The following discussion of the tax law on the hoppy loss issue was extracted from the F. Lee Baily case, noted below.   The issue is whether activities are engaged in for profit: general principles

The case also discussed Mr. Bailey's entitlement to deductions for the 1993 through 2001 tax years that arose from the yacht rental activity and the airplane remanufacturing activity 42 that he conducted through his two wholly owned S corporations. A taxpayer who is carrying on a trade or business may deduct ordinary and necessary expenses incurred in connection with the operation of the business. Sec. 162(a). However, a taxpayer generally may not deduct expenses incurred in connection with a hobby or other nonprofit activity to offset taxable income from other sources. Sec. 183(a).  Section 183(c) defines an “activity not engaged in for profit” as “any activity other than one with respect to which deductions are allowable for the taxable year under section 162 or under paragraph , conducted the three activities as separate activities for accounting purposes. He also hired a different set of employees to manage and carry out each activity.

Under section 212, an activity constitutes a “trade or business” within the meaning of section 162—and it escapes the limitation of  section 183—if the taxpayer's actual and honest objective is to realize a profit. Osteen v. Commissioner, 62 F.3d 356, 358 [76 AFTR 2d 95-6013] (11th Cir. 1995), aff'g in part and rev'g in part  T.C. Memo. 1993-519 [1993 RIA TC Memo ¶93,519]. The expectation of profit need not have been reasonable; however, the taxpayer must have entered into the activity, or continued it, with the objective of making a profit. Hulter v. Commissioner, 91 T.C. 371, 393 (1988); 26 C.F.R. sec. 1.183-2(a), Income Tax Regs. Whether the requisite profit objective exists is determined by looking at all the surrounding facts and circumstances. Keanini v. Commissioner , 94 T.C. 41, 46 (1990); 26 C.F.R. sec. 1.183-2(b). Greater weight is given to objective facts than to a taxpayer's mere statement of intent. Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), aff'd, 792 F.2d 1256 [58 AFTR 2d 86-5138] (4th Cir. 1986); 26 C.F.R. sec. 1.183-2(a).

Section 1.183-2(b) of the regulations provides a list of factors to be considered in the evaluation of a taxpayer's profit objective: (1) the manner in which the taxpayer carries on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort expended by the taxpayer in carrying on the activity; (4) the expectation that assets used in the activity may appreciate in value;

(5) the success of the taxpayer in carrying on other similar or dissimilar activities;

(6) the taxpayer's history of income or losses with respect to the activity; (7) the amount of occasional profits, if any, from the activity; (8) the financial status of the taxpayer; and (9) elements of personal pleasure or recreation. This list is nonexclusive, and the number of factors for or against the taxpayer is not necessarily determinative. Rather, all facts and circumstances must be taken into account, and more weight may be given to some factors than to others. Id.; see Dunn v. Commissioner, 70 T.C. 715, 720 (1978), aff'd, 615 F.2d 578 [45 AFTR 2d 80-683] (2d Cir. 1980).

, TC Memo 2012-96 , Code Sec(s) 61; 162; 183; 195; 274; 6651; 6662; 7491.

F. LEE BAILEY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent F. LEE BAILEY AND ESTATE OF PATRICIA S. BAILEY, F. LEE BAILEY, PERSONAL REPRESENTATIVE, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent .

Case Information:

Code Sec(s):       61; 162; 183; 195; 274; 6651; 6662; 7491

Docket:                Docket Nos. 3080-08, 3081-08.

Date Issued:       04/2/2012

HEADNOTE

XX.

Reference(s): Code Sec. 61; Code Sec. 162; Code Sec. 183; Code Sec. 195; Code Sec. 274; Code Sec. 6651; Code Sec. 6662; Code Sec. 7491

Syllabus

We now address these nine factors with respect to the yacht rental activity and the airplane remanufacturing activity.

V. Analysis of Mr. Bailey's yacht rental activity Mr. Bailey conducted the yacht rental activity through PBR from 1993 until the Government took control of the Spellbound in 1996. Mr. Bailey concedes that he never intended to profit from yacht rentals per se, and we therefore do not analyze that activity for a profit motive. Rather, Mr. Bailey contends that the yacht rental activity was really the continuation and winding down of his previous yacht refurbishing activity, which (he alleges) was engaged in for profit. Mr. Bailey also contends that the Commissioner is estopped by a settlement agreement from contesting his profit motive for the yacht rental activity.

Even if Mr. Bailey's yacht rental activity is viewed as a continuation of his previous yacht refurbishing activity, we find that it was not engaged in for profit during tax years 1993 though 1996. 43 We also find that the Commissioner is not estopped from contesting Mr. Bailey's profit motive.

        A.         Lack of profit motive for yacht refurbishing activity

Mr. Bailey contends that the yacht rental activity was really the continuation and winding down of his previous yacht refurbishing activity. He contends that the yacht refurbishing activity was engaged in for profit (i) before the tax years at issue, when he attempted to use the Spellbound as a prototype to refurbish and sell other used yachts, and (ii) during the tax years at issue, when he was winding down the yacht refurbishing activity. As Mr. Bailey correctly notes, a taxpayer does not lack a profit motive merely because his business fails and he takes a reasonable time to unwind it and minimize his losses. 44 44

See Helmick v. Commissioner T.C. Memo. 2009-220 [TC Memo 2009-220], slip op. at 27-28 ,   (continued...)

However, if the deductibility of the suit-years' yacht-related expenditures depends on the for-profit character of the pre-suit-years' yacht refurbishing activity, then it was incumbent on Mr. Bailey to prove that for-profit character. He did not do so, as the following consideration of the nine factors listed above shows.

1. Manner in which the activity is conducted Mr. Bailey kept his records for the yacht activity in the Lantana hangar before discarding them, but the record contains only Mr. Bailey's general claims about the adequacy of the records, and does not provide needed details about their type or quality. Mr. Bailey discarded those records (after giving the IRS an opportunity to review and copy them). Mr. Bailey thus failed to prove whether he kept records for the activity in a business-like manner. Mr. Bailey does not allege, nor does the record show, that he changed his operating methods to improve the profitability of the yacht refurbishing activity. This factor—the manner in which the activity is conducted—is strongly in the Commissioner's favor. 44 (...continued) (after “a catastrophic loss that could never be recouped,” a taxpayer who “thereafter expected to generate an overall prospective profit *** could not be said to lack a profit objective after the disaster merely because he would never recoup the prior loss”).

2. Expertise of the taxpayer and his advisers Mr. Bailey was an aviator, a lawyer, a speaker, an author, and a past owner of a helicopter company; but when he acquired theSpellbound he had no prior experience in yacht selling or refurbishing. Mr. Bailey did hire experts—Dennison Marine and the Roscioli Yachting Center—to execute his plans to refurbish the Spellbound; but he offered no evidence other than his own general testimony to show that they actually collaborated with or advised him in establishing a business of which the Spellbound was to be a prototype. We are not convinced that he was much more than a retail customer of Dennison Marine and the Roscioli Yachting Center. This factor—expertise—is in the Commissioner's favor.

3. Time and effort expended

Mr. Bailey did not establish how much time or effort he spent in refurbishing the Spellbound or developing a plan to sell yachts. Instead, Mr. Bailey was otherwise employed with his law practice. This factor—time and effort—is in the Commissioner's favor.

4. Expectation that assets may appreciate in value Mr. Bailey testified that he did not expect the Spellbound to appreciate. This factor—expectation that assets may appreciate—is in the Commissioner's favor.

5. Taxpayer's success in similar or dissimilar activities Though Mr. Bailey's career has been remarkably varied, he was not ever involved in a business venture similar to refurbishing and selling yachts. This factor—success in similar or dissimilar activities—is in the Commissioner's favor. 6-7. History of income or loss, amount of occasional profits Mr. Bailey refurbished only one yacht, theSpellbound, had difficulty selling it, and never used it as a prototype. Mr. Bailey's summaries show that the Spellbound generated a significant loss every year and a total loss of $922,137 over its brief four-year course. These factors—history of income or loss, and occasional profits—are moderately in the Commissioner's favor.

8. Financial status of the taxpayer

Substantial income from sources other than the activity in question, particularly if offset by claimed losses from the activity, may indicate that the activity is not engaged in for profit. On the other hand, a lack of income from sources other than the activity in question may make a profit objective more likely. 26 C.F.R. sec. 1.183- 2(b)(8). Mr. Bailey's average gross income from his law practice and speaking services exceeded $1 million a year during the tax years at issue, and he claimed the activity's losses to significantly reduce his income tax liabilities.

Mr. Bailey concedes that he “had a solid income from other sources” but insists that he “did not purposefully arrange to lose money through aircraft rental operations”. However, in determining whether, under  section 183, an activity is engaged in for profit, greater weight is given to objective facts than to a taxpayer's mere statement of intent. Mr. Bailey could afford to maintain a yacht for his use even if there was no expectation of future profit.

This factor—financial status—is in the Commissioner's favor.

