TAX COURT DENIES TREATY EXEMPTION, EXPENSE DEDUCTIONS AND UPHOLDS PENALTIES.

Randall E. Heath and Kristin H. Joe, for respondent.

In 2000, Zhang registered the trade name "Hotweb Design Company" with the State of Arizona. She paid a lawyer to help her do this. She obtained an employer identification number from the IRS under the trade name. Under the trade name and employer identification number, she filed Federal employment tax returns (IRS Forms 941, Employer's Quarterly Federal Tax Return), federal wage information returns (IRS Forms W-2, Wage and Tax Statement), Washington State tax returns for workers' compensation insurance, and Washington State tax returns for unemployment insurance. Zhang reported on the returns that she was employing her son to work on Hotweb and that she owed a few hundred dollars in federal and state employment taxes per year. The amounts that she reported on these returns to have paid her son are consistent with the amounts she claimed on her federal income tax returns to have paid her son. Zhang testified that she registered the Internet domain name hotwebexpress.com and paid for websitehosting service.

Zhang made large payments to her son and for his benefit, including payment of her son's college-tuition bills. She deducted them either as "wages" or, in the case of the payments of college expenses, as "employee benefits". In 2003, Zhang claimed deductions for $5,200 in wages and $9,045 in "employee benefits"; in 2004, $4,134 in wages and $22,000 in employee benefits; and in 2005, $460 in wages and no employee benefits on the tax-return Schedules C, Profit or Loss from Business (Sole Proprietorship), that she completed for Hotweb.

Zhang's son filed federal income tax returns for 2003, 2004 and 2005. He reported as income the amounts that his mother had reported that she paid him as "wages". He did not report, as income or otherwise, the amounts that his mother had reported that she paid him as "employee benefits". He claimed a deduction for a personal exemption for himself for each of 2003 and 2004, but not for 2005. On each year's return, he reported very little income tax liability. Zhang was the preparer of her son's 2003 return. Her continued practice of segregating college expenses as "employee benefits" and her son's continued practice of not reporting them suggest that she had a hand in the preparation of his 2004 return.

For 2003, though not 2004 or 2005, Zhang claimed a large "office expense" deduction for Hotweb. Most of this $6,190 deduction was for the cost of renting an apartment in Seattle in which her son lived. Zhang's son began college, at the University of Washington in Seattle, about September 29, 2003. He continued to study full time until he graduated with a degree in architecture. She explained that her son's move to Seattle would both help him and help her business because the city is a technology-industry hub. (We infer Zhang's son had lived with her in Phoenix, whence she brought him to college.) She also claimed that part of the deduction was the rental fee for a parking space in Seattle. She claimed that she rented the space because her son was in Seattle and because they needed a "travel car to buy things and for something". We infer that she deducted the entire cost of the apartment and parking space even though it is obvious that the apartment was used at least in part for personal or family purposes.

Zhang claimed on her return deductions for thousands of dollars in vehicle expenses for each of 2003, 2004, and 2005. She explained that these vehicle expenses largely related to traveling to Seattle, where her son was in college, but said little about the purpose of these trips.

     Description                         2003             2004         2005

     Description                              2003             2004

     Description                      2003             2004            2005

In 2005, apparently, Zhang wrote to offices of the United States Senate to ask for help with a dispute about her son's college tuition rate. In 2006, Zhang sued Honeywell for, as she alleged, (1) firing her on the basis of gender, race, national origin, disability, and age and (2) refusing to re-hire her on this basis and "because of her opposition to [its] unlawful employment practices." In June 2007, Zhang sued Honeywell and Internet technology company China Gate, Inc. for, as she alleged, underpaying her. As a part of the same proceeding, she sued several major technology companies for, as she alleged, later hiring H-1B visa holders instead of her when she was a permanent resident. Her lawsuit alleged that these companies were wrongfully using the H-1B temporary visa program to avoid hiring American workers, in part to discriminate on the basis of age and in part to undercut wage rates. It also alleged that she had sent a letter to the U.S. Senate about H-1B program abuse around March 2007. On December 28, 2007, the IRS issued the deficiency notice setting forth its determinations for the years at issue. Zhang presented to the Court documents showing that the U.S. Department of Labor took action in 2008 on immigrant-labor-related complaints she had made to the Department of Labor at times not known to us. Zhang also showed that in 2008 she had made a complaint to the Department of Labor other than those upon which she showed it took action in 2008.

