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Reynolds v. Commissioner of Internal Revenue

July 18, 2002


Appeal from the United States Tax Court No. 12112-97--John F. Dean, Special Trial Judge.

Before Flaum, Chief Judge, Cudahy, and Manion, Circuit Judges.

The opinion of the court was delivered by: Cudahy, Circuit Judge.


This dispute arises from certain tax deductions claimed by Charles and Beatrice Reynolds on their 1993 and 1994 tax returns. The Internal Revenue Service (IRS) challenged the deductibility of certain expenses related to a family farm business, rental properties and to Charles Reynolds' private law practice, which is, for better or worse, a sideline from his full-time employment as an IRS supervisor. *fn1 During the pendency of this dispute, the Reynolds received two brief letters from the IRS stating that they had no outstanding liability for the 1993 and 1994 tax years. The Reynolds asserted that these letters were binding admissions by the IRS, thus estopping the agency from pursuing any further action against them. The U.S. Tax Court rejected this argument and ruled on the merits, allowing some of the deductions and disallowing others. In addition, pursuant to 29 U.S.C. § 6662(a), the Tax Court upheld a 20% accuracy-related penalty because it found that some of the remaining errors were the result of negligence.

The Reynolds appeal the following: (1) the evidentiary weight given to the no-liability letters, (2) the classification of certain legal defense costs as personal costs rather than as business expenses related to Charles Reynolds' private law practice, (3) the denial of various automobile and travel expenses related to the private law practice, farming activity and the rental properties, and (4) the imposition of the accuracy-related penalties. We affirm the judgment of the Tax Court.


Charles Reynolds joined the IRS in 1976, where he worked as a revenue officer in the Chicago office. Several years later, Reynolds graduated from law school and was promoted to a supervisory position, which involved a case-load of taxpayer audits. In 1987 and 1988, Reynolds received permission from the IRS to practice law in addition to his primary employment with the IRS. However, in 1992, the IRS commenced an investigation of Reynolds springing from concerns that he may have been conducting his private law practice during his workday at the IRS. To defend himself, Reynolds hired a major Chicago law firm and incurred legal expenses. The investigation was officially terminated in 1995.

During 1993 and 1994, which is the time period relevant to this dispute, Charles Reynolds operated a small part-time law practice. These efforts were limited to a few real estate closings and related activities. In 1993, Reynold's Schedule C for this law practice reported gross receipts of only $700. *fn2 However, he claimed a net loss of $6,271. His deductions included $2,380 for legal fees related to the IRS investigation of certain questionable on-the-job activities. Similarly, in 1994, Reynold's Schedule C reported gross receipts of $450 with a net loss of $10,255. This amount included $5,615 in legal fees related to the ongoing investigation. In a subsequent audit, the IRS disallowed the business deduction of the legal expenses, ruling that they should instead be categorized as itemized personal expenses on Schedule A and thus deductible to the extent they exceeded the 2% "floor" limitation of 26 U.S.C. § 67(a).

In addition to the reclassification of the legal expense, IRS auditors also denied various other deductions, including automobile and travel expenses allegedly related to the law practice, to a family farm and to rental properties. Only the auto and travel expenses, however, are currently before us on appeal. From our own inspection of the record, we estimate the total amount of the deductions now in dispute to be approximately $3,359. *fn3 Included in this amount are travel and automobile expenses allegedly incurred by Charles Reynolds in the course of his law practice, including depreciation of a 1988 Toyota Camry. Similarly, the IRS denied travel and automobile expenses related to rental property owned by the Reynolds in Indiana, Kentucky and Virginia, and travel to Florida to evaluate a real estate development project that never materialized. Finally, the IRS denied travel and automobile expenses incurred in a trip to a family-owned farm in Kentucky, including the depreciation of a 1994 Ford van, which was supposedly used "to haul tillers, plows and farm tools from Virginia to Kentucky and for use in the operation of the farm." *fn4 Although the Reynolds did not keep a log of specific trips and the mileage that corresponded with each money-making activity, Charles Reynolds retained various receipts for gas, maintenance and repairs, and during the subsequent audit, he attempted to categorize each expense and to apportion it to the appropriate activities.

Nonetheless, the IRS denied the automobile and travel deductions on various grounds, including failure to comply with the substantiation requirements of 26 U.S.C. § 274(d). After the IRS had made several other adverse rulings that are not pertinent to this appeal, the agency calculated deficiencies of $4,732 and $3,092 for the 1993 and 1994 tax years, respectively, together with corresponding accuracy-related penalties of $946 and $618, respectively.

In August of 1997, the Reynolds petitioned the U.S. Tax Court for a redetermination of their 1993 and 1994 tax liability. In March of 1998, while this matter was still pending before the Tax Court, the Reynolds apparently sent a letter of inquiry to the IRS problem resolution office in Kansas City, Missouri, with respect to their 1993 and 1994 tax liabilities. It is important to note that this inquiry was not directed to the district counsel for the IRS, who was representing the respondent in the ongoing dispute before the Tax Court. A month later, the Reynolds received two short letters from the IRS, one pertaining to 1993 and the other to 1994, that were identically worded with the exception of the specific tax amounts peculiar to each. After listing credit adjustments for each year, both letters listed "the amount you now owe" as "none."

In April 1999, the case went to trial, and the Reynolds asserted that the IRS correspondence was tantamount to a binding admission by the government that estopped it from litigating the present case. The Tax Court rejected this argument as contrary to well-established law. The court went on to consider various testimony and exhibits, issuing a decision in part for the Reynolds and in part for the IRS. The restated liability was $2,422 and $1,937 for the 1993 and 1994 tax years, respectively, together with corresponding accuracy-related penalties of $484.40 and $387.40, respectively. Although the amount in controversy in the case is relatively small, the Reynolds assert that this appeal is being brought "to purge the taint on [Charles Reynolds'] reputation arising from the negligence penalty assessed against him." We agree that money is not the measure of all things worth fighting for, and the issues raised here are, for the most part, serious.


Pursuant to 28 U.S.C. § 2072, decisions of U.S. Tax Court are reviewable by this court. See 28 U.S.C. § 2072. The Reynolds present four issues for review: (1) Did the Tax Court err when it refused to consider the written notices sent to the Reynolds in relation to their 1993 and 1994 tax liability? (2) Did the Tax Court err in classifying Charles Reynolds' legal defense expenditures as § 67(a) itemized personal deductions rather than as § 162(a) business expenses? (3) Did the Tax Court err in ruling that the Reynolds had failed to adequately substantiate their automobile and travel-related expenses on Schedule C (law practice), Schedule E (rental properties) and Schedule F (farming business), as required by § 274(d)? (4) Did the Tax Court err in sustaining a § 6662(a) accuracy penalty against the Reynolds for negligent underpayments of their 1993 and 1994 taxes?

Before considering each issue in turn, we note that a decision of the Tax Court is subject to the same standards of review "that we apply to district court determinations in a civil bench trial: We review factual determinations, as well as applications of legal principles to those factual determinations, only for clear error." Cline v. Commissioner, 34 F.3d 480, 484 (7th Cir. 1994); accord Toushin v. Commissioner, 223 F.3d 642, 645-46 (7th Cir. 2000); Fruit of the Loom, Inc. v. Commissioner, 72 F.3d 1338, 1343 (7th Cir. 1996). However, deficiencies determined by the ...

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