T.C. Memo. 2013-239
UNITED STATES TAX COURT
PATRICK SCHLIEVERT AND SHIRLEY M. SCHLIEVERT, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 16113-12. Filed October 22, 2013.
Patrick Schlievert and Shirley M. Schlievert, pro se.
Stephen A. Haller, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
KROUPA, Judge: Respondent determined an $11,3021 deficiency in
petitioners’ Federal income tax for 2010. Respondent also determined that
1
All dollar amounts are rounded to the nearest whole number.
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[*2] petitioners were liable for the accuracy-related penalty under section 6662(a)2
for 2010.
We are asked to decide whether petitioners, a university professor and a
homemaker, engaged in their record label activity for profit under section 183
during 2010. We hold that they did not engage in their record label activity with a
bona fide profit objective and are therefore not entitled to deduct losses from the
activity. We are also asked to decide whether petitioners are liable for the
accuracy-related penalty under section 6662(a) for 2010. We hold that they are.
FINDINGS OF FACT
The parties have stipulated some facts. We incorporate the stipulation of
facts and the accompanying exhibits by this reference. Petitioners resided in Iowa
when they filed the petition.
I. Petitioners
Dr. Schlievert is a professor and the head of the Microbiology Department
at the University of Iowa, Carver College of Medicine (University). Before
becoming a professor, Dr. Schlievert worked as a geologist and pursued a Master’s
Degree in Science Education. Dr. Schlievert earned a $218,034 salary during
2
All section references are to the Internal Revenue Code (Code) in effect for
2010, and all Rule references are to the Tax Court Rules of Practice and
Procedure, unless otherwise indicated.
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[*3] 2010 from the University. Mrs. Schlievert is a homemaker. Together
petitioners have a net worth of $1.8 million.
Dr. Schlievert created and co-founded two biotechnology companies. These
companies develop drugs to prevent and treat infectious diseases. One company is
organized as an LLC while the other is incorporated. Each company employs an
attorney, at least one Ph.D. scientist and a CEO. The companies are built on Dr.
Schlievert’s expertise in immunology and infectious diseases. The companies
have a business plan and a timeline toward profitability but are not yet profitable.
Before 2010, petitioners had no experience with the music industry or
record labels.
II. Sara Schlievert and the Band
Sara Schlievert, petitioners’ only child, attended the University of Southern
California to study and major in Music Industry. Sara interned at Atlantic Records
as an acquisitions and repertoire specialist.3 While interning, Sara discovered the
rock band The Gallery (band). The band, originally from Massachusetts, moved to
California in hopes of making it big. The band was unable to sign with Atlantic
Records. Sara subsequently began managing the band sometime in 2009. A year
3
An acquisitions and repertoire specialist’s principal duties are to find and
recruit musical talent for a record company.
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[*4] later, Sara pitched the idea of producing the band’s record to petitioners.
Petitioners agreed.
Petitioners entered into an oral agreement (agreement) with the band to fund
the band’s expenses. The agreement provided that petitioners would be repaid for
all expenses from any money the band received from a future record label advance
or 50% of the money from record sales. Petitioners would also receive 10% of the
amount over $200,000 that the band earned. The agreement also required that
Sara continue to serve as the band’s manager for a 15% fee.
III. SURF
Petitioners named their record label activity “Schlievert’s Ultimate Record
Facility” or “SURF” because Dr. Schlievert enjoys surfing. Petitioners have not
registered SURF as a trademark nor advertised as SURF. Additionally, petitioners
have not incorporated SURF nor organized SURF as an LLC. Petitioners’ record
label activity has never had a bank account or any employees. Nor has petitioners’
record label activity invested in or sought out other bands. Petitioners have,
however, read a book to inform themselves how the music business operates.4
4
Petitioners testified to reading All You Need to Know About the Music
Business by Donald S. Passman.
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[*5] Petitioners also discussed their record label activity with University of
California professors.