The bulk of the deficiencies results from the deductions that Zhang had claimed for Hotweb. The IRS disallowed all the Hotweb deductions on the ground that the activity was not conducted for profit. Another significant portion of the 2003 deficiency stemmed from the deduction Zhang had claimed for her mother's medical and living expenses. The IRS disallowed that deduction on the ground that such expenses are "personal". The notice of deficiency did not disallow the 2004 deduction Zhang claimed for her own medical expenses on Schedule A.

Zhang filed a petition to contest the deficiency notice. Zhang was a resident of Oregon when she filed the petition. Zhang contests the income-tax deficiency determinations for her 2003, 2004, and 2005 taxable years and the accuracy-related penalty for each year. She further contends that the wages she received from Honeywell during 2003, 2004, and 2005 are exempt from tax under a treaty rule for visiting teachers and researchers, that the IRS audited her returns to retaliate against her for reporting violations of immigration law and allegedly unfair college-tuition rates, and that the IRS coerced her to sign the period-of-limitations consent form, which is necessary to the timeliness of notice of the 2003 deficiency, by hinting at having her deported.

Zhang introduced the photocopy of the receipt into evidence. The Court commented that the photocopy was hard to read. Zhang offered to provide the original, and the Court asked for it. Before handing the original to the clerk, Zhang obscured part of it with a black marker. We conclude from a credit-card statement showing a purchase and refund corresponding to the receipt, and from the store clerk's note that Zhang had obscured but failed to obliterate entirely, that what Zhang obscured was the writing added after the photocopy was made which showed that the laptop computer had been returned the same day.

Zhang claimed that what she obscured was a mark made by the store for security purposes as she left the store. We disagree. We believe that the faint x-mark that appears on the original and the copy was such a mark.

Zhang's mother is not a U.S. citizen, a U.S. national, a U.S. resident, or a resident of a country bordering the United States. We conclude, therefore, that Zhang is not entitled to a deduction for the $12,208 of expenses she paid for care and medical treatment of her mother.

Zhang claims that the substantial payments she made to or for the benefit of her son were compensation for services he provided. She presented documents that stated he worked for her 30-40 hours per week during the second half of 2003, 20 hours per week for the second and third quarters of 2004, and 5-6 hours per week for the fourth quarter of 2004. They also stated that he was "laid off" December 6, 2004. But what, if anything, Zhang's son was actually doing is not apparent. Zhang testified that he assembled computers, but it is not apparent that a small website business would have a use for more than a few computers. And there is no evidence that Zhang bought parts for more than a few computers. She also testified that her son reviewed her emails and other documents for grammar. But Zhang did not corroborate that her son reviewed any substantial quantity of documents or that the documents related to Hotweb. One of her unemployment-insurance-tax returns describes her son's work as "programming", but the record does not show that Zhang's son actually worked on any programs.

Zhang presented no explanation for these striking omissions. Her copious testimony and documentation on other matters suggest that her memory had not simply faded. We infer that fuller evidence would not have been favorable. The absence of a legitimate explanation for Zhang's striking failure to corroborate an activity that supposedly took a great deal of time and money indicates to us that she is not credible generally. See Igberaese v. Commissioner, T.C. Memo. 2010-284.

Section 1.183-2(b), Income Tax Regs., provides that "all facts and circumstances with respect to the activity are to be taken into account" in determining the existence of a profit motive and provides a nonexclusive list of factors to consider in determining whether a profit motive exists. Analysis of these factors satisfies us that Zhang lacked a profit motive for Hotweb.

The first factor is described by the regulations as follows:

Zhang did not establish that she (or anyone) conducted the purported website activity very much at all. In order to make money from a website, it is generally necessary to actually create a website, and Zhang has not shown that she tried very hard to do that. Mainly she attributed to the activity expenses that she would have incurred anyway. This factor weighs against a profit motive.

The second factor is described by the regulation as follows:

The third factor is described by the regulation as follows:

The fourth factor is the "expectation that assets used in [the] activity may appreciate in value." Sec. 1.183-2(b)(4), Income Tax Regs. There is no indication that Zhang expected any assets to appreciate, but there is also no indication that appreciation of assets would be important to the success of the news service or car brokerage she supposedly expected to operate. This factor is neutral.

The fifth factor is the success of the taxpayer in carrying on other activities, whether similar or dissimilar to the one for which a business deduction is sought. Sec. 1.183-2(b)(5), Income Tax Regs. Zhang had worked as a computer programmer for a large company. She would be better situated than most people to make Hotweb succeed. We conclude, therefore, that this factor weighs modestly in favor of the existence of a profit motive.

