Lerch v. C.I.R.

• Decision Date: 28 June 1989
• Docket Number: No. 88-1655,88-1655
• Citation: 877 F.2d 624
• Parties: -5085, 89-1 USTC P 9388 Ronald L. LERCH and Dalene Lerch, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 624

877 F.2d 624

64 A.F.T.R.2d 89-5085, 89-1 USTC P 9388

Ronald L. LERCH and Dalene Lerch, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE SERVICE, Respondent-Appellee.

No. 88-1655.

United States Court of Appeals, Seventh Circuit.

Argued Nov. 2, 1988.

Decided June 21, 1989.

As Amended June 28, 1989.

Merwin D. Grant, Beus, Gilbert, Wake & Morrill, Phoenix, Ariz., for petitioners-appellants.

Gary R. Allen, Chief, App. Sec., Tax Div., Dept. of Justice, Washington, D.C., William S. Rose, Jr., Asst. Atty. Gen., David I. Pincus, Tax Div., Dept. of Justice, POB 502, Washington, D.C., Stuart E. Horwich, Arlington, Va., for respondent-appellee.

Before BAUER, Chief Judge, WOOD, Jr. and KANNE, Circuit Judges.

HARLINGTON WOOD, Jr., Circuit Judge.

Taxpayers Ronald and Dalene Lerch appeal a decision of the United States Tax Court upholding deficiency determinations made by the Commissioner of Internal Revenue Service ("Commissioner") against the Lerches for the tax years 1977 through 1981. Although many issues were litigated before the Tax Court, in this appeal the taxpayers question only three of the Tax Court's rulings: (1) Did the Tax Court improperly deny the taxpayers any deduction for depreciation, mortgage interest payments, taxes, and other expenditures related to maintenance of real property from which the taxpayers derived rental income; (2) Was the Tax Court's determination of the price at which the taxpayers sold certain real property during tax year 1977 erroneous; and (3) Did the Tax Court incorrectly conclude that Ronald Lerch failed to report a particular item of income on his 1981 tax return.

I. FACTUAL BACKGROUND ¹

Between July 1983 and April 1985, the Commissioner sent the Lerches a total of five notices of tax deficiency, claiming that the Lerches had underpaid their federal income taxes for the tax years 1977 through 1981 by more than $300,000. The Commissioner also asserted additions to tax for fraud against the Lerches for the tax years of 1977 and 1978, and negligence penalties for the tax years of 1979 and 1980. Fraud penalties were claimed against Mr. Lerch for the 1981 tax year; negligence penalties were alleged against Mrs. Lerch for the same year.

The Lerches petitioned the United States Tax Court for review of the Commissioner's deficiency determinations against them. During the course of discovery related to the pending litigation, the Commissioner amended the original deficiency determinations asserted against the Lerches. The Commissioner claimed increased deficiencies and fraud penalties for the 1977 and 1979 tax years. Additional deficiencies and negligence penalties were asserted for the tax year 1980.

The Lerches thereafter engaged in a pattern of procedural maneuvers, the aim of which appears to have been avoidance of trial on the deficiency determinations. Two of the five Tax Court cases involving these taxpayers were initially set for trial on January 28, 1986 in Phoenix, the location of the Lerches' tax counsel. On January 13, 1986 the Lerches obtained a consolidation order combining the Phoenix cases with three others pending on the Tax Court's Indianapolis docket. Trial on all five petitions was scheduled for April 28, 1986 in Indianapolis.

On April 23, 1986 the Lerches filed for bankruptcy in the United States Bankruptcy Court for the Northern District of Illinois, which halted the Tax Court proceedings under the automatic stay provision of the Bankruptcy Code. ² Mr. Lerch filed for bankruptcy under Chapter 11, Mrs. Lerch under Chapter 7. On the morning of April 28, 1986, attorneys for the Commissioner petitioned the bankruptcy court for relief from the automatic stay, requesting that the Tax Court proceeding be permitted to go forward as planned. The bankruptcy judge lifted the stay as to the taxpayers as individuals (as opposed to their estates in bankruptcy) over the objection of the Lerches' bankruptcy attorney. The Lerches made an emergency appeal to the United States District Court seeking relief from the bankruptcy court's ruling, arguing that they were being improperly deprived of the protection of the Bankruptcy Code's automatic stay provision, and that they would have to proceed without counsel in the Tax Court because their tax attorney, Mr. Grant, had not received approval from the bankruptcy judge to represent their estates in the tax case.