IV. Record Label Activity
The agreement provided for Sara’s fronting the band’s expenses from her
personal checking account or with her personal credit card. Petitioners would then
reimburse Sara. Petitioners paid funds neither directly to the band nor for the band
via a separate bank account. At trial, petitioners presented a list of itemized
expenses but showed no receipts or invoices. Petitioners’ record label activity
sustained losses of $44,445 in 2010, $11,681 in 2011, and $1,000-$2,000 in 2012.
The band released an album in 2010, an extended play CD. Warren Huart
produced the CD, and the band copyrighted its content. Inside the jacket cover the
band gives “thanks” to petitioners, along with 32 other people. Petitioners did,
however, retain the master recordings.
Since 2010, petitioners have invested less and less in the band and likewise
in their record label activity. Petitioners have not pursued other talent or any other
related activity aside from investing money in the band. In 2013, petitioners
refrained entirely from investing in the band or their record label activity.
Petitioners presented no evidence of gross receipts or sales of any kind except with
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[*6] respect to the first quarter of 2013.5 Petitioners concede that they are waiting
to make any further investments until they can deduct expenses relating to their
record label activity. The band, on the other hand, has continued to tour and to
produce music.
V. Income Tax Returns
Petitioners filed a Form 1040 for 2010 and reported a $44,445 net loss on
the attached Schedule C. The Schedule C described petitioners’ business as
“Record Label (Recording Industry).” Petitioners claimed $4,850 of advertising
expenses, $617 of commissions and fees, $24,825 of legal and professional
services, $2,633 of supplies and $11,790 of travel expenses. Petitioners reported
no gross receipts or sales on the Schedule C and likewise reported no gross
income.
Petitioners reported a $11,681 net loss on the Schedule C for the following
year. The Schedule C for 2011 described petitioners’ business as “Music
Industry.”
Respondent disallowed the Schedule C losses for 2010, determined a
deficiency for that year and determined that petitioners were liable for an
accuracy-related penalty. Petitioners timely filed a petition.
5
Petitioners had a $2,000 net profit for the first quarter of 2013.
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[*7] OPINION
We must decide whether petitioners engaged in their record label activity
for profit under section 183 during 2010. Respondent asserts that petitioners’
record label activity was nothing more than a means to support and help Sara,
petitioners’ daughter, break into the music industry. Petitioners, on the other
hand, contend their record label activity was conducted with a bona fide profit
objective. We are also asked to decide whether petitioners are liable for the
accuracy-related penalty. We address each of these issues in turn.
I. Expense Deductions
We first address the burden of proof. Generally, the Commissioner’s
deficiency determination is presumed correct, and the taxpayer bears the burden of
proving the determination is improper. See Rule 142(a)(1); Welch v. Helvering,
290 U.S. 111, 115 (1933); Evans v. Commissioner, 908 F.2d 369 (8th Cir. 1990),
rev’g T.C. Memo. 1988-468.
An appeal in this case would lie to the U.S. Court of Appeals for the Eighth
Circuit (Eighth Circuit) absent a stipulation to the contrary. Where the Court of
Appeals to which appeal lies has decided an issue that is squarely in point, we will
follow the decision of that court. Golsen v. Commissioner, 54 T.C. 742, 757
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[*8] (1970), aff’d, 445 F.2d 985 (10th Cir. 1971). The Eighth Circuit requires that
a taxpayer have a bona fide objective of realizing profit from an activity to deduct
expenses relating to that activity. Evans v. Commissioner, 908 F.2d at 373; see
also Taube v. Commissioner, 88 T.C. 464 (1987). Accordingly, petitioners must
prove they engaged in their record label activity with a bona fide profit objective
to be entitled to deduct expenses relating to their record label activity. See Evans
v. Commissioner, 908 F.2d at 373.
We now turn to whether petitioners may deduct expenses related to their
record label activity. Deductions are allowed for all ordinary and necessary
expenses paid or incurred during the tax year in carrying on a trade or business or
for the production of income. Secs. 162(a), 212(1). We look to section 183 in
conjunction with section 162 to determine whether an activity is engaged in for
profit. This Court considers whether an activity is engaged in for profit on a case-
by-case basis, taking into account the facts and circumstances involved. See
Golanty v. Commissioner, 72 T.C. 411, 426 (1979), aff’d without published
opinion, 647 F.2d 170 (9th Cir. 1981). We structure our analysis of whether an
activity is engaged in for profit around nine nonexclusive factors. Sec. 1.183-2(b),
Income Tax Regs.
