Lemons v. Commissioner

T.C. Memo. 1997-404

UNITED STATES TAX COURT

WOODY F. LEMONS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

PAULA S. LEMONS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 16562-90, 16799-90. Filed September 11, 1997.

John D. Copeland and S. Cameron Graber, for

petitioners.

Henry C. Griego, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WHALEN, Judge: Respondent determined deficiencies in,

and additions to, the Federal income tax of each petitioner

as follows:
 - 2 -

Woody F. Lemons, Docket No. 16562-90
Additions to Tax
Sec. Sec. Sec.
Year Deficiency 6653(a)(1) 6661(a) 6651
1
1986 $230,650 $11,533 $57,663 --
1
1987 19,071 954 4,768 --
1988 7,138 357 1,785 --

Paula S. Lemons, Docket No. 16799-90
Additions to Tax
Sec. Sec. Sec.
Year Deficiency 6653(a)(1) 6661(a) 6651
1
1986 $195,644 $9,782 $48,911 --
1
1987 16,284 814 4,071 --
1988 14,139 1,246 3,535 $995

1
Plus 50 percent of the interest due with respect to
the portion of the underpayment attributable to negligence.

All section references are to the Internal Revenue Code as

in effect during the years in issue.

After concessions, the issues for decision are:

(1) Whether petitioners are entitled to an ordinary loss or

to a capital loss due to the fact that eight memberships in

the Moonlight Beach Club, Inc., owned by Mr. Lemons became

worthless in 1986; (2) whether petitioners are entitled to

deduct, as an ordinary and necessary business expense under

section 162(a), the annual dues which Mr. Lemons allegedly

paid in 1986 to the Moonlight Beach Club, Inc., by reason

of his ownership of the eight club memberships; (3) whether

petitioners' deductions of losses from various partnerships

in 1987 and 1988 should be disallowed; (4) whether
 - 3 -

petitioners are entitled to deduct in 1986 their basis in

the stock of Windsor Resources, Inc., on the ground that

the stock became worthless during the year; and (5) whether

the self-employment tax reported by Mr. Lemons should be

adjusted, as determined by respondent in the notice of

deficiency, and whether the self-employment tax reported by

Mrs. Lemons should be adjusted, even though no adjustment

was made in the notice of deficiency.

FINDINGS OF FACT

The parties have stipulated some of the facts.

The stipulation of facts filed by the parties and the

accompanying exhibits are incorporated herein by this

reference.

Petitioners are married individuals who filed

separate returns for each of the years in issue.

Respondent issued a separate notice of deficiency to

each petitioner and each filed a petition for

redetermination of the deficiency in this Court. At the

time they filed their petitions, both petitioners resided

in the State of Texas. The two cases were consolidated

pursuant to Rule 141. All Rule references are to the Tax

Court Rules of Practice and Procedure. Throughout this

opinion, all references to petitioner are to Mr. Woody F.

Lemons.
 - 4 -

Petitioner received a degree in finance and banking

from Texas Tech University in 1969. After graduation,

petitioner was employed until 1972 by Shell Oil as a

financial analyst. He then became employed by Vernon

Savings & Loan (Vernon). In 1981, he became Vernon's

president and chairman of its board. Petitioner left

Vernon's employ in April 1986. For general background

regarding petitioner and others involved in these cases,

see Federal Sav. & Loan Ins. Corp. v. Dixon, 835 F.2d

554 (5th Cir. 1987); Little v. Commissioner, T.C. Memo.

1996-270.

Moonlight Beach Club Issue

During 1981, Mr. Don R. Dixon, a real estate

developer in Dallas, Texas, bought a controlling interest

in Vernon's stock. Several months later, he transferred

the stock to a wholly owned company, Dondi Financial, Inc.,

that was formed for the purpose of holding the stock.

After acquiring Vernon, Mr. Dixon caused all of his

controlled corporations engaged in the real estate

development business to be merged into or acquired by

Vernon. He then formed Dondi Associates, Inc. (Dondi

Associates), a Texas corporation, that was owned by members

of his family for the purpose of engaging in real estate

development.
 - 5 -

At some time during the early 1980's, Mr. Dixon

learned of beachfront property located in Encinitas,

California, a town north of San Diego. The property

consisted of two contiguous parcels of land (the Moonlight

Beach Property). An old beach house, servants' quarters,

and a detached garage stood on one parcel. The other

parcel, consisting of approximately 17,000 square feet, was

vacant. Mr. Dixon believed that he could develop the

property by constructing a complex of six villas and other

amenities on the vacant parcel, and by remodeling the beach

house into a luxury duplex.

Initially, Mr. Dixon envisioned selling the six

villas in so-called time-share units. However, based on

discussions with lawyers and accountants who did not

believe that the project could qualify under California

laws regulating the sale of time-share units, Mr. Dixon

decided to change the structure of the project and to use

a "membership approach", under which a limited partnership

or nonprofit corporation would purchase the six villas and

would sell club memberships to the public. This structure

was similar to the time-share approach in that each club

membership would entitle its holder to use the club's

facilities for a certain number of days per year. An

integral part of the project was that the entire cost of

acquiring and developing both parcels of property would be
 - 6 -

financed by the sale of the six villas to be constructed on

the vacant parcel. After the development and sale of the

six villas, the developers would own the luxury duplex and

the land making up the first parcel free and clear.

As one of the first steps in acquiring and developing

the subject property, Mr. Dixon agreed with the owner of a

California construction company, Mr. Walter J. van Boxtel,

to form a partnership, the Moonlight Beach Venture (here-

inafter referred to as the joint venture). On October 21,

1982, Dondi Properties, Inc. (Dondi Properties), a Texas

corporation organized by Mr. Dixon, and Value Plus

Industries, Inc. (Value Plus), Mr. van Boxtel's construc-

tion company, executed the Moonlight Beach Joint Venture

Agreement (joint venture agreement). Dondi Properties took

an 80-percent interest in the joint venture, and Value Plus

took a 20-percent interest. The joint venture agreement

states that Mr. van Boxtel and his wife had entered into

a contract dated August 10, 1982, to purchase certain

property described as "Lots 4, 5, 6, 11, 12 and 13

(including a closed street and alley) in Encinitas Pitchers

Subdivision of the City of Encinitas, California." The

joint venture agreement describes the purposes of the

venture in the following terms:

(i) acquiring the Property [Moonlight Beach
Property] pursuant to the terms of the Purchase
 - 7 -

Contract,(ii) if the Venturers elect to do so,
acquiring Lot 3 out of the referenced subdivision
upon terms and conditions approved by the
Venturer * * * (iii) renovating the Existing
Improvements (defined in Section 3.06) and
developing and improving the Property with the
Additional Improvements (also defined in Section
3.06) (the said renovation, development and
improvements being called the "Project") and (iv)
selling the Additional Improvements in
the ordinary course of the Venture's business.

The joint venture agreement delegated the management

of the venture to Dondi Properties as manager and sales

manager, and it appointed Value Plus to be development

manager. The joint venture agreement addressed the scope

of each partner's authority as follows:

Except as otherwise expressly and specifically
provided in this Agreement, none of the Venturers
shall have any authority to act for, or to assume
any obligations or responsibility on behalf of,
any other Venturer or the Venture.

On February 24, 1983, the joint venture agreement was

amended (First Amended Agreement), by substituting Dondi

Associates for Dondi Properties as a joint venturer. On

April 14, 1984, the joint venture agreement was again

amended (Second Amended Agreement) to permit petitioner

to become a joint venturer. The Second Amended Agreement

recites that Dondi Associates had sold, assigned, and

transferred a 40-percent undivided interest in the capital

and equity of the joint venture to petitioner. After this
 - 8 -

transaction, the respective interests of the three partners

in the "capital and assets" of the joint venture were as

follows: Dondi Associates--40 percent, Value Plus--20

percent, and petitioner--40 percent.

Attached to the joint venture's 1985 tax return

are copies of the Schedules K-1, Partner's Share of Income,

Credits, Deductions, etc., issued to each partner.

According to the Schedules K-1, each partner's share of the

profits, losses, and capital of the joint venture as of the

end of 1985 was as follows:

Profit Loss Ownership
Partner Sharing Sharing of Capital

Dondi Associates 50% 50% 40%
Petitioner 50 50 40
Value Plus -- -- 20

The Second Amended Agreement also reformulated the

"management fee" to be paid to Value Plus. That provision

is as follows:

Section 3.09 Management Fees.

A. In consideration of the Development
Manager's services hereunder, the Venture
shall pay to Value Plus as Development Manager
a collective development, management and sales
fee (the "Management Fee") equal to some of the
following elements:

(1) Fifteen percent (15%) of the
approved "hard costs" of remodeling,
refurbishing and preparing for sale the
Existing Improvements (as defined in
 - 9 -

the Joint Venture Agreement) located
on the Subject Property including
specifically, the existing house and
servants' quarters, and;

(2) Five percent (5%) of the
approved "hard costs" of construction
of the Additional Improvements, as
defined in the Joint Venture, and;

(3) Twenty percent (20%) of the
"net profit" derived by the Venture
from the sale or other disposition of
the six units constituting the
Additional Improvements.

