Tax Court in Brief | Palmarini Inc. v. Commissioner, Palmarini v. Commissioner | Recordkeeping and Constructive Dividends

The Tax Court in Brief – December 12th – December 16th, 2022

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Tax Litigation:  The Week of December 12th, 2022, through December 16th, 2022

Palmarini Inc. v. Comm’r, Palmarini v. Comm’r, T.C. Memo. 2022-119 | December 7, 2022 | Gustafson, J. | Dkt. Nos. 1719-17, 1723-17

Opinion

Short Summary: During tax years 2013 and 2014 (the “Tax Years”), petitioners husband and wife filed joint Forms 1040, U.S. Individual Income Tax Returns. Petitioner wife worked as a procurement analyst for the U.S. Department of Defense. Petitioner husband worked as a cement contractor for petitioner corporation.

Petitioner husband owned an approximately 33% interest in petitioner corporation, with the remaining interests being owned by his brothers.  Petitioner husband also was the sole member of a limited liability company (“LLC”) that was engaged in the business of affiliated online marketing. Petitioner husband viewed all accounts of petitioner corporation and LLC as his own and used them for both business and personal purposes. Petitioner husband also owned various residential properties and hired professional real estate management companies to manage the renting of the properties to tenants.

While petitioner corporation in prior years had been primarily operated as a cement construction business, it did not receive any revenues from cement construction work or own any rental property as part its business activity during the Tax Years. Instead, all revenues from petitioner husband’s affiliated online marketing business were deposited into petitioner corporation’s corporate bank accounts and associated advertising expenses were paid from its corporate bank accounts.

Petitioner corporation did not keep books or records, a general ledger, or profit and loss statement, and did not engage the services of an accountant or bookkeeper for the Tax Years. In preparing petitioner corporation’s returns for the Tax Years, petitioner husband would review the corporation’s bank and credit card statements to identify business expenses versus personal expenses.

Petitioner corporation timely filed its Forms 1120, U.S. Corporation Income Tax Returns, for each the Tax Years. Starting shortly after filing the original return for the 2014 tax year, petitioner corporation filed multiple amended returns for both years. On its original returns for the Tax Years, petitioner corporation listed its business activity as “affiliate marketing,” although on the last amended return that petitioner corporation filed for its 2014 tax year, this was changed to “affiliate marketing (mainly) & cement work.” Petitioner corporation also indicated on its original returns for the Tax Years that it was on the cash method of accounting, although on some amended returns for these years it claimed to be on the accrual method.

On its returns for the Tax Years, petitioner corporation claimed deductions for officer compensation and wages but did not report to the IRS any wages paid to anyone on a Form W-2, Wage and Tax Statement, did not file a Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, or Form 941, Employer’s QUARTERLY Federal Tax Return, and did not pay any employment taxes. Petitioner corporation claimed a deduction for repairs and maintenance of residential properties owned by petitioner husband relating to petitioner corporation’s use of such properties for storage of machinery and equipment used in its inactive construction business. Petitioner corporation claimed bad deductions based on allegedly unpaid balance owed by a customer for affiliated online advertising services. Petitioner corporation deducted rent paid to petitioner husband’s brother for use of a garage as its principal place of business. Petitioner corporation claimed a depreciation deduction based on for a truck that was used in its cement construction business but that was owned by petitioner husband. Petitioner corporation also claimed a deduction for advertising expenses as well as various “other” deductions.

Petitioners husband and wife also timely filed their federal income tax returns for the Tax Years. On these returns, petitioners husband and wife claimed a casualty deduction on the basis of a decrease in the fair market value of their home after a series of severe storms caused trees at their residence to fall on their fence, destroying approximately twenty feet of the fence. On their Schedule C, Profit or Loss From Business, petitioners husband and wife reported only gross receipts and advertising expenses from LLC, reflecting a net loss. Petitioners husband and wife also included a Schedule E, Supplemental Income and Loss, with their 2013 federal income tax return relating to various rental properties.

The IRS examined petitioner corporation’s returns for the Tax Years. Because petitioner corporation did not provide any books or records reflecting its calculations of gross income for the Tax Years, the revenue performed a bank deposit analysis whereby the IRS issued summonses to all banks at which petitioner corporation held accounts and sent letters to third parties to verify the type of income reflected in the deposits. The revenue agent then performed a disbursement analysis using petitioner corporation’s bank and credit card statements, during the course of which a line-by-line survey was performed to distinguish business expenses from personal expenses. As a result of the examination, the IRS determined to increase petitioner corporation’s income for unreported gross income and disallowed deductions. The revenue agent also determined a constructive dividend to petitioner husband that that petitioner corporation was liable for accuracy related penalties.