9. Elements of personal pleasure

The Commissioner contends that Mr. Bailey took a great deal of personal pleasure from sailing on theSpellbound with his family and friends, but Mr. Bailey claims that "[i]t's no fun to drive a boat”. Mr. Bailey testified that the steering wheel and navigational instruments of theSpellbound are isolated from the rest of the deck, and the pilot is therefore isolated from the party-goers on the deck.

While it may be true that Mr. Bailey did not enjoy piloting the yacht, the record belies the claim that he derived no personal pleasure from it. First, the Spellbound was built to Mr. Bailey's specifications, and he testified that it was beautiful. Second, the record does not show that Mr. Bailey always took on the job of piloting the Spellbound. PBR hired a captain and crew to sail and maintain the Spellbound, and Mr. Bailey could have used their services to pilot the yacht any number of times. Even assuming arguendo that Mr. Bailey piloted the Spellbound on every personal trip—and that he disliked the task—we find that he derived pleasure from sharing the yacht with his family and friends and that he anticipated doing so when he purchased the yacht in 1989.

This factor—elements of personal pleasure—is in the Commissioner's favor.

10. Conclusion

We do not conclude that Mr. Bailey's contention that he intended to refurbish and sell yachts is a complete fabrication. He may well have contemplated the idea when deciding to buy the yacht, and he may have entertained the possibility as another justification for going ahead and making the purchase. But there is no indication that operating an activity of refurbishing and selling yachts for profit was the real or principal reason he bought the yacht. Consequently, we find that the yacht refurbishing activity before the years at issue was not entered into for profit; therefore, the winding down of that activity in the years at issue, involving the rental of the yacht, was not the continuation of a for- profit activity.

B. Equitable estoppel

1. Alleged agreement Mr. Bailey contends that the Commissioner is estopped by a settlement agreement from contesting his profit motive for the yacht rental activity. Mr. Bailey alleges that he and the IRS entered into a settlement agreement in 1996 which stipulated that Mr. Bailey's yacht refurbishing activity had been engaged in for profit for the 1990 through 1992 tax years. Revenue Agent Tabor acknowledges that he allowed Mr. Bailey favorable treatment on this issue for 1990 through 1992; but the only evidence of any written agreement is Mr. Bailey's testimony that “I think there's a letter out there, somewhere” that memorialized the alleged settlement agreement. Mr. Bailey did not submit into evidence a copy of the alleged settlement agreement or any other evidence to suggest that a settlement was reached, and we find that there was no such settlement.

Even if there had been a settlement as to the years 1990 through 1992, it would not govern the subsequent years that are now before us. Generally, “each taxable year stands alone, and the Commissioner may challenge in a succeeding year what was condoned or agreed to in a previous year.” Rosemann v. Commissioner, T.C. Memo. 2009-185 [TC Memo 2009-185] (citing Auto. Club of Mich. v. Commissioner ,  353 U.S. 180 [50 AFTR 1967] (1957), and Rose v. Commissioner, 55 T.C. 28 (1970)).

2. Alleged misleading

Mr. Bailey also asserts estoppel arising from his allegation that the IRS misled him. He asserts that the IRS misled him about its intention to challenge his profit motive for the yacht rental activity by agreeing that the yacht refurbishment activity was engaged in for profit. Equitable estoppel is a judicial doctrine that precludes a party from denying that party's own acts or representations that induce another to act to his or her detriment; and in extraordinary circumstances, equitable estoppel may bar the Commissioner from challenging his previous determinations; but the doctrine is to be applied against the Commissioner only with caution and restraint. See McCorkle v. Commissioner, 124 T.C. 56, 68 (2005). The essential elements of estoppel are: (i) there must be a false representation or wrongful misleading silence; (ii) the error must be in a statement of fact and not in an opinion or a statement of law; (iii) the person claiming the benefits of estoppel must be ignorant of the true facts; and (iv) he must be adversely affected by the acts or statements of the person against whom estoppel is claimed. Id.; see also Dickow v. United States, 654 F.3d 144, 152 [108 AFTR 2d 2011-5874] (1st Cir. 2011).

In particular, Mr. Bailey contends that he discarded his records for the yacht rental activity after June 2002 only because Revenue Agent Tabor “never suggested, until 2004, that *** [the yacht rental activity] was anything but a business”.

However, Mr. Bailey has not met his burden to prove that (i) the IRS deceived or misled him (ii) about a factual issue that relates to his profit motive for the yacht rental activity (iii) of which he was ignorant and (iv) as to which relied on the IRS on to his detriment. In fact, the record contradicts Mr. Bailey's contention that Revenue Agent Tabor “never suggested” that the IRS might challenge his profit motive for the yacht rental activity until 2004. Revenue Agent Tabor issued five IDRs to Mr. Bailey in April 2002 that each made requests with respect to the profitability of the yacht rental activity—two years before 2004, and only weeks before June 2002, when Mr. Bailey gave the IRS a final opportunity to review and copy his records before he discarded them. Thus, Revenue Agent Tabor was visibly investigating Mr. Bailey's profit motive weeks before the records were discarded, and Mr. Bailey had no reason to suppose that the IRS had conceded the issue.

Accordingly, we hold that the Commissioner is not estopped from contesting Mr. Bailey's profit motive for the yacht rental activity.

C. Lack of nexus between yacht refurbishing and yacht rental Even if we were to find that Mr. Bailey's yacht refurbishing had been a for- profit activity in the prior years, or were to hold that the Commissioner was estopped from contending otherwise, we would still have to evaluate his claim that his yacht rental activity in the years at issue was merely the unwinding of that prior activity. Mr. Bailey did not simply rent out the yacht to pay his docking fees and other inevitable expenses of holding theSpellbound for sale. Mr. Bailey entertained his family and friends on theSpellbound. Although he claims that his personal use constituted only a “small percentage” of the total use of theSpellbound, 45 the record shows otherwise. First, Mr. Bailey's summaries of revenue and expenses show that the yacht rental activity generated more than 10 times higher expenses than charter fees. Second, the timesheets kept by the crew of the Spellbound for 1995 show that the crew devoted at least twice as much time to personal or unpaid trips as it did to paid charters. Most of the use of the Spellbound was personal during the tax years at issue.

If the Spellbound had been originally purchased and refurbished for business purposes, we would conclude that in the years at issue it was converted to personal use and that the rentals were simply a means of covering some of the cost of that personal use.

D. Tax consequences

Because the yacht rental activity was not engaged in for profit, under section 183(b)(2) Mr. Bailey can deduct his yacht expenses only to the extent of yacht income. The notices of deficiency accomplish this effect by including in Mr. Bailey's income PBR's yacht rental receipts and capital gains and then allowing him deductions for PBR's expenses in the same amounts—deductions, however, that are subject to the limit of section 67(a) (i.e., as “miscellaneous itemized deductions” allowable only to the extent that in the aggregate they exceed 2 percent of adjusted gross income), because they are not among those excluded from that limit by  section 67(b). The notice of deficiency is sustained in this regard.

VI. Analysis of Mr. Bailey's airplane remanufacturing activity Mr. Bailey's airplane remanufacturing activity presents a sharp contrast to his yacht activity. He conducted the airplane remanufacturing activity—“Project 288”— from 1994 until its chief inspector and director of maintenance resigned in April 1996. On the basis of all the facts and circumstances, we do find that Project 288 was engaged in for profit from 1994 to April 1996.

A. Profit motive under section 183 Examining the nine factors suggested in the regulations under  section 183, we find that the activity was engaged in for profit.

1. Manner in which the activity is conducted Mr. Bailey failed to prove that he kept records for the airplane remanufacturing activity in a business-like manner. Although we found that Mr. Bailey kept his records for the activity in the Lantana hangar before discarding them, the record does not show their type or quality. This tends against a finding of a profit motive.

However, a strong business-like feature of Project 288 was Mr. Bailey's attempt to obtain FAA approval for the modifications his company developed for the Twin Comanche design and then applied to the Bailey Bullet. PBR contracted for the services of Bill Wall, who served as the administrator of East Coast Avionics, an FAA-certified designated alteration station. In that capacity, he was authorized to issue supplemental type certificates on behalf of the FAA to approve modifications to aircraft designs. On September 21, 1995, Mr. Wall issued five supplemental type certificates to PBR, which approved a number of the modifications that he helped to develop for Project 288.

As the Commissioner correctly notes, the issuer of a supplemental type certificate is required to file, inter alia, two copies of the certificate with the FAA within 30 days of the date of issue. 14 C.F.R. sec. 21.463 (1995). Mr. Wall apparently failed (unbeknownst to Mr. Bailey) to file the required copies of the five supplemental type certificates with the FAA, and this failure makes questionable the validity of those certificates. However, even if the five supplemental type certificates are invalid, that fact does not indicate that Mr. Bailey failed to conduct Project 288 in a business-like manner. Mr. Bailey reasonably relied on Mr. Wall to carry out his regulatory duty and file the required copies with the FAA. Mr. Bailey had no reason to suspect that Mr. Wall would fail to do his job. Mr. Wall's lapse did not evidence any lack of seriousness on Mr. Bailey's part about obtaining permission to resell remanufactured planes.

