T.C. Memo. 2015-131



                   UNITED STATES TAX COURT



CHRISTOPHER HOLDEN AND KAREN A. HOLDEN, Petitioners v.
   COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 14915-11.                          Filed July 16, 2015.



   In 2007 P-H operated a medical practice through his wholly owned
S corporation (S). On its 2007 Federal income tax return S reported
income and claimed deductions for various expenses. S reported a
net loss for the year, which flowed through to Ps’ 2007 tax return. R
contends that Ps received but failed to report additional income from
S’s business and that Ps failed to substantiate many of the expenses
underlying S’s claimed deductions.

    Held: Ps established by a preponderance of the evidence that some
of the alleged unreported income consisted of nontaxable loan
proceeds, but the balance constitutes taxable income.

   Held, further, Ps adequately substantiated some, but not all, of the
expenses for which S claimed deductions. R properly disallowed
deductions for the expenses that Ps have not adequately substantiated.

   Held, further, Ps are liable for the I.R.C. sec. 6662(a) accuracy-
related penalty.
                                          -2-

[*2] Walter D. Channels, for petitioners.

      Jenny R. Casey and David J. Warner, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


      WHERRY, Judge: Respondent determined a $254,951 deficiency in

petitioners’ 20071 Federal income tax and a $50,990 section 6662(a) accuracy-

related penalty.2 After the filing of a stipulation of facts, second stipulation of

facts, and stipulation of settled issues,3 the facts of which are agreed to by the


      1
        Concurrently with our consideration of Dr. Holden’s 2007 tax year, his
2008 and 2009 tax years were before another Judge of this Court, who issued an
opinion as to those tax years in Holden v. Commissioner, T.C. Memo. 2015-83.
The two cases feature some common characters and issues, but they were tried
separately and have distinct evidentiary records. We apply the law and render our
opinion on the basis of the testimony and documentary evidence in the record of
this case.
      2
        Unless otherwise indicated, all section references are to the Internal
Revenue Code of 1986 (Code), as amended and in effect for the tax year at issue,
and all Rule references are to the Tax Court Rules of Practice and Procedure. We
round all amounts to the nearest dollar.
      3
       In the stipulation of settled issues: (1) respondent conceded that petitioners
were entitled to deduct a $135,804 net operating loss carryforward; (2) petitioners
conceded that they received but failed to report a $1,686 taxable refund of
California income tax; and (3) petitioners conceded respondent’s elimination of
the income and expenses they had reported on Schedule C, Profit or Loss From
Business, as well as respondent’s transfer of the amounts of those original items to
                                                                        (continued...)
                                        -3-

[*3] parties and incorporated herein by this reference, the issues remaining for

decision are:

      (1) whether petitioners received, but failed to report, $171,177 of taxable

income from Christopher Holden’s wholly owned S corporation, Christopher

Holden MD, Inc. (CHMD), for 2007;

      (2) whether, and if so to what extent, petitioners may deduct $387,442 of

passthrough loss from CHMD, comprising the following expenses allegedly paid

by CHMD during 2007: $111,138 of salaries and/or wages, $80,300 of equipment

rental expenses, $80,099 of interest expenses, $41,122 of depreciation, $11,613 of

supplies expenses, $36,258 of office expenses, $6,401 of dues and subscriptions

expenses, $9,970 of contract labor expenses, and $10,541 of auto and truck

expenses; and




      3
       (...continued)
Christopher Holden MD, Inc.’s Form 1120S, U.S. Income Tax Return for an S
Corporation, and ultimately to petitioners’ Schedule E, Supplemental Income and
Loss. In the stipulation of facts, respondent conceded some or all of the
disallowed deductions for various categories of reported expenses, thus narrowing
the deduction amounts at issue here. Notwithstanding petitioners’ concession
concerning their California income tax refund in the stipulation of settled issues,
respondent conceded this issue in his opening brief. In his answering brief
respondent avers that the parties will reconcile their contrary concessions in the
Rule 155 computation.
                                          -4-

[*4] (3) whether petitioners are liable for the section 6662(a) accuracy-related

penalty.

                                FINDINGS OF FACT4

      Petitioners Christopher and Karen Holden lived in California when they filed

their petition. They filed a joint Federal income tax return for 2007 but were

divorced in August of that year. Christopher Holden is a doctor with a family

practice specializing in geriatric medicine. Karen Holden teaches high school.

I.    CHMD

      During 2007 Dr. Holden operated his medical practice entirely through his

wholly owned S corporation, CHMD. At the beginning of 2007 CHMD had two

offices, one in Orange, California (Orange office), and the other in Anaheim,

California (Anaheim office). The Orange office predated the Anaheim office,

which opened in 2004. In addition to seeing patients at these two offices, Dr.

Holden typically spent his mornings visiting nonambulatory patients at board and

care facilities, skilled nursing facilities, assisted living facilities, and Chapman

Hospital. He sometimes returned to these rounds in the late afternoon or early




      4
      The Court created several schedules summarizing and synthesizing
evidence in the record to aid its analysis of that evidence. We have attached those
schedules as appendices to this opinion.
                                         -5-

[*5] evening after seeing patients at his offices. In 2007 Dr. Holden had no

business activities or material source of income other than his medical practice.

      A.      Office Staff

      At the beginning of 2007 CHMD employed about 25 people, some of whom

were independent contractors.

      John Rhondo, who has worked as a business consultant since 1988, primarily

for medical practices, served as CHMD’s practice manager during 2007. In that

capacity, he oversaw the practice and sought to improve its profitability and

efficiency.

      Jane Garcia provided management services to CHMD as an independent

contractor from February 2004 through approximately August 2009. When

providing services to CHMD she generally shared an office with Dr. Holden at

CHMD’s Orange office. Ms. Garcia’s duties consisted of paying bills, managing

the two offices and their staffs, and maintaining CHMD’s books using Quickbooks

software. Because Ms. Garcia often drove back and forth between the two offices

and also to other locations for projects necessary for the business, as part of her fee

compensation Dr. Holden sometimes wrote separate checks to her in the amount of

her monthly car payments.
                                       -6-

[*6] Drs. Depinder Mann and Edward M. Andujar, each of whom also had his or

her own separate medical corporation, worked for CHMD as contractors and saw

patients at its Anaheim office. Nurse practitioner Donna Do and office manager

Ninpapha Niangnouansy also worked at the Anaheim office. Jennifer M. Rivera

worked as a medical assistant at the Orange office. During 2007 CHMD made

payments to Drs. Mann and Andujar, Ms. Do, Ms. Niangnouansy, and Ms. Rivera

as compensation for their services.

      B.     Office Administration

      CHMD relied on a payroll processing company, Automatic Data Processing

(ADP), to prepare its payroll checks. For each pay period, Ms. Garcia would

telephone ADP to report the hours worked by each employee and independent

contractor on CHMD’s payroll. ADP would then prepare and deliver the payroll

checks to CHMD, to be signed by either Dr. Holden or Ms. Garcia and then

disbursed to the staff.

      Ms. Garcia kept CHMD’s books. She entered bills into Quickbooks as

payables upon receipt, updated the entries to reflect payment when she wrote

checks or made online payments, and maintained hard copy records with

annotations in vendor-specific folders. Ms. Garcia classified CHMD’s expenses

within various available Quickbooks categories. An unrelated company would
                                        -7-

[*7] review CHMD’s books quarterly and would sometimes suggest that certain

expenses be reclassified. Ms. Garcia would discuss these suggestions with Dr.

Holden and make adjustments if appropriate.

      CHMD maintained only one bank account during 2007, a checking account

at Bank of America (BofA account). Dr. Holden maintained a separate, personal

account at Cal National USBank. Ms. Garcia and Dr. Holden were both signers on

the BofA account, and Ms. Garcia sometimes paid bills from the account through

an online billpay feature rather than by writing out checks. Also during 2007,

CHMD maintained or established business credit card accounts with Advanta Bank

Corp. (Advanta), American Express, and Platinum Plus.

      C.     Office Equipment

      During 2007, in addition to medical care CHMD provided cosmetology

services. These services, which included injections, laser therapies for skin

blemishes and cancer biopsies, and a skin-tightening treatment known as

Thermage, required specialized equipment. CHMD leased most of the equipment

in the Anaheim office, including the Thermage machine, aculight laser, hyperbaric

chamber, infrared sauna, and puroflow. CHMD had purchased other equipment in

the Anaheim office, including the X-ray machine. Similarly, CHMD had

purchased the X-ray machine at the Orange office and owned its scales,
                                        -8-

[*8] stethoscopes, echoscopes, autoclave for sterilization, and surgical instruments.

CHMD also leased nonmedical equipment, such as its copy machines and the

equipment associated with its security system.

      CHMD leased its rented equipment from a variety of vendors. These

vendors included LFG, MBF Leasing, HPSC, IFC Credit Corp., Great America,

Banc of America Leasing, Compare Business Systems, Inc., Protection One, and

GE Healthcare Financial Services (GE).5 These companies billed CHMD, usually

monthly, and Ms. Garcia paid the bills on their stated due dates. When she

received bills from leasing companies, Ms. Garcia would enter them in

Quickbooks.

      On or about December 29, 2006, CHMD and two lessors, Key Equipment

Finance, Inc. (Key), and Marlin Leasing (Marlin), entered into agreements labeled

as leases (purported leases). The purported leases covered identical sets of

equipment, including computer and printer servers, software, equipment for a local

area network, and laptop computers. Each purported lease identified the “vendor”

for these items as MedSoft Solutions, Inc. (Medsoft). Marlin purchased from

      5
       Great America is alternately identified on canceled checks, bank
statements, and CHMD’s profit and loss statement (P&L) as “Great America”,
“Great America Leasing”, “Great America Leasing Corp”, “Greatamerica Leasing
Corp”, and “Great American Leasing Corp.” Similarly, Banc of America Leasing
sometimes appears as “Bank of America”.
                                        -9-

[*9] MedSoft the items covered by its purported lease at CHMD’s request. CHMD

used the equipment acquired from Key at its Orange office and the equipment

acquired from Marlin at its Anaheim office. Each purported lease provided for an

initial, lump-sum payment followed by 60 equal monthly payments. The Marlin

agreement was, by its terms, irrevocable, and the agreement with Key

unconditionally mandated that CHMD pay all amounts due thereunder.

      Pursuant to the purported leases CHMD made the following payments, each

consisting of a base lease charge and in some instances taxes and fees, to Marlin

and Key:6




      6
        Petitioners obtained the purported lease with Marlin and related documents
from Marlin via subpoena. The documents include a “Payment History Report”
that reflects receipt of payments from CHMD during 2007 and indicates that the
check amounts included various taxes and fees in addition to the base monthly
charge. Ms. Garcia recorded interest and finance charges associated with
expenses under separate Quickbooks categories, and CHMD’s P&L reflects that
she recorded taxes and other fees paid to Marlin Leasing under separate
Quickbooks categories. We have omitted payments for which the report indicates
CHMD’s checks were returned as unpayable.
       The purported lease with Key specifies monthly payments of $1,378, and
we have identified 10 payments in this amount, one in each month other than
February, on CHMD’s bank statements. For most of the payments, the statements
simply list a check number, but in two instances, they identify Key as the payee.
                                  - 10 -

[*10]                                         Amount
                                            allocable to
                     Payment       Total     base lease
        Pay date      form        payment      charge       Payee
          1/2/2007 Cash            $2,861     $2,586       Marlin
          1/2/2007 Direct debit     2881       2,881       Key1
        2/15/2007 Check 2184        1,417      1,293       Marlin
        3/12/2007 Check 2256        1,587      1,293       Marlin
        3/12/2007 Check 2249        1,378      1,378       Key
          4/9/2007 Check 2322       1,378      1,378       Key
        4/10/2007 Direct debit      1,393      1,293       Marlin
          5/4/2007 Direct debit     1,378      1,378       Key
        5/16/2007 Check 8667        1,393      1,293       Marlin
          6/7/2007 Direct debit     1,378      1,378       Key
        6/14/2007 Check 8861        1,705      1,293       Marlin
          7/3/2007 Check 8836       1,378      1,378       Key
        7/16/2007 Check 8668        1,393      1,293       Marlin
          8/2/2007 Check 8921       1,378      1,378       Key
        8/20/2007 Check 8991        1,452      1,293       Marlin
          9/4/2007 Check 8922       1,378      1,378       Key
        9/13/2007 Check 8990        1,452      1,293       Marlin
        10/9/2007 Check 8986        1,378      1,378       Key
        11/5/2007 Check 2545        1,378      1,378       Key
        11/9/2007 Check 2554        1,646      1,293       Marlin
        12/5/2007 Check 2619        3,128      2,585       Marlin
                                         - 11 -

    [*11] 12/5/2007 Check 2627            1,378         1,378     Key

         1
         CHMD’s bank statements identify the payee of some direct debit
      payments to Key as “Leasing Services DES”.

      Under the agreement with Marlin, unless CHMD exercised its purchase

option, it was obliged to maintain the equipment “in good operating order” and to

return the equipment at the end of the lease term “in good working condition”, and

it would be liable to Marlin for any damage “beyond ordinary wear and tear.” The

agreement also required CHMD to pay any and all taxes due on the equipment, to

insure it, and to bear all repair and maintenance costs for it. In addition, the

agreement expressly reserved all tax benefits associated with the equipment to

Marlin unless CHMD received, at the outset, an option to purchase the equipment

at the end of the term for $1. The agreement did grant CHMD the option to buy at

term-end, but for $101 rather than $1. The Marlin agreement expressly stated that

it was a “TRUE LEASE” and not a “CONDITIONAL SALE”.

      The agreement with Key obliged CHMD to purchase the equipment at the

end of the lease term for $1. During the term, CHMD was required to pay any and

all taxes due on the equipment and to insure it. The Key agreement further recited

that the parties intended it to be “a true lease or a time-sale of goods (for which a

cash price was offered to Lessee)”.
                                      - 12 -

[*12] CHMD’s certified public accountant, Ashley Hallsman, who as of 2007 had

prepared CHMD’s tax returns for at least five years, determined which equipment

items would be depreciated without guidance from or consultation with Dr.

Holden.

      D.    Office Finances

      CHMD earned income from the medical and cosmetology services it

provided to patients, many of whom were covered by health insurance from which

CHMD would receive postappointment payment. As of 2007 CHMD received

most of its income from one insurance provider, Medicare.

      In or around October 2004 Medicare had ceased making payments to Dr.

Holden because of a dispute. Dr. Holden and Medicare ultimately resolved the

dispute, and Medicare released funds owed to Dr. Holden in December 2005. In

April 2006 Medicare suspended payments to CHMD, resuming only after several

months. For at least some portion of 2007 Medicare made no payments to CHMD.

During this time, CHMD’s expenses remained constant, but its receipts declined by

roughly half.

      After its Medicare payments halted, CHMD struggled to meet its expenses

and payroll and so sought to borrow from all available sources. At Dr. Holden’s

direction, Ms. Garcia obtained loans for CHMD from loan companies and credit
                                       - 13 -

[*13] card companies at interest rates up to approximately 40%. Mr. Rhondo

introduced Ms. Garcia to Peter Lee, a financial expert who specialized in finding

financing from banks, mortgage companies, and leasing companies, as well as hard

money. Medware Group, Inc. (Medware), which specialized in medical software,

hardware, and leasing, was among the companies from which CHMD obtained

funds during this period of financial difficulty. As part of her management duties,

Ms. Garcia completed application paperwork for a loan from Medware on CHMD’s

behalf. CHMD provided no services and sold no products to Medware during

2007.

        CHMD received 16 payments totaling $144,258 from Medware during 2007

(Medware advances):

           Check No.     Check date     Amount      Deposit date     Post date
              1509        1/12/2007      $9,900       1/12/2007     1/12/2007
              1510        1/12/2007       9,700       1/12/2007     1/12/2007
              1511        1/12/2007       9,800       1/12/2007     1/12/2007
              1512        1/12/2007       9,500       1/12/2007     1/12/2007
              1513        1/12/2007       9,900       1/12/2007     1/12/2007
              1514        1/12/2007       9,800       1/12/2007     1/12/2007
              1515        1/12/2007       9,700       1/16/2007     1/16/2007
              1516        1/12/2007       9,900       1/16/2007     1/16/2007
                                        - 14 -

 [*14]       1517         1/12/2007        9,500       1/16/2007     1/16/2007
             1518         1/12/2007        6,558       1/16/2007     1/16/2007
             1670         5/18/2007        2,913       5/21/2007     5/21/2007
             1697           6/5/2007       9,832        6/6/2007       6/6/2007
             1698           6/5/2007       9,679        6/6/2007       6/6/2007
             1699           6/5/2007       9,978        6/7/2007       6/7/2007
             1700           6/5/2007       9,988        6/7/2007       6/7/2007
             1701           6/5/2007       7,610        6/8/2007       6/8/2007

The payee on each of these checks was “Christopher Holden”. Medware required

no collateral, and CHMD made no principal or interest payments to Medware.

Medware went out of business at some point after 2007.7




      7
        According to the online records of the California secretary of state,
Medware Group, Inc., was incorporated as a California corporation on August 25,
2005, and at some point before the date of this opinion, its corporate powers were
suspended by the Franchise Tax Board, California’s income tax agency. We take
judicial notice of these adjudicative facts pursuant to Fed. R. Evid. 201(b). See
Sears v. Magnolia Plumbing, Inc., 

, 84 n.6 (D.D.C. 2011)
(taking judicial notice of corporate resolutions available through the Maryland
Department of Assessments and Taxation’s Web site); Grant v. Aurora Loan
Servs., Inc., 

, 1265 (C.D. Cal. 2010) (taking judicial notice
of, inter alia, the Delaware secretary of state’s certificate of authentication for a
certificate of incorporation and a certificate of conversion from a corporation to an
LLC); Lengerich v. Columbia Coll., 

, 607 n.2 (N.D. Ill. 2009)
(taking judicial notice of a corporation filing for Columbia College Chicago on the
Illinois secretary of state’s Web site).
                                       - 15 -

[*15] Ms. Garcia also lent money to CHMD on several occasions. To facilitate Dr.

Holden’s acquisition of the Anaheim office, she lent him $100,000, at least

$50,000 of which was delivered in April 2004. In December 2004 she delivered

another $20,000. On April 2, 2007, Ms. Garcia lent CHMD $3,985 to cover

medication and practice expenses, and she lent another $9,000 on April 16. Ms.

Garcia did not charge interest on her April 2007 loans, which were repaid over the

course of 2007, but she did charge interest on the loans she made in 2004.