B. The remaining "net profit" from the
operation, sale, or other disposition of both
the Existing Improvements and the Additional
Improvements, shall be distributed equally to
Dondi and Lemons, pro rata, according to their
equity percentages in the Venture and no portions
thereof, except for those items specifically set
forth in Section 3.09, A, immediately above,
shall inure to or be distributed to Value Plus.

C. Advances against the payments to be
received by Value Plus as Development Manager
pursuant to this Section 3.09 shall constitute
the entire compensation due Value Plus from the
Venture by reason of services rendered to the
Venture or by reason of the contribution to the
Venture of capital or by reason of Value Plus's
equity interest in the Venture. Upon full and
final payment to Value Plus of said Development
Manager's compensation as aforesaid, Value Plus
shall have no further right, title or interest
in and to the Subject Property, the Existing
Improvements or the Additional Improvements."

On June 1, 1984, the joint venture borrowed $4,700,000

from Anchor Savings of Shawnee Mission, Kansas (hereinafter

referred to as Anchor), for the purpose of acquiring and

developing the Moonlight Beach Property. Repayment of the
 - 10 -

loan was due in 18 months. According to the loan closing

statement, a reserve was established from the loan proceeds

for construction costs in the amount of $2,879,500. The

remaining proceeds of the loan, $1,820,500, were used to

purchase the property and to pay other costs. Petitioner

and Mr. Dixon both agreed to be personally liable for

repayment of the loan.

After the Moonlight Beach Property was acquired, Value

Plus, acting as the general contractor, commenced renova-

tion of the existing improvements and construction of

the six villas. The renovation and construction of the

improvements took approximately 1 year and was substan-

tially completed by the summer of 1985.

As mentioned above, Mr. Dixon initially contemplated

the formation of a Texas limited partnership which would

purchase the six villas and related land from the joint

venture and would sell 36 limited partnership interests

to the public. Each limited partnership interest would

entitle the holder to the use of a villa for 60 days per

year. That plan was described in a promotional booklet

that was prepared sometime before completion of the

construction phase of the project as follows:

Participating ownership in Moonlight Beach
Club will be offered in the form of a limited
partnership interest in a Texas limited part-
nership composed of 36 limited partners and
 - 11 -

three (managing) general partners. The general
partners will be Don R. Dixon, Woody F. Lemons,
and W.J. Van Boxtel to be called Moonlight Beach
Club, Ltd. The limited partnership will own six
oceanside villas and a 1/36 limited partnership
will provide each partner with full membership in
Moonlight Beach Club including 60 days residence
per year in one of the six villas. * * * Each
full partnership in Moonlight Beach Club provides
for 1/39 ownership in the land, all improvements,
furniture, furnishings and equipment. * * *
Annual dues will be set to cover all insurance,
staff services, equipment, automobile costs,
interior and exterior maintenance, housekeeping,
pantry and cellar stocking. These dues are
estimated to be approximately $4,000.00 for the
initial year, per full partner, under current
conditions.

The structure contemplated by the promotional booklet,

quoted above, was not used. Rather, Mr. Dixon and

petitioner formed a Texas nonprofit corporation, Moonlight

Beach Club, Inc. (hereinafter referred to as the club or

beach club), in lieu of the Texas limited partnership

mentioned in the promotional booklet. The club purchased

the six villas and related land from the joint venture

and sold club memberships to the public. Each membership

in the club entitled the holder to the exclusive use of one

of the six villas for a specified period of time per year.

The record of these cases contains the Restated

Articles of Incorporation of the club that were filed in

the Office of the Secretary of State of Texas on

September 6, 1985 (hereinafter referred to as Restated
 - 12 -

Articles). The record also contains the First Amended

Bylaws of the club, dated July 30, 1985 (hereinafter

referred to as First Amended Bylaws).

The First Amended Bylaws describes the purposes of the

club in the following terms:

Purposes. The primary purposes for which
Moonlight Beach Club, Inc. (the "Corporation")
has been formed are to acquire and own certain
real property (the "Land") consisting of
approximately 17,000 square feet of land at 130
Fifth Street in the City of Encinitas, County
of San Diego, State of California, and to own,
operate, and maintain a beach club thereon (the
"Club") exclusively for the benefit, pleasure and
recreation of its Members (defined below). The
Club consists of six (6) residential units (the
"Units" or, if only one, the "Unit") with each
Unit containing approximately 2,000 square feet
of living space, with a television, music system,
fireplace, and certain furniture, furnishings,
and other items included within each of the Units
(the "Interior Amenities"). The Club also con-
sists of, in addition to the Units and Interior
Amenities, certain other amenities (the "Exterior
Amenities"), including, but not limited to, a
swimming pool, security gate, and an automobile
for each Unit (the Land, Units, Interior
Amenities, and Exterior Amenities may sometimes
be collectively referred to herein as the "Club
Facilities").

According to the Restated Articles and the First

Amended Bylaws, there were to be three classes of member-

ship in the beach club: Classes A, B, and C. Each class A

membership entitled its holder to the exclusive use of one

of the villas for 60 days per year in consideration of the
 - 13 -

payment of a "membership fee" of $15,000 and an "initiation

fee" of $140,000. Each class B membership entitled its

holder to the exclusive use of one of the villas for 30

days per year in consideration of the payment of a

"membership fee" of $7,500 and an "initiation fee" of

$70,000. The club's Restated Articles and First Amended

Bylaws provide that class B members would be sold only in

pairs, and each pair of class B members would reduce the

number of class A memberships by one.

Each class C membership entitled its holder to the

exclusive use of one of the villas for 10 days per year

in consideration of the payment of a "membership fee" of

$2,500 but no "initiation fee". Class C memberships were

given to Mr. Dixon, petitioner, and Mr. Ralph Armstrong,

who are specifically named in the club's Restated Articles

and First Amended Bylaws as class C members. Mr. Armstrong

is a real estate broker in San Antonio whom Mr. Dixon and

petitioner retained to manage the marketing of the project.

The maximum number of days on which all six villas

could be used during the year is 2,190 (i.e., 6 villas x

365 days). The club's Restated Articles and First Amended

Bylaws specify that the number of class A memberships

would be no more or less than 36. Because each class A

membership entitled its holder to use a villa for 60 days
 - 14 -

during the year, the 36 class A memberships account for

2,160 of the available days on which the complex could be

used during the year (i.e., 36 memberships x 60 days). The

30 remaining available days were allocated to the class C

memberships. Under the Articles and Bylaws, the total

number of class C memberships is three, and each class C

membership entitled its holder to use a villa for 10 days

per year.

The consideration specified in the Restated Articles

and First Amended Bylaws for each class A membership is

$155,000 (i.e., "membership fee" of $15,000 and "initiation

fee" of $140,000). Typically, a prospective member paid

the membership fee in cash and issued a promissory note,

payable to the club, for the initiation fee. Thus, the

total consideration that the club would receive from the

sale of 36 class A memberships is $5,580,000. The

consideration specified in the Restated Articles and First

Amended Bylaws for each class C membership is $2,500 (i.e.,

"membership fee" of $2,500 and no "initiation fee"). Thus,

the total consideration that the club would receive from

the sale of three class C memberships is $7,500. The

maximum amount of money that the club could realize from

the sale of 36 class A memberships and three class C

memberships was $5,587,500 (i.e., $5,580,000 plus $7,500).
 - 15 -

The First Amended Bylaws specify the voting rights of

each class of membership as follows:

Voting. Class A Members shall each have two
(2) votes, Class B Members shall each have one
(1) vote, and Class C Members shall each have one
(1) vote, respectively, on any and all matters to
be voted on by the Members. Moreover, no class
voting shall take place or is permitted on any
matter. However, notwithstanding the foregoing
statement that each Class C Member shall have one
(1) vote on any and all matters to be voted on,
prior to the date that Members other than Class C
Members collectively possess, in the aggregate,
more than sixty-six (66) votes, Class C Members
shall each have twenty-two (22) votes on any and
all matters to be voted on by the Members.

The First Amended Bylaws prohibit members of the club

from renting the use of a villa. The First Amended Bylaws

provide as follows:

No Rental Rights. Any Member may permit
a guest, friend, client, or business associate
(collectively referred to herein as the "Guests"
or, if only one, the "Guest") to use a Unit
which such Member has rightfully and properly
reserved or is otherwise entitled to use;
provided, however, that no Member can rent or
otherwise receive any consideration from the
Guest for such permitted use. It is the intent
of the corporation to provide the use of the Club
Facilities and, more specifically, the Units only
to Members and any other persons to whom such
Members desire to gratuitously grant rights of
use.

Shortly before completion of the construction phase

of the project, Mr. Dixon and petitioner began marketing
 - 16 -

memberships in the club. They directed their marketing

efforts toward individuals who were the principals of

"small to medium-size Texas corporations that were

expanding their business activities into the Southern

California area." Mr. Dixon and petitioner caused the

promotional booklet described above to be prepared, and

they drew up a list of prospective buyers. They sent

letters and copies of the promotional booklet to the

prospective buyers on the list, and shortly thereafter

they made followup contacts with those persons.