Ultimately, the fact that Mr. Bailey engaged in the sophisticated and costly process of obtaining “multi-use” supplemental type certificates to modify an aircraft design—rather than simply applying for the simpler and cheaper “one-off” field approval to modify a single aircraft for his personal use—is weighty evidence that he conducted Project 288 in a business-like manner. It is difficult to explain this effort unless Project 288 was undertaken with an intention to make a profit as Mr. Bailey alleges.

We conclude that this factor—the manner in which the activity is conducted—is overall in Mr. Bailey's favor, indicating that he had the requisite profit objective.

2. Expertise of the taxpayer and his advisers By 1993 Mr. Bailey had modest relevant expertise: He had decades of experience in flying small airplanes, which acquainted him with the industry, the product, and its market. His law practice gave him general experience in running a business. And for 10 years he had owned Enstrom Helicopter Corp. While that relevant expertise was arguably modest, Mr. Bailey consulted with and hired an impressive array of experts in the aviation industry to assist him with the conduct of Project 288. First, Mr. Bailey consulted with Robert A. Hoover, a famed air show and test pilot; Charles B. Cusick, an aeronautical engineer and former executive with Narco and Cessna Aircraft Co.; and LeRoy Patrick LoPresti, an aeronautical engineer and former executive with Beechcraft and Piper Aircraft,

Inc., before selecting the Twin Comanche over the Beechcraft Baron as the focus of Project 288. Second, Mr. Bailey hired Douglas Vasco, an FAA-certified designated airworthiness representative, as the chief inspector and director of maintenance for Project 288. He also hired two FAA-certified airframe and powerplant mechanics to work under Mr. Vasco. Third, Mr. Bailey contracted for the services of Bill Wall, the administrator of an FAA-certified designated alteration station, to develop and approve modifications to the Twin Comanche design and apply those modifications to the Bailey Bullet. The quantum, sophistication, and content of this advice was beyond what any hobbyist would have obtained and makes sense only in view of Mr. Bailey's plan to refurbish airplanes as a business.

We conclude that this factor—expertise—is in Mr. Bailey's favor and indicates that he had the requisite profit objective.

3. Time and effort expended

Mr. Bailey contends that he was very “hands-on” in managing Project 288 and spoke with his employees and contractors on a regular basis. Mr. Bailey did personally choose the features that were added to the Bailey Bullet, but Mr. Bailey was busy with his law practice. He hired about a dozen employees to disassemble and reconstruct the airplanes, and the record does not show how closely he managed Project 288.

We conclude that this factor—time and effort—is neutral for assessing whether Mr. Bailey had the requisite profit objective.

4. Expectation that assets may appreciate in value Mr. Bailey concedes that Project 288's “hardware”, such as the Bailey Bullet, could not be expected to appreciate, but he contends that its “intangibles”, such as the supplemental type certificates, could be expected to appreciate. We agree. Mr. Bailey expected the “multi-use” supplemental type certificates to appreciate, as his anticipated reselling business grew. He expected to install the modifications permitted by those certificates to an increasing number of Twin Comanches, and he actively tried to increase the value of that prospect by promoting the Bailey Bullet at the NBAA convention.

We conclude that this factor—expectation that assets may appreciate—is in Mr. Bailey's favor for assessing whether he had the requisite profit objective.

5. Taxpayer's success in similar or dissimilar activities Mr. Bailey contends that he had prior success in two similar activities—his ownership of Enstrom Helicopter Corp. and his participation in an airplane refurbishing and rental company named Marshfield Aviation, both of which he asserts were profitable. However, the record does not show much detail of Mr. Bailey's role in Enstrom and does not show whether the company was profitable. Morever, Mr. Bailey failed to establish that he was involved with Marshfield Aviation or any other business ventures related to leasing, buying, or selling aircraft. Thus, the record does not support Mr. Bailey's contention that he was involved with two profitable aircraft companies.

We conclude that Mr. Bailey failed to show success in similar activities and that this factor is in the Commissioner's favor. 6-7. History of income or loss, amount of occasional profits In the tax years at issue, Mr. Bailey claimed losses from PBR, and Project 288 incurred losses for every year of its short history and never generated any profits. However, the Commissioner acknowledges that Project 288 was in its start-up phase during the 1994 through 1996 tax years. 26 C.F.R. section 1.183- 2(b)(6), provides that a series of losses and a lack of occasional profits during the start-up phase of an activity may not necessarily be an indication that the activity is not engaged in for profit. See Strickland v. Commissioner, T.C. Memo. 2000-309 [TC Memo 2000-309]. Accordingly, we decline to take the fact that Project 288 never generated a profit as an indication that it was not engaged in for profit.

We conclude that these factors—history of income or loss, and occasional profits—are neutral for assessing whether Mr. Bailey had the requisite profit objective.

8. Financial status of the taxpayer

As we discussed above in connection with the yacht activities, Mr. Bailey does not dispute that he was a successful attorney who earned millions of dollars during the tax years at issue. He therefore had an incentive to claim the activity's losses to reduce his income tax liability.

We conclude that this factor—financial status—is in the Commissioner's favor.

9. Elements of personal pleasure

Mr. Bailey contends that the Bailey Bullet was not developed or used for his personal enjoyment. Instead, he contends that Project 288 was his latest attempt to generate a stream of “business income” that would allow him, as he got older, to step back from his stressful and labor-intensive law practice.

Mr. Bailey is a veteran pilot who chose to work with small airplanes his entire career. Despite his protestations to the contrary, we have no doubt that Mr. Bailey enjoyed heading up Project 288 and flying the Bailey Bullet. However, several critical facts contradict the Commissioner's contention that Mr. Bailey conducted Project 288 for personal pleasure or recreation. First, Mr. Bailey already owned several aircraft (through BEI and then PBR). He did not need to purchase or design a new airplane to take to the skies. Second, as is noted above, Mr. Bailey went to great lengths to obtain “multi-use” supplemental type certificates to modify an aircraft design. If pleasure had been the goal, and Mr. Bailey had merely sought to customize a single airplane for his personal use, then applying for a “one-off” field approval would seem to have been preferable.

We conclude that this factor—elements of personal pleasure—is neutral in determining whether Mr. Bailey had the requisite profit objective.

10. Conclusion

While some of the factors discussed above support the Commissioner's position and some are neutral, we are convinced that as a whole the record supports Mr. Bailey's contention that his airplane remanufacturing activity was engaged in for profit from 1993 through April 1996, and that he is therefore entitled to deduct the expenses attributable to that activity if and to the extent he substantiated them and showed that they are currently deductible.

B. Timing of deductions

1. The Commissioner's alternative contention With small exceptions, 46 the Commissioner contends that the expenses incurred in connection with Project 288 are not currently deductible and must be disallowed. The Commissioner's principal position—the one reflected in the notices of deficiency—is that the expenses for Project 288 were not deductible because it was not entered into for profit, a position we have rejected. The Commissioner makes an alternative contention—not reflected in the notices of deficiency—that since Project 288 had only begun to produce a prototype and did not ever develop a production line for the remanufacture and sale of airplanes, its expenses are nondeductible, because they were either start-up expenditures under  section 195 (i.e., incurred before the airplane refurbishing business was a going concern) 47 or capital expenditures pursuant to  section 263(a)(1) (i.e., incurred to 47 “A taxpayer is not carrying on a trade or business under  section 162(a) until the business is functioning as a going concern and performing the activities for which it was organized.” Glotov v. Commissioner, T.C. Memo. 2007-147 [TC Memo 2007-147]. 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. Hardy v.   (continued...) develop a capital asset, the Bailey Bullet). The Commissioner has the burden of proof for these contentions (which are “new matter[s]", see Rule 142(a)(1)).

2. Start-up expenditures If the expenditures were start-up expenditures of a business, then they are not currently deductible. Section 195(a) generally disallows a current deduction for start-up expenditures, and there is no evidence that Mr. Bailey made the election under section 195(b) that would have entitled him to amortize his start-up expenditures over 180 months. Section 195(c)(1) defines “start-up expenditure” to mean 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 47 (...continued) Commissioner, 93 T.C. 684, 687-688 (1989). business referred to in subparagraph (A)), would be allowable as a deduction for the taxable year in which paid or incurred. That is, an enterprise ceases to incur “start-up expenditures” when it becomes an “active trade or business”.

When a taxpayer fails to make the election permitted by  section 195, the consequence is that any start-up expenses incurred must be capitalized,see Vianello v. Commissioner, T.C. Memo. 2010-17 [TC Memo 2010-17], and can be deducted only when the activity ceases altogether, see Krebs v. Commissioner, T.C. Memo. 1992-154 [1992 TC Memo ¶92,154].