      CHMD paid interest to various lenders, credit card companies, and leasing

companies during 2007. In some cases, Ms. Garcia wrote checks to cover interest

only, with no payment toward principal.

      CHMD closed its Anaheim office in July 2007 because of its financial

difficulties. On August 27, 2009, Dr. Holden filed for personal bankruptcy. Mr.

Rhondo assisted Dr. Holden in preparing the paperwork for his bankruptcy filing.

The creditors schedule Dr. Holden filed with the bankruptcy court does not list

Medware among Dr. Holden’s creditors.

      E.    Office Floods

      From 2001 through the time of trial, CHMD rented its Orange office from

TCI Properties, Inc. (TCI), a property management company owned by William

Griffith, who also owns the building in which the Orange office is located. The
                                        - 16 -

[*16] Orange office experienced water leaks on several occasions during that time,

including in 2007 and 2009.

      On or around September 29, 2007, a pipe burst after heavy rains, causing

severe damage that took a year to fully repair. CHMD hired Leonel Miguez, a

construction contractor, to repair damaged drywall and flooring. Mr. Miguez

brought in Francisco Alatriste, an electrician, to perform electrical work related to

the repairs. CHMD made various payments totaling $7,180 to one or the other of

these men in December 2007. TCI, the landlord, also engaged contractor B&B

General Construction Services, Inc. (B&B), to perform work at the premises after

the 2007 flood.

      Two years later, on or around December 13, 2009, heavy rains again caused

a pipe to break at the Orange office over a weekend. Unlike the 2007 flood, the

2009 leak affected the area of the Orange office where medical records, computers,

billing records, records of CHMD’s debts, Dr. Holden’s books, and Dr. Holden’s

and Ms. Garcia’s desks were located. Because, following the creditors meeting,

Dr. Holden’s bankruptcy trustee had asked to review five years’ worth of

documentation related to CHMD’s business, Mr. Rhondo had gathered all of the

relevant documents and hard drives and placed them in a designated area against a

wall of Dr. Holden’s office in or around October or November 2009 and before the
                                        - 17 -

[*17] December 2009 flood. In an unfortunate twist of fate, the pipe broke directly

above these records, drenching and thus mostly destroying them. CHMD’s regular

cleaning crew bagged up the sodden paperwork and carried it out of the building.

      After both the 2007 and 2009 floods, CHMD filed claims with its property

insurer. It received $11,728 in 2007 and $350 in 2009 under its policy. CHMD

included the $11,728 received in 2007 as income on its Form 1120S.

II.   Tax Returns and Audit

      Petitioners filed a joint Form 1040, U.S. Individual Income Tax Return, for

the 2007 taxable year. They reported income from CHMD on Schedules C and E,

but the parties have stipulated that petitioners should have reported this income

only on Schedule E. On Schedule C they reported gross income of $344,532 and

total expenses of $344,483. On Schedule E they reported a $29,479 net nonpassive

loss from CHMD.

      CHMD filed Form 1120S for the 2007 taxable year. It reported $923,014 of

total income and claimed $952,493 of total deductions, for a net loss of $29,479.

CHMD claimed deductions for, inter alia, the following expenses:
                                          - 18 -

[*18]                              Expense           Amount
                        Salaries and wages          $280,774
                        Rents                        178,762
                        Interest                      80,099
                        Depreciation                  41,122
                        Other deductions
                          Supplies                   122,144
                         Office                       37,270
                         Dues and subscriptions       11,973
                         Contract labor               24,744
                         Auto and truck               10,541

Although CHMD’s Quickbooks file was maintained on the accrual method of

accounting, it reported its income for tax purposes in accordance with the cash

method of accounting.

        Respondent assigned Revenue Agent Beth Stroud (RA Stroud) to examine

CHMD’s return. In the course of her examination, RA Stroud never gained access

to CHMD’s books and records. She conducted a bank deposits analysis of

CHMD’s BofA account and determined that $1,316,827 had been deposited into

that account during 2007. From this amount, she debited $227,147 of nontaxable

deposits. Respondent also determined that $4,510 of deposits into Dr. Holden’s

personal bank account were taxable income of CHMD. From these numbers,
                                       - 19 -

[*19] respondent computed CHMD’s total 2007 income as $1,094,191, or

$171,177 more than CHMD reported on its return.

      On March 28, 2011, respondent mailed petitioners a notice of deficiency for

the 2007 taxable year determining a deficiency in tax of $254,951 and a section

6662(a) accuracy-related penalty of $50,990. As is relevant here, that

determination rested upon a positive adjustment of $813,309 to petitioners’

reported passthrough loss from CHMD, made on the basis of RA Stroud’s

examination. That adjustment arose, in turn, from RA Stroud’s increase of

CHMD’s gross receipts or sales and her disallowance of nearly all of CHMD’s

claimed deductions for interest, depreciation, and other business expenses.

Petitioners timely petitioned this Court for redetermination of the deficiency and

penalty on June 23, 2011. Their case was tried on December 13, 2013.

                                     OPINION

      The Commissioner’s determination of a taxpayer’s tax liability is generally

presumed correct, and the taxpayer bears the burden of proving the determination

improper. Rule 142(a); Welch v. Helvering, 

, 115 (1933). This rule

generally governs the nonpenalty issues in this case.
                                        - 20 -

[*20] I.     Unreported Income

      Respondent contends that CHMD received but failed to report income of

$171,177 for the 2007 tax year.8 In their answering brief petitioners concede that

they failed to report $4,510 of deposits into Dr. Holden’s personal bank account

that should have been deposited into CHMD’s BofA account, reducing the amount

at issue to $166,667.9 Petitioners contend that, of that amount, $144,258 consisted

of nontaxable loans from Medware and $12,985 consisted of nontaxable loans from

Ms. Garcia. They make no argument and presented no evidence concerning the

$9,424 balance, so we will treat this amount as conceded. Thus, the parties dispute

whether CHMD received but failed to report $157,243 of income for 2007.

      Because of the difficulty inherent in proving a negative, where the

Commissioner determines that a taxpayer received unreported income, he “must


      8
       On brief respondent computes this amount as $182,905. This computation
ignores CHMD’s reporting of $11,728 of other income on its Form 1120S and
contradicts paragraphs 15 and 24 of the parties’ stipulation of facts. We will rely
on the stipulated numbers absent obvious computation errors.
      9
        Also in their answering brief petitioners contend that their conceded receipt
of a $1,686 State income tax refund should be set off against the amount of
unreported income in dispute. The notice of deficiency, however, makes clear that
respondent determined this $1,686 increase to petitioners’ income separately from
his determination of a $813,309 increase in their income attributable to his
adjustment of CHMD’s return. The State income tax refund and CHMD’s net
income are separate issues, and petitioners’ concession as to the former will not
affect the latter.
                                       - 21 -

[*21] offer some substantive evidence showing that the taxpayer received income

from the charged activity” before he may rely upon the presumption of correctness.

Weimerskirch v. Commissioner, 

, 360 (9th Cir. 1979), rev’g 

 (1977).10 If the Commissioner provides a “minimal factual foundation” for his

determination, the burden of proof shifts to the taxpayer. Palmer v. United States,

, 1312 (9th Cir. 1997); accord Petzoldt v. Commissioner, 

, 689 (1989). At this second stage, the taxpayer must endeavor to rebut the

presumption in favor of the Commissioner’s determination “by establishing by a

preponderance of the evidence that the deficiency determination is arbitrary or

erroneous.” Rapp v. Commissioner, 

, 935 (9th Cir. 1985).

      A.    Respondent’s Evidentiary Foundation

      The Commissioner may employ any reasonable method to reconstruct a

taxpayer’s income and thereby lay the requisite evidentiary foundation. See

Petzoldt v. Commissioner, 92 T.C. at 693; see also Palmer, 116 F.3d at 1312

(method need only be “rationally based”). For example, “[t]he use of the bank


      10
        This Court “follow[s] a Court of Appeals decision which is squarely in
point where appeal from our decision lies to that Court of Appeals and to that
court alone.” Golsen v. Commissioner, 

, 757 (1970), aff’d, 

 (10th Cir. 1971). When they filed their petition, petitioners lived in
California, a State within the jurisdiction of the Court of Appeals for the Ninth
Circuit, so we will follow decisions of that court. See sec. 7482(b)(1)(A).
                                       - 22 -

[*22] deposit method for computing unreported income has long been sanctioned

by the courts.” Clayton v. Commissioner, 

, 645 (1994); see also

Weimerskirch v. Commissioner, 596 F.2d at 362 (listing the taxpayer’s bank

deposits as one means by which the Commissioner could have attempted to

substantiate the charge of unreported income). The method “assumes that all

money deposited in a taxpayer’s bank account during a given period constitutes

taxable income”. Clayton v. Commissioner, 102 T.C. at 645. Although the

Commissioner must “take into account any nontaxable source or deductible

expense of which * * * [he] has knowledge”, “[b]ank deposits are prima facie

evidence of income”. Id. at 645-646.

      RA Stroud employed the bank deposits method to reconstruct CHMD’s 2007

income. She computed total deposits into the BofA account and, to the extent of

her knowledge, eliminated all nontaxable deposits. She followed the procedure we

sanctioned in Clayton, and petitioners do not dispute her computations. As

petitioners do not contend otherwise, we therefore conclude that respondent has

established a minimal evidentiary foundation for his determination of unreported

income. See Weimerskirch v. Commissioner, 596 F.2d at 361.
                                         - 23 -

[*23] B.     Petitioners’ Evidentiary Riposte

      Petitioners offered evidence concerning two groups of allegedly nontaxable

deposits: $144,258 received from Medware and $12,985 received from Ms.

Garcia. Respondent has not disputed that during 2007 CHMD underwent serious

financial difficulties, that Dr. Holden sought financing from multiple sources to

keep the business afloat, or that CHMD received and deposited into its BofA

account $144,258 from Medware. At issue is whether the Medware advances

represent taxable income or the proceeds of a nontaxable loan. As for the funds

from Ms. Garcia, respondent introduced the evidence of these advances but on

brief objects that supporting facts are not in evidence. We analyze the two sets of

alleged loans separately.

             1.     Medware

      For tax purposes, a loan is “‘an agreement, either expressed or implied,

whereby one person advances money to the other and the other agrees to repay it

upon such terms as to time and rate of interest, or without interest, as the parties

may agree.’” Commissioner v. Valley Morris Plan, 

, 618 (9th Cir.

1962) (quoting Nat’l Bank of Paulding v. Fid. & Cas. Co., 

, 123-

124 (S.D. Ohio 1954)), rev’g 

 (1959), and rev’g Morris Plan Co. of
                                         - 24 -

[*24] Cal. v. Commissioner, 

 (1960). Whether an advance constitutes a

loan is a question of fact. Fisher v. Commissioner, 

, 909 (1970).

      In determining whether a payment constitutes a loan, “we examine the

transaction as a whole.” Welch v. Commissioner, 

, 1230 (9th Cir.

2000), aff’g T.C. Memo. 1998-121, 

 (1998).

      The conventional test is to ask whether, when the funds were
      advanced, the parties actually intended repayment. * * *

             However, courts have considered a number of other factors as
      relevant in assessing whether a transaction is a true loan, such as: (1)
      whether the promise to repay is evidenced by a note or other
      instrument; (2) whether interest was charged; (3) whether a fixed
      schedule for repayments was established; (4) whether collateral was
      given to secure payment; (5) whether repayments were made; (6)
      whether the borrower had a reasonable prospect of repaying the loan
      * * *; and (7) whether the parties conducted themselves as if the
      transaction were a loan.” * * * [Id.]

“No one factor is necessarily determinative, and the factors considered do not

constitute an exclusive list.” Calloway v. Commissioner, 

, 37 (2010),

aff’d, 

 (11th Cir. 2012).

      We may quickly dispose of three of these factors. The record contains no

evidence that: (1) CHMD and Medware ever executed any written instrument

embodying a loan agreement; (2) Medware imposed an interest charge, deferred or

otherwise, on its advances to CHMD; or (3) CHMD and Medware established any
                                        - 25 -

[*25] fixed repayment schedule. We recognize that loan documents between

CHMD and Medware, if they existed, may have been destroyed in the 2007 or the

2009 flood at the Orange office. But a loss of original records due to

circumstances beyond a taxpayer’s control merely entitles the taxpayer to establish

facts with other credible evidence; it does not shift the burden or proof, which

remains with the taxpayer. See Malinowski v. Commissioner, 

, 1124-

1125 (1979). Petitioners failed to carry that burden with respect to these three

factors, so they weigh against finding a loan.

      Although the record does contain evidence relevant to the next two factors,

neither weighs in petitioners’ favor: (4) Medware required no collateral, and (5)

CHMD never made any principal, interest, or other payments to Medware.

      Continuing with the sixth factor, when Medware advanced funds to CHMD,

CHMD was in dire financial straits, but its situation was not hopeless. Medware

wrote 10 checks to CHMD totaling $94,258 on January 12, 2007. At that time,

payments from CHMD’s principal source of income, Medicare, had been frozen for

several months. Yet, Medicare had once before stopped payments and then

resumed them. Moreover, Dr. Holden’s bankruptcy schedule reveals that Chase

issued him a credit card in January 2007, evidence that an arm’s-length lender did

not consider him wholly uncreditworthy at that time. CHMD received additional
                                        - 26 -

[*26] funds from Medware in May and June 2007. It is unclear from the record

whether these funds were disbursed pursuant to the same loan arrangement as the

funds disbursed in January. Nevertheless, soon after receiving them, in July 2007,

CHMD closed its Anaheim office. Given that the Orange office had been

profitable, closure of the Anaheim office enhanced the prospect of a turnaround.

Further bolstering this prospect, Medicare had resumed its payments to CHMD in

the first half of 2007. We conclude that the sixth factor weighs slightly in favor of

finding a loan.

      The seventh factor, the parties’ conduct with respect to the advances, is

ambiguous. On one hand, Medware, the purported lender, required CHMD to

complete a loan application, a formality consistent with commercial lending

practices. On the other hand, Medware disbursed an irregular amount of funds in

irregular tranches at irregular intervals, which was not consistent with conventional

lending practices. Oddly, of the 16 Medware checks totaling $144,258 that CHMD

deposited during 2007, none had a face value greater than $10,000, and several had

face values just below that amount. As for CHMD, Ms. Garcia testified generally

that she entered loans on CHMD’s books as loans and that she had entered the

Medware advances on CHMD’s general ledger. The advances do not appear in the

income section of CHMD’s P&L, but petitioners did not introduce its general
                                        - 27 -

[*27] ledger or balance sheet. We thus cannot verify whether, and if so, how,

CHMD recorded the advances from Medware on its books. We do know, however,

that Dr. Holden did not list Medware as a creditor in his bankruptcy schedules filed

in 2009.

      In sum, five factors weigh against finding a loan, one weighs in favor, and

one is ambiguous. These factors are simply analytical aids, not essential elements.

See Welch v. Commissioner, 204 F.3d at 1230. The ultimate question, which is a

factual one, is whether the parties intended a loan when the funds were advanced.11

See id.

      To prevail on this issue, petitioners needed to establish by a preponderance

of the evidence that such was the parties’ intent. While disputed fact issues as to

which parties have produced credible evidence are rarely so close that burden of

proof matters, we are not convinced. Medware did require a loan application, and

      11
        We typically address this question in cases in which the Commissioner has
proposed an alternative characterization for the alleged loan. See, e.g., Calloway
v. Commissioner, 

, 27 (2010) (stock sale proceeds), aff’d, 

 (11th Cir. 2012); Kaider v. Commissioner, T.C. Memo. 2011-174, slip op. at
13-14 (services compensation); Teymourian v. Commissioner, T.C. Memo. 2005-
232, 

, 352 (2005) (constructive dividends). Respondent has
proffered no alternative characterization here, perhaps because the record suggests
no plausible alternative explanation for the Medware advances. For instance,
petitioners offered testimony, and we have found as a fact, that CHMD provided
no services and sold no products to Medware during 2007. Dr. Holden explained
that he had never met anyone at Medware, which tends to rule out a gift.
                                        - 28 -

[*28] petitioners’ witnesses testified unequivocally that the Medware advances

were loans. But neither Ms. Garcia nor Dr. Holden nor Mr. Rhondo could recall

any terms of the alleged loan. Further, the manner in which the funds were

advanced and the utter absence of evidence that Medware ever expected or sought

repayment strongly suggest that no genuine loan was intended. Although we may

not know the reason for the Medware advances, “the paucity of records * * *

makes it impossible to separate the possible wheat from the definite chaff in the

transfers of funds” at issue here. See Welch v. Commissioner, 75 T.C.M. (CCH) at

2068-2069 (taking into account “confusion, contradictions, and other anomalies” in

the facts, including the “unusual business habits” of the purported lender, in

concluding that the taxpayer had not established that disputed advances were

loans).

      Petitioners have failed to establish that the Medware advances were

nontaxable loans, and we will sustain respondent’s determination that these

advances were taxable income to CHMD.

             2.    Ms. Garcia

      On cross-examination Ms. Garcia testified that CHMD had paid her interest

on a loan during 2007. Respondent then introduced into evidence a declaration

dated December 22, 2012, and signed by Ms. Garcia under penalty of perjury, in
                                       - 29 -

[*29] which she describes making loans to CHMD in April and December 2004

and in April 2007. Ms. Garcia declared that she had lent $3,985 on April 2 and

$9,000 on April 16, 2007.

      Respondent concedes that Ms. Garcia made these loans but objects that

petitioners have not shown that the lent funds were deposited into the BofA

account. With respect to the April 2 loan, although we found Ms. Garcia’s

testimony credible and believe that she made the loan, we can find no evidence that

the funds were ever deposited into CHMD’s bank account. Consequently, the

amount of the April 2 loan cannot be applied to reduce the amount of unreported

deposits treated as income in respondent’s bank deposits analysis. With respect to

the April 16 loan, however, CHMD’s bank statement reflects a $9,000 deposit from

“American Express DES” on that day. Ms. Garcia’s declaration does not reveal the

means by which she made the April 16 loan, but it is plausible that she transferred

$9,000 to CHMD from an American Express credit card. In any event, we find the

exact coincidence between the amounts of the April 16 deposit and loan persuasive

when coupled with Ms. Garcia’s testimony. Petitioners have established that

CHMD received and deposited a $9,000 nontaxable loan from Ms. Garcia on April

16, 2007.
                                       - 30 -

[*30] In sum, we conclude that CHMD’s total income for 2007 was $1,085,190,

computed as follows:

                             Source                         Amount
            Total deposits into BofA account               $1,316,827
            Nontaxable deposits conceded by
             respondent                                      (227,147)
            Nontaxable deposit of April 16, 2007,
             loan from Ms. Garcia                              (9,000)
            Taxable deposits into Dr. Holden’s
             personal account                                  4,510
                                                           _________
               Total income of CHMD                          1,085,190

Consequently, CHMD received but failed to report $162,176 of income for 2007.