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[*9] The nine factors are: (1) the manner in which the taxpayer carried on the
activity, (2) the expertise of the taxpayer or his or her advisers, (3) the time and
effort the taxpayer expended in carrying on the activity, (4) the expectation that
the assets used in the activity may appreciate in value, (5) the taxpayer’s success in
carrying on other similar or dissimilar activities, (6) the taxpayer’s history of
income or loss with respect to the activity, (7) the amount of occasional profits, if
any, which are earned, (8) the taxpayer’s financial status and (9) whether elements
of personal pleasure or recreation are involved. Id.
No single factor or set of factors is determinative, nor is the existence of a
majority of factors favoring or disfavoring a profit objective controlling. Verrett
v. Commissioner, T.C. Memo. 2012-223; see Evans v. Commissioner, 908 F.2d at
373; sec. 1.183-2(b), Income Tax Regs. Certain factors may be given more weight
than others because they are more relevant to the facts. See Vitale v.
Commissioner, T.C. Memo. 1999-131, aff’d without published opinion, 217 F.3d
843 (4th Cir. 2000). Not all factors may apply in any case. See Green v.
Commissioner, T.C. Memo. 1989-436; see also Akelis v. Commissioner, T.C.
Memo. 1989-182. Greater weight is given to objective facts over the taxpayer’s
subjective intent. See Engdahl v. Commissioner, 72 T.C. 659, 666 (1979); sec.
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[*10] 1.183-2(a) and (b), Income Tax Regs. We focus now on each of the nine
factors, in turn.
1. Manner in Which the Taxpayer Conducts the Activity
We begin by considering whether petitioners carried on their record label
activity in a businesslike manner. See sec. 1.183.-2(b)(1), Income Tax Regs. We
consider whether the taxpayer conducted the activity in a manner substantially
similar to other activities of the same nature that were profitable and whether the
taxpayer kept accurate books and records. Engdahl v. Commissioner, 72 T.C. at
666-667; Johnson v. Commissioner, T.C. Memo. 2012-231; Wilmot v.
Commissioner, T.C. Memo. 2011-293; Smith v. Commissioner, T.C. Memo. 2007-
368, aff’d, 364 Fed. Appx. 317 (9th Cir. 2009); sec. 1.183-2(b)(1), Income Tax
Regs.
Petitioners contend that they carried on their record label activity in a
businesslike manner by advertising, educating themselves and relying on experts
in the music industry. Respondent contends that petitioners did not operate their
record label activity like a business.
The trial record does not reflect that petitioners ran their record label
activity like a business. Specifically, the trial record does not reflect that
petitioners formed an entity (as they were advised to do) or prepared a business
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[*11] plan, a profit or loss statement, a balance sheet or a financial break-even
analysis for their record label activity. While a sophisticated business plan is not
necessary, a taxpayer should keep records that enable the taxpayer to make
informed business decisions. Burger v. Commissioner, 809 F.2d 355, 359 (7th
Cir. 1987), aff’g T.C. Memo. 1985-523; Dodge v. Commissioner, T.C. Memo.
1998-89, aff’d without published opinion, 188 F.3d 507 (6th Cir. 1999).
Theoretically, a business plan and records are used to develop a profitable
business. Failure to maintain adequate records, however, indicates a lack of
necessary profit intent. Montagne v. Commissioner, 166 Fed. Appx. 265 (8th Cir.
2006), aff’g T.C. Memo. 2004-252; Zidar v. Commissioner, T.C. Memo. 2001-
200.
Further, Sara paid all of the band’s expenses through her personal checking
account or her personal credit card. Petitioners would then reimburse Sara.