The IRS also examined petitioners husband’s and wife’s returns for the Tax Years. Petitioners husband and wife did not provide any original books or records showing how they calculated LLC’s gross receipts for the Tax Years. As a result, the revenue agent performed a bank deposits analysis on petitioners husband and wife individually. The revenue agent increased petitioners husband’s and wife’s qualified dividends for the Tax Years because of her determination that petitioner husband had received constructive dividends from petitioner corporations during those years. The revenue agent disallowed deductions reported on the Schedule C for the LLC, because the expenses were paid from petitioner corporation’s bank accounts. Regarding petitioners husband’s and wife’s Schedule E, the revenue agent disallowed all deductions claimed for the Tax Years.

The IRS issued notices of deficiency to petitioner corporation and petitioners husband and wife for the Tax Years determining federal income tax deficiencies and accuracy-related penalties. Attached to each notice of deficiency were Letters 950 signed by the revenue agent’s group manager. Petitioner corporation and petitioners husband and wife timely filed petitions with the Tax Court.

Key Issues:

• Was the IRS’s use of a bank deposits analysis to determine petitioner corporation’s unreported income for the Tax Years appropriate when petitioner corporation did not maintain adequate books records?
• Was it appropriate for the IRS’s determine that all advertising income and expenses in connection with petitioner husband’s advertising activities were properly reportable on petitioner corporation’s returns for the Tax Years?
• In light of petitioner corporation’s failure to maintain books and records, should petitioner corporation’s income for the Tax Years consist only of amounts that third parties reported on Forms 1099 as having paid to it?
• Is petitioner corporation entitled to a deduction for officer compensation?
• Is petitioner corporation entitled to a deduction for salaries and wages?
• Is petitioner corporation entitled to a deduction for repairs and maintenance?
• Is petitioner corporation entitled to a bad debt deduction?
• Is petitioner corporation entitled to a deduction for rent?
• Is petitioner corporation entitled to a depreciation deduction?
• Is petitioner corporation entitled to deductions for advertising expenses?
• Is petitioner corporation entitled to other deductions?
• Were certain payments made by petitioner corporation constructive dividends to petitioner husband?
• Was it appropriate for the IRS to assess accuracy-related penalties against petitioner corporation during the Tax Years?
• Were petitioners husband and wife entitled to a casualty loss deduction on their 2014 federal income tax return?
• Were any advertising income and expenses properly reportable on petitioner husband’s Schedule C?
• Were certain expenses reported on petitioner husband’s and wife’s Schedule E in connection with the repair and maintenance of rental properties deductible?
• Was the imposition of accuracy-related penalties against petitioner husband and wife appropriate?

Primary Holdings:

