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CHRISTOPHER R. PANGELINA, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, T.C. Memo. 2024-5

Overview

Petitioner operated a tiling business as a sole proprietor under the name B.C. Tile (BC). Petitioner reported income and expenses attributable to BC on Schedules C.

At a time not disclosed in the record, a revenue agent with respondent’s Small Business and Self-Employed (SB/SE) Division commenced an examination of petitioner’s federal income tax returns for 2010–16. The SB/SE agent concluded that petitioner is reported gross receipts for BC for 2010, 2011, and 2012 should be increased; certain business expense deductions petitioner claimed for BC for 2010, 2012, 2013, 2014, 2015, and 2016 should be disallowed; and various penalties and additions to tax for 2010–16 should be imposed. Since petitioner had not filed a return for 2017 by March of 2019, the SB/SE agent prepared a Substitute For Return (SFR) on petitioner’s behalf pursuant to section 6020(b) on March 19, 2019. The SFR attributed to petitioner gross receipts of $13,401 and accorded him single filing status, a personal exemption, and the standard deduction.

On March 19, 2019, the SB/SE agent completed a Civil Penalty Approval Form for the imposition of accuracy-related penalties for 2010–13, 2015, and 2016. The penalties were imposed on the basis of underpayments attributable to substantial understatements of income tax and negligence. The agent’s immediate supervisor signed the Civil Penalty Approval Form on March 22, 2019. The SB/SE Division issued petitioner a notice of deficiency covering the years at issue on May 1, 2019.

2010

Petitioner filed his return for 2010, which had been prepared by a paid preparer, on January 30, 2017; it was due April 18, 2011. Petitioner reported $286,174 in gross income from BC. Respondent determined that petitioner had failed to report $34 in taxable interest and disallowed the $100,246 deduction petitioner claimed under “other expenses” for contractors. He let stand $154,380 in other claimed Schedule C deductions. As substantiation for the disallowed deduction, petitioner offered the 2010 monthly statements for the bank account he maintained for BC.

2011

Petitioner filed his return for 2011, which had been prepared by a paid preparer, on October 16, 2017; it was due October 15, 2012, pursuant to a granted extension of time to file. Petitioner reported $36,806 in gross income from BC. Respondent determined that petitioner had failed to report $31 in taxable interest but did not disallow any Schedule C deductions.

2012

Petitioner filed his return for 2012, which had been prepared by a paid preparer, on January 30, 2017; it was due October 15, 2013, pursuant to a granted extension of time to file. Petitioner reported $130,941 in gross income from BC. Respondent determined that petitioner had failed to report $18 in taxable interest and disallowed Schedule C deductions petitioner claimed for $18,259 in expenses classified as rent or lease of other business property and $34,791 for expenses classified as wages. He let stand $75,441 in other claimed Schedule C deductions.

As substantiation for the disallowed deductions, petitioner offered a profit and loss statement for 2012 that he prepared in October 2020, but he was unable to produce the underlying records used to produce it. He also offered the 2012 monthly statements for the bank account he maintained for BC.

2013

Petitioner filed his return for 2013, which had been prepared by a paid preparer, on January 30, 2017; it was due April 15, 2014. Petitioner reported $130,941 in gross income from BC. Respondent disallowed Schedule C deductions petitioner claimed for expenses classified as other interest of $5,008, repairs and maintenance of $18,259, and wages of $34,391. He let stand $73,878 in other claimed Schedule C deductions. As substantiation for the disallowed deductions, petitioner offered the 2013 monthly statements for the bank account he maintained for BC, but no profit and loss statement.

2014

Petitioner filed his return for 2014, which had been prepared by a paid preparer, on October 15, 2017; it was due April 15, 2015. Petitioner reported $18,082 in gross income from BC. Respondent disallowed the entire $61,468 deduction petitioner claimed on Schedule C for car and truck expenses and $2,948 of the $6,175 deduction claimed for other expenses—payroll. He let stand the remaining $13,284 in deductions claimed on Schedule C. As substantiation for the disallowed deductions, petitioner offered a profit and loss statement for 2014, that he prepared in October 2020, but he was unable to provide the underlying records used to produce it. He also offered the 2014, monthly statements for the bank account he maintained for BC.