Petitioners provided a list of itemized expenses but provided no evidence of Sara’s
giving petitioners receipts or invoices of the band’s expenses. Such commingling
of funds indicates that an activity is more closely related to a hobby than a
business. See Bush v. Commissioner, T.C. Memo. 2002-33, aff’d, 51 Fed. Appx.
422 (4th Cir. 2002); Lundquist v. Commissioner, T.C. Memo. 1999-83, aff’d
without published opinion, 211 F.3d 600 (11th Cir. 2000).
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[*12] Nor did petitioners pursue and produce music in a businesslike manner.
Petitioners represent only one band and have made no effort to develop or find
other talent. Petitioners have no Internet presence for their music activity, no
active presence in the recording or producing industry and have not sought
methods to increase their exposure to the industry. Unlike others in the music
industry, petitioners do not represent any other bands, nor do they have any
employees. Due to the risky nature of the music industry, it is imprudent to work
with only one band.
Petitioners never advertised as a record label. Petitioners’ activity is not
even recognized as a record label on the only album they purportedly produced.
Save for petitioners’ being “thanked” on the CD jacket along with 32 other people,
nowhere on the band’s record is the label SURF or anything indicating petitioners’
professional relationship with the band. Rather, the copyright on the CD belongs
to the band, and the production credits go to Warren Huart.
We are not questioning whether the band members are bona fide musicians.
We are, however, questioning whether petitioners’ relationship to the band was
carried on in a businesslike manner. Because petitioners do not invest in any other
band, their record label activity is inextricably tied to the band’s activity. Here,
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[*13] petitioners are conflating their record label activity with the legitimacy of
the band.
We hold that petitioners did not conduct their record label activity in a
businesslike manner.
This factor favors respondent.
2. The Expertise of the Taxpayer or His or Her Advisers
We now turn to the second factor, the expertise of petitioners and their
advisers. Extensive study of accepted business principles or consultation with
experts in the given field may demonstrate a profit motive. Sec. 1.183-2(b)(2),
Income Tax Regs. Additionally, a taxpayer should undertake a bona fide
investigation of factors that would affect the activity’s profitability. Burger v.
Commissioner, 809 F.2d at 359; Golanty v. Commissioner, 72 T.C. at 432;
Mitchell v. Commissioner, T.C. Memo. 2001-269; Underwood v. Commissioner,
T.C. Memo. 1989-625.
Petitioners argue that they took steps to educate themselves and consulted
experts about the music industry. Petitioners talked to University of California
professors, read a book and relied heavily on their daughter because they
themselves have no experience or background in the music industry.
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[*14] Petitioners testified to having consulted University of California professors
who told them that it is common practice to have an oral contract with a band.
The trial record does not reflect, however, the nature of the professors’ expertise.
Nor does the trial record provide a basis for us to believe that the professors
petitioners consulted at the University of California were experts in the music
industry. Further, investing large sums of money, as petitioners here did, over an
extended period and without a written contract is poor business practice, even if
done pursuant to advice. Petitioners were also encouraged to form an LLC for
liability purposes, yet they appear to have ignored that advice.
Petitioners also read a book about the music business. We are not
convinced, however, that petitioners heeded the advice in the book they read.
Moreover, one book does not an expert make.
Finally, petitioners contend they relied on Sara’s expertise. Sara majored in
Music Industry, interned in the industry and managed the band for a year before
petitioners began funding the band. We do not question Sara’s enthusiasm for the
music industry. We do, however, question her expertise. Sara had no experience
managing any other band. And a degree coupled with an internship in any field
falls short of qualifying anyone as an expert. We give little weight to petitioners’
reliance on Sara as an expert.
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[*15] The trial record does not show that petitioners sought reliable advice on
how to operate a record label.
This factor favors respondent.
3. The Taxpayer’s Time and Effort
The amount of time and effort petitioners expended in carrying on the
activity is the third factor. See sec 1.183-2(b)(3), Income Tax Regs. A taxpayer
who dedicates a substantial amount of personal time and effort to the activity may
have a profit objective, especially where the activity does not involve substantial
personal or recreational aspects. Giles v. Commissioner, T.C. Memo. 2005-28. If,
however, a taxpayer spends little time and effort on the activity but hires a
competent and qualified person to carry on the activity, a profit motive may still be
indicated. Burrus v. Commissioner, T.C. Memo. 2003-285.