• Because petitioner corporation did not maintain adequate books and records, the IRS’s use of a bank deposits analysis to determine petitioner corporation’s unreported income for the Tax Years appropriate.
• It was appropriate for the IRS to determine that all advertising income and expenses in connection with Petitioner Husband’s advertising activities were reportable on Petitioner corporation’s returns for the Tax Years. Petitioner corporation reported its business activity to be affiliate marketing and reported significant gross receipts and expenses from affiliate online marketing during the Tax Years. The bad debt deduction claimed by Petitioner corporation for the Tax Years related to unpaid advertising services. While Petitioner husband allocated income and expenses from Petitioner corporation to LLC during the tax years, he could not provide any factual basis for these allocations and apparently only allocated expenses to LLC in order to generate losses that would be reportable on Schedule C of his individual returns which would offset Petitioner Wife’s otherwise taxable income.
• Petitioner corporation’s income for the Tax Years should not only consist of amounts that third parties reported on Forms 1099 as having paid to it. The IRS’s bank deposits analysis determined that petitioner corporation received more than what was reported on the Forms 1099 issued for the Tax Years. Moreover, petitioner corporation’s amended returns for the Tax Years themselves showed gross receipts in excess of the amounts reported on the Forms 1099. Thus, the IRS established its burden to provide predicate evidence connecting petitioner corporation to unreported gross receipts, and petitioner corporation did not demonstrate any flaw in the IRS’ methodology or calculations.
• Petitioner corporation was not entitled to a deduction for officers’ compensation because petitioner corporation did not prove that the amounts intended as compensation were in fact paid to officers.
• Petitioner corporation was entitled to deduct salaries and wages for the Tax Years in connection with petitioner corporation’s renovation of a structure that would later be used as an office. The salaries and wages paid were reflected on invoices and reference check numbers corresponding with disbursements that the IRS identified as “Cash.”
• Petitioner corporation was not entitled to claim deductions for repairs and maintenance because such deductions lacked substantiation.
• Petitioner corporation was not entitled to claim a bad deduction in connection with amounts that a customer failed to pay for affiliate online advertising. There was no creditor-debtor relationship between petitioner corporation and the customer. Moreover, petitioner corporation previously had been a cash basis taxpayer, there was no evidence that petitioner corporation had ever elected to change its method of accounting, and there was no evidence that any unpaid balance was accrued as income in a prior year.
• Petitioner corporation was only entitled to deduct rent that it paid in connection with properties that it did not own during the Tax Years.
• Petitioner corporation was not entitled to a deduction for depreciation in connection with a truck that was owned by petitioner husband, because there were no adequate records to ascertain the business use percentage of the truck.
• Petitioner corporation did not establish that it was entitled to deduct additional amounts for advertising.
• Petitioner corporation did not establish that it was entitled to additional “other” deductions when petitioner corporation’s disorganized recordkeeping did not enable the Tax Court to verify the business purposes and specific amounts paid for “other” expenses.
• Petitioner husband received constructive dividends from petitioner corporation in the amount of certain personal and rental expenses that petitioner corporation paid on behalf of petitioner husband and in connection with petitioner husband’s properties.
• Petitioner corporation was liable for accuracy-related penalties under either a negligence theory based on its failure to maintain adequate records or a substantial understatement theory based on the extent of its underreported income and overstated deductions.
• Petitioners husband and wife were not entitled to a casualty loss deduction on their 2014 federal income tax return, because no receipts were provided reflecting the cost of restoration work actually done on the fence and there was no appraisal of the decrease in value of the property as a result of the casualty. The best evidence of the casualty loss was the $2,500 deductible that petitioners husband and wife were required to pay. Moreover, petitioners husband’s and wife’s net casualty loss of $2,500 was less than 10% of their adjusted gross income, which meant the entire casualty loss should be disallowed.
• No advertising income or expenses were properly reportable on petitioner husband’s Schedules C. All income from the advertising activities was deposited into petitioner corporation’s bank accounts. Moreover, petitioner husband admitted that his primary objective in preserving his Schedules C was to generate a loss to offset petitioner wife’s wages and reduce the individual income tax owed.
• Petitioner husband and wife did not maintain adequate records to show whether the repair and maintenance of rental property were ordinary or whether they produced a capital benefit to the property that would last more than one year. Thus, the Tax Court assumed that the expenditures were capital that the adjusted basis of the rental property consisted only of these expenditures, and allowed a depreciation deduction with respect to the property.
• The imposition of accuracy related penalties against petitioner husband and wife was appropriate when the revenue agent obtained supervisory approval of the penalties obtained before sending petitioner husband and wife her proposed report. Moreover, the Tax Court found that petitioner husband and wife were liable for accuracy related penalties under either a negligence theory based on their failure to maintain adequate records or on a substantial understatement theory based on the extent of their underreported income and overstated deductions. Petitioner husband and wife did not show any “reasonable cause” that would justify relief from accuracy-related penalties.