During the period from May or June of 1985 through the

end of that year, Mr. Dixon, petitioner, and Mr. Armstrong

encouraged a number of prospective buyers to fly from Texas

to Southern California to visit the project. Vernon paid

for their airfare to California, and the joint venture paid

for their expenses in California. An individual who was

employed by the club to manage the project, Mr. Michael

Osuna, was responsible for attending to the needs of the

prospective buyers while they were staying at the project.

On September 19, 1985, the joint venture transferred

to the beach club the portion of the Moonlight Beach

Property which included the six condominium units. The

deed for the transfer was recorded by the club on

December 3, 1985. The club took title to the Moonlight
 - 17 -

Beach Property subject to the $4,700,000 loan from Anchor,

and it issued a promissory note, payable to the joint

venture, in the amount of $887,500 (i.e., $5,587,500 less

$4,700,000). Both the joint venture and the beach club

treated the transfer of the Moonlight Beach Property as

having occurred on or about January 16, 1986, the date on

which the permanent loan was funded and the construction

loan was paid off, as discussed below. The joint venture

retained title to the parcel of land on which the beach

house was located.

On December 23, 1985, an application to register the

project under the Texas Time-share Act was filed with the

Texas Real Estate Commission. The application was filed on

behalf of the beach club by the club's accountant, Mr. Tom

D. Winslett II. On August 6, 1986, the Texas Real Estate

Commission notified the club that, as a condition precedent

to registration in Texas, the project would have to be

registered and qualified in the State of California.

Originally, Mr. Dixon and petitioner had not sought to

register the project in California. In part, this was due

to the fact that they had been advised that the project

would not qualify under California law because of a so-

called blanket encumbrance problem. That is, under the

proposed structure of the transaction, the permanent lender
 - 18 -

could declare the entire project in default if the club

failed to remit a mortgage payment, even though members of

the club had timely made all of their note payments to the

club.

After receiving the August 6, 1986, letter from the

Texas Real Estate Commission, Mr. Winslett, acting on

behalf of the club, authorized attorneys to seek registra-

tion of the project in California. Also, discussions were

held with representatives of the permanent lender, Sandia

Federal Savings & Loan (Sandia), to see if Sandia would

allow the permanent loan to be amended to alleviate the

blanket encumbrance problem by releasing members who had

fully paid their initiation fee note. Ultimately, these

discussions were not successful and registration was never

obtained in either Texas or California.

On or about January 16, 1986, the beach club secured

permanent financing for the project from Sandia. On that

date, Mr. Dixon, acting as the club's president, and

petitioner, acting as the club's secretary, executed a

secured promissory note to Sandia in the principal amount

of $4,760,000, payable in 60 equal payments of $181,308.08

each, due on the 15th day of each July, October, January,

and April during the term of the loan, commencing on
 - 19 -

April 15, 1986, and ending January 15, 2001. The note

states that payment of the note is secured as follows:

Security. This Note is secured by Maker's [i.e.,
the club's] assignment of those certain Class A
Initiation Fee Notes pursuant to that certain
Collateral Assignment of Notes and Security
Agreement of even date herewith. This Note is
further secured by, among other things, a Deed
of Trust and Assignment of Rents of even date
herewith (the "Trust Deed") to First American
Title Insurance Company, as Trustee, covering
certain real property situated in the County
of San Diego, State of California. Reference
is made to the Deed of Trust with respect to
the rights of acceleration of the indebtedness
evidenced by this Note.

Mr. Dixon and petitioner also personally guaranteed the

loan from Sandia. The club used the proceeds of the loan

from Sandia in the amount of $4,760,000 together with other

funds to retire the construction loan from Anchor, the

principal and interest on which amounted to $4,870,457.16

through January 17, 1986.

By the end of 1985, before the interim construction

loan became due, prospective purchasers had committed to

buy only 18 of the 36 class A memberships. However, as

a condition for providing permanent financing for the

project, Sandia required that all the time-share

memberships be sold. Therefore, in order to obtain

permanent financing, Mr. Dixon and petitioner each
 - 20 -

purchased nine class A memberships in the club. On or

about January 16, 1986, in connection with the closing of

the club's loan from Sandia, Mr. Dixon and petitioner each

paid $135,000 in cash to the club (i.e., $15,000 x 9) and

signed nine promissory notes payable to the club, in the

aggregate principal amount of $1,260,000 (i.e., $140,000

x 9). Mr. Dixon and petitioner each borrowed the cash

payment of $135,000 from the joint venture. These loans

were never repaid.

On or about January 24, 1986, petitioner sold one

of his club memberships to a California resident, Mr. Jack

Anderson, for $155,000. As discussed in more detail below,

each petitioner reported one-half of this sale on a

Schedule C, Profit or (Loss) from Business or Profession,

filed with his or her 1986 return. Petitioner and

Mr. Dixon used the toss of a coin to determine that

Mr. Anderson would purchase one of petitioner's club

memberships. They agreed that the next club membership

to be sold would be one of Mr. Dixon's and that they would

alternate until all of the club memberships were sold.

On November 2, 1986, the joint venture agreement was

again amended (Third Amended Agreement), to liquidate Value

Plus' interest in the joint venture in consideration of the

venture's payment of $75,000 pursuant to a promissory note.
 - 21 -

The promissory note was to accrue interest at the annual

rate of 9 percent and was to mature on November 30, 1986.

Payment of the note was personally guaranteed by Mr. Dixon

and petitioner. The Third Amended Agreement also provides

as follows:

All remaining net profits of the Joint Venture,
determined in accordance with the provisions of
the Joint Venture Agreement, not otherwise
payable to [sic] distributable to Value Plus
pursuant to Paragraph 2 of this Third Amendment
[the paragraph providing for the note described
above], shall be paid over, share and share alike
to Dondi and Lemons [petitioner].

Thus, after the Third Amended Agreement, the equity and

capital of the joint venture were held by Dondi Associates

and petitioner on a 50-50 basis, and Value Plus was

formally withdrawn as a joint venturer. One of the

recitals of the Third Amended Agreement states as follows:

On January 16, 1986, the Joint Venture
conveyed a portion of the Subject Property to
Moonlight Beach Club, Inc., a Texas corporation.
The profits to the Joint Venture from such sale
and disposition is conditioned upon the sale by
Moonlight Beach Club, Inc. of various membership
units in said Club. Until complete sale and
disposition of said units, it is not possible
to determine the exact net profit to the Joint
Venture from such sale and disposition.
Accordingly, the parties desire by this Agree-
ment to settle and liquidate the amount of net
profit due Value Plus pursuant to the terms of
the Joint Venture Agreement rather than waiting
 - 22 -

for the final sale of all units in Moonlight
Beach Club, Inc.

In mid to late 1986, a number of club members stopped

making payments on their initiation fee notes. As a

result, the club defaulted on the permanent loan owed to

Sandia. About this time, petitioner realized that he would

not be able to resell his eight memberships in the club.

Accordingly, since the club was in default on the permanent

loan, and Sandia's foreclosure of the land and improvements

owned by the club seemed imminent, petitioner considered

his memberships in the club to be worthless.

Mr. Winslett prepared the joint venture's 1984 and

1985 tax returns. However, Mr. Winslett did not prepare

the joint venture's 1986 return because all of the

financial records of Dondi Associates and the joint venture

had been either seized by the FBI or subpoenaed by a grand

jury in connection with an investigation into Vernon's

activities. Accordingly, Mr. Winslett and petitioner's

accountant, Mr. Garry L. David, estimated the joint

venture's profit in 1986 from the transfer of the Moon-

light Beach Property to the club. They estimated that

petitioner's share of the profit was $664,200. The record

of these cases does not explain the basis for that

estimate. Based thereon, the aggregate gain realized by
 - 23 -

the joint venture from its sale of villas and land to the

club in 1986 amounted to $1,328,400.

During 1986, petitioner, along with his wife, was

active in attempting to organize a corporation called First

Equity Mortgage.

On June 24, 1987, the club's board of directors

adopted a resolution that the club should either

voluntarily file for bankruptcy under chapter 11 of the

U.S. Bankruptcy Code, consent to entry of an involuntary

chapter 11 petition, or request the bankruptcy court to

convert any involuntary chapter 7 petition filed to a

chapter 11 proceeding. On July 6, 1987, the club informed

its members that on June 25, 1987, it had filed for

protection under chapter 11 of the U.S. Bankruptcy Code.

On or about December 4, 1987, the Superior Court of

California, County of San Diego, entered a default judgment

against petitioner for $1,132,239.38 in favor of Sandia.

Sandia caused the default judgment to be filed in the

District Court for Dallas County, Texas.

Prior to April of 1986, petitioner was under investi-

gation for criminal bank fraud and conspiracy with respect

to his activities at Vernon. Petitioner was convicted and

sentenced to serve two consecutive 5-year terms in prison.