The sixth factor is "The taxpayer's history of income or losses with respect to the activity." Sec. 1.183-2(b)(6), Income Tax Regs. This factor weighs against a profit motive. Zhang consistently reported losses, without any gross income or even gross receipts, for Hotweb. In describing this factor, the regulation says: "A series of losses during the initial or start-up stage of an activity may not necessarily be an indication that the activity is not engaged in for profit." Id. But Hotweb's supposed activities were not so much starting up as never begun.

The seventh factor, "The amount of occasional profits, if any, which are earned", is likewise negative. Sec. 1.183-2(b)(7), Income Tax Regs. The regulation continues:

The eighth factor is described by the regulation as follows:

The ninth factor is described by the regulation as follows:

We conclude from the factors in section 1.183-2(b), Income Tax Regs., that Zhang did not conduct Hotweb, the purported business to which she claimed her business-expense deductions related, for profit during any of the years at issue. The most important reason for this conclusion is that she failed to conduct much website activity at all.

As discussed, Zhang failed to establish that her purported activity even existed to any significant extent and, relatedly, failed to establish that she had a profit motive for it. Additionally, she has failed to show that most of her claimed expenses have any connection with a website (including, for instance, by financing or advertising a website). This last failure is an independent ground requiring disallowance of her claimed deductions for "office expense" (i.e., rent for her son's apartment), "employee benefit programs" (i.e., tuition for her son's college education), and "wages" (i.e., money paid to him). Zhang has not shown that the apartment was not used entirely as living space, her explanations of the work her son supposedly performed in exchange for the employee benefits and wages are scanty and implausible, and her relationship to him suggests that the rent, tuition, and money were simply gifts from her to him. We decline, however, to consider whether every one of the expenses Zhang claimed for Hotweb lacked a connection with a website.

The IRS contends that because Zhang's son claimed exemptions for himself on his returns, Zhang cannot claim personal exemptions for him. But the fact that Zhang's son claimed personal exemptions on his own returns is irrelevant in ascertaining Zhang's entitlement to personal exemptions for him. Section 151(a) provides a personal exemption for the taxpayer, and section 151(c) provides the taxpayer additional personal exemptions if he or she has dependents. The term "dependent" includes, but is not limited to, a child of the taxpayer over one-half of whose support the taxpayer provided for the year in question. Sec. 152(a). The taxpayer's additional personal exemption is not contingent on the dependent's not claiming a personal-exemption deduction on his or her own return.

In support of its contention, the IRS points us to section 151(d)(2). Section 151(d)(2) prohibits a taxpayer who is a dependent of another from claiming a personal-exemption deduction on his or her own return. But this provision affects only the dependent. Thus, the mere fact that Zhang's son claimed exemptions for himself for 2003 and 2004 does not mean that Zhang is not entitled to claim him as a dependent for those two years. The IRS raises no other challenges to the personal-exemption deduction. On the basis of the record before us, we find that Zhang is entitled to claim her son as her dependent for 2003 and 2004.⁶ Consequently, she is entitled to an additional personal-exemption deduction for each of those years.

We do not find Zhang to have substantiated her inference that the audit was retaliatory. No evidence before us indicates that Zhang's immigration-law or college-tuition-related issues had any bearing on IRS decisions about auditing her returns.

We also note that Zhang claimed deductions that were facially dubious, such as thousands of dollars of vehicle expenses for a small website business. This suggests that the IRS simply audited her returns in order to determine whether they were correct.

She also testified that an unknown person called her at home and told her that he or she knew Zhang was in the country illegally and asked her for money. She said that not many people knew her presence in the United States was unlawful and that the caller therefore must have been from the IRS. She said there was a police record of these incidents but did not introduce the police record as evidence. She did not corroborate these alleged calls or testify about them in detail.

Zhang tried to deceive us by altering a receipt in court. She also tried to deceive us, as she had for years tried to deceive the IRS, by disguising family expenses as expenses of an essentially fictitious business. Therefore, we give her vague, uncorroborated testimony little weight and do not conclude that the alleged incidents occurred. Even if the alleged harassing telephone call did occur, Zhang's contention that the IRS was involved is nothing more than speculation.

Zhang argued that her tax returns were correct. As we have explained, they were not. The additional personal-exemption deductions to which Zhang's son's status as her dependent entitles her for 2003 and 2004 do, however, reduce her deficiencies, underpayments, and penalties for those years.

Under section 7491(c), the IRS must come forward with sufficient evidence that it is appropriate to impose penalties. See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). However, once the IRS has met this burden of production, the burden of proof remains with the taxpayer, including the burden of proving that the penalties are inappropriate because of reasonable cause or substantial authority. See Rule 142(a); Higbee v. Commissioner, supra at 446-447.

