T.C. Memo. 2008-237



                       UNITED STATES TAX COURT



             WEST COVINA MOTORS, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4802-04.                Filed October 27, 2008.



     Steven Ray Mather, for petitioner.

     Alan Cooper, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     KROUPA, Judge:    Respondent determined a $380,652 deficiency

in petitioner’s Federal income tax for 1999 and a $415,073

deficiency for 2000.   Respondent also determined a $54,880
                                  -2-

accuracy-related penalty under section 66621 for 1999 and a

$63,548 penalty for 2000.

        After concessions,2 we are left to decide five issues.    We

first decide whether petitioner may deduct legal expenses it

incurred in the bankruptcy of its landlord, Hassen Imports

Partnership (HIP) for 1999 and 2000 (the years at issue).        We

find that petitioner may not deduct these expenses.     The second

issue is whether petitioner may deduct legal expenses related to

the purchase of Clippinger Chevrolet (Clippinger) for the years

at issue.     We find that it may not.   The third issue is whether

petitioner may deduct $54,558 in miscellaneous legal expenses for

1999.     We find that petitioner is not entitled to the deduction.

The fourth issue is whether petitioner is entitled to claim cost

of goods sold attributable to the write-down of inventory for the

years at issue.     We find that petitioner is not entitled to such

costs.     The final issue is whether petitioner is liable for

accuracy-related penalties under section 6662(a) for the years at

issue.     We find that petitioner is liable for the penalties.




     1
       All section references are to the Internal Revenue Code in
effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
     2
       The parties resolved issues relating to the deductibility
of management fees, imputed interest, employee benefits expenses,
transit expenses, and prepaid expenses, resulting in an $87,225
net increase in taxable income for 1999 and a $275,459 increase
for 2000. Other issues are computational. In addition, we find
no merit to petitioner’s racial profiling argument.
                                  -3-

                         FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulation of facts and the accompanying exhibits are

incorporated by this reference.    Petitioner is a California

corporation with its principal place of business in West Covina,

California.   Zaid Alhassen (Mr. Alhassen) owned 100 percent of

the stock in petitioner, which operated a Dodge dealership.

Legal Fees Incurred in the HIP Bankruptcy

     Mr. Alhassen and his two brothers owned 100 percent of

Hassen Holding Co., the parent and owner of Hassen Imports Inc.

Hassen Imports, Inc. was a 1-percent general partner of HIP,

petitioner’s landlord, which owned and leased to petitioner the

site of the Dodge dealership (West Covina property).

     HIP filed for chapter 11 bankruptcy in April 1998 to prevent

foreclosure of the West Covina property.      The mortgagor bank

expressed its intent to “toss out” petitioner from the property

during the bankruptcy proceeding.       The leases between petitioner

and HIP provide, however, that a foreclosing mortgagor is deemed

to have assumed and agreed to carry out the covenants and

obligations of the leases.   Mr. Alhassen signed these leases as

the representative for both petitioner and HIP.      Petitioner

participated in HIP’s bankruptcy reorganization and was able to

expand its business to two additional parcels of land that HIP

acquired as a result of the reorganization.      Petitioner directly

paid $46,897 of bankruptcy-related fees in 1999 and $194,802 in
                                 -4-

2000.    Petitioner reimbursed HIP for $21,192 of bankruptcy-

related fees in 1999 and $52,833 in 2000.    Petitioner claimed

these fees as deductions on its returns for the respective years.

Legal Fees Incurred in the Clippinger Acquisition

     In an unrelated transaction, Mr. Alhassen entered into an

agreement to purchase (purchase agreement) the assets of

Clippinger, an established new car dealership in Covina,

California.    Mr. Alhassen assigned the purchase rights to

petitioner, who consummated the purchase agreement with

Clippinger in November 1999.    Petitioner acquired Clippinger’s

inventory of new and used automobiles, automobile parts and

accessories, new automobile deposits, fixed assets including shop

equipment and machinery, and intangible assets including goodwill

and trademark rights.    Escrow documents list the Clippinger

purchase price as $6,206,813.81.    The purchase agreement assigned

specific dollar values to the assets as follows:    $250,000 to

fixed assets, $1 to miscellaneous assets, and $3,500,000 to

goodwill and other intangible assets.