II.   Disallowed Deductions

      Deductions are a matter of legislative grace, and taxpayers bear the burden of

proving their entitlement to any claimed deduction. Rule 142(a); INDOPCO, Inc.

v. Commissioner, 

, 84 (1992). A taxpayer must identify each deduction

available, show that he or she has met all requirements therefor, and keep books or

records that substantiate the expenses underlying the deduction. Sec. 6001;

Roberts v. Commissioner, 

, 836 (1974). If a taxpayer’s records are lost

or destroyed because of circumstances beyond his control, the taxpayer may instead
                                        - 31 -

[*31] substantiate the expenses with other credible evidence. See Malinowski v.

Commissioner, 71 T.C. at 1124-1125.

      Under Cohan v. Commissioner, 

, 543-544 (2d Cir. 1930), if a

taxpayer claims a deduction but cannot fully substantiate the expense underlying

the deduction, the Court may generally approximate the allowable amount, bearing

heavily against the taxpayer whose inexactitude is of his own making. The Court

must have some basis upon which to make its estimate, however, or else the

allowance would amount to “unguided largesse”. Williams v. United States, 

, 560 (5th Cir. 1957); Vanicek v. Commissioner, 

, 742-743

(1985).

      A.     Business Expenses

      Section 162(a) permits a taxpayer to deduct all of the ordinary and necessary

expenses paid or incurred during the taxable year in carrying on the taxpayer’s

trade or business. “To qualify as an allowable deduction under [section] * * *

162(a) * * * an item must (1) be ‘paid or incurred during the taxable year,’ (2) be

for ‘carrying on any trade or business,’ (3) be an ‘expense,’ (4) be a ‘necessary’

expense, and (5) be an ‘ordinary’ expense.” Commissioner v. Lincoln Sav. & Loan

Ass’n, 

, 352 (1971). An expense satisfies the second element only if it

is “directly connected with or pertaining to the taxpayer’s trade or business”. Sec.
                                        - 32 -

[*32] 1.162-1(a), Income Tax Regs. An expense qualifies as necessary if it is

“appropriate and helpful” to the taxpayer’s business, Welch v. Helvering, 290 U.S.

at 113, and as ordinary if the underlying transaction is a “common or frequent

occurrence in the type of business involved”, see Deputy v. du Pont, 

,

495 (1940). A taxpayer must establish these essential elements with credible

evidence. See sec. 1.6001-1(a), Income Tax Regs.

      While business expenses are generally deductible, personal, living, and

family expenses are typically nondeductible. See sec. 262(a). A business expense

claimed as a deduction must be incurred primarily for business rather than personal

reasons. See Walliser v. Commissioner, 

, 437 (1979). Where an

expense exhibits both personal and business characteristics, the “test[] requires a

weighing and balancing of all the facts * * * bearing in mind the precedence of

section 262, which denies deductions for personal expenses, over section 162,

which allows deductions for business expenses.” Sharon v. Commissioner, 

, 524 (1976) (citing costs of commuting and ordinary clothing as examples of

expenses helpful and necessary to an individual’s employment that are “essentially

personal” and hence nondeductible), aff’d per curiam, 

 (9th Cir.

1978).
                                        - 33 -

[*33] We apply the foregoing rules to each category of disputed business expenses

in turn.

             1.    Salaries and Wages

       Of CHMD’s claimed $280,774 salaries and wages deduction, $111,138

remains in dispute (disputed salaries). The disputed salaries exclude wages CHMD

paid to employees for which it prepared Forms W-2, Wage and Tax Statement, and

also remuneration paid to Ms. Garcia that she reported on her 2007 Form 1040.

CHMD prepared no Forms W-2 and filed no Forms 1099-MISC, Miscellaneous

Income, with respect to any portion of the disputed salaries. Petitioners claim that

CHMD paid $76,794 of salaries and wages to five individuals to whom it did not

issue either Forms W-2 or Forms 1099-MISC.

       Section 162(a)(1) authorizes a deduction for “salaries or other compensation

for personal services actually rendered”. To be deductible, compensation must be

reasonable and “purely for services.” Sec. 1.162-7(a), Income Tax Regs.; accord

Nor-Cal Adjusters v. Commissioner, 

, 362 (9th Cir. 1974), aff’g T.C.

Memo. 1971-200.
                                      - 34 -

[*34] Petitioners produced copies of canceled checks, all cashed during 2007,

establishing total payments of $74,994,12 consisting of $28,000 paid to Dr. Mann,

$4,000 paid to Dr. Andujar, $8,755 paid to Ms. Do, and $34,239 paid to Ms.

Niangnouansy (salary checks). Ms. Garcia identified Drs. Mann and Andujar as

physicians who saw patients at CHMD’s Anaheim office, Ms. Do as a nurse

practitioner who worked at the Anaheim office, and Ms. Niangnouansy as an office

manager at the Anaheim office. She further recognized the salary checks as payroll

checks prepared by ADP.13 Ms. Garcia explained that the salary checks

represented payment for services as employees or independent contractors.



      12
        Petitioners’ Exhibit 18-P claims to substantiate $76,794, but it double-
counted check No. 557, payable to Ms. Niangnouansy, in the amount of $1,440,
which appears twice within the exhibit. Petitioners also included check No. 528,
payable to Jennifer M. Rivera, in the amount of $360. Although the check was not
cashed until August 30, 2007, it was issued on December 29, 2006. For a cash
method taxpayer such as CHMD, where a check is issued in one tax year but
presented and honored in a subsequent tax year, “[f]or Federal tax purposes, the
subsequent payment of the check relates back to the date of delivery”. See Weber
v. Commissioner, 

, 57 (1978). Hence, the check to Ms. Rivera was
deductible only for 2006, its tax year of issue, not for 2007.
      13
        CHMD’s P&L includes a “Salaries & Wages” account, and a few checks
payable to Drs. Mann and Andujar and Ms. Do are listed there. Most of the
Salaries & Wages account entries on the P&L do not include specific check
numbers and payees, but from their notations and periodicity, we conclude that
these entries reflect aggregated payroll expenses as computed by ADP. The dates
on the canceled checks petitioners produced correspond to the dates on which
CHMD accrued these payroll expenses.
                                       - 35 -

[*35] Respondent contends that the foregoing evidence does not adequately

substantiate any portion of the disputed salaries because: (1) petitioners provided

no written evidence of the services provided, none of the named individuals

testified, and Ms. Garcia did not provide enough detail in her testimony concerning

the specific services rendered by these five individuals; (2) CHMD did not issue

Forms W-2 or Forms 1099-MISC to any of the named individuals; and (3) although

Ms. Garcia testified that Drs. Mann and Andujar had their own professional

corporations, the salary checks were made payable to and endorsed by them

personally.

      Beginning with respondent’s first contention, Ms. Garcia credibly testified to

the roles Drs. Mann and Andujar, Ms. Do, Ms. Niangnouansy, and Ms. Rivera

played in CHMD’s practice. She noted, for example, that Dr. Mann “provided

family medicine services to our patients in the Anaheim office.” Respondent

demands greater detail about these “services”, but for most anyone who has ever

visited a doctor’s office, medical services are privileged and private. Moreover,

family medicine is hardly a mysterious and esoteric subspecialty demanding further

elucidation. Respondent points to no authority, and we know of none, that requires

the service provider’s own testimony or particular forms of written documentation

for substantiation of compensation expenses. Ms. Garcia’s specific,
                                       - 36 -

[*36] uncontroverted testimony and the canceled checks clearly suffice. If

respondent desired the doctors’ testimony, he was free to subpoena either or both

of them (much easier for respondent than for petitioners, because of the rules

regarding payment of travel and fee expenses) and to call them.

      That CHMD failed to issue Forms W-2 or 1099-MISC to these five

individuals does not mean that it did not pay them for services. Although the

absence of tax forms could indicate that the payments were for purposes other than

services compensation, Ms. Garcia identified the salary checks as payroll checks

prepared by ADP. Consistent with that testimony, the salary checks were

periodically issued, and the other canceled checks in the record have four-digit

numbers whereas the salary checks have three-digit numbers. Ms. Garcia testified

that, along with handling CHMD’s payroll, ADP produced and issued Forms W-2

on CHMD’s behalf. That ADP issued payroll checks to these five individuals but

may not have issued them Forms W-2 or 1099-MISC does not establish that the

payroll checks were in fact payments for something else; rather, these facts indicate

that ADP either erred or was erroneously advised that CHMD would issue Forms

1099-MISC. CHMD may not have issued or caused to be issued by ADP
                                       - 37 -

[*37] these forms, as the Code would have obliged it to do.14 Section 6721(a)

prescribes a monetary penalty for neglecting that obligation, not disallowance of a

deduction for the payment that should have been reported. In any event, we need

not speculate about why tax forms were apparently not issued because issuance of

such forms is not a prerequisite to the deduction of salaries and wages.

      Respondent’s third and final contention similarly misses the mark. That Drs.

Mann and Andujar had their own corporations does not mean that they always

worked exclusively for their corporations or received payments for their services in

their corporate names. Indeed, respondent alleges that certain checks made out to

Dr. Holden and deposited into his personal account should have been payable to

CHMD. Additionally, the parties stipulated that Dr. Holden was erroneously

issued Forms 1099-MISC under his personal Social Security number rather than

CHMD’s employer identification number. Plainly, it is not impossible or even all

that unusual for a physician with a professional corporation to receive payments for

services rendered in his or her own name.


      14
        Sec. 6041 and the regulations thereunder require every person engaged in
a trade or business to prepare and file Form 1096, Annual Summary and
Transmittal of U.S. Information Returns, or Form 1099-MISC for each person to
whom it pays, in the course of its trade or business, services compensation of at
least $600 during the taxable year, unless it issues that person a Form W-2. Secs.
1.6041-1(a)(1)(i)(A), (2), 1.6041-3(a), Income Tax Regs.
                                        - 38 -

[*38] Ms. Garcia credibly testified, after reviewing the salary checks, that the

salary checks all represented compensation for services. Considering their

periodicity and the nature of the services being compensated, the payments are

reasonable in amount. Petitioners have adequately substantiated $74,994 of

ordinary and necessary expenses for salaries and wages of CHMD’s staff, and we

hereby redetermine respondent’s determination to that extent. As for the $36,144

balance of the disputed salaries, with respect to which petitioners have offered no

evidence or argument except for faulty evidence relating to $1,800 of that amount,

we will sustain respondent’s determination.

             2.    Equipment Rental

      Of CHMD’s claimed $178,762 rental expense deduction, $80,300 remains in

dispute. Petitioners attribute this amount entirely to equipment rental expenses.

      Ms. Garcia and Dr. Holden both testified that CHMD rented numerous items

of equipment used in the operation of Dr. Holden’s medical practice. These items

ranged from specialized medical equipment, such as the Thermage machine, to

mundane office equipment, such as copy machines. Ms. Garcia identified LFG,

MBF Leasing, HPSC, IFC Credit Corp., Great America, Banc of America Leasing,

Compare Business Systems, Inc., Protection One, and GE (collectively, leasing

companies) as companies from which CHMD had leased equipment used in its
                                       - 39 -

[*39] business during 2007. Petitioners offered bank statements and canceled

checks documenting payments CHMD made during 2007 to each of the leasing

companies. In comparing CHMD’s bank statements against its P&L, we have

identified additional payments CHMD made to the leasing companies during

2007.15 Ms. Garcia could not recall which specific equipment CHMD rented from

each leasing company, with the exception of Protection One, from which CHMD

leased DVR security cameras and recorders for both offices. Annotations on the

P&L indicate that CHMD rented, inter alia, its copy machines from Banc of

America Leasing, its Thermage machine, omni light, and hyperbaric chamber from

GE, security equipment from Protection One, and telephone-related items from

Great America. In total, the record contains evidence of payments to the leasing

companies totaling $77,858.




      15
         In some instances, a bank statement or canceled check establishes that a
payment was made to HPSC, but the P&L lists the payee as GE. Because the
dollar amounts and dates correlate with one another, we consider this discrepancy
unimportant. Also, in numerous instances, the total payment amount included
taxes, finance charges, insurance charges, and/or charges for associated services,
all of which Ms. Garcia tracked in separate categories of the P&L. Because
CHMD claimed an equipment rental expense deduction equal to the total expenses
recorded in the equipment rental category on its P&L, we have omitted taxes,
finance charges, and other ancillary items in computing total substantiated
equipment rental expenses.
                                         - 40 -

[*40] Respondent deems the foregoing evidence insufficient because (1) Ms.

Garcia was unable to specifically identify which items CHMD rented from each

leasing company; (2) petitioners produced no lease agreements with any of the

leasing companies; (3) the P&L lists no equipment rental expenses for Marlin or

Key; (4) CHMD made no lease payments to either Marlin or Key during the 2007

tax year; and (5) neither Ms. Garcia nor Dr. Holden specifically mentioned Marlin

or Key.

      With respect to respondent’s first two contentions, the Court finds it

unremarkable that Ms. Garcia was unable to associate each specific leased item

with its respective lessor, six years after the tax year at issue and four years after

she ceased working for CHMD. She and Dr. Holden adequately identified the

leased equipment, and Ms. Garcia adequately identified the lessors. To the extent

that evidence linking each payment to the specific equipment to which it applied is

necessary, CHMD’s P&L provides it.16 Furthermore, petitioners credibly explained

why they could not produce written contracts between CHMD and each of the

leasing companies: Many of CHMD’s records, and in particular those

      16
       Dr. Holden’s creditors schedule filed with the bankruptcy court likewise
links many of the leasing companies with the specific equipment leased from
them. For example, the schedule reflects that CHMD leased two laser machines, a
neurometrix machine, a hyperbaric chamber, and a sauna from GE and credit card
machines from MBF Leasing.
                                        - 41 -

[*41] relating to creditors such as the leasing companies, were destroyed in an

unfortunate (and drenching) turn of fate in 2009. Between Ms. Garcia’s testimony

and the ample documentary evidence, we think petitioners have amply

reconstructed this evidence. See Malinowski v. Commissioner, 71 T.C. at 1124-

1125.

        We need not address respondent’s last three contentions because, as

described infra part II.C, we conclude that the purported leases with Marlin and

Key were in fact conditional sales contracts, so payments CHMD made to Marlin

and Key must be analyzed accordingly.

        Petitioners have established that CHMD paid $77,858 of equipment rental

expenses during 2007. The items rented, ranging from specialized medical

equipment to typical office equipment, were directly connected with and

appropriate and helpful to CHMD’s operation of two medical offices that also

provided cosmetology services. It is common, if not customary, for a professional

office to lease rather than purchase specialized equipment, copy machines, and

computer systems; and the sheer number of leasing companies from which CHMD

rented equipment demonstrates the existence of a robust market for such services.

The equipment rental expenses were therefore ordinary as well as necessary. We

hold that petitioners have established with credible evidence all essential elements
                                        - 42 -

[*42] under section 162(a), see Commissioner v. Lincoln Sav. & Loan Ass’n, 403

U.S. at 352; sec. 1.6001-1(a), Income Tax Regs., and the Court will redetermine

respondent’s disallowance of CHMD’s equipment rental deductions to the extent of

an additional $77,858 deduction.

            3.       Supplies

      Of CHMD’s claimed $122,144 supplies expense deduction, $11,613 remains

in dispute. This amount represents the sum of three expenses that respondent

contends CHMD was not entitled to deduct:

                                Quickbooks
              Date              subcategory           Payee         Amount
            Jan. 22, 2007 Pharmaceuticals        American Express   $1,848
            Jan. 22, 2007 Medical                American Express     8,641
            Mar. 9, 2007    Pharmaceuticals      American Express     1,124

These expense items appear in CHMD’s P&L. The P&L indicates that check Nos.

2255, 8555, and 8565 were used to make the payments, but of these only one is

shown in the bank statements as having cleared. That check, No. 2255, was used

for the March 9 payment, which cleared CHMD’s account on March 12, 2007. But

the amount of this check is only $500, not $1,124. There is no identifiable

evidence that the other two checks, Nos. 8555 and 8565, ever cleared the bank.

Otherwise, petitioners offered no testimony or documentary evidence to
                                        - 43 -

[*43] substantiate that these expenses were actually incurred and paid or to explain

the discrepancies, and no evidence of the alleged expenditures’ purposes. There is

insufficient evidence here to warrant application of the Cohan rule. See Vanicek v.

Commissioner, 85 T.C. at 743. We will consequently sustain respondent’s

disallowance of $11,613 of CHMD’s claimed supplies expense deduction.

            4.      Office

      Of CHMD’s claimed $37,270 office expense deduction, $36,258 remains in

dispute. This amount represents the sum of two expenses that respondent contends

CHMD was not entitled to deduct:

                              Quickbooks
             Date             subcategory            Payee            Amount
            Jan. 5, 2007     Office expense   Platinum Plus          $12,649
          Feb. 18, 2007      Office expense   Bank of America Visa    23,610

These expense items appear in CHMD’s P&L. Petitioners introduced no evidence-

-other than the notation in the P&L that check No. 8543 was used to make the

payment--to establish that the January 5 expense was actually incurred and paid, or

if so, for what purpose. There is no evidence in the bank statements that this check

ever cleared. CHMD’s bank statement reflects that check No. 2207, which the

P&L indicates was used to make the February 18 payment, cleared CHMD’s

account on February 26, 2007. Curiously, the amount of that check as cashed was
                                        - 44 -

[*44] only $1,000, not $23,610, suggesting that CHMD may have accrued the full

amount of a credit card statement but made only a $1,000 payment. In any event,

petitioners have not established that the remaining $22,610 of expenses was in fact

incurred and paid nor provided evidence of a business reason for any amount of the

February 18 expense. We will sustain respondent’s disallowance of $36,258 of

CHMD’s office expense deduction.

            5.     Dues and Subscriptions

      Of CHMD’s claimed $11,973 dues and subscriptions expense deduction,

$6,401 remains in dispute. This amount represents the sum of five expenses that

respondent contends CHMD was not entitled to deduct (disputed dues):

                            Date                 Payee   Amount

                       Mar. 29, 2007        Advanta       $

, 2007        Advanta      1,100
                       Sept. 28, 2007       Advanta      2,000
                       Oct. 29, 2007        Advanta        551
                       Oct. 29, 2007        Advanta      2,000
                                       - 45 -

[*45] CHMD’s P&L lists checks numbers for these five items, and canceled checks

as well as its bank statements reflect that these checks did clear CHMD’s account.