These contentions were properly rejected by the district court, as no prejudice to the bankruptcy estates would result from the Tax Court's determination of the individual tax liability of the debtors, and the bankruptcy court's approval of Mr. Grant's representation of the taxpayers was unnecessary because neither the trustee of Mrs. Lerch's estate nor the debtor in possession of Mr. Lerch's estate was involved in the Tax Court litigation. ³ The district court therefore affirmed the lifting of the stay on April 30, 1986. On the same day, the Tax Court denied the Lerches' motion for a continuance (made for them by their bankruptcy attorney) and instructed the Lerches to appear for trial on the following morning.

Trial began on the Lerches' petitions on the morning of May 1, 1986. Mr. Grant, the Lerches' tax attorney, failed to appear at the proceedings without leave of the Tax Court. ⁴ Mr. Lerch orally moved for a continuance which was denied. Thereafter, trial proceeded with Mr. and Mrs. Lerch representing themselves. Although the Tax Court gave the Lerches sufficient opportunity to present witnesses and documentary evidence to rebut the Commissioner's claimed increases in the Lerches' tax liability, the Lerches offered virtually no evidence, either testimonial or documentary. Mr. Lerch repeatedly refused to answer questions, basing his refusal on his fifth amendment privilege not to incriminate himself. ⁵ In the end, the Tax Court upheld essentially all of the Commissioner's claimed deficiencies against the Lerches, with some modifications based primarily upon computational errors committed by the Commissioner.

II. ANALYSIS

The Lerches raise only three narrow issues on appeal. First, they question the Tax Court's disallowance of any deductions for depreciation, mortgage loan interest payments, taxes, and other ordinary and necessary expenses associated with their ownership of income-generating rental property during the 1979, 1980 and 1981 tax years. Second, the Lerches contend that the Tax Court erroneously set the selling price on a piece of real estate that the Lerches sold in 1977 at $100,000. Finally, the Lerches claim that the Tax Court wrongly decided that Mr. Lerch failed to report, as part of his gross income for 1981, a $15,750 commission he earned as a sales representative. We address each of these issues in turn.

A. Ordinary and Necessary Business Expense Deductions

During the tax years at issue, the Lerches owned property in Fort Wayne, Indiana (referred to as the Pittsburg Street property) which they leased to Power-Hose Coupling, Inc. (now known as Power Products, Inc. but referred to here as Power-Hose), a closely held corporation owned by the Lerches and a few of their relatives. Power-Hose conducted its business from the Pittsburg Street property. The Lerches received rental income from the lease to Power-Hose every year at issue in this appeal. The Lerches fully reported that income on their returns. The Lerches also claimed depreciation and expense deductions related to the Pittsburgh Street property. The Commissioner did not contest the Lerches' claim to these deductions for the tax years 1977 and 1978. For the years 1979, 1980 and 1981, however, the Commissioner disallowed all deductions, including depreciation, mortgage interest payments, taxes, and other expenses relating to the Pittsburgh Street property. ⁶ The Tax Court affirmed these disallowances, despite the Lerches' contention that the rule laid down in Cohan v. Commissioner, 39 F.2d 540, 544 (2d Cir.1930), required the Commissioner to give the Lerches some allowance for these deductions, even absent documentation by the Lerches. The Lerches argue that the Tax Court erroneously refused to apply the Cohan doctrine to their claims of deductible expenses.

In Cohan the taxpayer, George M. Cohan, had not maintained records of items he claimed as business entertainment expenses. The Commissioner disallowed the entire deduction, despite the fact that the taxpayer established that he did indeed have some such expenses. The Board of Tax Appeals (the precursor to the modern Tax Court) affirmed the Commissioner's decision. The Second Circuit reversed, however, holding that when the Commissioner concedes the legitimacy of a claimed deduction, the deduction cannot be entirely disallowed merely because the taxpayer cannot prove an exact figure. Writing for the court, Judge Learned Hand stated:

Absolute certainty in such matters is usually impossible and is not necessary; the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making. But to allow nothing at all appears to us inconsistent with saying that something was spent. True, we do not know how many trips Cohan made, nor how large his entertainments were; yet there was obviously some basis for computation, if necessary by drawing upon the Board's personal estimates of the minimum of such expenses. The amount may be trivial and unsatisfactory, but there was basis for some allowance, and it was wrong to refuse any, even though it were the traveling expenses of a single trip. It is not fatal that the result will inevitably be speculative; many important decisions must be such. We think that the Board was in error as to this and must reconsider the evidence.

Cohan, 39 F.2d at 544.

In the past this court has repeatedly recognized the applicability of the Cohan rule. See, e.g., Zeddies v. Commissioner, 264 F.2d 120 (7th Cir.) (estimating taxpayer's expenses where taxpayer failed to...