     Clippinger also required petitioner to assume Clippinger’s

legal fees for structuring a seller-financing arrangement when

petitioner was unable to proceed with the transaction on a cash

basis.    Petitioner paid $100,000 in fees to Clippinger’s counsel

in 1999 for preparing multiple loan documents and lease

agreements, and petitioner incurred $19,251 of legal fees in 1999

and $19,214 in 2000 for its own representation in the Clippinger
                                 -5-

acquisition.    Petitioner claimed all these fees, including those

paid to Clippinger’s counsel, on its returns for the respective

years.

     The parties also dispute whether $54,558 of miscellaneous

legal expenses may be deducted for 1999.3

Inventory Write-Down

     Respondent also challenges petitioner’s method of writing

down inventory.4   Petitioner assigned a stock number to each new

and used automobile in its inventory.    Petitioner referenced the

stock number in records comparing the cost and the market value

of each automobile for purposes of determining the proper write-

down, if any.    Petitioner did not include, however, complete

information concerning the year, make, and model for several

automobiles in these records, nor did these records indicate the

condition, mileage, or equipment options of any of the

automobiles.    Petitioner’s accountants estimated market value

based on the Kelly Blue Book average wholesale prices without

reference to the actual condition, mileage, or equipment options

of any of the automobiles.




     3
       Respondent originally disallowed $358,711 in miscellaneous
legal fees but conceded that petitioner had substantiated and was
entitled to claim $304,153.
     4
       The parties stipulated that it is industry custom to use
the lower of cost or market method of inventory valuation under
which items are valued at the lower of cost or market value.
This method usually results in an adjustment to inventory, by
means of a write-down of inventory to market value.
                                  -6-

     Petitioner’s write-down calculations show that the inventory

write-down should have been $309,172.04 for 1999 and $344,207.67

for 2000.   Petitioner recorded the inventory write-down

adjustment for the years at issue, however, as a trial balance

sheet item titled “UV Res for Writedown.”   Petitioner offset

$340,181.09 against a reserve for each of the years at issue,

rather than using the write-down amounts from its records.

     Petitioner’s ending inventory for 2000 consisted of 96

automobiles, 35 of which had been listed in petitioner’s ending

inventory for 1999.   Petitioner did not adjust the cost of these

automobiles at the beginning of 2000 by the write-down taken at

the end of 1999, resulting in a $79,824.75 overstatement of

inventory write-down in 2000.

     Petitioner timely filed its Federal income tax returns for

the years at issue.   Respondent examined petitioner’s returns and

issued a deficiency notice disallowing various deductions and

cost of goods sold.   The amounts still in dispute include legal

fees incurred in the HIP bankruptcy, in the Clippinger

acquisition, and for other legal expenses, as well as the cost of

goods sold attributable to inventory write-down.

                                OPINION

I.   Character of Legal Fees

     We are asked to decide whether petitioner is entitled to

deduct various legal expenses as ordinary and necessary business
                                 -7-

expenses under section 162 or must capitalize them under section

263.    It is well established that attorney’s fees that are paid

as ordinary and necessary expenses may be deductible.     See Bagley

v. Commissioner, 

, 134 (1947).     No deduction is

allowed, however, for attorney’s fees that are considered capital

expenditures.    Sec. 263; Woodward v. Commissioner, 

,

575 (1970); Flint v. Commissioner, T.C. Memo. 1991-405.        The

parties agree that the legal expenses at issue here must be

analyzed under the “origin of the claim” doctrine.     See Mosby v.

Commissioner, 

(1986).

       Courts apply the origin of the claim test to determine

whether expenses are deductible under section 162 or subject to

capitalization under section 263.      Woodward v. 

; United States v. Gilmore, 

(1963).     The

substance of the underlying claim or the nature of the

transaction out of which the expenditure in controversy arose

governs whether the item is a deductible expense or a capital

expenditure, regardless of the payor’s motives or the

consequences resulting from the failure to defeat the claim.         See

Woodward v. 

at 578; Newark Morning Ledger Co.

v. United States, 

, 935 (3d Cir. 1976); Clark Oil &

Ref. Corp. v. United States, 

, 1220 (7th Cir. 1973);

Anchor Coupling Co. v. United States, 

, 433 (7th Cir.