Under these principles, the Project 288 expenditures incurred in 1994 were start-up expenditures. However, in 1995 Project 288 was no longer a start-up but rather had graduated to going concern status. "[A]n enterprise need not have generated sales or other revenue to have begun to carry on a business, [but] it must nonetheless have started to function in a particular and identifiable line of work.” Weaver v. Commissioner, T.C. Memo. 2004-108 [TC Memo 2004-108]. Mr. Bailey established that in 1995 the Bailey Bullet was operational and airworthy and that in that year PBR, acting as a commercial vendor, presented the plane at a trade show to generate orders. The Commissioner presented no evidence to seriously contradict the conclusion that the Project 288 business was a going concern at this point, however ill fated it may have been. Project 288 continued briefly as a going concern until 1996, when Mr. Bailey was incarcerated and the activity was decisively terminated.

3. Capital expenditures

If the expenditures were capital expenditures of building a specific asset (such as the supplemental type certificates, or the Bailey Bullet prototype), then they are part of the basis of that asset. The supplemental type certificates arguably became worthless when they were not filed in October 1995, but the Bailey Bullet remained unsold during the years at issue. The record does not show whether there were other distinct assets created by Project 288 expenditures.

To determine the timing of the deductibility of the Project 288 expenditures, we must determine whether and the extent to which the expenses for Project 288 are capital expenditures or start-up costs (a determination as to which, again, the Commissioner has the burden of proof).

4. Analysis

We first address the question whether specific amounts can be allocated to any assets other than Project 288 as a whole. The record suggests no assets created by Project 288 other than the Bailey Bullet plane and the supplemental type certificates. Beyond the research expenditures whose current deduction the Commissioner concedes, no distinct expenditures can be allocated to the supplemental type certificates.

We therefore turn to the question of expenditures incurred to create the Bailey Bullet. We begin by noting the difficulty of distinguishing between expenditures for the start-up of a plane remanufacturing business and expenditures for the construction of the prototype plane. Simply to state that distinction is to indicate its difficulty, since those two notions overlap. 48 TheFdevelopment of a prototype is often a major part of starting up a business. The work done on a prototype may have a value that exceeds—and would not be justified by—the making of a single item . When the prototype plane was finished, PBR had not only one plane but also a substantial body of know-how and expertise that its team hoped to employ in building more planes. To attribute the entire cost of their work to the single plane they had produced might be completely contrary to business sense. Consequently, a well-prepared attempt to prove a distinction between the capital expenses of the Bailey Bullet and the start-up expenses of Project 288 would include substantial evidence, and perhaps expert testimony.

However, no evidence was offered at trial to make the distinction (which the Commissioner first raised during the course of trial) between start-up expenditures for the business per se and capital expenditures for the Bailey Bullet. We find,see supra note 22, in the absence of any more specific information, that PBR's expenditures fairly allocable to the building of the plane were $169,907 for 1994 and $169,907 for 1995. These amounts are capital and go toward Mr. Bailey's basis.

The remainder of the Project 288 expenses for 1994 (i.e., the total of $424,787, minus the $169,907 spent on the Bailey Bullet and the currently deductible research expenses of $30,635, yielding $224,245) constituted general expenses of the development of the Project 288 business—i.e., start-up expenditures not currently deductible that are deductible instead for 1996, the year that Project 288 was decisively terminated.

We have held that for 1995 Project 288 was no longer a start-up but rather had graduated to going-concern status. We therefore hold that the general expenses of Project 288 were currently deductible for 1995 and 1996. For 1995 those consisted of the total of $456,286, minus the Bailey Bullet expenses of $169,907 and the currently deductible research expenses of $21,744, yielding $264,635. For 1996 those consisted of the entire Project 288 expenses of $125,694.

VII. Miscellaneous adjustments The notices of deficiency reflect numerous miscellaneous adjustments made by the agent to Mr. Bailey's income and deductions. We uphold them in large part, as is detailed below. The IRS's adjustments include computational adjustments prompted by changes to his adjusted gross income. Recomputation of these computational adjustments will be necessary and can be made when the parties recompute Mr. Bailey's liability pursuant to Rule 155. We therefore do not include them in the following discussion.

       A.      Mr. Bailey's position

The primary counter-evidence that Mr. Bailey produced at trial to support his position and contradict the agent on these miscellaneous adjustments was Quicken registers and cashflow reports for the 1993 through 2001 tax years. That is, he did not offer receipts or other transactional documents to substantiate the items on his return; he simply relied on his secondary Quicken records.

For several of the years he lacked even those records; but on the eve of trial in 2009, Mr. Bailey was finally able to “unlock” password-protected copies of his Quicken database, from which he made new printouts for all nine years. The data on the three available printouts made earlier (printed in October 1997 for tax year 1996, in October 2000 for tax year 1999, and in October 2001 for tax year 2000) and the data on the 2009 printouts for those same three years are not identical and cannot be correlated with each other. We do not conclude that the later-produced printouts constitute an attempt to falsify the data; we presume that Mr. Bailey presented them in good faith; but we find them unreliable. The differences between the 2009 printouts and the prior ones apparently arise from post-2002 data entries, so it is clear that the entries were not made contemporaneously during the years at issue (1993-2001). Rather, they were evidently made after 2002 and before the later reports were printed in 2009. In his testimony Mr. Bailey expressed the belief that the database used in 2009 might actually be an earlier version, not a later version, of the database that produced the printouts in 2002, but we cannot tell whether that is correct. The later printouts may reflect entries made in good faith as intended corrections of the data; but the record does not show—and Mr. Bailey does not even claim to know—who made the corrections nor the information on which the corrections were based.

And in any event, the corrected data (if they are correct) on the later printouts (if they really are later) do not correspond to the tax returns. Mr. Bailey's arguments on brief often amount to demonstrating that amounts in dispute are duly reflected in the 2009 printouts; but if he would thus rely on a later printout, then he would have to show that a disputed item of income that does appear on that printout also appears on the return, or that expenses that appear on the printout are not among those that the notice of deficiency allowed and did not adjust. To show that fees were duly reported on the 2009 printout is to prove only that they should have been reported on Mr. Bailey's tax returns; that showing does not prove that they actually were reported.

Rather than correlating the 2009 printouts with the returns, Mr. Bailey simply criticizes the Commissioner's position for failing to take into account the 2009 printouts. The Court has attempted to puzzle through Mr. Bailey's factual assertions and determine whether the 2009 printouts can be reconciled with the returns and correlated to the notices of deficiency, but the record does not include sufficient information to make possible such comparisons. That is, Mr. Bailey has largely failed in his burden of proof. Mr. Bailey did not show how the 2009 Quicken printouts support or tie to the amounts reported on his returns.

B. Analysis

We now address the particular adjustments that the IRS made:

              1.       Income items

                        a.    Barnett Bank interest

Mr. Bailey acknowledges that he received interest income of $207 in 1993 from Barnett Bank of Palm Beach County that was not reported on his 1993 Federal income tax return. b. Gross receipts The IRS determined that Mr. Bailey had additional gross receipts under  section 61(a)(2) in the amount of $86,808 in 1994, consisting of amounts (not related to Claude Duboc) that were deposited into Mr. Bailey's Credit Suisse account. However, Mr. Bailey contends that the fees so paid were retainers not yet earned. Mr. Bailey says that he treated the Credit Suisse account as if it were a sort of trust account for certain clients (in a manner similar to the arrangement he made with the Government for Duboc stock) and that when he had earned the fees, he transferred them to his Barnett account, which (he says) would have resulted in their being reported as income at that time, given the method he used for reporting income. His contention is not implausible, but he does not point to any entry in the record showing any later-reported income items as including these amounts, and the Court is not able to find any such entries. The IRS's adjustment in this respect is therefore sustained. c. Capital gain The IRS determined that in 1994 Mr. Bailey had additional long-term capital gain income from the sale of 150,000 shares of Biochem Pharma stock on October 20, 1994. However, we have held that the deposit of stock sale proceeds into Mr. Bailey's Credit Suisse advance account did not constitute an appropriation of those proceeds by him. Rather, Mr. Bailey realized ordinary income upon his receipt of proceeds from the sale of the shares when the money was transferred to his Barnett account in 1994 and 1995. The IRS's capital gain adjustment is therefore not sustained. d. Pension income The IRS determined that Patricia Bailey had additional unreported pension income of $1,951.00 in 1993. Mr. Bailey's response is to state in his brief that “I believe” that a Form 1099 for the income “was given to” his return preparer and so it was presumably reported on the return. But Mr. Bailey did not show that he actually reported this item on his return, and the IRS's adjustment is sustained.