Dr. Schlievert purportedly devoted a substantial amount of time and effort
to their record label activity. The objective facts, however, contradict his
assertion. Dr. Schlievert is a full-time professor, the head of the Microbiology
Department at the University and a co-founder of two other companies in that
field. Mrs. Schlievert did not testify to contributing any amount of time to their
record label activity. Although a taxpayer may engage in more than one trade or
business at any one time, it is unlikely petitioners were able to devote a substantial
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[*16] amount of time and effort to their record label activity. See Gestrich v.
Commissioner, 74 T.C. 525, 529 (1980), aff’d without published opinion, 681
F.2d 805 (3d Cir. 1982); Storey v. Commissioner, T.C. Memo. 2013-59; Vitale v.
Commissioner, T.C. Memo. 1999-131.
Petitioners emphasize that they financed Warren Huart, a prominent record
producer, to produce the band’s CD. Mr. Huart, however, was not an employee of
petitioners’ record label activity. Here, again, petitioners are conflating the
activities of the band (paying someone to produce the band’s record) with the
activity of providing funds to the band. Petitioners admit that their record label
activity had no employees.
Petitioners failed to hire a qualified and competent person to carry on their
record label activity. Thus, this factor favors respondent because petitioners did
not have any employees and did not spend a substantial amount of time on the
activity.
4. Expectation That Property Will Appreciate in Value
Next, we turn to whether there is an expectation that the assets used in the
activity will increase in value. A taxpayer may intend to reap a profit not only
from the operation of an activity but also from the appreciation of assets used in
the activity. Sec. 1.183-2(b)(4), Income Tax Regs. The test is whether there was a
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[*17] bona fide expectation that the assets used in the activity would increase in
value. Engdahl v. Commissioner, 72 T.C. at 669. Although an appreciation
expectation may indicate a profit objective, expectation alone is not sufficient to
demonstrate the activity was engaged in for profit. Sanders v. Commissioner, T.C.
Memo. 1999-208; Lujan v. Commissioner, T.C. Memo. 1992-417; Beltran v.
Commissioner, T.C. Memo. 1982-153.
Petitioners own the master recording of the songs used to produce the
band’s CD. If the band were to be successful, petitioners might expect the master
recording to increase in value. Nowhere in the trial record, however, is the value
of the master recording, much less the amount petitioners expect the recording to
be worth in the future. The recording may, in fact, greatly appreciate. The chance
of great appreciation, however, is low.
This factor is neutral.
5. Taxpayer’s Success in Other Similar or Dissimilar Activities
We now look to petitioners’ success in other activities. Finding that a
taxpayer has successfully engaged in making other activities profitable may show
that the taxpayer has a profit objective even though the current activity is
unprofitable. Sec. 1.183-2(b)(5), Income Tax Regs. Petitioners argue that their
background and experience co-founding two biotechnology companies lends
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[*18] credence to qualifying their record label activity as a trade or business.
Respondent argues that petitioners’ lack of experience or success in the music
industry is in line with a lack of profit motive. We agree with respondent.
Dr. Schlievert established two biotechnology companies. The
biotechnology companies have a timeline toward profitability and are built on Dr.
Schlievert’s expertise in immunology and infectious diseases. Neither company
is, however, profitable. Petitioners’ record label activity, on the other hand, has no
employees, no apparent business plan and no timeline toward profitability.
Furthermore, Dr. Schlievert’s only connection to the music industry is through his
daughter.
The manner in which the biotechnology companies are run is vastly
different from that of petitioners’ record label activity. For example, each
biotechnology company employs professionals and has a business plan. Their
record label activity, in contrast, had neither employees nor a business plan. The
manner in which petitioners carried on their record label activity makes it less
likely that they entered into their record label activity with a bona fide profit
motive.
This factor favors respondent.