However, the evidence suggests that CHMD accrued the full amounts of expenses

charged to the Advanta card as reflected on its monthly statements but made only

partial payments toward the balance owed. Check No. 2297, which the P&L

associates with the two March 29 expenses totaling $1,850, had a face amount of

only $300. Similarly, check No. 9117, which the P&L links to the $2,000

September 28 expense, had a face amount of only $500. And check No. 2504,

which the P&L associates with the two October 29 expenses totaling $2,551, had a

face amount of only $540. Because CHMD computed its income for tax purposes

on the cash method, it was entitled to deduct only expenses actually paid. See sec.

1.446-1(c)(1)(i), Income Tax Regs. Nevertheless, by charging expenses to the

Advanta card, CHMD actually paid those expenses using funds borrowed from

Advanta and so would be entitled to deduct them in full. See Granan v.

Commissioner, 

, 755 (1971).

      Relying on Granan, respondent objects that, even if the disputed dues were

deductible expenses, they would have been deductible when charged to the

Advanta card, not when payments were made toward the balance owed on the

Advanta card. In Granan, the taxpayer had borrowed funds to pay medical
                                        - 46 -

[*46] expenses and then claimed deductions for those expenses when, in a

subsequent tax year, he made payments on the loan. Id. Applying “the general rule

* * * that when a deductible payment is made with borrowed money, the deduction

is not postponed until the years in which the borrowed money is repaid”, we held

that the taxpayer was not entitled to the claimed deductions in the subsequent year.

Id. at 755-756. CHMD accrued expenses for and made payments toward Advanta

card bills during 2007, but similarly to the taxpayer in Granan, it claimed

deductions for 2007 for the payments to Advanta rather than for the underlying

expenses. Therefore, respondent contends, they must establish that the underlying

expenses were actually paid in (and hence deductible for) the tax year at issue.

      Although the record does not disclose precisely when CHMD incurred the

underlying obligations or when it charged those obligations to the Advanta card,

the dates on which CHMD accrued the payments to Advanta establish general

timeframes. It is plausible that the expenses underlying the Advanta charges

accrued on March 29, 2007, were incurred and paid in 2006. With respect to the

September 28 and October 29, 2007, charges--accrued just before or during the

fourth quarter of 2007--the underlying expenses were more likely than not
                                        - 47 -

[*47] incurred and paid in the 2007 tax year. Therefore, to the extent those

expenses were ordinary and necessary, petitioners would be entitled to deduct

them.

        The evidence in the record indicates those underlying expenses satisfied the

requirements of section 162(a). Ms. Garcia confirmed that the Advanta checks

were for dues and subscriptions. The P&L corroborates Ms. Garcia’s assertion.

The P&L “memo” entry for the September 28 expense and one of the October 29

expenses is “Amespa”. Although it may now be defunct, for the year at issue the

American Medical Education & Services Physician Association (AMESPA) was a

membership organization that purported to provide continuing education to

physicians. We find that payments to such an organization qualify as ordinary and

necessary business expenses of CHMD’s medical and cosmetology offices. The

memo entry for the second October 29 expense is “DEA Registra”. Federal law

requires physicians who dispense controlled substances to register annually with

the Drug Enforcement Administration (DEA), 21 U.S.C. sec. 822(a)(1), (b) (2006);

21 C.F.R. sec. 1301.11 (2009), and we conclude that the second October 29

expense served this purpose. Hence, the expenses underlying the September 28

and October 29 disputed dues were ordinary and necessary business expenses

deductible under section 162(a).
                                        - 48 -

[*48] We find that CHMD was entitled to deduct $4,551 of the disputed dues;

otherwise, we sustain respondent’s determination concerning them.

             6.    Contract Labor

      Of CHMD’s claimed $24,744 deduction for contract labor expense, $9,970

remains in dispute. This amount represents the sum of five expenses that

respondent contends CHMD was not entitled to deduct:

                        Date                     Payee       Amount
                   Dec. 17, 2007       Leonel Miguez          $2,780
                   Dec. 21, 2007       Francisco Alatriste     1,500
                   Dec. 24, 2007       Leonel Miguez           1,400
                   Dec. 24, 2007       Leonel Miguez           1,500
                   Dec. 31, 2007       Francisco Alatriste     2,790

      Dr. Holden related--and a “Loss List” under CHMD’s insurance policy

supports him--that on or around September 29, 2007, a pipe in the Orange office

burst after heavy rains, causing severe damage that took a year to fully repair. Ms.

Garcia and Dr. Holden testified that CHMD hired Leonel Miguez, a construction

contractor, to repair damaged drywall and flooring and to remodel part of the

office, and that Mr. Miguez brought in Francisco Alatriste, an electrician, to

perform electrical work related to the repairs. Petitioners also introduced four

canceled checks dated for and cashed during December 2007 that establish
                                        - 49 -

[*49] payments totaling $5,680 to Mr. Miguez and $1,500 to Mr. Alatriste. With

respect to these four payments, petitioners have established actual payment and

offered credible evidence of the services remunerated and the business reason for

them.

        Although petitioners did not introduce a canceled check to substantiate the

claimed $2,790 payment to Mr. Alatriste on December 31, 2007, reflected in

CHMD’s P&L, the P&L links that payment to check No. 2705. That check did not

clear CHMD’s account during 2007, and there is no evidence it cleared in a later

year. Because CHMD reported its income for tax purposes on a cash basis, it was

not entitled to deduct expenses for Mr. Alatriste’s services until it had actually paid

those expenses. See sec. 1.446-1(c)(1)(i), Income Tax Regs. CHMD may have

delivered a $2,790 check to Mr. Alatriste in 2007, but a check is merely a

conditional payment and relieves an obligor of his liability only if and when it is

presented and honored. See Weber v. Commissioner, 

, 57 (1978);

Heritage Org., LLC v. Commissioner, T.C. Memo. 2011-246, slip op. at 13. “For

Federal tax purposes, the subsequent payment of the check relates back to the date

of delivery so as to allow deductions even where checks are presented and honored

during later years.” Weber v. Commissioner, 70 T.C. at 57. Absent evidence that a

check was presented and honored, however, a cash basis taxpayer may not deduct
                                        - 50 -

[*50] the underlying expense. See id. That rule applies squarely to CHMD’s

December 31 payment to Mr. Alatriste and precludes its deduction.

      Respondent deems petitioners’ evidentiary showing insufficient across the

board because: (1) neither Mr. Miguez nor Mr. Alatriste testified at trial, and

petitioners provided no written quotes, invoices, receipts, contracts, or other

documents relating to their alleged services and (2) petitioners have not explained

why, given that TCI hired B&B to perform reconstruction work, CHMD, a tenant,

would need to hire and pay its own construction crew.

      With respect to respondent’s first objection, testimony from Messrs. Miguez

and Alatriste might have enhanced petitioners’ evidentiary showing, but it was far

from necessary. Together with the testimony and documentary evidence of the

2007 flood, Ms. Garcia’s and Dr. Holden’s testimony concerning the services these

men provided adequately established the nature of those services. Further, because

the 2009 flood destroyed many of CHMD’s original records, petitioners were

entitled to substantiate these expenses with credible evidence other than original

receipts. See Malinowski v. Commissioner, 71 T.C. at 1124-1125.

      As for respondent’s second objection, TCI did hire B&B to perform repair

work after the 2007 flood, but we see no reason why this fact would cast doubt on

whether CHMD’s payments to Messrs. Miguez and Alatriste were ordinary and
                                        - 51 -

[*51] necessary business expenses. CHMD’s lease for the Orange office is not in

the record. Dr. Holden testified that utilities were not included in the lease, but we

otherwise know none of its terms. In particular, we do not know how the lease

allocated financial responsibility for repairs and maintenance of the leasehold

improvements at Orange office, and whether there were common areas or structural

components that B&B might have repaired. In short, we have no factual basis for

presuming, as respondent would have us do, that TCI should have borne, and did

bear, all repair costs associated with the 2007 flood. Respondent, too, is free to call

witnesses once petitioners have met their burden of going forward with credible

evidence on the disputed factual matter.

      In sum, respondent’s objections presume a greater evidentiary burden than

that actually required under section 162(a). Petitioners have substantiated $7,180

of ordinary and necessary contract labor expenses. We will reject and redetermine

respondent’s determination to that extent.

             7.    Auto and Truck

      The entire amount of CHMD’s claimed $10,541 auto and truck expense

deduction remains at issue. Although the familiar rules of section 162(a) still

apply, the expenses underlying this deduction are subject to rules of substantiation

that supersede the Cohan doctrine. Sanford v. Commissioner, 

, 827-
                                       - 52 -

[*52] 828 (1968), aff’d per curiam, 

 (2d Cir. 1969); sec. 1.274-5T,

Temporary Income Tax Regs., 50 Fed. Reg. 46014 (Nov. 6, 1985). Specifically,

section 274(d) provides that no deduction shall be allowed for, among other things,

expenses with respect to listed property (as defined in section 280F(d)(4) and

including passenger automobiles) “unless the taxpayer substantiates by adequate

records or by sufficient evidence corroborating the taxpayer’s own statement”

certain specific elements. For expenses with respect to a passenger automobile,

those elements are: (1) “[t]he amount of each separate expenditure”, (2) the

amount (in time or mileage) of each business use, (3) the date of each expenditure

or use, and (4) the business purpose of each expenditure or use. Sec. 1.274-

5T(b)(6), Temporary Income Tax Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985). If the

taxpayer cannot produce records adequate to satisfy section 274(d) because those

records were lost through circumstances beyond his control, “such as destruction

by * * * flood,” the taxpayer may substantiate an expense “by reasonable

reconstruction of his expenditure or use.” Id. para. (c)(5), 50 Fed. Reg. 46022.

      Petitioners’ Exhibit 24-P, which consists of numerous canceled checks and

annotated bank and credit card statements, establishes the amounts and dates of the

auto and truck expenses for which CHMD claimed deductions. Many of the
                                         - 53 -

[*53] checks were payable to Ms. Garcia. She testified that these payments

represented a “car allowance” paid to her as an independent contractor because she

often drove back and forth between the Orange and Anaheim offices and also to

other locations for projects necessary for the business. Ms. Garcia stated that her

monthly car payment was $646, and petitioners’ documentary evidence reflects that

CHMD paid that amount to Ms. Garcia monthly throughout 2007. Because these

amounts represent part of Ms. Garcia’s independent contractor compensation, they

constitute services compensation rather than auto and truck expense and are

deductible as such. See sec. 162(a)(1); sec. 1.162-7(a), Income Tax Regs.

      In addition to the payments related to Ms. Garcia’s car, CHMD also made at

least two payments toward Dr. Holden’s Mercedes Benz. Ms. Garcia testified that

in addition to seeing patients at the Orange and Anaheim offices, Dr. Holden

typically spent his mornings visiting nonambulatory patients at board and care

facilities, skilled nursing facilities, assisted living facilities, and Chapman Hospital.

She noted that he sometimes returned to these rounds later in the day. Even

assuming that Dr. Holden drove his Mercedes during these patient visits,

petitioners have not established the date, mileage, and purpose of each business use

of the vehicle, nor the extent of business versus personal use. Hence,
                                       - 54 -

[*54] petitioners have not established that these expenses were deductible. See

secs. 262(a), 274(d); Walliser v. Commissioner, 72 T.C. at 437.

      Finally, petitioners offered no evidence as to the business purpose or other

reason for four miscellaneous expenses--a $46 credit card charge to “Shell Oil”, an

$84 check payment to “PepBoys Auto”, a $46 check to Ms. Garcia,17 and check No.

8779, for $377, to an unknown payee--documented in Exhibit 24-P. Because

petitioners have not established a business purpose for any of these expenditures,

they are not deductible.

      In sum, petitioners have not, to the extent required by section 274(d),

substantiated any auto and truck expense, so we will sustain respondent’s

determination in that regard. We will, however, allow an additional $7,752 salaries

and wages expense deduction for Ms. Garcia’s car payments.

      B.     Interest

      The entire amount of CHMD’s $80,099 interest expense deduction remains

in dispute. CHMD’s P&L reflects that this amount consists of $47,396 of loan

interest and $32,703 of finance charges.

      17
         The check is dated May 3, 2007, and bears the notation “U Haul Gas Ana
Move” on the memo line. One might infer that this check reimbursed Ms. Garcia
for fueling a rented U-Haul truck used in moving CHMD’s property out of the
Anaheim office postclosure, but that office did not close until July 2007, two
months after the check was written.
                                        - 55 -

[*55] Complementing the allowance in section 162 of deductions for business

expenses, section 163 authorizes a corporation to deduct “all interest paid or

accrued within the taxable year on indebtedness”, including interest paid or accrued

on business-related debt. As with other business expenses, however, a taxpayer

must substantiate any interest expense for which he claims a deduction. See sec.

6001; Roberts v. Commissioner, 62 T.C. at 836.

      To substantiate CHMD’s claimed interest expense, petitioners offered Ms.

Garcia’s testimony and Exhibit 20-P, which consists of 135 pages of canceled

checks and annotated bank statements. At trial petitioners’ counsel afforded Ms.

Garcia time to review the documents in Exhibit 20-P, and after she advised that

she had completed her review, asked her whether any of the payments reflected in

those documents were interest payments. Ms. Garcia testified that the documents

reflected “[v]arious payments to credit cards, leasing companies, [and] loan

repayments” and that some of them were interest payments. She explained that,

when she entered a loan or credit card payment into Quickbooks, she would record

any interest or finance charge separately from the payment toward principal.

      When petitioner’s counsel asked whether all of the payments reflected in

Exhibit 20-P were “ordinary” and “necessary” payments for CHMD’s business,

Ms. Garcia answered affirmatively. The Court found Ms. Garcia to be a credible
                                        - 56 -

[*56] witness, and we believe this answer to have been sincere. Nevertheless, we

find it implausible that any person could, even with prior preparation, affirm with

certainty after only a few moments’ scrutiny that 135 documents all shared a

particular, substantive character. We therefore give the foregoing, blanket

assertion little weight.

      Turning to Exhibit 20-P itself, to facilitate our analysis we classify the

payees on the alleged interest payments into three groups: (1) Dr. Holden and Ms.

Garcia, (2) Marlin and some of the leasing companies, and (3) credit card

companies and others.

             1.     Dr. Holden and Ms. Garcia

      Exhibit 20-P includes one check, dated January 8, 2007, in the amount of

$583, made out to Dr. Holden. No facts link this purported interest check to any

loan from Dr. Holden to CHMD or otherwise tend to show that such a loan existed.

We have only Ms. Garcia’s generalized testimony that some of the checks in

Exhibit 20-P were for interest. We cannot, on the current record, conclude that this

check to Dr. Holden was among them.

      Next, Exhibit 20-P includes six canceled checks made out to Ms. Garcia that

petitioners contend reflect interest paid to her in 2007. Ms. Garcia’s testimony and

her prior written declaration established that she lent money in 2004 to finance
                                       - 57 -

[*57] the acquisition of the Anaheim office and for practice expenses and that she

charged interest on those loans.

      Ms. Garcia confirmed that two of the checks in Exhibit 20-P--both in the

amount of $208--covered interest only. A third check for $1,000 bears the notation

“Int Loan” on the memo line, much like the “Loan Repay Int” notation on one of

the checks Ms. Garcia confirmed was for loan interest. We conclude that

petitioners have adequately substantiated these three payments of interest, and that

the underlying loans had a clear nexus to CHMD’s business.

      We reach the opposite conclusion regarding the other three payments. Ms.

Garcia expressed uncertainty as to whether the fourth check, for $1,000, was

actually for interest or instead reimbursement for an office supplies purchase. The

fifth check, for $10,000, is marked “Loan Repayment Bal Paid in Full”, which

together with its round number amount strongly suggests that it represented full

payment of the principal balance on one of Ms. Garcia’s loans to CHMD.

CHMD’s P&L reflects that $15 of this payment constituted interest, but petitioners

offered no corroborating testimony or documentary evidence of this fact. For the

foregoing reasons, respondent properly disallowed CHMD’s deduction of these

two claimed interest expenses.
                                        - 58 -

[*58] Ms. Garcia testified that the sixth and final check, dated April 6, 2007, in the

amount of $167, represented reimbursement of the interest on her car payment. But

that same day CHMD also wrote her check No. 2304 for the full amount of her car

payment, interest included. Moreover, even assuming that Ms. Garcia remitted

$167 to her lender after depositing CHMD’s check, the character of that second

payment does not translate through to the first. Interest is “compensation for the

use or forbearance of [borrowed] money”. Deputy v. Dupont, 308 U.S. at 498. A

payment to an independent contractor intended to offset the cost of her contract-

related car travel is not compensation for the use of borrowed funds. It is,

however, deductible under section 162(a)(1), and we will allow it on that basis.

      We conclude that petitioners have adequately substantiated $1,416 of interest

expense paid to Ms. Garcia and an additional $167 of salaries and wages expense.