Even with the additional personal-exemption deductions, Zhang's "understatements" of income tax for 2003 and 2004 are "substantial" because they exceed both (1) 10 percent of the tax required to be shown on the returns and (2) $5,000 for each year.⁷ The IRS has met its burden of producing evidence of the deficiency, and the substantial understatement undisputedly follows as a computational matter.

Zhang does not have a "substantial understatement" of income tax for 2005. But Zhang's contrivance of the supposed Hotweb activity to claim business-expense deductions for numerous personal and family expenses not only meets the IRS's burden of production but persuades us that as to its deductions, the source of her deficiency for that year, she neglected or disregarded her tax obligations.

Section 6664(c) provides that no penalty shall be imposed under section 6662 with respect to any portion of an underpayment if it is shown that there was a reasonable cause for, and the taxpayer acted in good faith with respect to, such portion.

Zhang did not specifically argue that we should apply the reasonable-cause-and-good-faith exception to any part of any of her underpayments, and the facts in the record do not establish that the exception applies. Zhang used a return-preparation computer program each year. She claims that she took a tax course from a return-preparation firm in 2003. But nothing before us indicates that any error in Zhang's return resulted from an erroneous explanation of tax law provided by a tax instructor, IRS employee, or computer program, or from an erroneous computation performed by a program. She claims that in the course of preparing one of her returns, she asked an IRS employee what address to use for Hotweb (Schedule C asks for the "business address"), and the employee suggested she use her son's apartment address. But Zhang did not explain why it would be reasonable for her to think, on the basis of this suggestion, that the apartment was deductible. We observe that Zhang's erroneous deduction for her mother's living and medical expenses could have followed from a misunderstanding of a complex issue: section 213 does allow a deduction for medical and long-term-care expenses of a taxpayer and certain dependents. But Zhang failed to indicate specifically what led her to claim this deduction.

To reflect the foregoing,

Decision will be entered under Rule 155.

² For 2004, Zhang deducted on her Schedule C $22,000 in "employee benefit programs". At trial Zhang claimed that a portion of this $22,000 consisted of a benefit program for herself in the form of payment of her own medical expenses. The portion of the $22,000 that consisted of Zhang's own medical expenses is not deductible. In addition to the lack of a profit motive for the activity to which this and the other Schedule C expenses allegedly relate, Zhang cannot deduct employee benefits provided to herself. A sole proprietorship and its proprietor are the same entity. See Osborne v. Commissioner, T.C. Memo. 2002-11. Moreover, although medical expenses are deductible under sec. 213 even if they are expenses not related to a business, Zhang has not demonstrated that the portion of the $22,000 consisting of her own medical expenses, if any, was not already deducted on Schedule A. (The entire $22,000 entry seems instead to have reflected Zhang's son's college expenses.)

³ The fact that the supposed activity centered on creating documents, some to be displayed on a website and others to instruct a computer, makes the absence of evidence especially striking.

⁴ Sec. 183(c) defines "activity not engaged in for profit" as "any activity other than one with respect to which deductions are allowable for the taxable year under section 162 [trade-or-business expenses] or under paragraph (1) or (2) of section 212 [expenses for production of income or management, etc., of property held for production of income]." A "trade or business" (which we refer to simply as a "business"), like an activity "for production of income", requires a profit motive. See Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987); Gajewski v. Commissioner, 723 F.2d 1062 (2d Cir. 1983), revg. T.C. Memo. 1983-133.

⁵ Zhang's own tax savings did not come at the cost of a significant increase in the reported taxes of her son. His reported tax liabilities were unaffected by Hotweb's small purported "wages" because they were offset by the standard deductions and personal exemptions he claimed. His reported tax liabilities were unaffected by Hotweb's larger "employee benefits" because he did not report them as income.

⁶ If true, Zhang's allegation that she provided her son money and covered his college expenses as compensation for working on Hotweb could weigh against her claim that he is her dependent. See sec. 152(a) (taxpayer must have provided more than one-half of dependent's support); Limpert v. Commissioner, 37 T.C. 447, 450 (1961) (amounts received as compensation considered support provided by oneself, rather than support provided by payor). But the IRS has not questioned whether Zhang satisfied the support test.

⁷ Sec. 6662(d)(2)(B) excludes from the definition of "understatement" for this purpose a deduction supported by "substantial authority" or a "reasonable basis" and disclosure. Zhang has not explained what substantial authority or reasonable bases may have existed for her erroneous deductions. Nor do we find on our own that her positions had substantial authority or reasonable bases. See sec. 1.6662-3(b)(3), (d)(2), Income Tax Regs. (describing the "reasonable basis" and "substantial authority" standards for support of a tax position which ultimately proves to be erroneous).