The IRS determined that Mrs. Bailey had additional pension income under  section 61(a)(11) of $69,527 in 1999. Mr. Bailey contends that $60,000 of the amount received “went to another, specifically Lana McGovern” (i.e., Mrs. Bailey's mother). However, Mr. Bailey did not show that he or his wife reported this item, and he did not show how a payment to his mother-in-law could have reduced their liability for tax on the pension income. e. Bartering income The IRS attributed $10,183 of unreported bartering income to Mr. Bailey for 1995, but we conclude that the IRS misunderstood the transaction. In return for work done by a Project 288 employee, Mr. Bailey wrote a check from his law practice's account to pay a legal expense on behalf of that employee (i.e., fees to another law firm). If in return for the employee's services Mr. Bailey had rendered his own services, then that would have been barter—but that is not what happened. Instead, Mr. Bailey wrote a check for the employee's services. f. Deposits to office accounts The IRS determined that in 1995, Mr. Bailey received $3,955 of reimbursements for expenses that had been deducted on the return, so those deposits should be included in income. However, those checks were deposited into an office account from which income was not reported on his return. Mr. Bailey offers no evidence that such deposits were not made to the account or that deductions were not claimed for the related expenses. We therefore sustain the adjustment.

Likewise, the IRS determined that in 1997 Mr. Bailey received fees of $33,696 that he deposited into an office account from which fees were not included on his return. These unreported fees came from three sources that the agent named, and they were evidenced by canceled checks that were admitted into evidence, in amounts that the agent specified. Mr. Bailey's response is to state that he “cannot divine the source of Respondent's claimed $33,696 `additional income”. Since the source was plainly given, and since Mr. Bailey did not make any showing that these amounts had already been included in income, we sustain the IRS's adjustment.

The IRS determined that in 1998 Mr. Bailey received and deposited into his office account, but did not report on his return, fees and reimbursements from six named payers, in amounts totaling $9,257. Mr. Bailey responds as to only one of the deposits (the largest) and states that it “appears to be” a payment for overhead, i.e., reimbursement of a deductible expense. His implicit position seems to be that since the expense being reimbursed was deductible, then the non-reporting of the corresponding income would be a “wash”, with no tax effect (and that including the item in income would in effect deny him a deduction to which he was entitled). That would be true only if he had not in fact claimed on his return a deduction for the overhead expense, which he did not attempt to show (and which seems highly unlikely). He makes no response as to the other five items in this group. The IRS's adjustments must be sustained.

The IRS identified specific checks totaling $7,526 that were deposited to his office account in 2000 but not reported as income. Mr. Bailey's response is that “The alleged additional income deposited in Petitioner's Office Account is incorrect”; but he cites no evidence and does not explain how or why the determination is incorrect. We therefore sustain the adjustment.

Also in 2000, checks totaling $38,333, in apparent payment of fees owed to Mr. Bailey by three clients, were deposited to his sister's office account; but the IRS determined that they were not among the amounts in his “Cash Flow Report” that he reported as income. Mr. Bailey responds: “The amounts deposited into Nancy Bailey's account was [sic] all transferred to # 1443 [Mr. Bailey's account from which fees were reported], as [t]he records and testimony show, but which Respondent has chosen to ignore.” He cites no such records or testimony, and we are aware of none that contravenes the IRS's analysis. We sustain the adjustment. g. Arithmetic error The IRS determined that Mr. Bailey had under-reported his 1996 fee income because of a $100,000 mathematical error. At trial the Commissioner demonstrated the error by showing the total income reported on Schedule C for Mr. Bailey's law practice ($1,870,209), showing on the workpaper of Mr. Bailey's assistant the component thereof that related to “Fees - Palm BC” (i.e., $386,167.81), and showing a reconstruction of the actual fees, which totals exactly $486,167.81.

Mr. Bailey could have answered this assertion by reconstructing the $386,167.81, or by otherwise showing how the $1.8 million total on the Schedule C accounted for all of the income. He did neither. Rather, in response, he attempted to undermine the reliability of the documents (from his own records) that his assistant gave to the IRS and to propose a different source document for the supposedly correct amount—but without showing how the entries on that document can be reconciled either with his return or with the information previously provided. (On the contrary, the Commissioner demonstrates that Mr. Bailey's different source document substantiates the larger, corrected amount of fees.) The IRS's adjustment is not effectively challenged, and we therefore sustain it. h. Speech income The Schedule C law practice income for 1996 as explained to the IRS by Mr. Bailey's representative included speech income of only $2,000, which the IRS's examining agent thought to be an unusually low amount. The agent thereafter found in Mr. Bailey's records evidence of speech income totaling $15,700, and the IRS determined additional income in that amount. Mr. Bailey admits that he realized the income, but he asserts that "[t]he $15,700 *** was indeed duly reported.” But this summary assertion is not supported by any analysis of the income reported nor any other evidence. The adjustment is sustained.

For 1998 the agent determined that $20,000 of unreported speech income was deposited into an account of Mrs. Bailey's. Mr. Bailey responds that "[t]he income deposited into Patricia Bailey's account was largely transferred to Petitioner's account #1443 and picked up as income there.” He asserts this without any citation of evidence, and his imprecise qualification that the income was “largely” transferred suggests that he has not even tracked the numbers through himself, much less on the record of this case. The adjustment is sustained.

The total income reported on Mr. Bailey's 2000 Schedule C for his “attorney” activity was $325,040. Consistent with that, his Quicken “Cash Flow Report” for 2000 shows income of $269,995 in fees (broken down by client), $16,545 in reimbursements, and $38,500 in “Total Royalty”, all totaling $325,040, as reported. However, the IRS found that “royalty” checks had been written to Mr. Bailey not for $38,500 but for $55,000 and $10,000, and it therefore made the appropriate adjustment for $26,500. Mr. Bailey asserts—without evidence—that “The royalty income was in fact reported”; but he does not explain where in the reported $325,040 those extra royalties might be found. We sustain the adjustment.

The IRS also determined that Mr. Bailey received additional unreported royalty income of $20,000 from West Publishing for 1999. However, the agent notes that Mr. Bailey duly reported royalty income from West Publishing for both 1998 and 1999, paid to Mr. Bailey by a collaborator who received the royalties from the publisher and paid a share to Mr. Bailey. Mr. Bailey contends that those royalties were fully reported. For 1999 the agent adjusted royalty income upward by the amount of a $20,000 payment made not to Mr. Bailey but to someone else, and the theory for attributing it to Mr. Bailey is unclear. In this instance we accept Mr. Bailey's general insistence that he reported all the income that was actually his. This 1999 adjustment is not sustained. i. Unreported Boston fees The Schedule C law practice income for 1996 as explained to the IRS by Mr. Bailey's representative included fees received by the Boston office totaling $1,370,663. The IRS compared this amount to the larger amount of gross receipts appearing on the general ledger for the Boston office, and determined additional income in the amount of the difference, i.e., $58,374. Mr. Bailey's response is simply the assertion—without any elaboration or citation of supporting documentation—that “There were no unreported fees from the Boston Office.” The IRS's adjustment is sustained. j. Fees from client McCorkle The IRS agent made a detailed tracking of fees from Mr. Bailey's client McCorkle into various accounts and onto the returns, but determined that they were reported only in part on the returns, and that $26,713 went unreported in 1997. In response to this detail, Mr. Bailey simply asserts, without evidentiary support, that the fees were reported. The adjustment is therefore sustained.

Fees from client McCorkle were again deposited into an account of Mrs. Bailey's in 1998. The IRS agent again tracked fees between and among the various accounts and onto the returns, but determined that for 1998 $110,000 went unreported. In response, Mr. Bailey simply asserts, without any citation of the record, “Some McCorkle money was deposited into Patricia's [i.e., his wife's] account, then transferred to Petitioner's # 1443 account and picked up as income, as Petitioner has show in much detail.” The agent's analysis is not at all answered by a showing that “some” of the McCorkle fees were duly reported; but Mr. Bailey did not make even that modest showing. We cannot tell what he intends by his reference to “much detail”. The adjustment is sustained. k. Fees from client Vidu Mr. Bailey admits that in 1998 he received a check of $7,280 from client Vidu in payment of legal fees. However, the check was deposited into an account of Mrs. Bailey's. Mr. Bailey had evidently borrowed money from his wife, and he gave her the check toward that debt. The IRS determined that he had failed to report the income, and adjusted his income upward by that amount. Mr. Bailey asserts that “The Vidu fees were all properly reported”; but he cites no evidence and makes no analysis to support that assertion. The adjustment is therefore sustained. l. Fees from client Dubey The IRS determined that in 2000 Mr. Bailey received from client Dubey fees of $63,473 that he did not report as income. Mr. Bailey admits that he received payment from his client Dubey, but he states—without any citation of evidence—that “all of Subu Dubey's fees were reported—the amount in question was escrowed from 2000 (December) to 2001.” If that were true (which he does not show), then he should have reported the income for 2001 (which he also does not show). The adjustment is sustained. m. Flow-through from Tel-Share Tel-Share was an S corporation in which Mr. Bailey had an ownership interest. For 2000 Tel-Share reported to the IRS that Mr. Bailey's share of its income was $2,423. He did not report this amount on the appropriate schedule of his 2000 tax return (i.e., on Schedule E), and the agent adjusted his income upward in that amount. Mr. Bailey's response is to assert that “This transaction(s) was a `wash”; but this contention (which he elsewhere uses to deny the includibility in his income of payments Tel-Share made to reimburse expenses paid by his law practice) is simply inapplicable here. The adjustment is sustained. n. Other Duboc-related income The IRS adjusted Mr. Bailey's 1995 income upward by $106,758, consisting of checks returned to his Credit Suisse account in that year that had been allowed as a deduction in 1994. Since we have held that Biochem Pharma stock loan proceeds in the Credit Suisse account were not income to Mr. Bailey, and that sale proceeds were not income until transferred from that account to his other accounts, he had no income from that source in 1994, and payments from those proceeds in 1994 were not deductible for him. Therefore, any amounts paid out from those proceeds in 1994 and returned in 1995 were not income in 1995, and the adjustment is not sustained. o. Miscellaneous unreported income In 1995 Mr. and Mrs. Bailey received a California State income tax refund of $1,469 and interest from three sources totaling $389. The IRS determined that these amounts were not reported on the Baileys' 1995 Federal income tax return, and Mr. Bailey was unable to show that they were so reported. We therefore sustain the adjustment.