1970).    This test requires examination of all the facts and
                                -8-

events underlying the claim, and each case turns on its special

facts.   Boagni v. Commissioner, 

, 713 (1973).

II.   Legal Fees Incurred in the HIP Bankruptcy

      Against this background, we address whether the legal fees

petitioner incurred must be capitalized or are currently

deductible.   First we address the legal fees petitioner paid to

defend HIP in the bankruptcy reorganization.    Respondent

determined that the bankruptcy-related legal fees were ordinary

and necessary expenses of petitioner but nevertheless were not

deductible because they were rooted in the defense of title.

Petitioner argues that these expenses were paid to stave off its

extinction and are therefore deductible.    We agree with

respondent.

      Legal expenses incurred to defend claims that would injure

or destroy a business are ordinary and necessary expenses.

Commissioner v. Heininger, 

, 471-472 (1943).     The

expenses incurred in defending legal title, however, are not

deductible and must be capitalized. Duntley v. Commissioner, T.C.

Memo. 1987-579; sec. 1.263(a)-2(c), Income Tax Regs.    We have

held that legal expenses incurred in defending or postponing

foreclosure actions must be capitalized because they are actions

in defense of title. Flint v. 

; Boyajian v.

Commissioner, T.C. Memo. 1970-78.     We see no difference where a
                                  -9-

tenant, as here, takes the highly unusual action of paying

expenses to defend its landlord’s title.

       A taxpayer may not deduct the expenses of another as a

general rule.    See Deputy v. du Pont, 

(1940).     We

have recognized a narrow exception where the original obligor is

unable to make payment and the taxpayer satisfies the obligation

to protect its own business interests.      See Hood v. Commissioner,

, 180-181 (2000) (and cases cited thereat); Lohrke v.

Commissioner, 

(1967).       The adverse consequences for

the payor taxpayer’s business must be direct and proximate,

however, as demonstrated by the impact on the payor’s business of

an obligor’s inability to meet its obligations.       Hood v.

at 180-181.     Here, there is no suggestion

that HIP was unable to pay the bankruptcy-related legal fees.         In

fact, HIP had paid some of the fees, and petitioner reimbursed

HIP.    Accordingly, we conclude that petitioner may not deduct

these expenses because the benefits to petitioner are not as

direct and proximate as required for the narrow exception set out

in Lohrke.

III. Legal Fees Incurred in the Clippinger Acquisition

       We now turn to the legal fees petitioner incurred to acquire

Clippinger.    Respondent argues that the $119,251 of legal

expenses in 1999 and the $19,214 of legal expenses in 2000 are

capital expenditures because petitioner incurred them while
                                -10-

acquiring a capital asset.    Petitioner counters that these fees

are deductible because they relate to inventory, which turns over

every 90 to 150 days and does not provide significant benefit

beyond a taxable year.    Petitioner further argues that these fees

were either directly linked to physical inventory and inventory

financing or were related to the Clippinger purchase in which 74

to 90 percent of the purchase price was attributable to

inventory.

     We agree with respondent that the expenses incurred in the

Clippinger acquisition are not deductible because they constitute

capital expenditures.    It is well settled that legal expenses

incurred in the acquisition or disposition of a capital asset are

capital expenditures.    Woodward v. 

.

     Moreover, we find petitioner’s argument that most of the

Clippinger purchase price represented automobile inventory

conflicts with the evidence in the record.    Escrow documents list

the Clippinger purchase price at $6,206,813.81, and removing the

amounts allocated in the purchase agreement to non-inventory

items5 leaves less than $2,400,000 (i.e., less than 40 percent)

of the purchase price allocated to Clippinger’s inventory and

other assets.   We find Mr. Alhassen’s uncorroborated testimony



     5
       The amount representing non-inventory items includes
$100,000 for legal fees paid to Clippinger’s counsel, $250,000
for fixed assets, $1 for miscellaneous assets, and $3,500,000 for
goodwill and intangible assets.
                                 -11-

concerning the portion of the purchase price allocated to

inventory insufficient to overcome the information found in the

escrow documents and purchase agreement.6   We are not required

to, nor do we in this instance, accept the self-serving testimony

of interested parties without probative corroboration.   See

Tokarski v. Commissioner, 

, 77 (1986); Yang v.