2015

Petitioner filed his return for 2015, which had been prepared by a paid preparer, on March 28, 2018; it was due October 17, 2016, pursuant to a granted extension of time to file. Petitioner reported $48,269 in gross income from BC. Respondent disallowed the Schedule C deduction petitioner claimed for $49,786 in car and truck expenses and $12,638 of the $16,456 deduction claimed for contractor expenses. He let stand the remaining $20,910 in claimed Schedule C deductions. As substantiation for the disallowed deductions, petitioner offered a profit and loss statement for 2015, that he prepared in October 2020, but he was unable to provide the underlying records used to produce it. He also offered the 2015, monthly statements for the bank account he maintained for BC.

2016

Petitioner filed his return for 2016, which had been prepared by a paid preparer, on April 9, 2018; it was due April 18, 2017. Petitioner reported $45,477 in gross income from BC. Respondent disallowed the Schedule C deductions claimed for $36,683 in car and truck expenses, $17,060 in expenses for rent or lease of other business property, and $7,377 for contractor expenses. He let stand the remaining $7,451 in claimed Schedule C deductions. As substantiation for the disallowed deductions, petitioner offered a profit and loss statement for 2016, that he prepared in October 2020, but he was unable to provide the underlying records used to produce it. He also proffered the 2016 monthly statements for the bank account he maintained for BC.

2017

As petitioner failed to file a return for 2017, the SB/SE agent prepared a Substitute For Return on petitioner’s behalf pursuant to section 6020(b) and notified him of the same on March 19, 2019. Petitioner has not paid the amounts shown as due on the SFR. The SFR adjustments were incorporated in the notice of deficiency and included determinations that petitioner had unreported gross receipts of $13,401 and was entitled to single filing status and one personal exemption.

On February 1, 2021, two days before the first scheduled trial date in this case, petitioner provided respondent’s counsel with an unsigned return for 2017. The return, which had been prepared by a paid preparer, reports his filing status as head of household and claims a personal exemption for himself and dependency exemptions for three children. The return also claims the additional child tax credit and the earned income tax credit. Finally, Schedule Cof the unsigned return reports that BC had gross receipts of $79,781 (offset by a $13,605 cost of goods sold) and claims the following deductions for expenses.

As substantiation for the disallowed deductions, petitioner proffered a profit and loss statement for 2017, that he prepared in October 2020, but he was unable to provide the underlying records used to produce it. He also proffered the February and March 2017, monthly statements for the bank account he maintained for BC.

OPINION

Burden of proof

Generally, the Commissioner’s determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving that those determinations are erroneous. Under section 7491(a), in certain circumstances the burden of proof may shift from the taxpayer to the Commissioner. Petitioner has not claimed or shown that he has satisfied the requirements of section 7491(a) so as to shift the burden of proof to respondent as to any relevant factual issue.

Schedule C Deductions

Applicable law

Deductions are a matter of legislative grace, and a taxpayer must prove his or her entitlement to a deduction. A taxpayer claiming a deduction on a federal income tax return must demonstrate that the deduction is allowable pursuant to a statutory provision and must further substantiate that the expense to which the deduction relates has been paid or incurred. A taxpayer must substantiate deductions claimed by keeping and producing adequate records that enable the Commissioner to determine the taxpayer’s correct tax liability. Under section 162(a) a deduction is allowed for “ordinary and necessary expenses paid or incurred . . . in carrying on any trade or business.” An ordinary expense is one that commonly or frequently occurs in the taxpayer’s line of business.

Generally, if a taxpayer provides sufficient evidence that he or she has incurred a trade or business expense contemplated by section 162(a) but is unable to adequately substantiate the amount, the Court may estimate the amount and allow a deduction to that extent. For the Court to estimate the amount of an expense, there must be some basis upon which an estimate may be made.

