German v. Commissioner

• Decision Date: 22 February 1993
• Docket Number: Docket No. 12711-90.
• Citation: 65 T.C.M. 1931
• Parties: Harry German, Jr. and Carol German v. Commissioner.
• Court: U.S. Tax Court

65 T.C.M. 1931

T.C. Memo. 1993-59

Harry German, Jr. and Carol German v. Commissioner.

Docket No. 12711-90.

United States Tax Court.

Filed February 22, 1993.

John Gigounas and Edward B. Simpson, for the petitioners. Elizabeth Groenewegen and Debra K. Estrem, for the respondent.

Memorandum Findings of Fact and Opinion

DAWSON, Judge:

This case was heard by Chief Special Trial Judge Peter J. Panuthos pursuant to the provisions of section 7443A(b)(4) and Rules 180, 181, and 183.¹ The Court agrees with and adopts the Chief Special Trial Judge's opinion, which is set forth below.

Opinion of the Special Trial Judge

PANUTHOS, Chief Special Trial Judge:

In a notice of deficiency dated March 16, 1990, respondent determined a deficiency in petitioners' 1988 Federal income tax in the amount of $4,869, and an addition to tax pursuant to section 6653(a)(1) in the amount of $243.² Petitioners filed a timely petition. Petitioners also filed an amended petition alleging that respondent is estopped from examining petitioners' Federal income tax returns on any and all items. Respondent was granted leave to file an amended answer which raises as an additional issue a change in the method of accounting employed by petitioners. The amended answer alleges an increased deficiency totaling $20,680 and additions to tax pursuant to section 6653(a)(1) in the amount of $1,034 and section 6661 in the amount of $5,170 for the 1988 taxable year. During trial, respondent adjusted her claim, alleging that the deficiency should be reduced to $17,546 and the additions to tax pursuant to section 6653(a)(1) reduced to $877 and section 6661 reduced to $4,387.

Following concessions by the parties,³ the issues for decision are: (1) Whether respondent should be permitted to change petitioners' method of accounting relating to the deduction of certain interest expenses; (2) whether such interest is personal interest subject to the disallowance provisions of section 163(h); (3) whether petitioners are entitled to additional deductions for job-seeking expenses and certain other expenses relating to their antique business; and (4) whether petitioners are liable for the addition to tax for negligence pursuant to section 6653(a)(1).

Findings of Fact

Some of the facts are stipulated and are so found. The stipulation of facts and the attached exhibits are incorporated herein by this reference.

At the time of filing the petition herein, petitioners resided in Lafayette, California. At all times relevant to this proceeding, petitioners were husband and wife who filed joint Federal income tax returns.

Around 1981, petitioners each commenced studies at John F. Kennedy University Law School (JFK) located in Walnut Creek, California. They graduated and received their J.D. degrees from JFK in 1986. Neither petitioner is admitted to the practice of law in any State.

1. Work Experience

Prior to and during their attendance at JFK, Carol German (hereinafter Mrs. German) was employed as a claims examiner for an insurance company and Harry German, Jr. (hereinafter Mr. German) was employed as a legal researcher. On their 1985 tax return, petitioners reported income and deductions on Schedule C for German's Legal Research, Inc., a company which provided legal services to attorneys. The letterhead listed petitioners as "Harry German J.D.; M.A.; B.S." and "Carol German J.D.; B.S." Sometime in 1987, Mr. German was employed by an attorney named John Robinson. Mr. German's position involved legal research, hearing representation, as well as clerical and administrative duties. Mr. German ceased working for John Robinson in October 1987 as a result of a dispute. Thereafter, Mr. German applied for and received unemployment compensation from the State of California. As a condition to continued receipt of unemployment compensation, Mr. German filed with the Employment Development Department weekly reports listing attempts which he made to secure employment. His efforts at securing employment included sending out resumes and placing telephone calls to potential employers. He also visited some places of business without an appointment to inquire as to employment. During this time, petitioners resided in Pittsburgh, California. Although petitioner generally confined his job search to the area surrounding his home (San Francisco Bay Area), he occasionally would travel farther away, such as to Los Angeles. Despite his efforts, Mr. German was not successful in obtaining employment during 1988.

For the years 1987 and 1988, petitioners bought and sold antiques.⁴ They did not maintain a store at which such items were regularly held out for sale. Rather, they traveled about, renting spaces at antique shows and fairs. Petitioners did not maintain any books or records pertaining to this activity.