Petitioner's sentence was subsequently reduced to 5 years
 - 24 -

in consideration of his cooperation with the Government

in connection with its investigations of other savings and

loan associations.

In December 1990, Mr. Dixon was convicted on 23 counts

of bank fraud and was sentenced to serve a term of 5 years

in prison. In July of 1992, Mr. Dixon entered into a plea

bargain with respect to eight other counts of bank fraud

for which he had been indicted. He was sentenced to serve

another term of 5 years in prison, with the second term to

run consecutively with the first. Mr. Dixon ultimately

served 44 months in prison. As part of his 1992 plea

bargain, Mr. Dixon cooperated with the Government in its

investigations of other savings and loan associations.

Mr. Dixon testified in two trials about criminal activities

at Vernon.

The separate 1986 income tax returns filed by

petitioners include identical Schedules C, Profit or (Loss)

From Business or Profession, for a business described as

"Time-Share Unit Sales". Each petitioner reported one-half

of the amount realized from the sale of a club membership

to Mr. Anderson, $77,500, as "Gross receipts or sales" from

that business. Each petitioner also reported the same

amount, $77,500, as "Cost of goods sold" and accordingly,

reported no gross profit from that business.
 - 25 -

Each petitioner also reported on the Schedule C an

ordinary loss in the amount of $620,000, labeled "Loss on

worthlessness of eight Moonlight Beach Club time-share

Memberships which Could Not Be Sold." This amount is one-

half of the aggregate cost of the eight club memberships

held by petitioner when the project collapsed ($155,000

x 8 = $1,240,000).

Finally, each petitioner reported on a Schedule E,

Supplemental Income Schedule, one-half of petitioner's

share of the estimated gain realized by the joint venture

from its sale of the six villas and land to the club.

Thus, each petitioner reported gain in the amount of

$332,100 (i.e., one-half of $664,200). The return of each

petitioner states that the "amount shown is an estimate."

In the subject notices of deficiency, respondent

disallowed the loss that each petitioner claimed on his

and her 1986 return in the amount of $620,000 due to the

worthlessness of eight memberships in the club. The

notices give the following explanation of these adjust-

ments: "Since nonbusiness worthlessness of assests [sic]

must be treated as capital losses, we have adjusted your

income as shown in the accompanying schedule." The notices

of deficiency permit petitioners to treat the loss from the

worthlessness of the club memberships as long-term capital
 - 26 -

loss. However, in computing the long-term capital loss,

it appears that respondent treated petitioner as having a

basis of $1,120,000 in the eight memberships, or $140,000

per membership, rather than a basis of $1,240,000, or

$155,000 per membership.

Annual Dues Issue

At the time petitioner purchased 9 of the 18 unsold

class A memberships in the club, he signed membership

documents identical to those signed by the other members.

He thereby obligated himself to pay the annual dues

attributable to each membership. As described by the

promotional booklet issued to prospective purchasers,

the dues covered various expenses, including insurance,

staff services, such as the manager's salary, and

maintenance costs incurred in running the club. According

to the booklet, the dues were estimated to be approximately

$4,000 for the first year. Based upon the eight class A

memberships that petitioner held during 1986, it would

appear that he was liable to pay $32,000 in dues during

the year.

On the Schedules E, Supplemental Income Schedule,

that are attached to petitioners' 1986 income tax

returns, each petitioner claims a deduction of $5,250

for "management fees" attributable to the beach club.
 - 27 -

Respondent disallowed the deductions, and both notices of

deficiency give the same explanation for these adjustments:

"Because there is no business purpose for this transaction

your deduction is denied."

Partnership Loss Issue

Petitioner's 1987 and 1988 income tax returns claim

deductions on Schedule E, Supplemental Income Schedule, for

partnership losses in the aggregate amounts of $97,789.65

and $21,986.69, respectively. Set out below is a schedule

of the partnership losses claimed in each year:

Petitioner's
Income Tax Returns 1987 1988

Speed Line Investment ($2,091.48) ($2,035.02)
Oakbrook III, Ltd. (32,104.53) (12,453.97)
Dondi Presidents' Partnership II (7,050.85) 422.35
1626 NY Associates Ltd. Partnership (24,273.40) (4,931.60)
Bear Creek West Rental Properties (6,035.00) --
Haywood Lane Joint Venture (10,102.50) --
Murfreesboro Road Joint Venture (9,082.00) --
Lemons & Hite (751.37) (646.29)
Dondi Motor Car Properties (2,166.00) (2,283.98)
Berkley Apartments Ltd. Partnership (4,067.51) (640.68)
Caprice Investments (271.51) --
Freeport-McMoran 206.50 594.00
Energy Partners., Ltd. -- --
Freeport-McMoran -- 6.50
Resource Partners., Ltd. -- --

(97,789.65) (21,968.69)

Mrs. Lemons' returns claim identical deductions.

The notices of deficiency issued to petitioners adjust

the above partnership losses by disallowing $57,634 of the

amount claimed in 1987 and $29,448 of the amount claimed in

1988. Both notices of deficiency provide the following
 - 28 -

explanation of these adjustments: "We decreased your part-

nership loss deduction because it is more than the amount

you have 'at risk.'" Neither notice of deficiency sets

forth any further explanation or itemizes the computation

of the amount of the adjustment.

Respondent's post-trial brief states that respondent

disallowed the following losses claimed on petitioner's

Schedules E for 1987 and 1988:

Amounts Disallowed 1987 1988

Speed Line Investment ($2,091.48) ($2,035.02)
Oakbrook III, Ltd. (12,453.97)
Dondi Presidents' Partnership II (7,050.85) (1,431.15)
1626 NY Associates Ltd. Partnership (24,273.40) (4,931.60)
Bear Creek West Rental Properties (6,035.00) --
Haywood Lane Joint Venture (10,102.50) --
Murfreesboro Road Joint Venture (9,082.00) --
Lemons & Hite -- --
Dondi Motor Car Properties -- --
Berkley Apartments Ltd. Partnership -- --
Caprice Investments -- --
Freeport-McMoran Energy Partners, Ltd. -- --
Freeport-McMoran Resource Partners, Ltd. -- --

Total (58,635.23) (20,851.74)

Amount disallowed per notice of deficiency 57,634.00 29,448.00

Difference (1,001.23) 8,596.26

The aggregate partnership losses disallowed in 1987,

according to the notices of deficiency, $57,634, is

$1,001.23 less than the amount disallowed according to

respondent's post-trial brief. Respondent's post-trial

brief states that this discrepancy is: "due to the nature

of the § 469 (passive activity loss) computational
 - 29 -

adjustment required. The final adjustment to Schedule E

will be submitted under Rule 155."

The aggregate partnership losses disallowed in 1988,

according to the notices of deficiency, $29,448, is

$8,596.26 more than the above amount disallowed according

to respondent's post-trial brief. Respondent's post-trial

brief states this discrepancy is:

due to a computational error. Respondent con-
cedes the difference between the Notice amount
and this amount, subject only to a further
correction due to the section 469 computational
adjustment. (See the previous note.)

The Schedules K-1, Partner's Share of Income, Credits,

Deductions, etc., issued to petitioner by the subject

partnerships for 1987 state the following:

1987 Tax Year

Beginning Distributive Other Contributed Withdrawals Ending
Capital Share Ordinary Income Capital and Capital
Partnership Account Income (Loss) (Loss) for Year Distributions Account

Speed Line ($32,602.00) ($4,806.00) ($1,553.00) -- -- ($38,961.00)
Investment1
Oakbrook III, (369,191.00) (77,242.00) -- -- -- (446,433.00)
Ltd.2
Dondi Presi- (38,049.00) (16,785.00) -- -- -- (54,834.00)
dents' Part-
nership II
1626 NY
Associates,
Ltd. Partner-
ship2 (81,453.56) (58,064.00) -- $26,259.00 -- (112,988.56)
Bear Creek (14,320.00) (12,070.00) (4,450.00) 2,044.00 ($28,796.00) --
West Rental
Properties
Haywood Lane (10,649.00) (20,205.00) (24.00) -- (30,878.00) --
Joint Venture2
Murfreesboro
Road Joint (9,800.00) (18,029.00) (25.00) -- (27,854.00) --
Venture1 2
 - 30 -
1
Capital account information on Schedule K-1 was supplied by petitioner's accountant,
Mr. Garry L. David.
2
Petitioner had a limited partnership interest only.