Key Points of Law

• The IRS’s determination of a deficiency generally is presumed correct, and the taxpayer has the burden of proving it wrong. Welch v. Helvering, 290 U.S. 111, 115 (1933); see also Tax Court Rule 142(a)(1).
• However, where the IRS alleges that a taxpayer underreported income, he must “provide some predicate evidence connecting the taxpayer to the charged activity” before the presumption of correctness attaches to his determination. Gerardo v. Commissioner, 552 F.2d 549, 554 (3d Cir. 1977), aff’g in part, rev’g in partC. Memo. 1975-341.
• Determinations of constructive dividends are determinations of underreported income, and to support such determinations, the IRS must establish a sufficient connection between the income and the taxpayer before the presumption of correctness attaches to his determination of a constructive dividend. See, e.g., Austin Otology Assocs. v. Commissioner, T.C. Memo. 2013-293, at *23; D’Errico v. Commissioner, T.C. Memo. 2012-149, 103 T.C.M. (CCH) 1802, 1809.
• Once the IRS connects the taxpayer with the unreported income, the taxpayer then bears the burden of proving that he did not receive the income and that the Commissioner’s determination of a deficiency is incorrect. See Walker v. Commissioner, 757 F.2d 36, 38 (3d Cir. 1985), rev’g and remandingC. Memo. 1983-538; see also Tax Court Rule 142(a).
• Every person liable for any tax imposed under the Internal Revenue Code, or for the collection thereof, shall keep such records, render such statements, make such returns, and comply with such rules and regulations as the Secretary of the Treasury may from time to time prescribe. R.C. § 6001.
• A taxpayer must “keep such permanent books of account or records . . . as are sufficient to establish the amount of gross income, deductions, credits, or other matters required to be shown by such person in any return of such tax or information” Reg. § 1.6001-1(a). The taxpayer must keep such books or records “for inspection by authorized internal revenue officers or employees . . . so long as the contents thereof may become material in the administration of any internal revenue law.” Id. § 1.6001-1(e).
• A C corporation is a separate federal income tax-paying entity, distinct from its shareholders. Moline Properties, Inc. v. Commissioner, 319 U.S. 436, 438–39 (1943).
• By choosing to incorporate, a C corporation’s shareholders assume both the benefits and burdens of the corporate form, and they may not disregard its separate status if they find it is disadvantageous for tax purposes. See Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 149 (1974) (“[W]hile a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice, whether contemplated or not, and may not enjoy the benefit of some other route he might have chosen to follow but did not.” (citations omitted)).
• A taxpayer’s gross income includes “all income from whatever source derived.” I.R.C. § 61(a).
• If a taxpayer fails to keep adequate records, the Commissioner may determine the existence and amount of the taxpayer’s income by any method that clearly reflects income. § 446(b).
• A taxpayer may compute taxable income under the cash receipts and disbursement method. Id. § 446(c).
• Under the cash receipts and disbursements method, income is recorded in the year received and expenses are deducted in the year paid. Reg. § 1.461-1(a)(1); see also I.R.C. §§ 451(a), 461(a).
• Use of a bank deposits analysis to determine unreported income is well-recognized, and it begins by assuming that all bank deposits are taxable income unless the taxpayer can show otherwise. Estate of Mason v. Commissioner, 64 T.C. 651, 656–57 (1975), aff’d, 566 F.2d 2 (6th Cir. 1977). However, the Commissioner must take into account any nontaxable items or deductions for which he has knowledge. DiLeo v. Commissioner, 96 T.C. 858, 868 (1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
• “When a taxpayer keeps no books or records, has large bank deposits, and offers no plausible explanation of such deposits, the Commissioner is not arbitrary or capricious in resorting to the bank deposit method for computing income.” Estate of Mason, 64 T.C. at 657; see also Clayton v. Commissioner, 102 T.C. 632, 645 (1994); DiLeo, 96 T.C. at 867.
• When deductions are in dispute, the taxpayer must satisfy the specific requirements for any deduction claimed. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).
• A taxpayer must also maintain records adequate to substantiate his income and deductions. I.R.C. § 6001.
• Amounts reported on tax returns, even though signed under penalty of perjury, are insufficient to substantiate the deductions claimed thereon. Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979) (citing Roberts v. Commissioner, 62 T.C. 834, 837 (1974) and Halle v. Commissioner, 7 T.C. 245 (1946), aff’d, 175 F.2d 500 (2d Cir. 1949)).
• A taxpayer may deduct “a reasonable allowance for salaries or other compensation for personal services actually rendered” as an ordinary and necessary business expense. R.C. § 162(a)(1).
• The test for determining the deductibility of compensation payments is (1) whether they are reasonable in amount and (2) whether they are in fact payments purely for services. Reg. § 1.162-7(a).