Section 274 imposes strict substantiation rules on certain specified expenses. No deductions under section 162 shall be allowed for “any traveling expense (including meals and lodging while away from home),” or “listed property,” as defined in section 280F(d)(4), “unless the taxpayer substantiates [them] by adequate records or by sufficient evidence corroborating the taxpayer’s own statement.” Thus, substantiation of any expense categorized as car and truck or meals and entertainment is governed by section 274.

To meet these strict substantiation rules, a taxpayer must substantiate by adequate records or by sufficient evidence corroborating his own statement: (1) the amount of the expense, (2) the time and place the expense was incurred, and (3) the business purpose of the expense. § 274(d). To substantiate by adequate records, the taxpayer must provide (1) an account book, a log, or a similar record, and (2) documentary evidence, which together are sufficient to establish each element of an expenditure.

2010

The bank records petitioner offered to substantiate the disallowed $100,246 Schedule C deduction for contractors do not do so. Most of the entries are for debit card purchases or ACH debits for certain identified commercial establishments. We are unable to see how such transactions could constitute payments to contractors. There are also entries for payments of checks, but these show only a check number and an amount. Without any reference to a payee or a purpose, these check payment entries do not substantiate payments to contractors. Petitioner has failed to substantiate the deduction, and we sustain respondent’s disallowance of it.

2011

No Schedule C deductions were disallowed for this year.

2012

The 2012 profit and loss statement and bank statements for that period, which petitioner offered to substantiate the disallowed $18,259 deduction for rent or lease payments and the disallowed $34,791 deduction for wage payments, are insufficient to do so. Petitioner prepared the 2012 profit and loss statement in October 2020, and he concedes that he does not have any records (other than the bank statements) to substantiate the entries. The 2012 profit and loss statement contains numerous discrepancies as between the statement itself and the corresponding entries on petitioner’s 2012 return. This may suggest that petitioner’s return preparer found fault with some of the profit and loss statement entries. Moreover, there are also discrepancies between the 2012 profit and loss statement figures and the bank statements for that period. The determinations in the notice of deficiency to disallow the claimed Schedule C deductions for rent or lease payments and wage payments are presumptively correct, and petitioner bears the burden of proof to show that the determinations are incorrect.

2013

Petitioner did not offer a profit and loss statement for 2013 but only the monthly statements for the bank account he maintained for BC for that year. We are unable to find any entries in those bank statements that provide clear substantiation for the claimed deductions for expenses classified as other interest of $5,008, repairs and maintenance of $18,259, and wages of $34,391.

2014

Petitioner proffered both a 2014 profit and loss statement and BC’s monthly bank statements for that period to substantiate the $61,468 deduction claimed for car and truck expenses and the $2,948 deduction claimed for payroll expenses. But the proffered substantiation is insufficient. Petitioner prepared the profit and loss statement in October 2020 and concedes that he does not have any of the supporting documentation (other than the bank statements) used to prepare it. The discrepancy between the 2014 profit and loss statement and the 2014 return is substantial for the car and truck expenses. Whereas the combined figure for “Auto and Truck Expenses” and for “Fuel” on the profit and loss statement is $3,674.03, the amount claimed on the return for car and truck expenses is $61,468. As for the amounts claimed for payroll expenses, there is no traceable connection between the checks that were written from the bank account and amounts recorded as payroll on the profit and loss statement. The foregoing is insufficient to overcome the presumptive correctness of the notice of deficiency’s determinations to disallow the claimed deductions for car and truck expenses and payroll expenses.

2015

Petitioner offered both a 2015 profit and loss statement and BC’s monthly bank statements for that period to substantiate the $49,786 deduction claimed for car and truck expenses and the $12,638 deduction claimed for contractor expenses. Petitioner prepared the profit and loss statement in October 2020 and concedes that he does not have any of the supporting documentation (other than the bank statements) used to prepare it. The discrepancy between the 2015 profit and loss statement and the 2015 return is substantial for the car and truck expenses. Whereas the combined figure for “Auto and Truck Expenses” and for “Fuel” recorded in the profit and loss statement is $5,376.39, the amount claimed on the return for car and truck expenses is $49,786. As for the amounts claimed for contractors, there is no traceable connection between checks that were written from the bank account and amounts recorded as payroll on the profit and loss statement. (There are no entries on the 2015 profit and loss statement for contractors.) The foregoing is insufficient to overcome the presumptive correctness of the notice of deficiency’s determinations to disallow the claimed deductions for car and truck expenses and contractor expenses.