At the time of trial, Mr. German was employed as a workman's compensation claims examiner and Mrs. German was employed as a manager with an insurance company.

2. Interest Expense

Petitioners financed their respective legal educations with loans obtained through education loan programs sponsored by the State of California and the Federal Government. According to a consolidated loan statement sent to Mr. German by the Student Loan Marketing Association (Sallie Mae), the principal amount owed by Mr. German for his law school loans as of June 1987 was $24,102.65, bearing annual interest at 9 percent. A similar consolidated statement sent to Mrs. German by Sallie Mae states that the principal amount of Mrs. German's law school loans as of June 1987, was $21,558.44, also bearing annual interest at 9 percent.

Petitioners paid approximately $840 in interest during 1985. However, on the 1985 return, petitioners deducted $22,410 in interest. This amount was determined pursuant to the Rule of 78's.⁵ Petitioners were obligated to pay approximately $4,109⁶ in interest during 1987, but deducted $20,184 in interest on their 1987 return. During 1988, Mr. German did not make any payments on his law school loans because he qualified for deferment. According to the terms of the deferment, interest continued to accrue on the loan principal but was added to the principal in lieu of payment. Mrs. German made a $1,944.70 payment on her student loan for 1988. However, pursuant to the Rule of 78's, petitioners deducted $14,200 in student loan interest on their 1988 Federal income tax return.

Petitioners characterized the Sallie Mae interest deductions as "investment interest" on Schedule A of their 1985, 1987, and 1988 tax returns. On brief, petitioners claimed that their respective law school educations were a business investment and deductible pursuant to section 162. The claimed deductions created carryovers of the purported unused investment interest expense for the years 1985, 1987, and 1988.⁷

3. Examination of Petitioners' Tax Returns

Sometime in March 1987, petitioners' 1985 Federal income tax return was selected for examination. An Internal Revenue Service (IRS) auditor conducted an examination of the 1985 return. Petitioner submitted documentation at an initial meeting. At a second meeting, petitioners submitted a document to the auditor which stated in part that "Harry and Carol German adopt the Accrual method of accounting for the 1985 tax year." The document indicates that petitioners intended to use the Rule of 78's accounting method in calculating deductions for their Sallie Mae interest expense.⁸ Petitioners did not complete an IRS Form 3115, which is required to be filed by any taxpayer seeking to change their method of accounting. Furthermore, respondent did not expressly give consent to a change in accounting method. Sec. 446(e); sec. 1.446-1(e)(2)(i), Income Tax Regs.

After the examination was concluded, the matter was referred to respondent's Appeals Office in Sacramento. In June 1988, the matter was returned to the Examination Division for additional examination. The Examination Division ultimately determined that petitioners were entitled to a deduction for interest expense under the accrual method in the amount of $29,099.⁹ The increased deduction on the 1985 return left petitioners with a carryforward of approximately $9,995 which petitioners applied to their 1987 and 1988 returns.

In September 1989, petitioners' 1987 return was surveyed by an IRS agent but no examination was conducted. After the survey, the return was accepted as filed. Petitioners were not asked for, nor did they submit, any documentation bearing on the 1987 tax year. As previously noted, petitioners claimed an interest expense deduction of $20,184 on their 1987 return. Schedule A of the return noted that petitioners used the Rule of 78's to calculate such deduction. The IRS agent surveying the 1987 return was aware of the notation.

Petitioners filed a joint Federal income tax return for taxable year 1988 which reflected adjusted gross income of $42,630.53 and taxable income of $104.53. Petitioners claimed deductions on Schedule A as follows:

                State and local income taxes ..............   $   415
                Real estate taxes .........................     1,211
                Mortgage interest .........................     9,100
                Investment interest (per Rule of 78's) ....    14,200
                Contributions .............................       250
                Job-hunting expenses ......................     7,725
                Balance of 1985 Sallie Mae interest expense
                  carryover per IRS audit .................     3,775
                                                              _______
                                                              $36,676
                

A Schedule C relating to petitioners' antique business reported gross income of $966 and total deductions of $2,188, resulting in a net loss of $1,222.¹⁰

4. Respondent's Determination

In the notice of deficiency for 1988, respondent disallowed $750 of Schedule C expenses relating to petitioners' antique business, disallowed the entire amount claimed on Schedule A, and allowed a $5,000 standard deduction. In respondent's amended answer to petitio...