In 1998 Mr. Bailey received life insurance proceeds of $328,508 from Phoenix Home Life Mutual. The company reported to Mr. Bailey that $11,288 of the distribution was taxable, but the IRS determined that he had not reported it on his income tax return, and made an adjustment increasing his income. Mr. Bailey testified that the proceeds “went into Patricia's account. That was the remnant of the policy we had to cash or borrow heavily against to raise money to get me out of jail. And, at the time, it was her policy.” However, the report from the company clearly indicates that Mr. Bailey was the payee, and he made no showing that Mrs. Bailey (who did not file a joint return with him for 1998) reported on her own return the taxable portion of the proceeds. We therefore sustain the adjustment.

An entity called Entertainment Partners reported that it had paid Mr. Bailey wages of $1,541 in 1999, and Principal Life Insurance Company reported that it had paid him $61 in interest in 1999—neither of which, the IRS determined, was reported on his 1999 return. At trial Mr. Bailey testified, “I don't know offhand what that's about. I guess she [his sister Nancy Bailey] deposited the money in 1999. We're not finding a deposit to cover that. So, my answer is, I don't know what happened to it.” We therefore sustain the adjustment. p. Favorable income adjustments The IRS made adjustments to income that were favorable to Mr. Bailey: $1,300 for reimbursed income in 1995; $40,394 for income that was included twice in 1995; and three credits (of $2,426 for income transferred from another account, of $19,600 for corrections to income, and $991 for double-counted interest income) totaling $23,017 in 1996. Mr. Bailey does not object, and we sustain the adjustments.

2. Deductions a. Dues and publications The IRS disallowed deductions of $13,383 for 1993 and $10,200 for 1994 that Mr. Bailey claimed for dues and publications. Of the $13,383 disallowed for 1993, $755 is disallowed for lack of substantiation, and $12,628 was nondeductible dues to a private club. Mr. Bailey contends that these were paid in connection with the storing of theSpellbound when it was being held for sale; but since we find that the yacht activity was not for profit, the payments are nondeductible in any event. Of the $10,200 disallowed for 1994, $200 was disallowed as a political contribution (which Mr. Bailey calls de minimis and does not dispute) and $10,000 was a charitable contribution that the IRS has allowed as a Schedule A deduction. The IRS's adjustments are sustained. b. Legal and accounting fees The IRS disallowed deductions of $2,750 for 1993 and $2,289 for 1994 that Mr. Bailey claimed for legal and accounting fees. The IRS determined that the $2,750 deducted for 1993 and $2,250 of the amount deducted for 2004 was paid for personal tax preparation expenses (which Mr. Bailey disputes but did not disprove) and should therefore be allowed as Schedule A deductions. The IRS disallowed the remaining $39 of the 1994 deduction as a meals and entertainment reduction, which Mr. Bailey did not dispute. The IRS's adjustments are sustained. c. Telephone expense Mr. Bailey claimed a deduction of $22,414 for 1993 for telephone expenses, but the IRS disallowed $1,558 of that amount, determining that $704 was for a cell phone used by Mrs. Bailey and that the remainder was simply unsubstantiated. Mr. Bailey evidently misinterprets the $704 adjustment to be a disallowance of personal toll calls supposedly made from his home office by Mrs. Bailey (which he denies were made) and he failed to offer substantiation for the remainder. The IRS's disallowance is sustained. d. Tel-Share travel expense The records that back up Mr. Bailey's tax returns show that, of the $89,765 of travel expenses for which he claimed deductions for 1993, $3,447 was attributable not to Mr. Bailey's business but to Tel-Share, the S corporation in which he had an ownership interest. He explains in his brief that "[a]ny travel conducted for TelShare would have been for the two books of [Mr. Bailey's] that the company published, `To Be A Trial Lawyer' and `Lie Detector Man'; this expense is properly deductible, since Petitioner was the author.” Assuming that the facts he states were correct, then some but not all of Tel-Share's deduction would have passed through to him. However, he points to no evidence in the record to support this explanation, nor does he show that Tel-Share did not claim these deductions on its own return. The IRS's disallowance is sustained. e. Meals and entertainment Mr. Bailey's 1993 deduction for “office expenses” of his Boston office included $5,805 for meals and entertainment. Section 274(n) as in effect for 1993 allowed a deduction of only 80 percent of such expenses, so the IRS disallowed 20 percent, or $1,161. Mr. Bailey's brief states that he “believes that the 20% adjustment had been made”. However, if that were correct, then he should have substantiated $7,256 of meals and entertainment expenses, of which the allowable 80 percent would have been $5,805; but he did not do so. The IRS's adjustment is sustained. f. Schedule E flow-through from BEI

Mr. Bailey reported on his returns flow-through losses from BEI (his S corporation that he merged into Palm Beach Roamer in 1994) in the amounts of $119,103 for 1993 and $138,632 for 1994. The IRS determined that those losses included expenses of $6,425 for 1993 and $3,850 for 1994 that were not substantiated, so the IRS disallowed the flow-through losses to that extent. Mr. Bailey's response was not to substantiate the expenses but to argue:

These purport to be Agent Tabor's notes, obviously erased and changed in 2004 (despite the poor copy furnished Petitioner) after the audit turned hostile and Tabor was instructed that P.B. Roamer would be disallowed in its entirety . Tabor offered no testimony to explain this set of circumstances. The figures on Ex. # 43R [Revenue Agent Tabor's worknotes] and in 47 [of the Commissioner's brief] purport to be “adjustments”, not unsubstantiated expenses. These notes should be treated as unreliable. Again, this contention misallocates the burden of proof, which Mr. Bailey cannot satisfy by assailing the reliability of the agent's work. Mr. Bailey was obliged to substantiate his losses at trial, but he did not do so. (The “Adjustment” reflected in the worknotes was for the amount that was the difference between what was claimed “Per Return” and what the agent was able to establish “Per Audit”—i.e., the amount that was not substantiated.) We sustain the partial disallowance that the IRS made. g. Itemized deductions For 1993 the IRS disallowed a charitable contribution deduction of $1,000, which Mr. Bailey's brief states (without support from the trial record) “was made at a charitable event at Aventura, a development owned by Don Soffer.” Mr. Bailey did not show that the recipient was an organization described in  section 170(c)(2), so the disallowance is sustained. For 1993 the IRS also made some adjustments favorable to Mr. Bailey (i.e., allowance of a tax preparation expense of $2,750 as a miscellaneous deduction, and deduction of flow-through expenses to the extent of income from PBR ($5,707)) that we do not disturb.

For 1994 the IRS increased Mr. Bailey's allowable itemized deductions—i.e., the $10,000 additional charitable contribution deduction disallowed as a dues and publications, as explained above, and tax preparation expense of $2,250. Mr. Bailey has no objection, and we sustain the adjustment.

The IRS allowed Mr. Bailey a deduction of $931,698 for 1994 and $302,454 for 1995 for Duboc expenses that he paid from the Credit Suisse account in those amounts. Mr. Bailey should certainly get the benefit of (and not owe tax on) the funds he expended for that purpose. However, these allowances were premised on the prior upward adjustment to Mr. Bailey's income for the Biochem Pharma stock from the proceeds of which the expenditures were made, which adjustment we did not sustain. Since we have held that Mr. Bailey realized income not from the Credit Suisse account, but only when funds were transferred to his other accounts, such a deduction is no longer appropriate and is not sustained.

For 1996 the IRS determined that Mr. Bailey's documentation substantiated only a portion of his claimed mortgage interest and real estate tax deductions, and it disallowed the remainder—i.e., $14,244 of the mortgage interest and $2,362 of the real estate taxes. He offered no evidence on the subject, and the adjustment is sustained.