Commissioner, T.C. Memo. 2000-263.

      In addition, petitioner’s records contradict its position

that inventory turned over every 90 to 150 days as 35 of the 96

automobiles included in the 2000 year-end inventory were also

listed in the 1999 year-end inventory.   We conclude that the

acquisition-related legal fees are not deductible as ordinary and

necessary business expenses.

IV.   Miscellaneous Legal Fees

      Respondent also disallowed $54,448 of miscellaneous legal

fees for 1999.   Petitioner has not provided the Court with any

information regarding these miscellaneous legal fees.

Accordingly, we find that petitioner is not entitled to deduct

these fees.




      6
       Petitioner also failed to provide invoices or records for
the acquisition-related legal services, indicating that these
services related specifically to physical inventory or inventory
financing, nor did we find the accountant’s testimony credible as
to this issue.
                               -12-

V.   Cost of Goods Sold Related to the Write-Down of Inventory

     We now turn to petitioner’s method of accounting for

inventory write-down.   Respondent disallowed $306,163 of cost of

sales expenses related to inventory write-down for the years at

issue.   Respondent argues that petitioner both failed to

substantiate the write-downs and violated the regulations under

section 471 by using a reserve amount.   Petitioner argues that

its accounting complied with industry standards and the write-

downs should be allowed.7   We disagree with petitioner.

     A taxpayer is required to use a method of accounting for

inventory that clearly reflects the taxpayer’s income.     Sec. 471;

Best Auto Sales, Inc. v. Commissioner, T.C. Memo. 2002-297, affd.

(11th Cir. 2004).   The taxpayer has a heavy

burden of proving that the Commissioner’s determination is

plainly arbitrary and constitutes an abuse of discretion if the

Commissioner determines that the taxpayer’s method of accounting

for inventory under section 471 is improper.     Thor Power Tool Co.

v. Commissioner, 

, 532-533 (1979).

     A taxpayer using the lower of cost or market method of

valuing inventory may write-down a decline in the value of

merchandise from its cost to a lower market value in the year in

which the decline occurs, even though the goods have not been



     7
      Petitioner also argued that the inventory write-down had no
taxable effect. We find this argument to be without merit.
                                -13-

sold.    Sec. 471; sec. 1.471-2(c), Income Tax Regs.   This is

referred to as an inventory write-down.    If the market value of

the inventory at the end of the year is lower than its cost, the

taxpayer writes down the basis of the inventory to the lower

market value, thereby reducing gross income.    Thor Power Tool Co.

v. 

at 534-535; sec. 1.471-4(c), Income Tax

Regs.    Deducting a reserve for price changes from the inventory

or writing down inventory based on mere estimates, however, is

not allowable.    Sec. 1.471-2(f)(1), Income Tax Regs.   Further, we

will not disturb the Commissioner’s determination disallowing a

taxpayers’s write-downs without objective evidence substantiating

an item-by-item comparison of cost-to-market value.      See Thor

Power Tool Co. v. 

at 536; Import Specialties,

Inc. v. Commissioner, T.C. Memo. 1982-41.

     Petitioner’s accountant determined market value for write-

down purposes as the wholesale Kelly Blue Book value with the

assumption that the automobiles were in average condition.8

Petitioner’s accountant testified that it is necessary to know

the make, model, and year of the automobile, as well as the

automobile’s condition, mileage, and equipment options to

determine the Kelly Blue Book value.    Yet petitioner’s write-down



     8
       We acknowledge than an official guide for used automobiles
may be used to determine the market value for write-down
purposes. Brooks-Massey Dodge, Inc. v. Commissioner, 

, 895 (1973).
                                  -14-

records do not include complete information.       Petitioner’s

records lack the make, model, and year of several automobiles and

do not include the mileage, condition, or options of any

automobiles.    Petitioner argues that this method is the industry

standard and any differences between the method used and a more

detailed analysis would have been immaterial.       We are not

persuaded given the incomplete write-down records and absence of

any corroborating evidence to support the estimated Kelly Blue

Book values.