The Schedules K-1 issued by the partnerships for 1988 state the

following:
1988 Tax Year

Beginning Distributive Other Contributed Withdrawals Ending
Capital Share Income Capital and Capital
Partnership Account Income (Loss) (Loss) for Year Distributions Account

Speed Line
Investment ($38,961.00) ($3,178) -- -- -- ($42,139.00)
Oakbrook III,
Ltd. (446,433.00) (11,875) $419,639 -- -- (38,669.00)
Dondi Presi- --
dents' Part-
nership II1 (54,834.00) (3,707) 16,921 -- ($35,206) --
1626 NY
Associates
Ltd. Partner-
ship (112,900.56) (44,640) -- -- -- (157,628.56)

1
Petitioner had a limited partnership interest only.

According to the Schedules K-1, petitioner's share of

the liabilities of each partnership is as follows:

1987 1988

Partnership Other Nonrecourse Other Nonrecourse

Speed Line Investment -- -- -- --
Oakbrook III, Ltd. -- $638,108 -- --
Dondi Presidents'
Partnership II $27,934 65,700 -- --
1626 NY Associates
Ltd. Partnership 53,057 428,488 $57,352 $309,682
Bear Creek West
1 1
Rental Properties -- --
Haywood Lane Joint
1 1
Venture -- --
Murfreesboro Road
1 1
Joint Venture -- --

Total 80,991 1,132,296 57,352 309,682

1
A Schedule K-1 was not entered into evidence.
 - 31 -

During the audit of petitioners' 1987 and 1988

returns, respondent's revenue agent noted that petitioner's

ending capital, as shown on the Schedules K-1 issued by the

partnerships, consisted of negative amounts. Respondent's

revenue agent asked petitioners' representatives why

petitioners had deducted losses in excess of their basis in

each of the partnerships. Petitioners' representatives

stated that their practice was to deduct the amount of

any loss shown on a Schedule K-1, irrespective of the

taxpayer's basis in the partnership. Respondent's agent

also asked petitioners' representatives to substantiate the

amount of any liabilities that would increase petitioner's

basis in any of the partnerships. Petitioners did not

provide any substantiation to respondent's agent.

Worthless Stock Issue

On the Schedules D, Capital Gains and Losses, filed

with their 1986 tax returns, both petitioners reported a

long-term capital loss in the amount of $4,441.35 that is

labeled "Windsor Resources". Respondent disallowed these

losses in the notices of deficiency.

Self-Employment Tax

For 1987, each petitioner filed a Schedule SE,

Computation of Social Security Self-Employment Tax, with
 - 32 -

his or her return and reported self-employment tax of

$2,334.87. It appears that the self-employment tax

computed by each petitioner for 1987 is based upon one-

half of the net earnings from three businesses reported

on Schedules C and a net loss from one or more farm

partnerships. A summary of the self-employment tax

computed by each petitioner for 1987 is as follows:

1987
Self-Employment Tax Total 1/2 Share

Schedule C, Production-Oil & Gas $61.30 $30.65
Schedule C, Financial Adviser 40,706.81 20,353.41
and investments
Schedule C, Pilot Lessons- (286.75) (143.38)
Charter Flights
Net Profit from Schedule C 40,481.36 20,240.68
& Schedule K-1
Net Farm Profit or Loss from
Schedule F & Farm Partnerships (2,516.00) (1,258.00)

37,965.36 18,982.68
Rate 0.123 0.123

Self-employment tax 4,669.74 2,334.87

For 1988, each petitioner filed a Schedule SE, Social

Security Self-Employment Tax, with his or her return and

reported self-employment tax of $1,100.47. It appears

that the self-employment tax computed by each petitioner

is based upon one-half of the net earnings from four

businesses reported on Schedules C, the income from two

joint ventures reported as miscellaneous income, and a net
 - 33 -

loss from one or more farm partnerships. A summary of the

self-employment tax computed by each petitioner for 1988 is

as follows:

1988

Schedule C, Production-Oil & Gas $26.15
Schedule C, Financial Adviser & Investments 5,789.01
Schedule C, Pilot Lessons-Charter Flights (531.25)
Schedule C, Coin Dealer (85.77)
Joint Venture--Middleton 750.00
Joint Venture--Tex-Mart 4,211.00

Net Profit from Schedule C & Schedule K-1 10,159.14
Net Farm Profit or Loss from Schedule F
& Farm Partnerships (1,707.00)

8,452.14
Rate 0.1302

Self-employment tax 1,100.47

The notice of deficiency issued to petitioner

determined that his self-employment taxes for 1987 and 1988

are $4,465 and $4,935, respectively. The only explanation

of this adjustment in the notice of deficiency is the

following: "We have adjusted your self-employment tax due

to a change in your net profit from this self-employment."

The notice of deficiency issued to Mrs. Lemons did not

adjust the self-employment tax that she reported.

OPINION

Moonlight Beach Club Issue

The principal issue in these cases involves the

characterization of the loss petitioner realized in 1986
 - 34 -

when eight memberships in the beach club became worthless.

Generally, a taxpayer is allowed to deduct any loss

sustained during the taxable year that is not compensated

by insurance or otherwise. Sec. 165(a). The amount of

the deduction is the taxpayer's adjusted basis provided

in section 1011 for determining the loss from the sale or

other disposition of property. Sec. 165(b). In the case

of an individual, the deduction is limited to: (1) Losses

incurred in a trade or business; (2) losses incurred in any

transaction entered into for profit, though not connected

with a trade or business; and (3) casualty losses. Sec.

165(c). Furthermore, if the loss is one that arose from

the sale or exchange of a capital asset, then the deduction

in the case of a taxpayer other than a corporation is

subject to the limitation on capital losses set forth in

section 1211(b). Sec. 165(f). Under that limitation,

the taxpayer is allowed to deduct losses from the sale or

exchange of capital assets only to the extent of gains from

the sale or exchange of capital assets plus $3,000. Sec.

1211(b). If there is excess capital loss, the taxpayer is

permitted to carry over the excess to the succeeding

taxable year. Sec. 1212(b).

As discussed above, the return filed by each

petitioner claims a deduction from gross income in the
 - 35 -

amount of $620,000. Respondent determined in the notices

of deficiency that petitioners are not entitled to deduct

ordinary losses of $620,000, but are entitled to deduct

long-term capital losses of $560,000. Several aspects

of respondent's determinations should be noted. First,

respondent's determinations that petitioners realized

capital losses in 1986 are, in effect, determinations

that the losses qualify under section 165(c)(1) as losses

incurred in a trade or business, or under section 165(c)(2)

as losses incurred in a transaction entered into for

profit. We have no reason, to conclude that respondent

determined that the losses arose from a casualty within

the meaning of section 165(c)(3).

Second, respondent determined that the amount of the

capital loss that can be deducted by each petitioner is

$560,000, rather than $620,000, the amount claimed on

their returns. In effect, respondent determined that

petitioner's basis in the eight club memberships that

became worthless was $1,120,000 (i.e., 2 x $560,000),

rather than $1,240,000 (i.e., 2 x $620,000). Presumably,

respondent agreed that petitioner's basis included each of

the eight initiation fee notes payable to the club in the

principal amount of $140,000, but did not include the

membership fees of $15,000, for each membership that
 - 36 -

petitioner acquired with funds borrowed from the joint

venture. However, one of the findings of fact requested by

petitioners in their post-trial brief states as follows:

"Petitioners basis in the partnerships which became

worthless was $1,240,000." Respondent answered

"no objection" to this requested finding and, in effect,

conceded this issue.

Third, respondent determined that Mr. Lemons had

realized a long-term capital loss in 1986. "Long-term

capital loss" means loss from the sale or exchange of a

capital asset held for more than 1 year. Sec. 1222(4).

In these cases, Mr. Lemons purchased the nine club member-

ships on or about January 16, 1986, at the time the beach

club closed the loan transaction with the permanent lender,

Sandia. The parties agree that the club memberships had

become worthless by the end of 1986. Petitioners disagree

that the losses should be treated as capital losses but

they have not raised an issue about the treatment of the

losses as long-term capital losses, rather than as a short-

term capital losses.

Fourth, respondent determined that the subject losses

arose from the sale or exchange of capital assets, the

club memberships. See sec. 165(f). Respondent's brief

acknowledges that the club memberships became worthless and
 - 37 -

makes reference to section 165(g), which provides that the

loss from a "security" which is a capital asset that

becomes worthless during the taxable year shall be treated

as a loss from a sale or exchange. Petitioners argue that

the club memberships are not capital assets, but they do

not question respondent's determination that they were

sold or exchanged. Petitioners do not argue that they

are entitled to ordinary loss treatment, even if the club

memberships are capital assets, on the ground they were not

sold or exchanged. See generally Leh v. Commissioner, 260

F.2d 489 (9th Cir. 1958), affg. 27 T.C. 892 (1957); Com-

missioner v. Pittston Co., 252 F.2d 344 (2d Cir. 1958),

revg. 26 T.C. 967 (1956).

Petitioners contend that they are each entitled to

deduct against ordinary income in 1986 one-half of

Mr. Lemons' basis in the subject club memberships, viz.

$620,000. Petitioners make two arguments in support of

that position. First, they argue that the subject club

memberships were not capital assets in Mr. Lemons' hands

because he held the memberships "primarily for sale to

customers in the ordinary course of his trade or business".