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[*19] 6. Taxpayer’s History of Income or Loss and Amount of Profits
We next examine the sixth and seventh factors, petitioners’ history of
income or losses and any amount of profits, in tandem. Sec. 1.183-2(b)(6) and (7),
Income Tax Regs. Losses during the startup stage of an activity may or may not
signal that the activity is engaged in for profit. Sec. 1.183-2(b)(6), Income Tax
Regs. Substantial losses may, however, indicate that the taxpayer did not conduct
the activity for profit. Golanty v. Commissioner,72 T.C. at 427; sec. 1.183-
2(b)(6), Income Tax Regs. We also consider the amount of occasional profits, if
any, from the activity. Sec. 1.183-2(b)(7), Income Tax Regs. Absent actual
profits, a showing of potentially substantial returns could indicate a profit motive.
See Giles v. Commissioner, T.C. Memo. 2005-28; Dawson v. Commissioner, T.C.
Memo. 1996-417.
Petitioners had no gross receipts or sales in 2010. Accordingly, petitioners
reported no income from their record label activity for 2010. For the two years
after 2010, petitioners claimed losses. The only income petitioners report is
$2,000 for the first quarter of 2013. Since 2010, petitioners have spent
substantially less on the band each year and have not spent anything on the band in
2013.
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[*20] Our examination of the agreement indicates that, theoretically, petitioners
should have received 50% of the band’s income from sales beginning in 2010.
The trial record shows the band released its CD and was selling tickets to shows
during 2010. Petitioners did not receive any proceeds until three years later,
however. Although the band’s profits were minimal, if the agreement had been
respected, petitioners would have received a portion of the band’s sales income. It
therefore appears as though profit was not petitioners’ primary motive because
they failed to collect revenue in 2010.
Petitioners concede that they are refraining from any further investing until
they are able to deduct expenses related to their record label activity. This
concession is particularly detrimental to petitioners’ argument because profit must
be the primary objective for expenses to be deductible and profit means economic
profit, independent of tax savings. See Surloff v. Commissioner, 81 T.C. 210, 233
(1983); Shapiro v. Commissioner, 40 T.C. 34 (1963).
Petitioners have discontinued investing in the band even though the band
has continued to tour and produce music. We are unpersuaded by petitioners’
reliance on the band’s activities to legitimize their own attempt to deduct expenses
relating to their record label activity.
These factors favor respondent.
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[*21] 7. Financial Status of the Taxpayer
We now look to petitioners’ financial status. Substantial income from
sources other than the activity may indicate that the activity is not engaged in for
profit. This is especially true where there are personal or recreational elements
involved. Sec. 1.183-2(b)(8), Income Tax Regs. Substantial income from other
sources may indicate the activity is not engaged in for profit, as losses from the
activity would generate substantial tax benefits. Id.; see Dirkse v. Commissioner,
T.C. Memo. 2000-356; Kahla v. Commissioner, T.C. Memo. 2000-127, aff’d, 273
F.3d 1096 (5th Cir. 2001).
Respondent argues that petitioners’ substantial wealth and income enabled
them to fund their daughter’s band promotion without affecting their living
standards. Petitioners nevertheless argue that, as a matter of public policy, this
Court should recognize the legitimacy of their record label activity to encourage
economic development. Petitioners’ counterargument that we should encourage
entrepreneurship is both creative and lacking in merit.
Dr. Schlievert has earned a substantial income as a successful
microbiologist and academic. And with a net worth of at least $1.8 million,
petitioners had sufficient wealth and income to fund the band while
simultaneously assisting their daughter to pursue her chosen career. Furthermore,
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[*22] the lack of profitability also benefited petitioners because they would have
paid more tax but for the deduction of the expenses.
This factor favors respondent.
8. Elements of Personal Pleasure
Finally, we weigh elements of personal pleasure in carrying on the activity.
Personal or recreational motives in conducting an activity may indicate a lack of
profit objective. Sec. 1.183-2(b)(9), Income Tax Regs. Respondent argues that
petitioners derived personal pleasure in watching their daughter succeed in her
field of choice. Petitioners argue that their record label activity is not a hobby and
that they derived no recreational benefit from carrying on their record label
activity.