      In addition, petitioner did not then use its write-down

calculations of $309,172.04 in 1999 and $344,207.67 in 2000 to

determine its cost of goods sold.        Rather, petitioner violated

the regulations when it substituted a reserve amount of

$340,181.09 as the write-down for both years.       See sec. 1.471-

2(f)(1), Income Tax Regs.

      We find that petitioner did not adequately substantiate the

inventory write-downs and relied on a reserve in violation of the

section 471 regulations.    We also find that petitioner failed to

prove that the Commissioner’s determination was arbitrary and an

abuse of discretion.   Accordingly, we sustain respondent’s

determination as to this issue.

VI.   Section 6662(a) Penalties

      We next address whether petitioner is liable for the

accuracy-related penalties under section 6662(a).       Respondent has
                                -15-

the burden of production under section 7491(c) and must come

forward with sufficient evidence that it is appropriate to impose

a penalty.   See Higbee v. Commissioner, 

, 446-447

(2001).   Respondent determined that petitioner was liable for

substantial understatements of income tax under section

6662(b)(2) for the years at issue.9    A taxpayer is liable for an

accuracy-related penalty of 20 percent of any part of an

underpayment attributable to, among other things, a substantial

understatement of income tax.   See sec. 6662(a) and (b)(2); sec.

1.6662-2(a)(2), Income Tax Regs.   There is a substantial

understatement of income tax if the understatement amount exceeds

the greater of 10 percent of the tax required to be shown on the

return, or $10,000.   Sec. 6662(d)(1)(B); sec. 1.6662-4(b)(1),

Income Tax Regs.

     Petitioner reported income tax of zero for the years at

issue and reported negative taxable income of $258,427 for

taxable year 1999 and zero taxable income for 2000.    Respondent

has met his burden of production because the adjustments related




     9
       Respondent determined in the alternative that petitioner
was liable for accuracy-related penalties for negligence or
disregard of rules or regulations under sec. 6662(b)(1) for the
years at issue. Because respondent has proven that petitioner
substantially understated its income tax for the years at
issue, we need not consider whether petitioner was negligent or
disregarded rules or regulations.
                                 -16-

to the conceded issues alone are sufficient to meet the threshold

amounts under section 6662(d)(1).10

     Petitioner urges us to waive the section 6662(a) penalties

for three reasons.    First, petitioner claims there was

substantial authority for the positions taken on its tax returns.

Next, petitioner argues it provided adequate disclosure of the

relevant facts affecting its tax treatment of the items on the

returns.    Finally, petitioner claims to have reasonable cause for

its positions on the returns.

     While the Commissioner bears the burden of production under

section 7491(c), the taxpayer bears the burden of proof with

regard to issues of reasonable cause, substantial authority, or

similar provisions.11    Higbee v. 

at 446.   We

address these arguments in turn.

     A.     Substantial Authority for Positions Taken

     Substantial authority for the tax treatment of an item

exists only if the weight of the authorities supporting the

treatment is substantial in relation to the weight of authorities

supporting contrary positions.    See Norgaard v. Commissioner, 

, 880 (9th Cir. 1991), affg. in part and revg. in part


     10
          See supra note 2.
     11
       Petitioner presented no evidence concerning the issues of
reasonable cause, substantial authority, or disclosure and
reasonable basis in relation to its positions for the conceded
issues and did not carry its burden as to these issues. See
supra note 2.
                                -17-

T.C. Memo. 1989-390; sec. 1.6662-4(d)(3)(I), Income Tax Regs.

The weight of an authority depends on its source, persuasiveness,

and relevance.    Sec. 1.6662-4(d)(3)(ii), Income Tax Regs.

     The weight of authority consistently favored respondent.      We

found no merit to petitioner’s arguments concerning the

deductibility of the attorney’s fees.    In addition,

petitioner’s position regarding the inventory write-down

explicitly contradicts the relevant income tax regulations.      Sec.