2016

Petitioner offered both a 2016 profit and loss statement and BC’s monthly bank statements for that period to substantiate the $36,683 deduction claimed for car and truck expenses, the $17,060 deduction claimed for rent or lease of other business property expenses, and the $7,377 deduction claimed for contractor expenses. Petitioner prepared the profit and loss statement in October 2020 and concedes that he does not have any of the supporting documentation (other than the bank statements) used to prepare it.

The discrepancy between the 2016 profit and loss statement and the 2016 return is substantial for the car and truck expenses. Whereas the combined figure for “Auto and Truck Expenses” and for “Fuel” recorded in the profit and loss statement is $5,949.08, the amount claimed on the return for car and truck expenses is $36,683. Given this discrepancy, the proffered records are insufficient to substantiate the deduction.

With respect to the deduction claimed for expenses for rent or lease of  other business property, there is in fact consistency between the profit and loss statement, the monthly bank statements, and the return. The profit and loss statement and the monthly bank statements both record nine payments totaling $17,060, which is the figure claimed on the return. The profit and loss statement records that the nine payments were made to Debbie Parson, whereas the monthly bank statements merely indicate that nine checks (totaling $17,060) were issued on dates corresponding to the dates in the profit and loss statement but without any indication of the payee. Without any testimony or other evidence establishing who Debbie Parson is or the purpose of the payments, the foregoing records are insufficient to substantiate any rental expense with a business purpose.

With respect to the deduction claimed for $7,377 in contractor expenses, the 2016 profit and loss statement contains a section entitled “Payroll Expenses,” the entries of which total $7,376.50. Putting aside the issue of whether a payroll expense, typically associated with employees, could be taken to indicate payments to contractors (an issue that we need not decide), the greater shortcoming in the probative value of the 2016 profit and loss statement—in addition to the fact that it was prepared in October 2020—lies in the 2016 monthly bank statements that purportedly support the profit and loss statement entries. The majority of the payroll entries in the profit and loss statement tie back to ATM withdrawals in the bank statements, while the remainder tie back to checks, but the check entries in the bank statements do not identify the payees. The profit and loss statement does identify an individual payee for each entry, but even if we were to accept the designated payees given in the profit and loss statement, there is no testimony or other evidence to establish who the payees were (other than petitioner himself, and his ATM withdrawals could have been for a multitude of purposes other than salary) or the nature of the services for which payment was made. On the basis of the foregoing, we conclude that petitioner has failed to substantiate the deduction for contractor expenses and accordingly sustain respondent’s disallowance of it.

2017

When petitioner had not filed a return for 2017 by sometime in 2019, the SB/SE agent prepared a Substitute For Return pursuant to section 6020(b) and notified petitioner of the same on March 19, 2019. The SFR adjustments were incorporated in the notice of deficiency and included determinations that petitioner had unreported gross receipts of $13,401 and was entitled to single filing status and one personal exemption.

In the course of the proceedings in this case, petitioner submitted to respondent’s counsel an unsigned Form 1040, U.S. Individual Income Tax Return, for 2017, and it is a stipulated Exhibit. An unsigned return submitted in a deficiency proceeding such as this has no legal effect. Nevertheless, in view of petitioner’s pro se status, we will treat the positions taken on the return, where appropriate, as claims pleaded by petitioner in the case, as the parties effectively tried them by consent. The unsigned return reports gross receipts from BC on Schedule C of $79,781 and claims various expenses totaling $51,534. The return also reports petitioner’s filing status as head of household and claims dependency exemptions for three children as well as a personal exemption for petitioner. In addition, the return claims the additional child tax credit and the earned income tax credit.