This case is not significantly different from any other case where this Court
has denied a parent’s attempt to deduct investments in his or her child’s career.
See Bernardo v. Commissioner, T.C. Memo. 2004-199 (taxpayer lacked requisite
profit motive for deducting expenditures she made to further daughter’s singing
career); Bush v. Commissioner, T.C. Memo. 2002-33 (taxpayer did not engage in
managing his daughter’s ballet career with a profit motive); McCarthy v.
Commissioner, T.C. Memo. 2000-135 (taxpayer did not engage in managing his
son’s motocross racing with intent to make a profit); DeMattia v. Commissioner,
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[*23] T.C. Memo. 1998-87 (taxpayer’s golf sponsorship agreement with his son
was not entered into with an honest objective of making a profit); Nova v.
Commissioner, T.C. Memo. 1993-563 (same).
Petitioners had no connection to the music industry or the band until Sara
facilitated the agreement between the two parties. Petitioners entered into the
agreement with the band at an important time in Sara’s life. Sara was not yet
employed full time, and petitioners were still supporting her by paying her living
expenses. By requiring the band to keep Sara on as their manager for a 15% fee,
petitioners sought to provide Sara with valuable experience as well as an income.
Sara is now fully employed and is progressing in her career. Instead of finding
new bands and expanding their opportunities, petitioners have discontinued
investing in their record label activity. Supporting Sara, though laudable, is not
deductible.
After considering all the factors as applied to the unique facts and
circumstances of this case and all other facts we consider relevant, we conclude
that petitioners did not engage in their record label activity for profit within the
meaning of section 183. Therefore, petitioners are not entitled to deduct expenses
in excess of gross income from the activity.
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[*24] II. Accuracy-Related Penalty
We now focus on whether petitioners are liable for an accuracy-related
penalty under section 6662(a) for 2010. A taxpayer is liable for an accuracy-
related penalty on any part of an underpayment attributable to either a substantial
understatement of income tax or negligence or disregard of rules or regulations.
Sec. 6662(b)(1) and (2). A “substantial understatement” includes an
understatement of income tax that exceeds the greater of 10% of the tax required
to be shown on the return or $5,000. Sec. 6662(a), (b)(2), (d)(1)(A); sec. 1.6662-
4(a), Income Tax Regs. “Negligence” includes any failure to make a reasonable
attempt to comply with the Code or to exercise ordinary and reasonable care in
preparing a tax return. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs. A
taxpayer fails to make a reasonable attempt to ascertain the correctness of a
deduction on a return that would seem to a reasonable and prudent person to be
“too good to be true” under the circumstances. Sec. 1.6662-3(b)(1)(ii), Income
Tax Regs.
The Commissioner has the burden of production and must come forward
with sufficient evidence showing that it is appropriate to impose a penalty. Sec.
7491(c); see Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001). The
taxpayer bears the burden of proof as to any defense to the accuracy-related
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[*25] penalty, such as reasonable cause. Sec. 7491(c); Rule 142(a); Higbee v.
Commissioner, 116 T.C. at 446.
Respondent has met his burden of production with respect to petitioners’
substantial understatement of income tax. See sec. 6662(b)(2). The record
indicates that petitioners reported income tax of $31,778 for 2010. As explained
above, petitioners understated their income tax liability for 2010 by $11,302. The
tax required to be shown on the return, for purposes of determining whether there
was a substantial understatement of income tax here, is the sum of these two
amounts, $43,080. Ten percent of the tax required to be shown on the return is
$4,308. The understatement of $11,302 is greater than $5,000, which is greater
than 10% of the tax required to be shown on the return. Respondent therefore met
his burden of production.
Petitioners do not address the penalty issue in their brief. Nor did
petitioners present evidence that they had reasonable cause for any portion of any
underpayment. We therefore find that petitioners are liable for the penalty.
We have considered all remaining arguments the parties made and, to the
extent not addressed, we find them to be irrelevant, moot or meritless.
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[*26] To reflect the foregoing,
Decision will be entered
for respondent.