1.471-2(f)(1), Income Tax Regs.    Accordingly, we find that the

substantial authority exception does not apply.

     B.     Disclosure of a Position and Reasonable Basis for
            Treatment

     We now address whether petitioner adequately disclosed its

position.   No accuracy-related penalty may be imposed for a

substantial understatement of income tax when the taxpayer

adequately discloses the relevant facts affecting the tax

treatment of an item and there existed a reasonable basis12 for

the treatment of that item.   Sec. 6662(d)(2)(B); sec. 1.6662-

4(e), Income Tax Regs.   A taxpayer may make adequate disclosure



     12
       A return position generally has a reasonable basis if it
is reasonably based on one or more of the following authorities,
among others: The Internal Revenue Code and other statutory
provisions; proposed, temporary, and final regulations construing
the statutes; court cases; and congressional intent as reflected
in committee reports. Sec. 1.6662-4(d)(3)(iii), Income Tax Regs.
The reasonable basis standard is not satisfied by a return
position that is merely arguable or is merely a colorable claim.
Sec. 1.6662-3(b)(3), Income Tax Regs.
                                 -18-

if the taxpayer provides sufficient information on the return to

enable the Commissioner to identify the potential controversy.

Schirmer v. Commissioner, 

, 285-286 (1987).    Merely

claiming the loss without further explanation, however, is

insufficient to alert the Commissioner to the controversial

nature of a loss claimed on the tax return.     McConnell v.

Commissioner, T.C. Memo. 2008-167 (citing Robnett v.

Commissioner, T.C. Memo. 2001-17).

     Petitioner did not provide sufficient facts to supply

respondent with actual or constructive knowledge of the tax

treatment of the disputed items.    See Robnett v. 

.    The returns do not mention petitioner’s inventory write-

down method, or that petitioner deducted legal fees related to

HIP’s bankruptcy and the Clippinger purchase.    We find that

petitioner did not adequately disclose its position, and the

adequate disclosure exception does not apply.

     C.     Reasonable Cause

     We now address whether petitioner had reasonable cause.      The

accuracy-related penalty under section 6662(a) does not apply to

any portion of an underpayment if it is shown that there was

reasonable cause for, and that the taxpayer acted in good faith

with respect to, that portion.    Sec. 6664(c)(1); sec. 1.6664-

4(a), Income Tax Regs.    The determination of whether the taxpayer

acted with reasonable cause and in good faith depends on the
                                 -19-

pertinent facts and circumstances, including the taxpayer’s

efforts to assess his or her proper tax liability, the knowledge

and experience of the taxpayer, and the taxpayer’s reliance on

the advice of a professional.     Sec. 1.6664-4(b)(1), Income Tax

Regs.

        Petitioner argues that it is not liable for the accuracy-

related penalties because it relied upon the advice of its

accountant concerning the tax treatment of the disputed items.

Reliance on the advice of a competent adviser can be a defense to

the accuracy-related penalty.     United States v. Boyle, 

, 250 (1985); Zfass v. Commissioner, 

(4th Cir.

1997), affg. T.C. Memo. 1996-167; sec. 1.6664-4(b)(1), Income Tax

Regs.     Reliance must be reasonable, in good faith, and based upon

full disclosure, however.     Ewing v. Commissioner, 

,

423-424 (1988), affd. without published opinion 

(9th Cir. 1991); Metra Chem Corp. v. Commissioner, 

,

662 (1987).

     Petitioner has not shown that it supplied its accountant

with all the correct and necessary information needed to

establish its position, that its error in underreporting was the

result of the preparer’s mistake, or that it discussed the tax

treatment of the legal fee deductions with its accountant before

filing the returns.
                                 -20-

     After considering all of the facts and circumstances, we

find that petitioner has not established that it had reasonable

cause and acted in good faith with respect to the substantial

understatements of income tax.    Accordingly, we sustain

respondent’s determination regarding the accuracy-related

penalties for the years at issue.

VII. Conclusion

     In reaching our holdings, we have considered all arguments

made, and to the extent not mentioned, we consider them

irrelevant, moot, or without merit.

     To reflect the foregoing and the concessions of the parties,



                                             Decision will be entered

                                        under Rule 155.