• Only payments intended as compensation are deductible, and compensatory intent is a question of fact. Paula Constr. Co. v. Commissioner, 58 T.C. 1055, 1058–59 (1972), aff’d, 474 F.2d 1345 (5th Cir. 1973).
• The taxpayer bears the burden of proving compensatory intent. King’s Court Mobile Home Park, Inc. v. Commissioner, 98 T.C. 511, 514 (1992).
• The cost “for permanent improvements or betterments made to increase the value of any property” be capitalized, not immediately deducted. R.C. § 263(a)(1).
• Only “[t]he cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as an expense” in the current year. Reg. § 1.162-4 (2011); see also id. § 1.263(a)-3(i)(1)(i). On the other hand, amounts paid for improvements, betterments, restorations, or adaptations of real property are considered capital expenditures. Seeid. § 1.263(a)-3(d), (j), (k).
• A taxpayer cannot take a deduction for repairs and maintenance to property it neither owned nor leased, even if it paid the expense and used these properties for business purposes. See, e.g., Arevalo v. Commissioner, 124 T.C. 244, 251 (2005) (“[W]hen a taxpayer never actually owns the property in question, the taxpayer is not allowed to claim deductions for depreciation”), aff’d, 469 F.3d 436 (5th Cir. 2006).
• A taxpayer a deduction for any bona fide debt that becomes wholly or partially worthless within the taxable year. R.C. § 166(a). To prove entitlement to a bad debt deduction, the taxpayer must show (1) the existence of a bona fide debt, (2) incurred in connection with a trade or business, (3) that became worthless within the taxable year. See id. § 166.
• “A bona fide debt is a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Reg. § 1.166-1(c).
• Whether a debtor-creditor relationship exists is a question of fact. Fisher v. Commissioner, 54 T.C. 905, 909 (1970).
• Factors indicating a bona fide debt include whether: (1) evidence of indebtedness exists; (2) any security is requested; (3) there has been a demand for repayment; (4) the parties’ records reflect the transaction as a loan; (5) any payments have been made; and (6) interest was charged. See Sundby v. Commissioner, T.C. Memo. 2003-204, 86 T.C.M. (CCH) 58, 61 (2003).
• “A debt arising out of the receivables of an accrual method taxpayer is deemed to be an enforceable obligation . . . to the extent that the income such debt represents have been included in the return of income for the year for which the deduction as a bad debt is claimed or for a prior taxable year.” Treas. Reg. § 1.166-1(c).
• “[A] taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary.” I.R.C. § 446(e).
• A taxpayer may deduct rental expenses, provided that the payment is made as a condition to the continued use or possession (for the purposes of the trade or business) of property in which the taxpayer has no title and no equity. I.R.C. § 162(a)(3).
• A taxpayer may take a deduction for depreciation of property “used in the trade or business” or “held for the production of income.” R.C. § 167(a).
• To prove entitlement to a deduction for depreciation, a taxpayer must show (1) the existence of a trade or business; (2) that the property in question is used in the trade or business; and (3) a depreciable basis in the asset by showing the cost of the property, its useful life, as well as any previously allowable depreciation. See, e.g., Cluck v. Commissioner, 105 T.C. 324, 337 (1995).
• A taxpayer claiming depreciation of a mixed-use asset must show the relevant proportions of business and personal use. See R.C. §§ 274(d), 280F(b), (d)(4); see also Finney v. Commissioner, T.C. Memo. 1980-23, 39 T.C.M. (CCH) 938, 950–51 (holding that the taxpayer has the burden to prove the percent of business use); Treas. Reg. §§ 1.167(a)-2, 1.280F-2T(i)(1).
• “[A]dvertising and other selling expenses” that “pertain to the taxpayer’s trade or business” are generally deductible under section 162 as an “ordinary and necessary” expense. See Reg. § 1.162-1(a)(1).
• A shareholder must include in gross income any portion of the distribution which is a dividend (i.e., it is paid out of the corporation’s earnings and profits). R.C. § 301(c).
• A constructive dividend arises “[w]here a corporation confers an economic benefit on a shareholder without the expectation of repayment, . . . even though neither the corporation nor the shareholder intended a dividend.” Magnon v. Commissioner, 73 T.C. 980, 993–94 (1980); see also C.F. Mueller Co. v. Commissioner, 479 F.2d 678, 683 (3d Cir. 1973) (“A taxpayer who is a shareholder has been held to have received a constructive dividend when he receives an economic benefit through a diversion of corporate earnings and profits”), aff’g 55 T.C. 275 (1970).
• “However, ‘not every corporate expenditure which incidentally confers economic benefit on a shareholder is a constructive dividend.’ The crucial test of the existence of a constructive dividend is whether ‘the distribution was primarily for the benefit of the shareholder.’” Magnon, 73 T.C. at 994 (emphasis added) (quoting Loftin & Woodard, Inc. v. United States, 577 F.2d 1206, 1214 (5th Cir. 1978)).