Sec. 1221(1). Petitioners assert that Mr. Lemons' primary

purpose for holding the club memberships was for sale to

customers. According to petitioners, that purpose is
 - 38 -

evident from the fact that he had no other purpose for

holding the club memberships. They claim that he did not

hold the club memberships for personal or family use, for

rental income, or for investment. Petitioners also assert

that Mr. Lemons was engaged in the trade or business of

selling memberships since the joint venture was engaged in

developing the Moonlight Beach property and petitioner and

Mr. Dixon "were simply carrying out their original

development plan when they 'subpurchased' the (18) unsold

memberships in their own names." Petitioners cite cases

involving the distinction between a "dealer" and an

"investor" in real property and argue that the factors used

in those cases show that petitioner's activities "rise to

the level of trade or business." Finally, they contend

that the factors identified in the regulations promulgated

under section 183 also show that petitioner was engaged in

a trade or business.

Petitioners' second argument is that they are entitled

to a deduction because the subject loss was incurred in a

transaction entered into for profit and is fully deductible

under section 165(c)(2). Petitioners cite Meyer v.

Commissioner, T.C. Memo. 1975-349, affd. 547 F.2d 943 (5th

Cir. 1977), and other cases and argue that the

characterization of the loss should be based on the "origin
 - 39 -

of the claim" and that the Court should "look-back" to the

nature of the asset in the hands of the joint venture.

Respondent argues that petitioner was not holding the

club membership for sale to customers. Respondent also

argues that petitioner was not in the business of selling

club memberships, nor was he acting as a nominee of the

joint venture. According to respondent, petitioner

purchased the memberships to assist the club "in obtaining

permanent financing for its project" and thereby to ensure

that the joint venture "would ultimately profit from the

project." Respondent cites Whipple v. Commissioner, 373

U.S. 193 (1963), and compares petitioner's purchase of

the memberships "to a stockholder lending funds to his

corporation to improve its financial condition, which in

itself does not amount to a trade or business." Respondent

argues that "petitioner was acting as MBC'S [the club's]

agent in selling his time-share memberships, and, thus,

held the memberships 'primarily' for the benefit of MBC."

Respondent denies petitioners' assertion that petitioner

purchased the memberships to complete the joint venture's

original development plan. If that were true, respondent

asks why the joint venture did not purchase the unsold

memberships. According to respondent, petitioner purchased

the unsold memberships as a matter of tax planning so they
 - 40 -

could argue that any gain was attributable to the sale of

a capital asset, and that any loss was attributable to the

sale of a noncapital asset. Respondent argues that the

factors identified in cases distinguishing real estate

dealers from investors show that petitioner was an

investor. In applying those factors, respondent focuses on

petitioner's activities after he acquired the memberships

and does not take into account any of the activities of the

joint venture.

The issue we must decide is whether the subject club

memberships were capital assets in petitioner's hands.

Section 1221 defines the term "capital asset" to mean

"property held by the taxpayer", except for the property

that falls into five enumerated categories. The first

category of property excluded from the definition of

capital asset is the following:

(1)stock in trade of the taxpayer or other
property of a kind which would properly be
included in the inventory of the taxpayer if
on hand at the close of the taxable year, or
property held by the taxpayer primarily for
sale to customers in the ordinary course of
his trade or business;

Sec. 1221. The statute requires a two-pronged inquiry:

First, whether the taxpayer held the property "primarily

for sale to customers", and second, whether the taxpayer
 - 41 -

held the property for sale "in the ordinary course of his

trade or business". E.g., Cottle v. Commissioner, 89 T.C.

467, 486-487 (1987); Buono v. Commissioner, 74 T.C. 187,

199-200 (1980); Howell v. Commissioner, 57 T.C. 546, 555

(1972).

The purpose of section 1221(1) is to differentiate

between the profits and losses arising from the every-

day operation of a business, on the one hand, and the

realization of appreciation in value accrued over a

substantial period of time, on the other hand. E.g.,

Bramblett v. Commissioner, 960 F.2d 526, 534 n.2 (5th

Cir. 1992), revg. T.C. Memo 1990-296 (1990); Devine v.

Commissioner, 558 F.2d 807, 814 (5th Cir. 1977), affg.

T.C. Memo. 1975-251 (1975). In the context of section

1221(1), the word "primarily" means "of first importance"

or "principally". Malat v. Riddell, 383 U.S. 569, 572

(1966). Thus, if a taxpayer has several reasons for

holding property, the sale purpose must be more than

substantial; it must be the primary purpose. Ferguson

v. Commissioner, T.C. Memo. 1987-257.

Petitioners bear the burden of proving that the club

memberships in Mr. Lemons' hands were not capital assets

as defined by section 1221. Rule 142(a). This issue is a

question of fact involving the manner in which petitioner
 - 42 -

held the subject club memberships. E.g., Byram v. United

States, 705 F.2d 1418, 1423 (5th Cir. 1983); United States

v. Winthrop, 417 F.2d 905, 910 (5th Cir. 1969); United

States v. Rosebrook, 318 F.2d 316, 319 (9th Cir. 1963);

Bauschard v. Commissioner, 31 T.C. 910, 915 (1959), affd.

279 F.2d 115, 117 (6th Cir. 1960).

In deciding whether property is held primarily for

sale to customers in the ordinary course of a taxpayer's

business, this and other courts look to various factors

such as:

(1)the nature and purpose of the acquisition
of the property and the duration of owner-
ship;(2)the extent and nature of the taxpayer's
efforts to sell the property;(3)the number,
extent, continuity and substantiality of the
sales;(4)the extent of subdividing, developing,
and advertising to increase sales;(5)the use of
a business office for the sale of the property;
(6)the character and degree of supervision or
control exercised by the taxpayer over any
representative selling the property; and(7)the
time and effort the taxpayer habitually devoted
to the sales.

United States v. Winthrop, supra at 910 (quoting Smith v.

Dunn, 244 F.2d 353 (5th Cir. 1955)); see also Biedenharn

Realty Co. v. United States, 526 F.2d 409, 415 n.22 (5th

Cir. 1976); Buono v. Commissioner, supra at 199.

As we view the facts of these cases, petitioner and

Mr. Dixon undertook the development of the Moonlight Bay
 - 43 -

property through the joint venture. Their plan called for

the construction of six villas and a duplex on the property

and the sale of the six villas to the public in the form

of "time-share" memberships in a club. To finance that

development, the joint venture entered into a construction

loan in the amount of $4.7 million. Petitioner and

Mr. Dixon personally guaranteed the loan. After construc-

tion of the improvements, they arranged for permanent

financing of the project in the form of a loan to the club,

the proceeds of which would be used to pay off the

construction loan. As a condition for the permanent loan,

the bank required, among other things, that all of the club

memberships be sold and that petitioner and Mr. Dixon

personally guarantee repayment of the permanent loan.

Petitioner and Mr. Dixon had no choice but to purchase

the 18 unsold club memberships in order to obtain the

permanent financing for the project. Otherwise, the need

to repay the construction loan, which was coming due,

threatened the survival of the project and the financial

position of the joint venturers, petitioner and Mr. Dixon,

who had personally guaranteed the loan. The joint

venturers purchased the memberships in their individual

names in order to obtain permanent financing for the

project with the hope that they could complete the sale of
 - 44 -

the memberships to the public. It was evident to the joint

venturers at the time, and it is evident to us now, that

the note issued by the club in connection with the club's

purchase of the villas and land from the joint venture

would not be satisfied until all of the club memberships

were sold to the public. The evidence does not support

respondent's assertion that the joint venturers purchased

the unsold club memberships for investment or for any

reason other than for sale to customers. Accordingly, we

find that petitioner held the subject memberships primarily

for sale to customers. See generally King v. Commissioner,

89 T.C. 445, 457-458 (1987); Cottle v. Commissioner, supra;

Kemon v. Commissioner, 16 T.C. 1026 (1951).

The second prong of our inquiry is whether petitioner

held the club memberships for sale in the ordinary course

of a trade or business. Sec. 1221(1). To find that a

taxpayer was engaged in a trade or business, we must find

that the taxpayer was involved in the activity with

"continuity and regularity" and that the taxpayer's primary

purpose for engaging in the activity was "for income or

profit." Commissioner v. Groetzinger, 480 U.S. 23, 35

(1987).

The focus of the inquiry in these cases is whether

petitioner's activities rise to the level of a trade or
 - 45 -

business and whether petitioner held the club memberships

for sale to customers in the ordinary course of that trade

or business. See Bramblett v. Commissioner, 960 F.2d 526

(5th Cir. 1992); Buono v. Commissioner, 74 T.C. at 205.

Petitioners survey the factors used by courts to

distinguish between dealers and investors in real estate

and conclude that "clearly, Lemons' activities do rise to

the level of a trade or business." In analyzing these

factors, petitioners take into account all of the

activities of the joint venture in developing, improving,

and selling the property. Respondent, on the other hand,

applies the same factors and concludes that petitioner was

not engaged in a trade or business. In coming to this

conclusion, respondent draws a sharp distinction between

petitioner and the joint venture and takes into account

only petitioner's individual actions with respect to the

club memberships but not his actions with respect to any

other aspect of the development of the Moonlight Beach

property.