For 1997 the IRS disallowed deductions for mortgage interest ($14,986) and real estate taxes ($11,327) that, as for 1996, Mr. Bailey did not substantiate. The adjustments are sustained. h. Travel expense The IRS determined that Mr. Bailey's claimed deduction of 1993 travel expenses included $12,976 that was not substantiated. The trial record includes the IRS agent's worknotes analyzing the subsidiary amounts that made up the total and reporting the supposed comments of Mr. Bailey's daughter-in-law and representative, Lainey Bailey. In his post-trial brief, Mr. Bailey argues: “The documents cited by Respondent (l) do not establish the claim, and (2) are incomplete and inaccurate.” However, this argument reflects a misunderstanding of the burden of proof. In view of the IRS's determination, however fallible, Mr. Bailey was obliged to substantiate his claimed deductions for travel expenses, but he did not do so. The IRS's adjustment is therefore sustained.

The IRS made adjustments to travel and entertainment expense deductions for 1995 and subsequent years on the basis of an agent's detailed analysis of the travel and entertainment expense that Mr. Bailey claimed for1996. She determined the portion of the total claimed (in 1996, $65,272) that was either unsubstantiated or else was for personal travel or other personal expense (in 1996, $22,080). She then applied that ratio to disallow a portion of the travel and entertainment expense that Mr. Bailey reported for other years—i.e., to disallow $48,199 for 1995, $20,480 for 1997, $45,201 for 1998, and $25,229 for 1999. (For year 2000 travel expense, see “Office expense” below.) Of course, the IRS's distinctions between personal and business could be in error; and its use of a ratio from another year, though potentially reasonable, is obviously rough at best and is certainly subject to improvement. Mr. Bailey therefore had the opportunity to provide that correction and to substantiate all of his claimed deductions, and it was incumbent on him to do so. He did not. As to 1996, he summarily asserts, “The `disallowed' travel and entertainment expenses were properly documented and should be allowed.” As to 1997, he complains that this was “arbitrarily determined”. But Mr. Bailey did not substantiate any of these expenses, and the adjustments are sustained. i. Computers Mr. Bailey claimed an office expense deduction for 1994 that included $5,457 for the purchase of two computers. As a general rule, such capital assets are not expensed but depreciated. Mr. Bailey does not claim any expense deduction therefor under section 179, nor does he show or allege that he elected such treatment. Rather, he asserts in brief that he “believes that the cost was incurred for rebuilding existing computers with new components”. He does not substantiate this assertion, and it would evidently fail in any event, because deductions are not allowed for “permanent improvements or betterments made to increase the value of any property”. Sec. 263(a)(1); see also 26 C.F.R.  sec. 1.162-4, Income Tax Regs. (”Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall *** be capitalized and depreciated”). The cost of these computers should have thus been depreciated rather than being fully expensed in 1994.

The IRS determined that the computers were "5-year property” (and therefore depreciated at the rate of $1,091 per year) that had been placed in service in the last quarter of 1994, so that a fourth of that annual amount—$273—was deductible for 1994. Mr. Bailey argues that “computers in that era went obsolete for business purposes in two years, and the same amount would have been written off over that time,” but he did not offer any evidence as to useful life nor any authority that would contradict the IRS's determination. In fact, his position contradicts the parties' stipulation that he was entitled to an additional $273 in depreciation for 1994.

However, it follows that Mr. Bailey was entitled to depreciation deductions not only for 1994 but also for the years after 1994, until his $5,457 basis in the computers was fully deducted by 1998. The recomputation of the deficiencies at issue in those subsequent years should therefore take that into account. j. Billed but unpaid expense Of the $474,097 for which Mr. Bailey claimed a deduction for 1994 for office expenses of his Boston legal practice, the IRS determined that $3,322 constituted expenses that were billed but that he did not actually pay. Mr. Bailey agrees that he did not pay them, but denies that they were deducted. However, that denial is not supported by any documentation nor even elaborated by any explanation. The IRS's adjustment is therefore sustained. k. Contract labor On his 1995 return Mr. Bailey claimed a deduction of $38,138 for “contract labor” incurred by his Boston office. The IRS agent determined that the ledger for the business supported only the amount of $36,164 and disallowed the difference of $1,974 as unsubstantiated. Mr. Bailey offered no evidence to substantiate this amount (or any amount); but in his brief he criticized the agent for erasures on his worknotes and stated, “This entry was made by Hon. Kenneth J . Fishman, then manager of the Boston Office, was doubtless for outside computer services, and should be honored.” It is unclear what "[t]his entry” might refer to. If Mr. Bailey supposes that there was a $1,974 entry on the return or the ledger that the agent disallowed, then he is evidently mistaken. In any event, his supposition stated in his brief is not sufficient to carry his burden of proof, and the adjustment is sustained. l. Interest expense The IRS disallowed $21,594 of interest expense claimed on Mr. Bailey's 1995 return—$15,852 of which was paid to Republic Bank and $5,742 to Credit Suisse. Mr. Bailey did not show that the loan from Credit Suisse was “properly allocable to a trade or business”, see sec. 163(h)(2)(A), and the adjustment is sustained. The Republic Bank interest was disallowed because Mr. Bailey's representative told the agent that “it was her belief *** that this was primarily a personal loan”. However, neither the representative nor the agent testified on this subject. The only witness who addressed this subject was Mr. Bailey, who testified credibly to the effect that the interest was paid on a line of credit that he took out to operate his business and on which he drew in 1991 and 1992. The Republic Bank portion of the IRS's adjustment—$15,852—is therefore not sustained. m. Expenses double-deducted The IRS agent disallowed $215,612 of the expenses claimed on Schedule C for Mr. Bailey's West Palm Beach Office for the year 1995 because he determined (as he demonstrated at trial) that these were in effect double-deducted: The expenses were incurred by a law partnership of which Mr. Bailey was a 50 percent partner, and they were deducted on the return of that partnership (which reported a small net loss), and Mr. Bailey reported his 50 percent share of the loss on his return and thereby obtained the benefit of his 50 percent share of the deductions. However, Mr. Bailey also deducted 50 percent of the partnership's expenses on Schedule C of his own return. In response, Mr. Bailey criticizes the agent's handling of this matter, but he does not contradict the evidence, the reasoning, or the conclusion, so we sustain the adjustment. n. Office expense Mr. Bailey's Schedule C for 1996 claimed a deduction of $921,857 for Boston office expenses. The IRS agent's workpapers note a discrepancy between this total and the lesser total of $719,775 that was substantiated by the general ledger for the Boston office; and Mr. Bailey did not substantiate any amount greater than this lower amount. The difference between those two amounts is $202,082, which should therefore be the amount of the resulting adjustment; but for reasons we cannot tell (and that the Commissioner on brief does not suggest), the agent made an adjustment of $754,750. We do not understand the detail of Mr. Bailey's argument against this adjustment, but he appears to be correct that it reflects an “erroneous calculation”. We therefore sustain this adjustment only to the extent of $202,082.

Mr. Bailey claimed a 1997 deduction for office expenses of $389,381, but the agent was able to substantiate only $182,897 to his satisfaction, and he therefore disallowed the difference—$206,484. Mr. Bailey argues that “the `disallowed' office expenses were arbitrarily determined, or from documents neither created nor used by Petitioner, in preparing the 1997 [Form] 1040.” But he did not attempt to substantiate an amount greater than IRS allowed, and the adjustment must be sustained.

Mr. Bailey claimed a 1998 deduction for office expenses of $1,109,328, but the agent was able to substantiate only $530,280, and he therefore disallowed the difference—$579,098. Mr. Bailey argues: “The `disallowed' office expenses were wrongfully cast aside, and were properly documented.” But he did not point to any documents that would substantiate an amount greater than the IRS allowed, and the adjustment must be sustained.

Mr. Bailey claimed a 1999 deduction for other office expenses of $753,893, but the agent was able to substantiate only $220,702, and he therefore disallowed the difference—$533,191. Against this adjustment (along with the travel expense adjustment for the same year), Mr. Bailey argues,

This disallowance is arbitrary, and a further example of an audit that turned into a `mission' hard on the heels of Judge Horn's preliminary findings in August, 2001 [i.e., Bailey v. United States, 26 Fed. Cl. 187 (2000)]. It should be noted throughout that nearly all of Agent Tabor's adverse reports, conclusions and speculations, the dates of origination (or erasure and modification) are after the above incident had occurred, mostly in 2002 . Why this happened, in an audit that had been running for years, is studiously avoided by Respondent. For the reasons we explained above in part I.A.3, these allegations of animus do not carry or shift the burden of proof. Mr. Bailey did not point to any documents that would substantiate amounts greater than the IRS allowed, and the adjustments must be sustained.