             2.    Marlin and Leasing Companies

      Exhibit 20-P includes numerous checks payable to Marlin, Banc of America

Leasing, Great America, GE, and HPSC. Beginning with Marlin, having compared

Marlin’s payment history report for CHMD with CHMD’s P&L and

bank statements, we conclude that petitioners have adequately substantiated the
                                        - 59 -

[*59] following late fees paid to Marlin:18

                          Check
                           No.       Amount      Date posted
                           2184        $24        2/16/2007
                           2256        194        3/12/2007
                           8861        194         6/8/2007
                           8918        194        7/13/2007
                           2554        194        11/9/2007
                           2619        194        12/4/2007
                            Total      994

CHMD properly deducted these amounts.19

      18
         Our comparison of these documents revealed several discrepancies in
CHMD’s P&L. On February 9, 2007, CHMD wrote check No. 7750 for $1,417
and booked a $24 finance charge from Marlin. Marlin’s payment history record
reflects that this amount is a “[f]ee”. We will allow deductions for these fees
under sec. 162(a) because of their nexus to CHMD’s acquisition of equipment
necessary to its business.
       In addition to the amounts listed in the table, CHMD accrued Marlin’s
standard late fee (15% of CHMD’s monthly lease payment) in August and
September 2007, but Marlin’s records reflect that it did not impose a late fee in
those months. On December 4, 2007, CHMD booked a $200 finance charge from
Marlin, but Marlin’s records reflect only its standard, $194 late fee. We will allow
only the amounts corroborated by Marlin’s record.
      19
       We have characterized these amounts as late fees rather than finance
charges on the basis of Marlin’s payment history record. Marlin’s contract with
CHMD provides for a late charge of the greater of $20 or 15% of the past-due
amount and creates a contractual obligation on the part of CHMD to pay that
amount. “[A]lthough an indebtedness is an obligation, an obligation is not
                                                                      (continued...)
                                       - 60 -

[*60] As for the leasing companies, taking into account our findings concerning

petitioners’ substantiation of CHMD’s equipment rental expenses, and having

compared the relevant documents in Exhibit 20-P against CHMD’s P&L and bank

statements, we conclude that petitioners have adequately substantiated the

following finance charges paid to the leasing companies:

                                                        Finance
                   Payee              Payment form      charge Date posted
           Banc of America Leasing Check No. 2201          $70       3/5/2007
           Banc of America Leasing Direct debit            100      4/16/2007
           Banc of America Leasing Check No. 2578          100    11/20/2007
           Banc of America Leasing Check No. 2654          100    12/18/2007
           GE                       Direct debit            99      1/26/2007
           GE                       Check No. 2235         100       3/6/2007



      19
        (...continued)
necessarily an ‘indebtedness’ within the meaning of * * * [section 163].” Deputy
v. Dupont, 

, 497 (1940) (holding that dividend-equivalent amounts
paid pursuant to a contractual obligation were not deductible under sec. 163’s
predecessor statute). A late fee charged by a lessor for failure to timely make a
lease payment is more in the nature of a penalty than “compensation for the use or
forbearance of money.” Like interest, the late fee provided for in the Marlin
contract is computed as a percentage of the amount owed. Unlike interest, the late
fee does not accrue periodically but is instead charged only once. Regardless of
whether the late fees are deductible as interest under sec. 163, because of their
nexus to CHMD’s acquisition of equipment used in the operation of its medical
practice, they qualify as ordinary and necessary business expenses and would be
deductible under sec. 162(a).
                                       - 61 -

 [*61]   GE                         Check No. 2236        242        3/6/2007
         GE                         Check No. 2237         50        3/6/2007
         Great America              Check No. 2267         37      3/19/2007
         Great America              Direct debit           37      4/16/2007
         Great America              Check No. 8933         74      7/19/2007
         Great America              Check No. 9105         37      9/24/2007
         Great America              Check No. 2660         74     12/21/2007
         HPSC                       Check No. 2147        239      2/13/2007
         HPSC                       Check No. 2148         61      2/13/2007
         HPSC                       Check No. 2149          88     2/13/2007
          Total                                         1,508

      Ms. Garcia credibly testified that CHMD leased equipment necessary to its

business from these companies, and petitioners’ evidence reflects that CHMD paid

each of the foregoing amounts via the same check or direct debit with which it

made a lease payment. We have already determined that the lease payments were

ordinary and necessary business expenses. On the basis of these facts, we conclude

that CHMD paid the finance charges pursuant to its leases with the leasing

companies. Accordingly, even if these amounts do not constitute interest, they are

deductible under section 162(a).
                                        - 62 -

[*62]         3.    Credit Card Companies and Others

        Exhibit 20-P also contains numerous canceled checks and bank statements

evincing payments CHMD made to Advanta, American Express, Bank of America,

Capital One, and Platinum Plus, all of which appear to be credit card providers, as

well as “Commercial Loans”, Popular Leasing, and McKesson Medical

(alternatively identified as McKesson Medical Surgical). CHMD’s P&L reflects

that it accrued interest or a finance charge in connection with each of these

payments.

        The P&L supplies the only evidence of how much of each payment was

interest or a finance charge (as opposed to principal).20 We have no evidence of

what expenses gave rise to the principal balances on which interest or a finance

charge was imposed. Only if those expenses were bona fide business expenses

would any interest or finance charge be deductible.21


        20
        Despite her broad assertion that some of the payments in Exhibit 20-P
were interest, Ms. Garcia proved unable to determine what portions of payments to
Commercial Loans and Capital One constituted interest and principal. Neither
counsel inquired about payments to other payees.
        21
         Sec. 163(h)(1) prohibits the deduction of personal interest. Although this
provision expressly applies only to noncorporate taxpayers, we think it highly
relevant here, where interest deductions claimed by petitioners’ wholly owned S
corporation would flow through to them. Allowing an S corporation to deduct
interest paid on debt incurred to pay personal expenses of its sole shareholder
                                                                        (continued...)
                                        - 63 -

[*63] Ms. Garcia testified that CHMD had credit card accounts with Advanta,

American Express, and Platinum Plus during 2007. But petitioners did not

introduce any statements for these accounts to establish the underlying expenses.

We lack sufficient evidence to determine whether these purported interest and

finance charges were deductible under section 163 or section 162. As petitioners

bore the burden of proof on this issue, we will sustain respondent’s disallowance of

these reported interest expenses.

      In conclusion, of the reported interest expenses remaining in dispute, CHMD

was entitled to deduct $1,416 paid to Ms. Garcia, $994 paid to Marlin, and $1,508

paid to the leasing companies, or a total of $3,918.




      21
        (...continued)
would run directly contrary to the purpose of sec. 163(h). In such cases, courts
may recharacterize the debt principal and any interest paid as constructive
distributions to the shareholder on which the shareholder would be subject to tax,
not entitled to deductions. See Noble v. Commissioner, 

, 442-443
(9th Cir. 1966) (holding that a corporation could not deduct, and its sole
shareholders must include in income, reimbursements paid to the shareholders for
personal expenses), aff’g T.C. Memo. 1965-84; Enoch v. Commissioner, 

, 793-794 (1972) (after concluding that a loan was, in substance, a personal
obligation of a corporation’s controlling shareholder, recharacterizing the
corporation’s loan repayment as a constructive distribution to the shareholder and
disallowing corporation’s claimed interest deductions).
                                       - 64 -

[*64] C.    Depreciation

      The entire amount of CHMD’s $41,122 depreciation deduction remains in

dispute. Section 167(a) allows taxpayers engaged in a trade or business to deduct

“a reasonable allowance for the exhaustion, wear and tear * * * of property used in

the trade or business”. As with other business expenses, however, a taxpayer must

substantiate any depreciation for which he claims a deduction. See sec. 6001;

Cluck v. Commissioner, 

, 337 (1995); see also, e.g., Castillo v.

Commissioner, T.C. Memo. 2013-72, at *14-*15 (sustaining disallowance of

claimed depreciation deduction where taxpayer failed to substantiate his cost basis

or otherwise allowable depreciation); Farran v. Commissioner, T.C. Memo. 2007-

151, 

, 1360 (2007) (sustaining disallowance of claimed

depreciation deduction because of taxpayer’s inadequate substantiation). To

substantiate entitlement to a depreciation deduction under the modified accelerated

cost recovery system (MACRS) of section 168, a taxpayer must show that the

property was used in a trade or business and establish its depreciable basis. See

Cluck v. Commissioner, 105 T.C. at 337; Liddle v. Commissioner, 

,

292-293 (1994), aff’d, 

 (3d Cir. 1995).

      On Form 4562, Depreciation and Amortization, filed with its 2007 Form

1120S, CHMD computed its depreciation deduction as the sum of deductions for
                                        - 65 -

[*65] assets placed in service before the 2007 tax year (pre-2007 assets) and for

five-year recovery property placed in service during 2007 (new assets).

             1.     Pre-2007 Assets

      With respect to the $28,320 CHMD reported for pre-2007 assets, petitioners

offered little documentary evidence and virtually no testimony.22 Exhibit 21-P

consists of pages apparently taken from CHMD’s 2005, 2006, and 2007 tax returns

and Federal summary depreciation schedules (summary schedules) presumably

prepared along with those returns. The summary schedules list purported cost

bases, useful life terms, and previously claimed depreciation for various items of

equipment and leasehold improvements.

      This evidence will not satisfy petitioners’ burden of proof. That a taxpayer

claims a deduction on an income tax return is not sufficient to substantiate the

underlying expense. Wilkinson v. Commissioner, 

, 639 (1979). An

income tax return “is merely a statement of the * * * [taxpayer’s] claim * * * ; it is

not presumed to be correct.” Roberts v. Commissioner, 62 T.C. at 837. We accord

no greater weight to depreciation schedules prepared to facilitate filing a


      22
         Dr. Holden described some of the equipment that CHMD owned,
including an X-ray machine, but provided no further information. Dr. Holden also
testified that CHMD’s accountant, Ashley Hallsman, determined which equipment
items would be depreciated without his guidance. Ms. Hallsman did not testify.
                                         - 66 -

[*66] return. See, e.g., Anyanwu v. Commissioner, T.C. Memo. 2014-123, at *28-

*29 (sustaining the Commissioner’s disallowance of a taxpayer’s depreciation

deduction where the taxpayer “did not provide any testimony or other evidence at

trial to explain the numbers appearing on” the Federal summary depreciation

schedule filed with her return); Basalyk v. Commissioner, T.C. Memo. 2009-100,

, 1519 (2009) (sustaining the Commissioner’s disallowance

of the taxpayers’ depreciation deduction where the taxpayers offered no “credible

testimonial or documentary evidence” to corroborate “unsubstantiated figures

asserted on the[ir] depreciation schedule”).

      Although we recognize that records substantiating CHMD’s depreciation

deduction may have been destroyed in the 2009 flood, this misfortune entitled

petitioners to establish the relevant facts with other credible evidence, not to rely

solely on tax returns and uncorroborated assertions. See Malinowski v.

Commissioner, 71 T.C. at 1124-1125. Although memories fade and third parties

do not retain records indefinitely, petitioners could have offered testimony

concerning what the assets were, when they were purchased, and/or generally how

much they cost; credit card statements or vendors’ records of the purchases; or

materials reflecting the market prices of the same or similar assets, historically or

even at the time of trial. They offered none of these things.
                                        - 67 -

[*67]         2.    New Assets

        With respect to the $12,802 CHMD claimed for new assets, petitioners

contend that CHMD purchased equipment from Marlin and Key during 2007 and

depreciated that equipment. Aligning with that theory, the 2007 summary schedule

shows depreciation of $12,802 for “COMPUTER/SOFTWARE” allegedly acquired

on June 11, 2007, with a depreciable basis of $64,010. We have found that CHMD

obtained equipment from and made payments totaling $33,470 to Marlin and Key

during 2007 pursuant to agreements that are, facially, lease agreements. Petitioners

in effect contend that these payments were not rent but rather installments toward

the equipment’s purchase price, and that having purchased the equipment from

Marlin and Key, CHMD was entitled to depreciate it.

        Whether CHMD was entitled to claim depreciation deductions for the

equipment it acquired under those agreements depends upon whether it bore the

economic loss of invested capital resulting from the equipment’s exhaustion, wear,

and tear. Helvering v. F. & R. Lazarus & Co., 

, 254 (1939).

        While it may more often be that he who is both owner and user bears
        the burden of wear and exhaustion of business property in the nature
        of capital, one who is not the owner may nevertheless bear the burden
        of exhaustion of capital investment. Where it has been shown that a
        lessee using property in a trade or business must incur the loss
                                         - 68 -

      [*68] resulting from depreciation of capital he has invested, the lessee has
      been held entitled to the statutory deduction. [Id.]

See also Corliss v. Bowers, 

, 378 (1930) (“[T]axation is not so much

concerned with the refinements of title as it is with actual command over the

property taxed--the actual benefit for which the tax is paid.”).

      In addressing which of the parties to an equipment lease is entitled to

depreciation deductions, we and other courts have in some instances

recharacterized purported lease agreements as conditional sales contracts. See,

e.g., Swift Dodge v. Commissioner, 

, 654 (9th Cir. 1982), rev’g 

 (1981); United Circuits, Inc. v. Commissioner, T.C. Memo. 1995-605, 

, 1621-1622 (1995); Lieber v. Commissioner, T.C. Memo.

1993-391, 

, 536-537 (1993).23

      A conditional sale is one in which “the seller reserves title until the buyer

pays for the goods. At that time, the condition is fulfilled and title passes to the

buyer.” Swift Dodge v. Commissioner, 692 F.2d at 653. Whereas a lease

      23
        The Economic Recovery Tax Act of 1981, Pub. L. No. 97-34, sec. 201(a),
95 Stat. at 214-216, created a safe harbor under which a purported lease would be
treated as a lease, and the lessor as the leased property’s owner, for purposes of
claiming deductions under the original accelerated cost recovery system (ACRS).
See also sec. 5c.168(f)(8)-1(a), Temporary Income Tax Regs., 46 Fed. Reg. 51907
(Oct. 23, 1981). When Congress replaced ACRS with MACRS in 1986, it did not
reenact the safe harbor, see Tax Reform Act of 1986, Pub. L. No. 99-514, sec.
201(a), 100 Stat. at 2125, so we will rely upon caselaw.
                                        - 69 -

[*69] contemplates only a lessee’s use of the property for a limited period and its

return at that period’s expiration, “‘a conditional sale contemplates the ultimate

ownership of the property by the buyer, together with the use of it in the

meantime’”. Bowen v. Commissioner, 

, 459 (1949) (quoting In re

Rainey, 

, 199 (D. Md. 1929)). Thus, the putative lessee under a

conditional sales contract may claim depreciation deductions. See, e.g., McKinsey

v. Commissioner, T.C. Memo. 1984-514, 

, 1234, 1239

(1984).

      In Swift Dodge the Court of Appeals for the Ninth Circuit examined several

factors in finding that an “open-ended” vehicle lease was in fact a conditional sale.

In that “open-ended” lease,

      the lessee was required to pay, when the lease terminated, the amount,
      if any, by which the estimated “depreciated value” of the vehicle, as
      set forth in the agreement, exceeded its actual wholesale value.
      Similarly, if the actual wholesale value of the vehicle exceeded its
      estimated “depreciated value,” the lessee would “receive any gain
      which result[ed] from final disposition of the vehicle. * * *” [Swift
      Dodge v. Commissioner, 692 F.2d at 652 (quoting Swift Dodge v.
      Commissioner, 

, 554, 568-569 n.11 (1981)).]

      The court looked to how the agreement allocated duties, noting that the

allocation did not differ from that typical of an installment sale. Id. at 653. For

example, the lessee was obliged to insure the vehicle and to pay all operating and
                                         - 70 -

[*70] maintenance expenses not covered by the manufacturer’s warranty. See id.

Then, the court examined the parties’ legal rights, again finding them “essentially

the same” as under a conditional sale contract providing for a balloon payment.

See id. Although the lessor retained legal title and could assign its right to receive

the lessee’s payments, the lessee had the right to use the vehicle so long as he

satisfied the agreement’s terms, and at the conclusion of the lease term, could

acquire title to the vehicle for its “depreciation value as specified in the

agreement.” Id.

      Next, the court analyzed the parties’ risks, concluding that the lessee

“assumed the risk of damage, theft, * * * destruction”, and depreciation, whereas

the lessor bore only the risk of the lessee’s default, as would be true of a security

interest holder in a conditional sale. See id. at 654. Finally, the court in Swift

Dodge evaluated the parties’ intentions, observing that their stated intention was to

engage in a lease arrangement. See id. Notwithstanding that stated intention, the

court concluded the leases were in fact conditional sales. See id.

      Our own caselaw reveals additional factors relevant to determining which

party under a purported lease bears the benefits and burdens of ownership. These

include whether the leased property has a useful life that extends beyond the lease

term, and whether the strike price of any purchase option at the end of the lease
                                       - 71 -

[*71] term is nominal relative to the total payments required under the purported

lease. See Levy v. Commissioner, 

, 860 (1988); Lockhart Leasing Co.

v. Commissioner, 

, 314-315 (1970), aff’d, 

 (10th Cir.

1971); Bowen v. Commissioner, 12 T.C. at 461; cf. Rev. Proc. 2001-28, 2001-1

C.B. 1156 (providing guidelines for obtaining an advance ruling concerning the

Federal tax treatment of purported leases); Rev. Rul. 55-540, 1955-2 C.B. 39

(listing factors the Commissioner considers in determining the Federal income tax

treatment of equipment leases).

      We begin with the parties’ duties under the purported leases. Like the

agreement in Swift Dodge, both the Marlin agreement and the Key agreement

obliged CHMD, as the putative lessee, to insure the equipment and to bear the cost

of all repairs and maintenance. The agreements additionally required CHMD to

pay any and all taxes due on the equipment. Turning to the parties’ rights, like the

lessee in Swift Dodge, while Marlin and Key retained legal title to the equipment,

CHMD was entitled to use it throughout the applicable term. It was also entitled

under the Marlin agreement, and obliged under the Key agreement, to purchase the

equipment for a specified nominal price at that term’s conclusion.

      Also like the lessee in Swift Dodge, CHMD bore the risks of damage, theft,

and destruction: Both purported leases placed all responsibility for damage to the
                                         - 72 -

[*72] equipment with CHMD and unconditionally required it to pay the full

amount of all payments provided for therein. CHMD also bore the risk of

depreciation. For tax purposes, both purported leases had five-year terms, and as

qualified technological equipment, see sec. 168(e)(3)(B)(iv), (i)(2)(A)(i), the

computers and peripheral items provided thereunder were five-year property and

would thus have been fully depreciated under MACRS at the end of the

agreements’ terms. If the equipment were exhausted more quickly, CHMD would

still be obliged to make all payments for it. If the equipment were exhausted more

slowly, CHMD might be able to realize a gain by purchasing the equipment at the

lease terms’ conclusions or by continuing to use it in the medical practice.

      Finally, like the agreement in Swift Dodge, the Marlin agreement recites the

parties’ intention that it be respected as a true lease; the Key agreement contains an

analogous provision. But like the Court of Appeals in Swift Dodge, we do not

consider these stated intentions dispositive in the light of the clearly contrary facts.

      Those contrary facts also distinguish this case from Lockhart Leasing Co. v.

Commissioner, 54 T.C. at 315, in which we rejected the Commissioner’s arguments

that alleged leases were sales. See also Nw. Acceptance Corp. v. Commissioner,

, 846-850 (1972) (on “nearly congruous” facts, refusing under Lockhart

Leasing Co. to recharacterize an alleged lease as a conditional sale agreement),
                                          - 73 -

[*73] aff’d, 

 (9th Cir. 1974). In Lockhart Leasing Co. v.

Commissioner, 54 T.C. at 301-302, the taxpayer’s “business activities consisted of

the purchase of personal property for use of other persons” pursuant to an

agreement titled as an equipment lease. As was true of Marlin, if not Key, the

taxpayer would generally buy equipment specified in advance by a prospective

lessee, then transfer it to the lessee. See id. at 302. Like the agreements here, the

taxpayer’s leases assigned the lessee all tax, insurance, and maintenance

obligations as well as all liability for loss, theft, destruction, or damage of the

equipment. See id. at 303-304. And like the Marlin agreement, the taxpayer’s

agreements often granted the lessee an option to purchase the equipment at the end

of the lease. See id. at 306-307.