Unreported gross receipts

Where a notice of deficiency has determined that the taxpayer had unreported income, it is presumptively correct so long as the Commissioner introduces some substantive evidence that the taxpayer received unreported income. The notice of deficiency and a Wage and Income Transcript for petitioner’s 2017 taxable year both reference the payment of income to petitioner by third parties. That is sufficient to meet respondent’s burden of production with respect to the unreported income. Petitioner has not disputed that he received gross receipts for 2017; indeed, in his unsigned return he reported that BC had gross receipts of $79,781. Accordingly, we sustain respondent’s determination that petitioner had unreported gross receipts of $13,401.

Filing status, exemptions, and credits

Petitioner offered no evidence to support his claims on the unsigned return that he is entitled to head of household filing status, dependency exemptions for three children, the additional child tax credit, or the earned income credit. We accordingly sustain respondent’s determination that petitioner is entitled to single filing status and one personal exemption. We conclude that petitioner has not shown entitlement to head of household filing status, dependency exemptions for three children, or any credits.

Schedule C deductions

The expenses listed on Schedule C of petitioner’s unsigned return lack substantiation. Petitioner offered a Profit and Loss Statement for 2017, but he offered bank statements only for the months of February and March 2017. Consequently, for many of the expenses listed on the Profit and Loss Statement and carried over onto the return, there is no proof that the payment of the expense was actually made. This absence of proof of payment covers the claims for legal and professional services, office expense, repairs and maintenance, and various items in the “other expenses” category, including garbage, parking fees, and bridge toll. In other cases, an expense listed on Schedule C has no corresponding entry on the profit and loss statement to support it, or there is a significant (and unexplained) discrepancy between the figure on Schedule C and the figure on the profit and loss statement. In this category are the expenses for commissions and fees, utilities, wages, and certain items grouped under other expenses (telephone and gas). As for the remaining expenses—namely, rent or lease of other business property, advertising, insurance, internet, and miscellaneous—the two months of bank statements are insufficient to establish that these expenses were actually paid in 2017. Consequently, petitioner has failed to show entitlement to any deduction for the expenses listed on Schedule C of the unsigned return.

Unreported interest income

Respondent also determined that petitioner had unreported taxable interest income of $34, $31, and $18 for 2010, 2011, and 2012, respectively. As noted, where a notice of deficiency has determined unreported income, the Commissioner must introduce evidence the taxpayer received unreported income in order for the determination to be presumed correct. The record includes Wage and Income Transcripts for petitioner’s 2010, 2011, and 2012 taxable years, and they record that an identified third-party payor filed information returns reporting the payment of interest to petitioner for the foregoing amounts and years. At trial petitioner testified that he did not dispute these amounts.

Penalties and additions to tax

Respondent determined that petitioner is liable for accuracy-related penalties under section 6662(a) for 2010–13, 2015, and 2016. He also determined that petitioner is liable for additions to tax under section 6651(a)(1) for failure to timely file for all years at issue and under section 6651(a)(2) for failure to timely pay for 2017.

Accuracy-related penalties

Section 6662(a) and (b)(2) imposes a 20% accuracy-related penalty on any portion of an underpayment of tax required to be shown on a return that is attributable to any substantial understatement of income tax. A substantial understatement of income tax exists if the amount of the understatement for the taxable year exceeds the greater of 10% of the tax required to be shown on the return for the taxable year or $5,000. For each of the taxable years 2010–13, 2015, and 2016, we have sustained deficiencies (and thus understatements of tax) that exceed 10% of the tax required to be shown on the return.

Additions to tax

Section 6651(a)(1) imposes an addition to tax if the taxpayer fails to file his or her income tax return by the required due date (including any extension of time for filing). The addition is equal to 5% of the amount required to be shown as due on the return for each month (or fraction thereof) after the due date, up to a maximum of 25%. For each year at issue, petitioner failed to file more than five months after the due dates for the returns.