On Mr. Bailey's Schedule C for 2000, he deducted a single aggregate expense of $940,744. During the audit his representative reconstructed this amount and showed that it included the following: (1) a claimed deduction of $109,870 for travel and entertainment was evidently the representative's 20 percent discount of the total of $127,337 spent as travel and entertainment. The IRS, however, discounted that total by the ratio developed in 1996, allowed only $86,462, and therefore disallowed $23,408. (2) A deduction of $114,798 was claimed for office expenses, but the IRS was able to substantiate only $84,279, so it disallowed $30,519. (3) Nine items totaling $133,421 were also disallowed. The grand total of these disallowances was $187,348. Once again Mr. Bailey offered no substantiation at trial, but only the argument that “The disallowed office expenses are arbitrary, and premised once again on Agent Tabor's `notes'. They should be rejected.” However, it was Mr. Bailey's burden to substantiate the amounts and character of the expenses to show them deductible, and he did not do so, so we sustain the adjustments. o. Household maintenance The IRS's examining agent determined that in 1997 Mr. Bailey received two checks payable from his law practice account, for amounts totaling $24,000, from funds that he did not report as law firm income or elsewhere on his return. In Mr. Bailey's records the checks are coded “Spoonbill Maintenance” (with Spoonbill being a name for Mr. Bailey's house). The agent treated them as personal expenses of Mr. Bailey paid for by the law practice and therefore as income to Mr. Bailey. Mr. Bailey's only opposition to this treatment is the argument that an expenditure for maintenance is, by definition, not an income item. While it is true that the expenditures were not income to the law practice per se, the expenditures made on his behalf and for his benefit were income to him. We therefore sustain the adjustment. p. Unexplained items The IRS disallowed a Schedule C deduction of $16,561 which the agents characterized as “unexplained items”. The items went unexplained at trial, too; and the explanation finally offered in Mr. Bailey's post-trial brief (without citation of any record evidence) is that "[o]f the $16,561 claimed, $10,000 was transferred to a special 006 cost account maintained for Subu Dubey and spent on his case, as the register (Ex. 234-P, p. R-5, date 2/7/2001[)] plainly shows. The balance of $6,561, was transferred to the Office Account as a matter of business routine, and spent in the ordinary course of business.” Even assuming that the cited entry relates to these items, it is not enough to show that they were expended on deductible purposes, if one does not also show (as Mr. Bailey failed to show) that he did not claim deductions for the expenditures when they were subsequently made. We sustain the adjustment including these items in income. q. Hangar expenses The IRS disputed the deductibility of a few (but not most) of the checks, totaling $6,486, that Mr. Bailey wrote to Chuck Herzberg in 2001, on the grounds that they were either outright personal household expenses ($735) or else expenses of PBR ($5,751). Similarly, the IRS disallowed, as PBR expenses, $19,469 paid for the hangar originally used by PBR. By 2001 PBR had discontinued, and the hangar was used to store Mr. Bailey's business records (a fact confirmed by the IRS agent) and Mr. Herzberg evidently worked in that connection. We therefore sustain the disallowance of household expense but allow the deductions related to the hangar. r. Life insurance premiums The IRS disallowed a deduction of $19,660 that Mr. Bailey claimed for 2001 for payment of premiums on a life insurance policy on Mr. Bailey's life. In his post- trial brief he explains, “The insurance premiums were for a policy protecting those from whom I had made loans in 1996 to secure Petitioner's freedom from debtor's prison, which were business loans.” This explanation lacks any support in the trial record. s. Payment to attorney The IRS disallowed, as a personal expense, a deduction for Mr. Bailey's payment of $1,150 to an attorney. Mr. Bailey offered no evidence at trial to support the deduction, and the disallowance is sustained. t. Net operating loss carryover On his 2001 return, Mr. Bailey claimed a net operating loss (NOL) deduction of $71,994, carried forward from claimed losses in prior years that are at issue here. The recomputation of Mr. Bailey's liability under Rule 155 will show whether there are any losses that could be carried into 2001 or any other year. VIII. Failure-to-file additions to tax under section 6651(a)(1)  Section 6651(a)(1) authorizes the imposition of an addition to tax for failure to file a timely return, unless the taxpayer proves that such failure is due to reasonable cause and is not due to willful neglect. See also United States v. Boyle,  469 U.S. 241, 245 [55 AFTR 2d 85-1535] (1985). For 1998, 1999, and 2000, the IRS determined that Mr. Bailey is liable for the addition to tax imposed by  section 6651(a)(1) for failure to timely file a return. Mr. Bailey's return for each of those three years was filed about two months late, and this fact satisfies the Commissioner's burden of production under section 7491(c).

The addition to tax applies “unless it is shown that such failure is due to reasonable cause and not due to willful neglect”. We find “reasonable cause” as to the 1998 return, on account of Mrs. Bailey's final illness during the time that the return was due in August 1999 and Mr. Bailey's filing of the return 50 days after her death in October 1999. However, Mr. Bailey makes no contention as to “reasonable cause” for the 1999 or 2000 return, and we hold that for those two years he is liable for the addition to tax under  section 6651(a)(1). IX. Accuracy-related penalty under section 6662

Section 6662(a) and (b)(1) imposes an “accuracy-related penalty” of 20 percent of the portion of the underpayment of tax that is attributable to the taxpayer's negligence or disregard of rules or regulations. 49 The notices of deficiency determine the penalty for all the years at issue except 1996 and 2001, and we therefore exclude those years from our analysis. Under  section 7491(c), the Commissioner bears the burden of production and must produce sufficient evidence that the imposition of the penalty is appropriate in a given case. Once the Commissioner meets this burden, the taxpayer must come forward with persuasive evidence that the Commissioner's determination is incorrect. Rule 142(a);Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001).

A. Negligence

For purposes of section 6662, the term “negligence” includes a failure to exercise ordinary and reasonable care in the preparation of a tax return. 26 C.F.R. sec. 1.6662-3(b)(1), Income Tax Regs. Negligence is defined as a lack of due care or failure to do what a reasonable and ordinarily prudent person would do under the circumstances. Neely v. Commissioner, 85 T.C. 934 (1985). The term “disregard” includes any careless, reckless, or intentional disregard of the rules or regulations.  Sec. 6662(c). It also “includes any failure by the taxpayer to keep adequate books and records to substantiate items properly.” 26 C.F.R.  sec. 1.6662-3(b)(1).

By this standard, we find that Mr. Bailey's underpayments for 1993 through 1995 and 1997 through 2000 were negligent. This is so whether and to the extent that the underpayments result from his failure to report income (whether from Duboc, the payments signed over to Broder, the $100,000 math error, or the other items of unreported income revealed during the audit) or from his claiming of deductions that he did not substantiate or to which he is not entitled. For most of the items adjusted in the notice of deficiency, he failed to keep records and thereby made the examination of his return a forensic and almost archeological challenge. The examination turned up multiple instances of his depositing income into multiple accounts in order to frustrate others' potential attempts to seize his funds; but one effect of this strategy was to introduce confusion into his own record- keeping and accounting.

We do not blame Mr. Bailey for failing to anticipate the outcome of his dispute with the Government about the Biochem Pharma proceeds, and had he reported fee income from Mr. Duboc in accordance with his professed theory (i.e., that he was entitled to take money for personal use as fees when earned), then we would not impose the penalty on the income he derived from the Biochem Pharma stock sales (i.e., derived temporarily until he had to repay it). However, he failed to report on any tax return any of the money he drew down from the Biochem Pharma sales. That failure was negligent.

B. Defenses

A taxpayer who is otherwise liable for the accuracy-related penalty may avoid the liability if he successfully invokes one of the three following provisions:

First, section 6662(d)(2)(B) provides that an understatement may be reduced where the taxpayer had substantial authority for its treatment of any item giving rise to the understatement. There is no authority that would warrant Mr. Bailey's position on any of the disallowed deductions. For the adjustments we have upheld, his factual arguments (that income had been reported or was not received, or that depreciations had been substantiated) had no evidentiary support. His legal arguments (that his income was not taxable to him when it was paid over to others, whether to cover office-sharing expenses, or to benefit his mother-in-law, or pay off loans, or to repay Duboc funds to the District Court) had no merit.

Second, section 6662(d)(2)(B) provides that an understatement may be reduced where the relevant facts affecting the item's treatment are adequately disclosed on the taxpayer's return and the taxpayer had a reasonable basis for its treatment of that item. Neither of these criteria is met here.

Third, section 6664(c)(1) provides that, if the taxpayer shows, first, that there was reasonable cause for a portion of an underpayment and, second, that he acted in good faith with respect to such portion, then no accuracy-related penalty shall be imposed with respect to that portion. Whether the taxpayer acted with reasonable cause and in good faith depends on the pertinent facts and circumstances, including his efforts to assess his proper tax liability, his knowledge and experience, and the extent to which he relied on the advice of a tax professional. 26 C.F.R. sec. 1.6664-4(b)(1), Income Tax Regs. If Mr. Bailey had disclosed to a tax professional the facts underlying the adjustments we have sustained, and if the professional had advised him to report the items as he did, then he might have a colorable claim of reasonable cause based on reliance on advice. However, Mr. Bailey offered no evidence of such informed advice, nor of any other claim of reasonable cause and good faith. This defense is therefore unavailing to Mr. Bailey.

Conclusion

The determinations in the IRS's notices of deficiency are sustained in part, as is explained above. So that the liabilities for the years at issue can be computed,

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