      Yet in sharp contrast to the instant case, the taxpayer in Lockhart Leasing

Co. did not prevent lessees from terminating their leases before the ends of their

terms, and it re-leased or re-sold property returned to it. See id. at 302, 304. The

Marlin and Key agreements unconditionally obligated CHMD to pay all amounts

due under the leases, through the end of their terms. The Key agreement

affirmatively required CHMD to buy the equipment. Although the Marlin

agreement’s purchase option appears not to have been obligatory, given the nature

of the “leased” equipment (computers and peripheral equipment), we question
                                        - 74 -

[*74] whether its useful life would have substantially exceeded the agreement’s

five-year term, such that Marlin could have re-leased or sold it had CHMD returned

it after five years.

       Further, the taxpayer in Lockhart Leasing Co. gave lessees the option to

purchase relatively rarely, generally at a price equal to 10% of the equipment’s

original cost, and when no such option was given, it negotiated a purchase price at

arm’s length. See id. at 307, 315. Here, in contrast, the option prices were

nominal--$101 under the Marlin agreement and $1 under the Key agreement. In

any event, the nominal $101 purchase price more than offsets any useful life

considerations given that the lessee, if it did not purchase the equipment, was

required to return it to the lessor “in good working condition in a manner and to a

location designated by” the lessor and to pay “any cost to refurbish the Equipment”

incurred by the lessor. Although the record does not disclose the equipment’s

original cost to Marlin and Key, the payments unconditionally due under the

agreements--$80,149 to Marlin and $85,274 to Key--so dwarfed the nominal strike

prices that CHMD would almost surely have exercised the options. CHMD’s

ultimate acquisition of title was tantamount to a foregone conclusion.

       Despite their labels, the purported leases were, in substance, installment sale

agreements. With respect to both Marlin and Key, we conclude that the parties
                                        - 75 -

[*75] contemplated from the beginning that CHMD would acquire outright

ownership of the equipment after five years. We hold that CHMD assumed the

benefits and burdens of ownership with respect to the equipment it acquired from

Marlin and Key in January 2007, and that it was accordingly entitled to a

depreciation deduction for that equipment.

      For CHMD to claim that deduction under MACRS, it must establish its

depreciable basis in the equipment. On its Form 1120S and on the depreciation

schedule petitioners introduced, CHMD claimed a cost basis in the equipment of

$64,010. CHMD’s agreements with Marlin and Key do not disclose purchase

prices or other values for the equipment, but they do provide for payments totaling,

respectively, $80,149 and $85,274. Viewing the leases as installment sale

agreements, these amounts must include both a profit and principal component--the

equipment’s purchase price, and hence CHMD’s cost basis--and an interest

component. Because the agreements are framed as leases, however, they do not

disclose the interest rates imposed, so we cannot rely upon these totals to compute

the principal due under each agreement.

      On the record before the Court, CHMD plainly had some depreciable basis

in the equipment and was entitled to claim a depreciation deduction, but CHMD

has not definitively established that basis or the amount of the allowable
                                       - 76 -

[*76] deduction. The Court will therefore apply the Cohan rule. Given the total

amounts due under CHMD’s agreements with Marlin and Key, and given the

nature of the equipment acquired thereunder, the Court concludes that $64,010 is a

reasonable computation of CHMD’s depreciable basis in that equipment. We will

therefore allow a depreciation deduction of $12,802 as claimed by petitioners and

redetermine respondent’s determination to that extent.

      D.    Summary

      For those keeping score, petitioners have adequately substantiated, and

CHMD was entitled to deduct, the following amounts of the disputed expenses:

                                                Amount     Amount
                         Expense                at issue   allowed
           Salaries and wages                   $111,138 $82,913
           Rents                                  80,300    77,858
           Interest                               80,099     3,918
           Depreciation                           41,122    12,802
           Other deductions
              Supplies                            11,613     -0-
              Office                              36,258     -0-
                      Dues and subscriptions       6,401     4,551
              Contract labor                       9,970     7,180
              Auto and truck                      10,541     -0-
               Total                             387,442 189,222
                                        - 77 -

[*77] III.   Accuracy-Related Penalty

      In the notice of deficiency respondent determined an accuracy-related

penalty under section 6662(a) and (b)(1), (2), or (3) on the basis of negligence or

disregard of rules and regulations, a substantial understatement of income tax, or a

substantial valuation misstatement.24 As a general rule, the Commissioner bears the

burden of production and “must come forward with sufficient evidence indicating

that it is appropriate to impose the relevant penalty.” Higbee v. Commissioner, 

, 446 (2001); see also sec. 7491(c). Once respondent has met this burden

of production, the burden will shift to petitioners to prove an affirmative defense or

that they are otherwise not liable for the penalty. See Higbee v. Commissioner, 116

T.C. at 446-447.

      A.     Petitioners’ Liability

      Section 6662(a) and (b)(3) provides for imposition of a 20% penalty on the

portion of an underpayment of tax required to be shown on a return that is

attributable to a substantial valuation misstatement. For returns filed on or after

August 17, 2006, as is relevant here, a substantial valuation misstatement occurs

when “the value of any property (or the adjusted basis of any property) claimed on



      24
       These represent alternative grounds for imposition of the penalty, as the
accuracy-related penalties do not stack. See sec. 1.6662-2(c), Income Tax Regs.
                                        - 78 -

[*78] any return of tax imposed by chapter 1 is 150 percent or more of the amount

determined to be the correct amount of such valuation or adjusted basis (as the case

may be)”. Sec. 6662(e)(1)(A). The notice of deficiency does not explain what

property’s value or adjusted basis respondent believes petitioners misstated.

Respondent did not discuss this issue at trial and has not addressed it on brief. As

the Court can find no basis for this penalty in the record, we find petitioners not

liable for the substantial valuation misstatement penalty.

      Section 6662(a) and (b)(1) and (2) provides for imposition of a 20% penalty

on the portion of an underpayment of tax attributable to negligence or disregard of

rules and regulations or a substantial understatement of income tax.

“‘[N]egligence’ includes any failure to make a reasonable attempt to comply with

the provisions of * * * [the Internal Revenue Code]”. Sec. 6662(c). It constitutes

“‘a lack of due care or the failure to do what a reasonable and ordinarily prudent

person would do under the circumstances.’” Freytag v. Commissioner, 

, 887 (1987) (quoting Marcello v. Commissioner, 

, 506 (5th Cir.

1967), aff’g 

 (1964) and T.C. Memo. 1964-299), aff’d, 

(5th Cir. 1990), aff’d, 

 (1991). “‘Negligence’ also includes any failure

by the taxpayer to keep adequate books and records or to substantiate items

properly.” Sec. 1.6662-3(b)(1), Income Tax Regs. Disregard of rules and
                                           - 79 -

[*79] regulations “includes any careless, reckless, or intentional disregard of” the

Code, regulations, or certain IRS administrative guidance. Id. subpara. (2). A

substantial understatement of income tax as to an individual taxpayer is generally

an understatement that exceeds the greater of $5,000 or 10% of the tax required to

be shown on the return. Sec. 6662(d)(1)(A).

      Whether a substantial understatement exists, and if so, in what amount, will

depend upon the recalculation of petitioners’ tax liability in the light of this

opinion. Although we leave this calculation to the parties under Rule 155, it seems

nearly certain, given the disallowance of more than $200,000 of petitioners’

claimed passthrough loss from CHMD, see supra part II.D, that petitioners’

understatement will exceed 10% of their tax liability, which will be greater than

$5,000, and that the penalty will apply.

      With regard to the negligence penalty, respondent contends that petitioners

were negligent because they failed to maintain books and records sufficient to

substantiate CHMD’s income and expenses. We agree. As set forth at length

supra, petitioners could not substantiate over half the amount of expenses

remaining at issue. Similarly, although they claimed that $157,243 of CHMD’s

$171,177 of unreported deposits was nontaxable loan proceeds, they substantiated

only a single loan, of $9,000. Petitioners offered no evidence or argument
                                        - 80 -

[*80] concerning the balance of CHMD’s unreported deposits, and they likewise

attempted to substantiate only portions of CHMD’s reported expenses. These

substantiation failures constitute negligence for purposes of section 6662(a). See

sec. 1.6662-3(b)(1), Income Tax Regs.

      Dr. Holden’s apparent lack of attention to his medical practice’s finances

exacerbated the dearth of documentary evidence concerning CHMD’s income and

expenses. For example, Dr. Holden testified that he recalled borrowing from

Medware but knew nothing about the company and could not recall the amount of

the loan or whether CHMD had repaid any of it. Granted, CHMD experienced

severe financial difficulties during 2007 and, in Dr. Holden’s words, was

“borrowing from anyone.” But we think that a reasonably prudent taxpayer whose

wholly owned S corporation borrowed more than $100,000 from a third party

would have at least some idea of how much was owed and whether any payments

had been made.

      Further, when petitioners’ counsel asked Dr. Holden to examine CHMD’s

bank statements, he asserted that he had not, “to [his] * * * knowledge”, run

personal expenses through CHMD’s business account. Yet petitioners themselves

presented evidence that CHMD made two payments on Dr. Holden’s Mercedes

Benz. “[A]ttempt[s] to deduct personal expenses in contravention of the plain
                                         - 81 -

[*81] language of section 262 constitute[] negligence.” Bond v. Commissioner,

T.C. Memo. 2012-313, at *13-*14 (fn. ref. omitted); accord, e.g., Cor v.

Commissioner, T.C. Memo. 2013-240, at *8; WSB Liquidating Corp. v.

Commissioner, T.C. Memo. 2001-9, 

, 1012 (2001).

       Respondent has satisfied his burden of production with regard to the

negligence penalty, so we turn to petitioners’ defense.

       B.     Petitioners’ Defense25

       Section 6664(c) generally provides a defense to the section 6662(a) penalty

with respect to any portion of an underpayment of tax for which the taxpayer had

reasonable cause and with respect to which the taxpayer acted in good faith. “The

determination of whether a taxpayer acted with reasonable cause and in good faith

is made on a case-by-case basis, taking into account all pertinent facts and

circumstances.” Sec. 1.6664-4(b)(1), Income Tax Regs. “Generally, the most

important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper

tax liability.” Id.



       25
         Petitioners did not raise an affirmative defense to the sec. 6662(a) penalty
in their petition. Ordinarily, an affirmative defense not pleaded “is deemed to be
waived.” Gustafson v. Commissioner, 

, 90 (1991). Because respondent
has not objected, however, and because both parties address the defense in their
briefs, we will treat it as an issue tried by implied consent of the parties under Rule
41(b)(1).
                                         - 82 -

[*82] On brief, petitioners contend, generally, that they have shown reasonable

cause for the underpayment set forth in the notice of deficiency. They assert that

they maintained books and records adequate to properly substantiate CHMD’s

expenses and exercised due care in filing their tax returns. On the record before us,

we interpret these assertions as references to CHMD’s loss of documents in the

2009 flood.26




      26
         A taxpayer may establish a sec. 6664(c) reasonable cause defense by
showing that he or she relied reasonably and in good faith on a third party’s advice
in taking the disputed tax position. See sec. 1.6664-4(c), Income Tax Regs. We
have held that, to establish this variation of the defense, “the taxpayer must prove
* * * that * * * : (1) The adviser was a competent professional who had sufficient
expertise to justify reliance, (2) the taxpayer provided necessary and accurate
information to the adviser, and (3) the taxpayer actually relied in good faith on the
adviser’s judgment.” See Neonatology Assocs., P.A. v. Commissioner, 

, 99 (2000), aff’d, 

 (3d Cir. 2002); Charlotte’s Office Boutique,
Inc. v. Commissioner, 

, 1212 & n.8 (9th Cir. 2005) (quoting three-
prong test in Neonatology Assocs. with approval), aff’g 

 (2003),
supplemented by T.C. Memo. 2004-43.
        Petitioners have not raised a reasonable reliance defense, and the record
would not support it. Dr. Holden testified that Ashley Hallsman, a certified public
accountant with Hallsman Accountancy Corp. who had prepared CHMD’s Federal
income tax returns for at least five years, prepared its 2007 return, as the tax return
itself indicates. Even assuming, arguendo, that Ms. Hallsman’s certified public
accountant (C.P.A.) credential and five or more years of experience rendered her a
competent professional with sufficient expertise to justify reliance, it is unclear
what information petitioners or CHMD’s staff provided to her or whether
petitioners relied in good faith upon her advice.
                                       - 83 -

[*83] Petitioners established that CHMD did maintain records of its expenses. Ms.

Garcia entered bills into Quickbooks as payables upon receipt, updated the entries

to reflect payment when she wrote checks or made online payments, and

maintained hard copy records with annotations in vendor-specific folders. An

independent third party reviewed and verified quarterly her classifications of

CHMD’s expenses within various available Quickbooks categories. CHMD used a

payroll processing company, ADP, to prepare its payroll checks. For each pay

period, Ms. Garcia would telephone ADP to report the hours worked by each

employee and independent contractor on CHMD’s payroll. ADP would then

prepare and deliver the payroll checks to CHMD, to be signed and then disbursed

to the staff.

       Petitioners further established that, on or around December 13, 2009, a pipe

broke in the area of the Orange office where Dr. Holden’s and Ms. Garcia’s desks,

Dr. Holden’s books, medical records, computers, billing records, and records of

CHMD’s debts were located. At the request of Dr. Holden’s bankruptcy trustee,

Mr. Rhondo had earlier placed documents and hard drives detailing the past five

years of CHMD’s income and expenses against a wall of Dr. Holden’s office. The

pipe broke directly above, drenching and thus destroying many of the records.
                                        - 84 -

[*84] On other facts, we might find that destruction of records in a flood provides

reasonable cause for deficient substantiation. See, e.g., Burkart v. Commissioner,

T.C. Memo. 1984-429, 

, 869 (1984) (where the taxpayers

established that their books and records were lost in a flood, finding that the

taxpayers were not liable for the negligence penalty under the predecessor statute

of section 6662). But see, e.g., Nguyen v. Commissioner, T.C. Memo. 2014-199, at

*3, *8-*11 (where the taxpayer established that he lost bills and receipts in a flood,

nevertheless finding that the taxpayer was liable for the accuracy-related penalty).

We decline to do so here for at three reasons.

      First, although petitioners did make some effort to reconstruct their lost

records, that effort was haphazard. On one hand, petitioners successfully

substantiated with secondary evidence most of the equipment rental expense

claimed on CHMD’s return. On the other hand, petitioners utterly failed to

substantiate various expenses paid with credit cards as well as interest paid to

credit card providers. The record contains only a single page from a single

statement for one credit card, which appears to be Dr. Holden’s personal card.

Petitioners did not retrieve from Advanta, American Express, Platinum Plus, or any

other credit card provider records of CHMD’s purchases. In addition,
                                         - 85 -

[*85] petitioners offered no explanation whatsoever for more than $34,000 of

reported salaries and wage expenses.

      Second, even had CHMD’s complete books and records been available and

all its reported expenses substantiated, some of CHMD’s deductions would still

have been disallowed. For example, petitioners’ own evidence established that, on

at least two occasions, CHMD paid Dr. Holden’s car payment. Absent any

evidence that Dr. Holden used his vehicle strictly for work-related travel (other

than commuting), which on the existing record we find implausible, these

expenditures were not business expenses deductible under sections 162 and 274(d).

      Third and finally, in determining whether a taxpayer acted with reasonable

cause and in good faith, the principal consideration “is the extent of the taxpayer’s

effort to assess the taxpayer’s proper tax liability.” Sec. 1.6664-4(b)(1), Income

Tax Regs. On the record before us, petitioners appear to have made virtually no

such effort. Dr. Holden testified only that he relied upon a C.P.A. to prepare

CHMD’s tax returns. His statements revealed a surprising lack of knowledge

concerning CHMD’s finances and tax reporting. Petitioners offered no evidence

that they reviewed the returns Ms. Hallsman prepared or strove to understand, even

at a very general level, the positions taken therein.
                                        - 86 -

[*86] For the foregoing reasons, we conclude that petitioners have not carried their

burden of establishing the reasonable cause and good faith defense to the section

6662(a) negligence (or substantial understatement) penalty. Consequently, the are

liable for the penalty with respect to the entirety of their underpayment of tax, as

computed in accordance with this opinion.

      The Court has considered all of the parties’ contentions, arguments, requests,

and statements. To the extent not discussed herein, we conclude that they are

meritless, moot, or irrelevant.