The premise of respondent's argument appears to be

that in evaluating whether petitioner was engaged in a

trade or business for the purpose of applying section

1221(1) the Court should look only to the activities

petitioner undertook after he acquired the club memberships
 - 46 -

in January 1986. In effect, respondent appears to treat

the joint venture like a corporation, the activities of

which are not ordinarily attributable to its shareholders.

E.g., Bramblett v. Commissioner, supra at 533. It is clear

that the trade or business of a corporation is distinct

from the trades or businesses of its stockholders. E.g.,

Whipple v. Commissioner, 373 U.S. at 202. On the other

hand, the trade or business of a joint venture or partner-

ship is the trade or business of each of the venturers or

partners. See generally Flood v. United States, 133 F.2d

173 (1st Cir. 1943); Butler v. Commissioner, 36 T.C. 1097

(1961); Bauschard v. Commissioner, 31 T.C. 910 (1959);

Ward v. Commissioner, 20 T.C. 332 (1953), affd. 224 F.2d

547 (9th Cir. 1955). In Stanchfield v. Commissioner, T.C.

Memo. 1965-305, we stated as follows:

While we agree with the Whipple opinion that
the trade or business of a corporation is
distinct from the trades or businesses of
its stockholders, we do not believe that a
similar distinction can be made in the case
of a partnership and its partners.

For example, in Butler v. Commissioner, supra, the issue

was whether or not certain loans made by a taxpayer to a

partnership of which he was a limited partner were to be

treated as business or nonbusiness bad debts. We noted

that by reason of his position as a limited partner the
 - 47 -

taxpayer was individually engaged in business. Id. at

1106. In view of the fact that the loans were made in

furtherance of that business and were proximately related

to the business activities of the partnership, we held that

the loans were business bad debts. Id. Similarly, in

Ward v. Commissioner, supra, we permitted a taxpayer who

had been a partner in a partnership to deduct, as ordinary

and necessary business expenses, payments in the nature of

pension payments made to a former employee of the partner-

ship. We noted that the taxpayer was engaged in a business

within the meaning of the predecessor of section 162(a)

"by reason of being a partner in a business". Id. at 343;

see also Flood v. United States, supra.

Finally, in Bauschard v. Commissioner, supra, the

issue presented to the Court was whether the taxpayer's

activities with respect to the purchase, development, and

sale of a tract of land constituted a trade or business.

The taxpayer contributed two-thirds of the purchase price

of an undeveloped tract of land which was placed in trust

for the taxpayer and the other buyer. Id. at 913. The

trust leased the property to a developer for a 5-year

term for the purpose of platting, subdividing, and improv-

ing the property, and it gave the developer an option of

purchasing any or all of the lots. Id. The developer
 - 48 -

formed a corporation to develop and improve the property

and assigned his interest in the lease to the corporation.

Id. at 914. The taxpayer reported his share of the gains

realized by the trust upon disposition of the lots as

capital gains. Id. at 915.

The Court held that the taxpayer and the developer

had entered into a joint venture for the purpose of

subdividing, developing, and selling the land. Id. at 916.

Since the activities of the developer and his corporation

constituted a trade or business, the Court found that the

taxpayer, as a member of the joint undertaking, was

similarly engaged and, thus, held the property for sale to

customers in the ordinary course of business. Id. at 917.

Accordingly, the Court held that the income realized from

the venture must be taxed at ordinary rates. Id.

In these cases, petitioner and Mr. Dixon undertook the

improvement of the Moonlight Beach property and the sale

of those improvements to the public in the form of time-

share memberships in the club. In order to obtain

permanent financing for the project, they agreed between

themselves to purchase any unsold club memberships and

continued to market them to the public. In effect, each

of them agreed to continue the activities of the joint

venture in his individual capacity. Respondent concedes
 - 49 -

that the joint venture was engaged in the trade or business

of developing the Moonlight Beach property, and we find

that petitioner continued that business in his individual

capacity during 1986. We also find that petitioner engaged

in that business in order to realize a profit from the

joint venture's sale of the villas and related land to the

club.

Annual Dues Issue

Petitioner claims to have paid annual dues of $10,500

to the beach club in 1986 with respect to the eight club

memberships that he owned during the year. Petitioners

assert that this expenditure, to the extent substantiated,

was made to maintain the club memberships. Accordingly,

petitioners argue that they are each entitled to deduct

one-half of the amount paid under section 162(a) as an

ordinary and necessary business expense. They do not claim

to be entitled to deduct that amount under section 212.

Respondent disallowed the deductions in the notices of

deficiency on the ground that "there is no business purpose

for this transaction". In respondent's post-trial briefs,

respondent concedes that the expenditure, to the extent

substantiated, would be deductible as a business expense if

the Court finds that the club memberships were held by
 - 50 -

petitioner for sale to customers in the ordinary course of

a trade or business. In that event, however, respondent

argues that "petitioners have failed to substantiate" their

payment of the annual dues. Petitioners bear the burden of

proving that each of them is entitled to the deduction.

Rule 142(a).

In the prior section of this opinion, we set forth our

basis for finding that Mr. Lemons held the subject club

memberships for sale in the ordinary course of a trade or

business. Thus, as recognized in respondent's post-trial

brief, petitioners are allowed to deduct under section

162(a) the amount of any annual dues "paid" to maintain

those club memberships. The question becomes whether

petitioners have proven that they paid any dues to the

club. They introduced no documentary evidence to

substantiate that payment. Mr. Dixon testified at trial

that the joint venture "loaned" the amount of the dues to

petitioner and himself and that neither of them repaid the

joint venture. Mr. Dixon's testimony on this issue is as

follows:

Q Did you pay any of those dues?

A I believe we did pay them.

Q You did pay them?
 - 51 -

A Yes. I believe the venture loaned us some
money to make the payments.

Q So you are saying the venture loaned you
the money to put the down payment and also
loaned you the money to make the payments
on the dues. Is that correct?

A That is my recollection.

Q And did you ever pay any of that money back
to the joint venture?

A No.

The record of these cases contains no documentary evidence

of indebtedness of the joint venture to Mr. Dixon or to

petitioner for the payment of annual dues.

During his testimony at trial, petitioner could not

say for certain whether he had paid the annual dues from

his own funds or whether he had received that amount from

the joint venture. Petitioner's testimony on this issue

is as follows:

Q Did you pay those dues with your own
money or did you borrow that from the
venture?

A I thought I paid with my own money.
I heard Mr. Dixon testify that he
borrowed it from the venture, and I
would assume if he did, I did. But
I don't remember it that way. I can't
swear either way. I don't think we
borrowed it from the venture.
 - 52 -

Furthermore, if petitioner paid the annual dues with funds

obtained from the joint venture, as mentioned above, there is

no evidence in the record of petitioner's indebtedness to

the joint venture for such payment. Therefore, based upon

the record of these cases, we cannot find that petitioner

"paid" annual dues of $10,500 to the beach club in 1986 as

required by section 162(a). Accordingly, we hereby sustain

respondent's disallowance of the deductions that petitioners

claimed in the amount of one-half of such amount, $5,250.

Partnership Losses for 1987 and 1988

The partnership losses that each petitioner claimed as

deductions on a Schedule E for 1987 and 1988 and the amount

that respondent disallowed according to respondent's post-

trial brief, are as follows:
 - 53 -

1987 1988

Loss Loss Loss Loss
Deducted Disallowed Deducted Disallowed

Speed Line Investment ($2,091.48) ($2,091.48) ($2,035.02) ($2,035.02)
Oakbrook III (7,050.85) (7,050.85) (12,453.97) (12,453.97)
Dondi Presidents' Partnership II (24,273.40) (24,273.40) 422.35 (1,431.00)
1626 NY Associates Ltd.
Partnership (6,035.00) (6,035.00) (4,931.60) (4,931.60)
Bear Creek West Rental Prop. (10,102.50) (10,102.50) -- --
Haywood Lane Joint Venture (9,082.00) (9,082.00) -- --
Murfreesboro Road Joint Venture (32,104.53) -- -- --
Lemons & Hite (751.37) -- (646.29) --
Dondi Motor Car Properties (2,166.00) -- (2,283.98) --
Berkley Apartments. Ltd. Partnerships (4,067.51) -- (640.68) --
Caprice Investments (271.51) -- 594.00 --
Freeport-McMoran Energy Partners, Ltd. 206.50 -- 6.50 --
Freeport-McMoran Resource Partners, Ltd. -- -- -- --
___________ ___________ ___________ ___________
(97,789.65) (58,635.23) (21,968.69) (20,851.59)

The subject notices of deficiency disallowed the

partnership losses claimed by each petitioner on the ground

that the amount deducted was "more than you have 'at

risk'". In her post-trial brief, respondent asserts that

the subject partnership losses should be disallowed for two

reasons. First, as to three of the partnerships, Speed

Line Investment, Dondi Presidents' Partnership II, and 1626

New York Associates Ltd. Partnership, respondent asserts

that the losses should be disallowed "because petitioner

has not shown that his adjusted basis in any of these

partnerships exceeded his distributive share of the

partnership losses under §704(d)." In effect, respondent

contends that petitioner had "insufficient basis"

to support the deduction of the subject partnership losses.

