable and, in turn, ordinary and necessary.

Travel expenses

On its Forms 1120S, KJJJ deducted $17,125, $11,311, and $23,964 for 2015, 2016, and 2017, respectively. Respondent contends that petitioners have not substantiated KJJJ’s reported travel expenses. To substantiate those expenses, petitioners submitted reconstructed travel logs.  However, the record does not contain any documentary evidence or other direct or circumstantial evidence of the time, location, and business purpose of each reported travel expense. Petitioners’ failure to produce such evidence (which one would expect to be in their exclusive possession or control) creates a presumption that it would not be favorable to them.

Penalties

Citing their reliance on Mr. Walker to prepare their and KJJJ’s returns, petitioners assert that they acted with reasonable cause. According to petitioners, Mr. Walker was a qualified CPA who was independent of CPS. Respondent does not dispute those assertions. However, the fact that petitioners hired Mr. Walker to prepare their returns does not, by itself, establish that they acted with reasonable cause and in good faith. They must also establish that they supplied him with all relevant information and relied in good faith on his professional judgment.

Petitioners have not established that they reasonably relied on Mr. Walker. To be sure, petitioners provided Mr. Walker information about the organizational changes to their business as contemplated by the Plan. However, the record does not establish that petitioners alerted Mr. Walker to the nature of JYJ’s purported marketing services, which deviated from those described in the Plan. Nor does the record clearly establish what information, if any, petitioners provided Mr. Walker about their and KJJJ’s reported travel expenses, the items petitioners have conceded, and the rental values of their properties. Because petitioners have failed to show that they provided Mr. Walker all relevant information, we cannot conclude that their reliance on him was reasonable.