      To reflect the foregoing,


                                           Decision will be entered under

                                        Rule 155.
                                             - 87 -

[*87]                                  APPENDIX A

                          Salary Payments Substantiated by Ex. 18-P

 Ex. 18-P                                                                 Ex. 5-P
 page No. Check date Check No.              Payee           Amount       page No. Date posted

    1       4/6/2007608          Depinder Mann               $3,500.00     29       4/11/2007
    2      4/20/2007621          Depinder Mann                3,500.00     31       4/23/2007
    3      3/23/2007598          Depinder Mann                3,500.00     24       3/28/2007
    4       3/9/2007588          Depinder Mann                3,500.00     22       3/14/2007
    5      2/23/2007577          Depinder Mann                3,500.00     19        3/2/2007
    6       2/9/2007566          Depinder Mann                3,500.00     14       2/14/2007
    7      1/26/2007555          Depinder Mann                3,500.00      9       1/30/2007
    8      1/12/2007543          Depinder Mann                3,500.00      6       1/16/2007
                                                             28,000.00

    9      1/26/2007553          Edward M Andujar             2,000.00      9       1/29/2007
   10      1/12/2007541          Edward M Andujar             2,000.00      5       1/12/2007
                                                              4,000.00

   11      4/20/2007620          Donna Do                       602.00     31       4/24/2007
   12       4/6/2007607          Donna Do                       646.00     29       4/11/2007
   13       2/9/2007565          Donna Do                     1,118.00     29       4/11/2007
   14      3/23/2007597          Donna Do                       823.20     29       4/11/2007
   15       3/9/2007587          Donna Do                     1,257.60     29       4/11/2007
   16      2/23/2007576          Donna Do                     1,405.60     29       4/11/2007
   17      1/26/2007554          Donna Do                     1,393.60     21        3/9/2007
   18      1/12/2007542          Donna Do                     1,509.20     14       2/12/2007
                                                              8,755.20

   19      1/12/2007545        Ninpapha Niangnouansy          1,183.14      6       1/16/2007
   20      1/26/2007557        Ninpapha Niangnouansy          1,440.00      9       1/30/2007
   21     DUPLICATE OF PAGE 20
   22       2/9/2007568        Ninpapha Niangnouansy          1,855.61     14       2/13/2007
   23      2/23/2007579        Ninpapha Niangnouansy          1,440.00     19        3/2/2007
   24       3/9/2007590        Ninpapha Niangnouansy          1,440.00     21       3/12/2007
   25      3/23/2007600        Ninpapha Niangnouansy          1,440.00     24       3/28/2007
   26       4/6/2007610        Ninpapha Niangnouansy          1,440.00     29       4/10/2007
   27      5/18/2007631        Ninpapha Niangnouansy          1,440.00     37       5/21/2007
   28      6/15/2007642        Ninpapha Niangnouansy          1,440.00     44       6/20/2007
   29      6/29/2007648        Ninpapha Niangnouansy          1,600.00     47        7/2/2007
                                    - 88 -

[*88]

  30     7/13/2007653   Ninpapha Niangnouansy    1,600.00   49    7/16/2007
  31     7/27/2007658   Ninpapha Niangnouansy    1,600.00   51    7/30/2007
  32     8/10/2007662   Ninpapha Niangnouansy    1,600.00   54    8/14/2007
  33     8/24/2007667   Ninpapha Niangnouansy    1,600.00   56    8/28/2007
  34      9/7/2007671   Ninpapha Niangnouansy    1,600.00   60    9/10/2007
  35     9/21/2007675   Ninpapha Niangnouansy    1,600.00   62    9/25/2007
  36     10/5/2007679   Ninpapha Niangnouansy    1,820.00   65   10/10/2007
  37    10/19/2007683   Ninpapha Niangnouansy    1,600.00   67   10/23/2007
  38     11/2/2007687   Ninpapha Niangnouansy    1,600.00   71    11/6/2007
  39    11/16/2007691   Ninpapha Niangnouansy    1,600.00   73   11/21/2007
  40    11/30/2007694   Ninpapha Niangnouansy    1,600.00   76    12/5/2007
  41    12/14/2007695   Ninpapha Niangnouansy    1,700.00   78   12/18/2007
                                                34,238.75

  42    12/29/2006528   Jennifer M. Rivera        359.84    57    8/30/2007

            TOTAL                               75,353.79
         Less 2006                               -$359.84
             Items
        NET TOTAL                               74,993.95
                                                                            - 89 -

[*89]                                                                 APPENDIX B

                                                  Payments to Leasing Companies Identified in Exhibit 19-P

Ex. 19-P                                    Lease Ex. 11-P Finance Ex. 11-P         Ex. 11-P Sales Ex. 11-P Security Ex. 11-P       Ex. 5-J
 page                              Check   charge  page charge page          Insur.  page     tax   page     mon.     page    Total  page
  No. Date accrued       Payee      No.    amount   No. amount No.          amount    No. amount No. amount No. payment No. Date cleared

  3       1/2/2007HPSC            8492      $711.33    24                                                                  $711.33    4    1/8/2007
          1/2/2007GE / HPSC       8493      1,543.51   24                                       $119.62      53            2,508.61
          1/2/2007GE / HPSC       8493       845.48    24
  1       1/2/2007Lfg                         55.30    24                                                                    55.30    2    1/2/2007
  1       1/2/2007Mbf Leasing                 91.14    24                                                                    91.14    2    1/2/2007
  1       1/2/2007Mbf Leasing                 91.14    24                                                                    91.14    2    1/2/2007
  4       1/5/2007IFC Credit Corp. 8540      174.68    24                                                                   174.68    5   1/10/2007
  5       1/5/2007IFC Credit Corp. 8541       43.57    24                                                                    43.57    5   1/10/2007
  6       1/5/2007IFC Credit Corp. 8542      163.39    24                                                                   163.39    5   1/10/2007
         1/22/2007Great America 8570         327.56    24                       $15.56    28                                343.12    7   1/22/2007
         1/26/2007GE / HPSC       8588       592.61    24    $99.00    31                                                   691.61    9   1/26/2007
         1/26/2007GE / HPSC       8589      1,543.51   24                                        119.62      53            2,508.61   9   1/26/2007
         1/26/2007GE / HPSC       8589       845.48    24
         1/26/2007GE / HPSC       8590       884.03    24                                                                   884.03    9   1/26/2007
         1/26/2007HPSC            8591      2,730.77   24                                                                  2,730.77   9   1/26/2007
  2      1/29/2007Protection One 8599        108.24    24                                          8.39      53   $77.61    194.24    9   1/29/2007
  2      1/29/2007Protection One 8600        107.82    24                                          8.36      53    78.03    194.21    9   1/29/2007
  7       2/1/2007Mbf Leasing     2090        91.14    24                                                                    91.14 12      2/1/2007
  7       2/1/2007Mbf Leasing     2091        91.14    24                                                                    91.14 12      2/1/2007
  7       2/2/2007Lfg             2092        55.30    24                                                                    55.30 12      2/2/2007
                                                                       - 90 -

[*90]

 14      2/5/2007IFC Credit Corp. 2166    174.68    24                                                 174.68 14    2/12/2007
 15      2/5/2007IFC Credit Corp. 2167    163.39    24                                                 163.39 14    2/12/2007
  8      2/7/2007GE / HPSC       2147    1,543.51   24   154.35   31                    119.62   53   2,747.51 14   2/13/2007
  8      2/7/2007GE / HPSC       2147     845.48    25    84.55   31
  9      2/7/2007GE / HPSC       2148     592.61    24    60.77   31                                   653.38 14    2/13/2007
 10      2/7/2007GE / HPSC       2149     983.03    24    88.40   31                                  1,071.43 14   2/13/2007
 11      2/7/2007HPSC            2150    1,308.95   24                                                1,308.95 14   2/13/2007
 12      2/7/2007Great America 2153       288.63    24                                                 288.63 14    2/13/2007
 13      2/7/2007Great America 2154       263.50    25                                                 263.50 14    2/13/2007
 16     2/15/2007Banc of America 2201     537.68    25    35.02 $31.00                                1,145.39 20    3/5/2007
 16     2/15/2007Banc of America 2201     537.67    25    35.02 $31.00
 17     2/16/2007Great America 2204       327.56    25                     15.56   28                  343.12 19     3/2/2007
 25      3/1/2007Mbf Leasing               91.14    25                                                  91.14 19     3/1/2007
 25      3/1/2007Mbf Leasing               91.14    25                                                  91.14 19     3/1/2007
         3/1/2007GE / HPSC       2235     983.03    25    99.63   31                                  1,082.66 20    3/6/2007
         3/1/2007GE / HPSC       2236    1,543.51   25   156.67   31                    119.62   53   2,751.10 20    3/6/2007
         3/1/2007GE / HPSC       2237     493.61    25    50.40   31                                   544.01 20     3/6/2007
         3/1/2007GE / HPSC       2236     845.48    25    85.82   31
 25      3/2/2007Lfg                       55.30    25                                                  55.30 19     3/2/2007
 21      3/3/2007Great America 2247       288.63    25                                                 288.63 22    3/14/2007
 20      3/3/2007Great America 2248       263.50    25                                                 263.50 22    3/14/2007
 18      3/8/2007IFC Credit Corp. 2258    210.48    25                                                 210.48 21    3/12/2007
 19      3/8/2007IFC Credit Corp. 2259    187.90    25                                                 187.90 21    3/12/2007
 23     3/15/2007Banc of America 2264     537.68    25                                                1,075.35 23   3/19/2007
                                                                      - 91 -

[*91]

 23     3/15/2007Banc of America 2264     537.67    25
 22     3/16/2007Great America 2267       327.56    25   36.96   31       15.56   28                               380.08 23    3/19/2007
 24     3/31/2007Compare          2300    835.99    25                                                             835.99 24    3/30/2007
                 Business
                 Services
 28      4/2/2007IFC Credit Corp. 2308    210.48    25                                                             210.48 28     4/6/2007

 29      4/2/2007IFC Credit Corp. 2309    187.90    25                                                             187.90 28     4/6/2007
 34      4/2/2007Mbf Leasing               91.14    25                                                              91.14 27     4/2/2007
 34      4/2/2007Mbf Leasing               91.14    25                                                              91.14 27     4/2/2007
 34      4/2/2007Lfg                       55.30    25                                                              55.30 27     4/2/2007
 27      4/4/2007GE / HPSC       2317    1,543.51   25                                 119.62   53                2,508.61 29   4/10/2007
 27      4/4/2007GE / HPSC       2317     845.48    25
 33      4/6/2007Great America 8613       288.63    25                                                             288.63 28     4/6/2007
 32      4/9/2007Great America 8620       263.50    25                                                             263.50 29     4/9/2007
 26     4/10/2007Protection One 2325      107.82    25                                   8.36   53   78.03   36    194.21 29    4/10/2007
 30     4/10/2007GE / HPSC       2315     592.61    25                                                             592.61 29    4/10/2007
 31     4/10/2007GE / HPSC       2316     983.03    25                                                             983.03 29    4/10/2007
        4/16/2007Banc of America 8708     537.67    25   49.90   31       13.12   28                              1,201.38 30   4/16/2007
        4/16/2007Banc of America 8708     537.67    25   49.91   31       13.11   28
        4/16/2007Great America 8709       327.56    25   36.96   31       15.56   28                               380.08 30    4/16/2007
         5/1/2007GE / HPSC       8718     592.61    25                                                             592.61 34     5/1/2007
         5/1/2007GE / HPSC       8714     983.03    25                                                             983.03 34     5/1/2007
         5/1/2007GE / HPSC       8719    1,543.51   25                                 119.62   53                2,508.61 34    5/1/2007
 35      5/1/2007Mbf Leasing               91.14    25                                                              91.14 34     5/1/2007
 35      5/1/2007Mbf Leasing               91.14    25                                                              91.14 34     5/1/2007
         5/1/2007GE / HPSC       8719     845.48    25
 35      5/2/2007Lfg                       55.30    25                                                              55.30 34     5/2/2007
  36     5/7/2007Great America 8614       288.63    25                                                             288.63 35     5/7/2007
                                                         - 92 -

[*92]

 36      5/7/2007Great America 8621       263.50    25                                                263.50 35     5/7/2007
 36      5/7/2007IFC Credit Corp. 8775    185.97    25                                                185.97 35     5/7/2007
 36      5/7/2007IFC Credit Corp. 8776    163.39    25                                                163.39 35     5/7/2007
 37     5/14/2007Protection One 8804      108.24    25                      8.39   53   77.61   36    194.24 36    5/14/2007
 43     5/15/2007Banc of America 8807    1,075.35   25       26.23   28                              1,101.58 36   5/16/2007
 38     5/18/2007Great America 8769       350.81    26                                                350.81 37    5/18/2007
 38     5/18/2007Great America 8770       320.28    26                                                320.28 37    5/18/2007
 38     5/21/2007Great America 8648       327.56    26       15.56   28                               343.12 37    5/21/2007
         6/1/2007GE / HPSC       8761    1,543.51   26                    119.62   53                2,508.61 42    6/7/2007
         6/1/2007GE / HPSC       8760     983.03    26                                                983.03 42     6/7/2007
         6/1/2007GE / HPSC       8762     592.61    26                                                592.61 42     6/7/2007
         6/1/2007GE / HPSC       8761     845.48    26
 39      6/4/2007Great America 8841       377.06    26                                                377.06 41     6/4/2007
 39      6/4/2007Great America 8842       412.99    26                                                412.99 41     6/4/2007
 39      6/4/2007Lfg                       55.30    26                                                 55.30 41     6/4/2007
 40      6/7/2007Mbf Leasing               91.14    26                                                 91.14 42     6/7/2007
 40      6/7/2007Mbf Leasing               91.14    26                                                 91.14 42     6/7/2007
 40      6/8/2007Mbf Leasing               32.74    26                                                 32.74 42     6/8/2007
 40      6/8/2007Mbf Leasing               32.74    26                                                 32.74 42     6/8/2007
 41     6/11/2007IFC Credit       8849    185.97    26                                                185.97 43    6/13/2007
                 Corporation
 42     6/11/2007IFC Credit Corp. 8850    163.39    26                                                163.39 43    6/13/2007

 43     6/15/2007Banc of America 8809    1,075.35   26       26.23   28                              1,101.58 43   6/18/2007
 44     6/15/2007Great America 8866        327.56   26       15.56   28                                343.12 44   6/21/2007
         7/2/2007Lfg                       55.30    26                                                 55.30 47     7/2/2007
         7/2/2007Mbf Leasing               91.14    26                                                 91.14 47     7/2/2007
         7/2/2007Mbf Leasing               91.14    26                                                 91.14 47
 48      7/3/2007GE / HPSC       8858    1,543.51   26                    119.62   53                2,508.61 48   7/10/2007
                                                                      - 93 -

[*93]

 47      7/3/2007GE / HPSC       8857     983.03    26                                                             983.03 48    7/10/2007
 49      7/3/2007GE / HPSC       8859     592.61    26                                                             592.61 48    7/10/2007
 48      7/3/2007GE / HPSC       8858     845.48    26
 46      7/5/2007IFC Credit Corp. 8893    210.48    26                                                             210.48 48     7/6/2007

 45      7/5/2007IFC Credit Corp. 8895    187.90    26                                                             187.90 48     7/6/2007

         7/6/2007Protection One 8915      108.24    26                                   8.39   53   77.61   36    194.24 48     7/6/2007
 50      7/9/2007Great America 8619       288.63    26                                                             288.63 48    7/10/2007
 51      7/9/2007Great America 8623       263.50    26                                                             263.50 48    7/10/2007
        7/11/2007Protection One 8917      107.82    26                                   8.36   53   78.03   36    194.21 48    7/11/2007
 52     7/16/2007Banc of America 8808    1,075.35   26                    26.23   28                              1,101.58 49   7/17/2007
 53     7/16/2007Great America 8933       327.56    26   73.92   32       15.56   28                               417.04 49    7/19/2007
 55      8/1/2007GE / HPSC       8924     983.03    26                                                             983.03 53     8/2/2007
 56      8/1/2007GE / HPSC       8926    1,543.51   26                                 119.62   53                2,508.61 53    8/2/2007
 57      8/1/2007GE / HPSC       8928     592.61    26                                                             592.61 53     8/2/2007
 64      8/1/2007Mbf Leasing               91.14    26                                                              91.14 52     8/1/2007
 65      8/1/2007Mbf Leasing               91.14    26                                                              91.14 53     8/1/2007
 56      8/1/2007GE / HPSC       8926     845.48    26
 65      8/2/2007Lfg                       55.30    26                                                              55.30 53     8/2/2007
 58      8/3/2007IFC Credit Corp. 8973    163.39    26                                                             163.39 54     8/8/2007
 59      8/3/2007IFC Credit Corp. 8972    185.97    26                                                             185.97 54     8/8/2007
 65      8/3/2007GE / HPSC                149.00    26                                                             149.00 53     8/2/2007
 61      8/7/2007Great America 8617       288.63    26                                                             288.63 55    8/14/2007
 60      8/7/2007Great America 8625       263.50    26                                                             263.50 55    8/14/2007
 62     8/15/2007Banc of America 8810    1,075.35   26                    26.23   28                              1,101.58 55   8/16/2007
                                                                       - 94 -

[*94]

 63      8/16/2007Great America 8867       327.56    26                    15.56   28                               343.12 55     8/21/2007
 70       9/4/2007GE / HPSC       8927     592.61    26                                                             592.61 60      9/7/2007
 66       9/4/2007Great America 8955       288.63    26                                                             288.63 59      9/5/2007
 67       9/4/2007Great America 8956       263.50    27                                                             263.50 59      9/5/2007
 71       9/4/2007GE / HPSC       8988    1,543.51   27                                 119.62   53                1,663.13 60     9/7/2007
 83       9/4/2007Lfg                       55.30    27                                                              55.30 59      9/4/2007
 83       9/4/2007Mbf Leasing               91.14    27                                                              91.14 59      9/4/2007
 83       9/4/2007Mbf Leasing               91.14    27                                                              91.14 59      9/4/2007
 69       9/5/2007IFC Credit Corp. 9072    185.97    27                                                             185.97 59      9/6/2007
 68       9/5/2007IFC Credit Corp. 9073    163.39    27                                                             163.39 59      9/6/2007
 72      9/14/2007Banc of America 8929    1,075.35   27                    26.23   28                              1,101.58 61    9/17/2007
 73      9/14/2007Great America 9105       327.56    27   36.96   32       15.56   28                               380.08 61     9/24/2007
 75      10/1/2007GE / HPSC       8982     592.61    27                                                             592.61 64     10/2/2007
 74      10/1/2007GE / HPSC       9083    1,543.51   27                                 119.62   53                1,663.13 64    10/2/2007
 80      10/1/2007Mbf Leasing               91.14    27                                                              91.14 64     10/1/2007
 80      10/1/2007Mbf Leasing               91.14    27                                                              91.14 64     10/1/2007
 80      10/2/2007Lfg                       55.30    27                                                              55.30 64     10/2/2007
 76      10/3/2007Great America 9055       288.63    27                                                             288.63 65     10/4/2007
 77      10/3/2007Great America 9058       263.50    27                                                             263.50 65     10/4/2007
 79      10/5/2007IFC Credit Corp. 9130    185.97    27                                                             185.97 66    10/11/2007
 78      10/5/2007IFC Credit Corp. 9129    163.39    27                                                             163.39 66    10/11/2007
 81      10/9/2007Protection One 9140      108.24    27                                   8.39   53   77.61   36    194.24 65     10/9/2007
 82     10/11/2007Protection One 9141      107.82    27                                   8.36   53   78.03   37    194.21 66    10/11/2007
        10/25/2007Great America 2496       327.56    27                    15.56   28                               343.12 68    10/30/2007
 85      11/1/2007GE / HPSC       2526    1,543.51   27                                 119.62   53                1,663.13 70    11/2/2007
                                                                         - 95 -

[*95]