• There is a two-part test to determine a constructive dividend: (1) the expense must be nondeductible to the corporation, and (2) it must represent some economic gain, benefit, or income to the shareholder. See, e.g., Dobbe v. Commissioner, T.C. Memo. 2000-330, 80 T.C.M. (CCH) 577, 587, aff’d, 61 F. App’x 348 (9th Cir. 2003).
• Where the Commissioner has determined a constructive dividend as unreported income, he bears the burden of production to show a connection between that income and the taxpayer. See, e.g., Austin Otology Assocs., T.C. Memo. 2013-293, at *23; D’Errico, 103 T.C.M. (CCH) at 1809.
• “The fact that the full amounts have been disallowed as deductions to the corporation does not necessarily mean that the full amounts are to be treated as dividends to the individual.” See Ashby v. Commissioner, 50 T.C. 409, 418 (1968).
• For each expense included in the constructive dividends, the Commissioner must first establish a connection with taxpayer and then show that the payment was primarily for the taxpayer’s benefit. See Gerardo v. Commissioner, 552 F.2d at 554; Magnon, 73 T.C. at 994.
• Section 6662(a) imposes an “accuracy-related penalty” equal to 20% of the portion of an underpayment of tax that is attributable to the taxpayer’s negligence or disregard of rules or regulations or that is attributable to any substantial understatement of income tax.
• Negligence means “any failure to make a reasonable attempt to comply with the provisions of this title [i.e., title 26 U.S.C., the Internal Revenue Code]”; and also includes “any failure by the taxpayer to keep adequate books and records or to substantiate items properly”. Reg. § 1.6662-3(b)(1).
• For corporations, an understatement of income tax is “substantial” if it exceeds the lesser of either 10% of the tax that should have been reported on the return (or, if greater, $10,000) or $10 million. I.R.C. § 6662(d)(1)(B).
• “It is a well-settled principle that the Internal Revenue Manual does not have the force of law, is not binding on the IRS, and confers no rights on taxpayers.” McGaughy v. Comm’r, T.C. Memo. 2010-183, 100 T.C.M. (CCH) 144, 148.
• A taxpayer may take a deduction for casualty losses incurred during the year that are not compensated by insurance or otherwise. R.C. § 165. The amount of the deduction equals the difference between the fair market value of the property before and after the casualty, to the extent of the taxpayer’s adjusted basis in the property. Treas. Reg. § 1.165-7(b)(1)(i).
• A deduction for casualty loss may be valued as the cost of repair where (a) the repair is necessary to restore the property to its pre-casualty condition, (b) the cost of repair is not excessive, (c) the repairs do not exceed the actual damage suffered, and (d) the repairs do not increase the value of the property beyond its pre-casualty value. § 1.165-7(a)(2)(ii).
• The deduction for casualty losses is limited in two ways: first by allowing a deduction only for casualty losses greater than $100 and second by allowing a deduction for casualty losses only to the extent that the loss exceeds the sum of the taxpayer’s personal casualty gain for the taxable year plus 10% of the taxpayer’s adjusted gross income (“AGI”). SeeR.C. § 165(h)(1), (h)(2)(A).
• For an individual (as for a corporation, discussed above), the section 6662(a) and (b)(1) and (2) accuracy-related penalty applies to the portion of an underpayment of tax required to be shown on a return that is attributable to either (1) the taxpayer’s negligence or disregard of rules or regulations or (2) a substantial understatement of income tax, defined for an individual by section 6662(d)(1)(A) as exceeding either 10% of the tax that should have been reported on the return or $5,000, whichever is greater.
• The Commissioner bears the burden of production with respect to the liability of an individual for any penalty. R.C. § 7491(c). To satisfy his burden, the Commissioner must present sufficient evidence to show that it is appropriate to impose the penalty in the absence of available defenses. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
• One element of the Commissioner’s burden of production is to show compliance with section 6751(b)(1), which requires the individual making the penalty determination to obtain written supervisory approval of the initial determination to assert any penalty. See Graev v. Commissioner, 149 T.C. 485, 493 (2017), supplementing and overruling in part 147 T.C. 460 (2016).
• Once the Commissioner meets his burden of production on penalties, the taxpayer must come forward with persuasive evidence that the Commissioner’s showing is incorrect. Higbee, 116 T.C. at 447; see also Tax Court Rule 142(a). Or he may defend against the penalty with a showing of “reasonable cause” and “good faith” under section 6664(c)(1).

Insight: This case demonstrates the importance for taxpayers to maintain records relating to income and expenses reported on their income tax returns. Additionally, this case shows the perils that taxpayers who own corporations may face if they ignore corporate formalities.