 84      11/1/2007GE / HPSC       2527       592.61    27                                  592.61 69     11/1/2007
 93      11/1/2007Mbf Leasing                 91.14    27                                   91.14 70     11/1/2007
 93      11/1/2007Mbf Leasing                 91.14    27                                   91.14 70     11/1/2007
 93      11/2/2007Lfg                         55.30    27                                   55.30 70     11/2/2007
         11/5/2007IFC Credit Corp. 2548      185.97    27                                  185.97 70     11/5/2007
 86      11/5/2007IFC Credit Corp. 2549      163.39    27                                  163.39 70     11/5/2007
 88     11/15/2007Banc of America 2578      1,075.35   27   99.80   33       26.23   28   1,201.38 73   11/20/2007
 87     11/15/2007Banc of America 2579      1,423.95   27                    26.23   28   1,450.18 73   11/20/2007
 89     11/26/2007Great America 2580         268.88    27                    31.12   28    300.00 73    11/26/2007
 90      12/1/2007GE / HPSC       2614       592.61    27                                  592.61 74    11/30/2007
 92      12/1/2007GE / HPSC       2615      1,663.13   27                                 1,663.13 74   11/30/2007
 91      12/1/2007GE / HPSC       2616      1,290.80   27                                 1,290.80 74   11/30/2007
 96      12/3/2007Great America 2622         288.63    27                                  288.63 76     12/6/2007
 97      12/3/2007Great America 2623         263.50    27                                  263.50 76     12/6/2007
 99      12/3/2007Lfg                         55.30    27                                   55.30 76     12/3/2007
 99      12/3/2007Mbf Leasing                 91.14    27                                   91.14 76     12/3/2007
 99      12/3/2007Mbf Leasing                 91.14    27                                   91.14 76     12/3/2007
 95      12/5/2007IFC Credit Corp. 2630      163.39    27                                  163.39 76     12/6/2007
 94      12/5/2007IFC Credit Corp. 2631      185.97    27                                  185.97 76     12/6/2007
 98     12/15/2007Banc of America 2654      1,075.35   27   99.80   33       26.23   28   1,201.38 78   12/18/2007
 100    12/16/2007Great America 2660         355.12    27   73.92   33       31.12   28    460.16 78    12/21/2007

                  Total Lease Charges:     80,247.37
                  Unsubstantiated         -$2,388.99
                  Total Substantiated:    $77,858.38
                                                 - 96 -

[*96]                                      APPENDIX C

                         Interest and Finance Charge Payments in Exhibit 20-P


Ex. 20-P                       Check     Check                      Interest            Ex. 11-P
page No.         Payee          No.     amount       Date paid      amount Date accrued page No.
  76       Advanta               2297     $300.00        4/2/2007    $115.86     3/29/2007   31
  94       Advanta               8945      707.00        8/1/2007     302.03     7/27/2007   32
  101      Advanta               9031      500.00       8/30/2007     315.94     8/27/2007   32
  114      Advanta               2504      540.00      10/30/2007     415.84    10/29/2007   32
  124      Advanta               2588    1,000.00      11/26/2007     392.53    11/27/2007   33
  135      Advanta               2672    1,000.00      12/28/2007     431.68    12/29/2007   33
  28       American Express              2,000.00       1/22/2007     177.29     1/22/2007   31
  74       American Express      2269      426.18       3/19/2007     267.90     3/17/2007   31
  80       American Express                500.00       4/13/2007       1.73     4/13/2007   31
  82       American Express                500.00        5/7/2007     165.01      5/7/2007   31
  83       American Express                500.00       5/14/2007      97.23     5/14/2007   31
  86       American Express              1,000.00       6/13/2007     104.41     6/13/2007   32
  89       American Express               $500.00        7/6/2007     233.07      7/6/2007   32
  91       American Express              1,000.00       7/13/2007     238.80     7/13/2007   32
  96       American Express              1,000.00       8/13/2007     299.47     8/13/2007   32
  102      American Express                500.00        9/6/2007     189.50      9/6/2007   32
  104      American Express              1,000.00       9/13/2007     308.31     9/13/2007   32
  108      American Express                500.00       10/9/2007     179.99     10/9/2007   32
  109      American Express      2480      319.00      10/17/2007     305.10    10/15/2007   32
  118      American Express      2550    1,589.62       11/5/2007     177.60     11/5/2007   32
  121      American Express      2571    1,000.00      11/16/2007     182.88    11/13/2007   32
  128      American Express      2633    1,000.00       12/4/2007     184.33     12/4/2007   33
  130      American Express      2653    1,000.00      12/13/2007     214.34    12/15/2007   33
  88       American Express                  5.95        7/3/2007
  80       Banc of America               1,201.38       4/16/2007      99.81     4/16/2007   31
            Leasing
  125      Banc of America       2578    1,201.38      11/20/2007      99.80 11/15/2007      33
           Leasing
  132      Banc of America       2654    1,201.38      12/18/2007      99.80 12/15/2007      33
            Leasing
  28       Bank of America               5,000.00         1/22/2007   468.45    1/22/2007    31
  34       Bank of America       2188      300.00         2/13/2007    50.10    2/12/2007    31
  67       Bank of America       2207    1,000.00         2/26/2007   981.68    2/18/2007    31
  75       Bank of America               1,000.00         3/20/2007 1,071.85    3/20/2007    31
  79       Bank of America                 300.00         4/10/2007   197.71    4/10/2007    31
                                          - 97 -

[*97]

  80    Bank of America              500.00     4/13/2007   678.48 4/13/2007         31
  81    Bank of America            1,000.00     4/20/2007   972.23 4/20/2007         31
  86    Bank of America            1,000.00     6/13/2007   810.04 6/13/2007         32
  87    Bank of America     1807   1,000.00     6/19/2007 1,041.16 6/19/2007         32
  93    Bank of America     2410   1,000.00     7/16/2007   838.35 7/16/2007         32
  99    Bank of America     2411     862.00     8/14/2007 1,293.69 8/13/2007         32
  100   Bank of America            1,000.00     8/17/2007 1,038.89 8/17/2007         32
  107   Bank of America            1,000.00     9/18/2007   945.50 9/18/2007         32
  111   Bank of America     2493     862.00    10/24/2007    41.35 10/23/2007        32
  113   Bank of America     2495   1,414.41    10/24/2007   998.20 10/23/2007        32
  123   Bank of America     2581   1,367.77    11/19/2007   998.96 11/18/2007        33
  85    Bank of America =   6807     331.00     6/11/2007   266.56 6/11/2007         32
        Platinum Plus
  112   Bank of America =   2494    180.00     10/24/2007       180.00 10/23/2007    32
        Platinum Plus
  105   BOUNCED CHECK
  131   Business Card       2661   1,327.80    12/18/2007       752.33 12/18/2007    33
  120   Business Card =     2511     862.00     11/9/2007        41.48 11/12/2007    32
        Bank of America
  129   Business Card =     2638    862.00     12/10/2007        37.44 12/11/2007    33
        Bank of America
  77    Business Card =     2318    230.00          4/9/2007    206.39    4/3/2007   31
        Platinum Plus
  116   Business Card =     2507    500.00         11/1/2007    260.99   11/2/2007   32
        Platinum Plus
  117   Business Card =     2540    100.00         11/3/2007    256.24   11/3/2007   32
        Platinum Plus
  126   Business Card =     2625    500.00         12/3/2007    206.00   12/3/2007   33
        Platinum Plus
   3    Capital One         2151   1,765.26     2/12/2007      1,036.01   2/7/2007   30
   5    Capital One         2233   1,765.26      3/6/2007      1,036.01   3/1/2007   30
   8    Capital One         2307   1,765.26     4/12/2007        959.59   4/2/2007   30
  81    Capital One                   30.00     4/20/2007         30.00 4/20/2007    31
  11    Capital One                1,765.26      5/1/2007        982.27   5/1/2007   30
  16    Capital One                1,765.26      7/2/2007        963.55   7/2/2007   30
  18    Capital One                1,765.26     7/19/2007        991.71 7/18/2007    30
  19    Capital One                1,765.26      8/1/2007      1,054.97   8/1/2007   30
  20    Capital One                1,765.26     8/31/2007      1,019.77 8/31/2007    30
  110   Capital One         2485     105.00    10/23/2007          4.61 10/22/2007   32
  23    Capital One         2530   1,765.26     11/2/2007        894.87 11/1/2007    30
  122   Capital One         2584     600.00    11/19/2007        112.69 11/21/2007   33
                                           - 98 -

[*98]

  25     Capital One         2617   1,765.26     12/3/2007      946.17 12/1/2007     30
  133    Capital One         2658   1,000.00    12/18/2007       71.25 12/21/2007    33
   1     Christopher Holden 2122      583.33     1/12/2007      583.33   1/8/2007    30
   2     Commercial Loans Debit       309.10      2/6/2007      309.10   2/6/2007    30
   7     Commercial Loans Debit      279.18          3/6/2007   279.18    3/6/2007   30
   10    Commercial Loans Debit      309.10          4/6/2007   309.10    4/6/2007   30

Ex. 5-J at Commercial Loans Debit    299.13          5/7/2007   299.13    5/7/2007   30
   35
   15      Commercial Loans Debit    309.09          6/6/2007   309.09    6/6/2007   30
   17    Commercial Loans Debit      299.13          7/6/2007   299.13    7/6/2007   30
   19    Commercial Loans Debit      309.10          8/6/2007   309.09    8/6/2007   30
   21    Commercial Loans Debit      309.09          9/6/2007   309.09    9/6/2007   30
   22    Commercial Loans Debit      297.44         10/9/2007   297.44   10/9/2007   30
   24    Commercial Loans Debit      711.16         11/6/2007   298.62   11/6/2007   30
   26    Commercial Loans Debit      711.16         12/6/2007   284.15   12/6/2007   30
   43    DUPLICATE OF PAGE 10
   44    DUPLICATE OF PAGE 11
   45    DUPLICATE OF PAGE 12
   46    DUPLICATE OF PAGE 13
   47    DUPLICATE OF PAGE 14
   48    DUPLICATE OF PAGE 15
   49    DUPLICATE OF PAGE 16
  50a    DUPLICATE OF PAGE 17
  50b    DUPLICATE OF PAGE 18
   51    DUPLICATE OF PAGE 19
   35    DUPLICATE OF PAGE 2
   52    DUPLICATE OF PAGE 20
   53    DUPLICATE OF PAGE 21
   54    DUPLICATE OF PAGE 22
   55    DUPLICATE OF PAGE 23
   56    DUPLICATE OF PAGE 24
   57    DUPLICATE OF PAGE 25
   58    DUPLICATE OF PAGE 26
                                            - 99 -

[*99]

  59    DUPLICATE OF PAGE 27
  60    DUPLICATE OF PAGE 28
  61    DUPLICATE OF PAGE 29
  36    DUPLICATE OF PAGE 3
  62    DUPLICATE OF PAGE 30
  63    DUPLICATE OF PAGE 31
  64    DUPLICATE OF PAGE 32
  65    DUPLICATE OF PAGE 33
  66    DUPLICATE OF PAGE 34
  37    DUPLICATE OF PAGE 4
  38    DUPLICATE OF PAGE 5
  39    DUPLICATE OF PAGE 6
  40    DUPLICATE OF PAGE 7
  41    DUPLICATE OF PAGE 8
  42    DUPLICATE OF PAGE 9
  68    GE Healthcare         2236   2,751.10         3/6/2007   242.49    3/1/2007   31
        Financial Services
  69    GE Healthcare         2237    544.01          3/6/2007    50.40    3/1/2007   31
        Financial Services
  70    GE Healthcare         2235   1,082.66         3/6/2007    99.63    3/1/2007   31
        Financial Services
  73    Great America         2267    380.08         3/16/2007    36.96   3/16/2007   31
        Leasing Corp
  80    Great America Leasing         380.08         4/16/2007    36.96   4/16/2007   31
        Corp.
  92    Great America         8933    417.04         7/16/2007    73.92   7/16/2007   32
        Leasing Corp
  134   Great America         2660    460.16     12/21/2007       73.92 12/16/2007    33
        Leasing Corp
  10    Great America Leasing         288.63          4/6/2007
        Corp.
  13    Great America Leasing         299.13          5/7/2007
        Corp.
  30    HPSC                  2147   2,747.51        2/13/2007   238.90    2/7/2007   31
  31    HPSC                  2149   1,071.43        2/13/2007    88.40    2/7/2007   31
  32    HPSC                  2148     653.38        2/13/2007    60.77    2/7/2007   31
   4    Jane Garcia           2181     208.33         2/9/2007   208.33    2/9/2007   30
                                               - 100 -

[*100]

    6    Jane Garcia            2241    208.33            3/5/2007   208.33   3/5/2007     30
    9    Jane Garcia            2305    166.67            4/4/2007   166.67   4/6/2007     30
   12    Jane Garcia            2363 1,000.00             5/7/2007 1,000.00   5/4/2007     30
   14    Jane Garcia            2383 1,000.00             6/7/2007 1,000.00   6/5/2007     30
   84    Jane Garcia            2391 10,000.00            6/8/2007    14.74   6/8/2007     31
   33    Marlin Leasing         2184 1,416.93            2/16/2007   193.91   2/9/2007     31
   71    Marlin Leasing         2256 1,586.83            3/12/2007   193.91   3/8/2007     31
   90    Marlin Leasing         8919    253.22           7/13/2007   253.22 7/10/2007      32
   98    Marlin Leasing         8991 1,452.23            8/16/2007   193.91 8/10/2007      32
   103   Marlin Leasing         8990 1,452.23            9/12/2007   193.91 9/10/2007      32
   119   Marlin Leasing         2554 1,646.14            11/9/2007   193.91 11/10/2007     32
   127   Marlin Leasing         2619 3,128.27            12/4/2007   200.38 12/4/2007      33
   106   McKesson Medical       9094    979.73           9/20/2007   979.73 9/17/2007      32
   115   McKesson Medical       2510 2,036.19            11/2/2007    78.70 11/1/2007      32
   27    Platinum Plus                1,000.00            1/9/2007   255.32   1/5/2007     31
   29    Platinum Plus                  500.00           2/13/2007   228.67   2/5/2007     31
   72    Platinum Plus                  462.00           3/15/2007   281.25 3/15/2007      31
   88    Platinum Plus                  813.01            7/3/2007   278.93   7/3/2007     32
   95    Platinum Plus                  500.00            8/3/2007   217.89   8/3/2007     32
   78    Popular Leasing        2324 3,178.39             4/9/2007   138.60   4/6/2007     31
   97    Popular Leasing        8966 3,178.39             8/8/2007   138.60   8/7/2007     32

                                Items on P&L Missing from Ex. 20-P


                                                                             Ex. 5-P      Date
  Subcategory    Date accrued          Payee               Amount Check No. page No.     posted

Loan interest       1/2/2007Capital One                    $1,010.21    8536
Loan interest      10/1/2007Capital One                      940.22     9118
Finance charge     1/21/2007Advanta                           75.07     5584
Finance charge     1/26/2007GE / HPSC                         99.00 Dir Debit    9     1/26/2007
Finance charge     2/15/2007Banc of America Leasing           35.02     2201    20      3/5/2007
Finance charge     2/15/2007Banc of America Leasing           35.02     2201    20      3/5/2007
Finance charge     2/27/2007Advanta                           62.40     2225    20      3/5/2007
Finance charge     2/28/2007Popular Leasing                  289.93     2228    20      3/5/2007
Finance charge      4/6/2007Popular Leasing                  138.60     2324    29      4/9/2007
Finance charge      5/9/2007Bank of America                  735.79     2367    36     5/11/2007
Finance charge     5/18/2007Advanta                          328.66     8823
                                             - 101 -

[*101]

Finance charge    5/22/2007Platinum Plus                    490.29     2374     38      5/23/2007
Finance charge     6/5/2007American Express                 183.55     8844
Finance charge     6/8/2007Marlin Leasing                   193.91     8861     43      6/13/2007
Finance charge    6/29/2007Advanta                          296.25     8884     48       7/5/2007
Finance charge    7/18/2007Bank of America                1,011.96     8871
Finance charge     8/6/2007American Express                 175.05 Dir Debit    54       8/6/2007
Finance charge    9/14/2007Great America Leasing             36.96     9105     61      9/24/2007
Finance charge    9/28/2007Advanta                          949.03     9117     64      10/2/2007
Finance charge    10/3/2007Platinum Plus                    609.07     9060
Finance charge   10/10/2007Marlin Leasing                   193.91     9145
Finance charge   10/12/2007Bank of America                   43.37     9146
Finance charge   11/29/2007Pharma Pac                        26.46     2577

                             Marlin Leasing Finance Charges Ex. 14-P

                                                                                     Finance
    Ex. 14-P                                Ex. 5-J                     Check        charge
    page No. Date posted     Check No.     page No.    Date posted     amount        amount

      19         3/12/2007          2256     21          3/12/2007     $1,586.83       $193.91
      19         6/14/2007          8861     43          6/13/2007      1,705.45         193.91
      19         7/16/2007          8918     49          7/13/2007        253.22         193.91
      20         7/30/2007                                                               193.91
     20-21       11/9/2007          2554     71          11/9/2007      1,646.14         193.91
      21         12/5/2007          2619     76          12/4/2007      3,128.27         193.91
    TOTAL                                                                              1,163.46
                                            - 102 -

[*102]                                 APPENDIX D

                            Marlin Leasing Payments in Exhibit 14-J

                                                                                   "Lease"
   Ex. 14-P                             Ex. 5-J                        Check       charge
   page No.   Date posted   Check No. page No. Date posted            amount       amount
      19           1/2/2007       CashN/A         N/A                 $2,860.83     $2,586.46
      19          2/15/2007       2184          15   2/16/2007         1,416.93      1,292.73
      19          3/12/2007       2256          21   3/12/2007         1,586.83      1,292.73
      19          4/10/2007 62950177            29   4/10/2007         1,392.92      1,292.73
      19          5/16/2007       8667          36   5/16/2007         1,392.92      1,292.73
      19          6/14/2007       8861          43   6/13/2007         1,705.45      1,292.73
      20          7/16/2007       8668          49   7/16/2007         1,392.92      1,292.73
      20          8/20/2007       8991          55   8/16/2007         1,452.23      1,292.73
      20          9/13/2007       8990          60   9/12/2007         1,452.23      1,292.73
    20-21         11/9/2007       2554          71   11/9/2007         1,646.14      1,292.73

      21          12/5/2007          2619          76    12/4/2007      3,128.27    2,585.46
    TOTAL                                                                          16,806.49


                             Payments to Key Equipment Finance

    Ex. 5-J
   page No.   Date posted       Amount                           Note

      2            1/2/2007     $2,881.42 Leasing Services - DES
     21           3/12/2007      1,378.21Check No. only - does not specify Key
     29            4/9/2007      1,378.21Check No. only - does not specify Key
     35            5/4/2007      1,378.21
     42            6/7/2007      1,378.21
     47            7/3/2007      1,378.21Check No. only - does not specify Key
     53            8/2/2007      1,378.21Check No. only - does not specify Key
     59            9/4/2007      1,378.21Check No. only - does not specify Key
     65           10/9/2007      1,378.21Check No. only - does not specify Key
     70           11/5/2007      1,378.21Check No. only - does not specify Key
     76           12/5/2007      1,378.21Check No. only - does not specify Key
   TOTAL                        16,663.52