Second, as to all of the partnerships for which an
 - 54 -

adjustment was made, other than Speed Line Investment,

respondent contends that "the provisions of §469(i)(5)(B)

do not allow petitioners to deduct any derivative losses

related to the above partnerships." As we understand the

argument, respondent contends that petitioners are not

entitled to deduct any of the losses from the subject

partnerships because they are not eligible for the $25,000

offset for rental real estate activities, prescribed by

section 469(i). Under that provision, the blanket

prohibition against deducting passive activity losses,

contained in section 469(a), is not applicable to the

portion of the passive activity loss, up to a maximum of

$25,000, which is attributable to rental real estate

activities in which the individual actively participates.

Sec. 469(i)(1). Respondent asserts that petitioners, who

filed separate returns but did not live apart during 1987

or 1988, are described in section 469(i)(5)(B) as taxpayers

to whom section 469(i) is not applicable. As a result of

being ineligible for the $25,000 offset for rental real

estate activities prescribed by section 469(i), respondent

argues that petitioners cannot deduct any passive activity

losses.

As to respondent's first reason, petitioners contend

that respondent's agent disallowed the partnership losses
 - 55 -

"in any case where the loss claimed exceeded the capital

account as shown on the K-1 (or if there was a negative

capital)". Petitioners contend that respondent is

"simply wrong on the facts", and, as to each partnership,

petitioner "had sufficient basis in the partnership to

claim the full amount of the loss shown on the K-1".

Petitioners contend that Mr. Lemons was subject to

"recourse liabilities" in each case and "when his capital

account, whether it be positive or negative, is added to

his share of recourse partnership liabilities, Lemons had

more than enough basis to utilize the full amount of the

loss shown on the K-1."

In passing, we note that both parties treat

respondent's first reason for disallowing the partnership

losses at issue; i.e., whether petitioner's adjusted basis

in each of the partnerships was equal to or greater than

petitioner's distributive share of the partnership loss

as required by section 704(d), as the rationale for the

adjustment made in the notice of deficiency; i.e., whether

the amount deducted was "more than you have 'at risk'".

Neither party raises section 465, which limits deductions

to the "amount at risk", or discusses the effect of that

section on the facts of these cases.
 - 56 -

As to respondent's second reason for disallowing the

partnership losses; i.e., that petitioner is not eligible

for the $25,000 offset for rental real estate activities,

provided by section 469(i), petitioners make two points.

First, they assert that this "is a new theory not raised

in the Notice * * * is outside the scope of the pleadings

* * * [and] was not tried by express or implied consent."

Second, they note that on the Forms 8582, Passive Activity

Loss Limitations, filed with their 1987 and 1988 returns,

both claimed passive activity losses, but neither claimed

eligibility for the $25,000 offset for rental real estate

activities prescribed by section 469(i).

We do not agree with respondent's second reason for

disallowing the partnership losses. We agree with

respondent that a married individual who files a separate

return for any taxable year is not entitled to the $25,000

offset for rental real estate activities unless the

taxpayer lives apart from his or her spouse at all times

during the year. Sec. 469(i)(5)(B). However, even if the

taxpayer is ineligible for the $25,000 offset for rental

real estate activities provided by section 469(i), the

taxpayer may be entitled to deduct losses from certain

passive activities by reason of other provisions set forth

in section 469. For example, section 469(m) provides a
 - 57 -

phase-in of the disallowance of losses and credits

attributable to interests held on the date of enactment

of section 469, defined as "pre-enactment [interests]" by

section 469(m)(3)(B). Similarly, losses from passive

activities for the taxable year can be offset against the

income from passive activities for that year. See sec.

469(d)(1).

The Forms 8582 filed by petitioners for 1987 claim

a deduction for the portion of petitioners' passive

activity losses attributable to "pre-enactment [interests]"

under the phase-in of disallowance rules set forth in

section 469(m). Similarly, the Forms 8582 filed with

petitioners' 1988 returns suggest that the losses from

certain passive activities were offset by income from other

passive activities. See sec. 469(d)(1). Respondent's

briefs do not explain why petitioners' ineligibility for

the $25,000 offset for rental real estate activities

provided by section 469(i) is in any way related to the

passive activity losses claimed by petitioners on the

Forms 8582 filed for 1987 and 1988. We perceive no

connection. Accordingly, we reject respondent's second

reason for disallowing the partnership losses.

Respondent's first reason for disallowing the

partnership losses is that petitioner had "insufficient
 - 58 -

basis" to support the deduction with respect to three

partnerships, Speed Line Investment, Dondi Presidents'

Partnership II, and 1626 New York Associates, Ltd.

Partnership. We review the record with respect to each

of these partnerships.

Petitioner was a general partner in Speed Line

Investment, a partnership formed to engage in the breeding

and sale of thoroughbreds and quarter horses. He held a

25-percent interest in the partnership during 1987 and

1988. He claims that in 1985 the partnership borrowed

$620,000 from the First City Savings Bank in Los Colinas

and that he and Mr. Dixon personally guaranteed the loan

and pledged a certificate of deposit in the amount of

$120,000 and the assets of the partnership as collateral.

He also claims that approximately $170,000 of the loan was

outstanding at the end of 1987. In effect, petitioner

claims that his share of the liability for 1987 would have

been $42,500 (i.e., $170,000 x 25 percent). Petitioner

testified that there was no change in 1988 for this

liability and for the amount of the partnership's debt.

Contrary to petitioner's testimony, the Schedules K-1,

Partner's Share of Income, Credits, Deductions, etc.,

issued to petitioner by Speed Line Investment, show that

petitioner had a negative capital account as of the end of
 - 59 -

1987 and 1988, and do not contain any entry on the lines

provided for "partner's share of liabilities". Petitioner

testified that his share of partnership liability exceeded

the negative balance of his capital account by more than

the amount of the loss deducted for 1987 and 1988.

However, the record contains no documentary evidence to

substantiate that testimony.

Petitioner was a general partner in the Dondi

Presidents' Partnership II, a partnership formed to acquire

and eventually resell 10 condominium units in Oceanside,

California. He held a 10-percent interest in the

partnership in 1987 and 1988. He claims that, in addition

to other debts of the partnership for which he had no

liability, the partnership borrowed $350,000 from Paris

Savings in Paris, Texas, and he "had full liability" for

that debt. Petitioner also testified that Paris Savings

eventually obtained a judgment against him with respect to

that debt in the amount of $306,690.87. Petitioners did

not introduce the judgment into evidence, and the record

does not state the date of that judgment. We note that the

Schedule K-1 issued to petitioner by Dondi Presidents'

Partnership II for 1987 shows that petitioner's share of

"nonrecourse" liabilities was $65,700 and his share of
 - 60 -

"other" liabilities was $27,934. For 1988, petitioners

reported income from the Dondi Presidents' Partnership II.

Petitioner was a limited partner in the 1626 New York

Associates Ltd. Partnership. Petitioner testified that he

paid approximately $405,000 for his interest in the

partnership by making a cash downpayment and signing a

promissory note. Petitioner could not recall the amount

of the downpayment or promissory note. According to

petitioner, his obligation under the note was "bonded" by

Continental Casualty in Chicago, which ultimately obtained

a judgment of $246,000 against him. Petitioners did not

introduce the judgment into evidence, and the record does

not state the date of the judgment.

We note that the Schedules K-1 issued to petitioner by

the 1626 New York Associates Ltd. Partnership show that his

capital at the end of 1987 and 1988 was ($112,988.56) and

($157,628.56), respectively. We further note that the

Schedule K-1 for 1988 shows nonrecourse liabilities of

$309,682 and other liabilities of $57,352, and the Schedule

K-1 for 1987 shows nonrecourse liabilities of $428,488 and

other liabilities of $53,057.

Petitioners make a general argument that respondent

erred by disallowing losses from the subject three

partnerships because the Schedules K-1, issued by the
 - 61 -

partnerships for both of the years in issue, showed a

negative capital account. Petitioners argue as follows:

That was a mistake. The capital account on these
K-1's did not purport to show basis; it only
showed the net of the partner's contributions
less withdrawals plus his share of income, less
his share of losses. It did not take into
account his share of recourse liabilities. There
is another place on the K-1 form to show the
partner's share of liabilities, both recourse and
nonrecourse. In most cases, that information was
simply not shown on the K-1. The regulations
provide that, under certain circumstances, a
partnership could elect not to include that
information on the K-1 and in many cases the
partnership made that election. In other cases,
the amount shown as "at risk" was simply
incorrect.

Petitioner's testimony made it clear that
he had sufficient basis in each partnership to
justify the full amount of loss claimed. The
testimony was unchallenged.

Petitioners also argue as follows:

Petitioner's testimony makes it very clear,
however, that the capital accounts as shown on
the K-1s were not his basis in his partnership
interest. In all cases, Lemons was liable for
his share of recourse liabilities and the amount
of that liability was not included in the capital
account figure shown on the K-1. When his
capital account, whether it be positive or
negative, is added to his share of recourse
partnership liabilities, Lemons had more than
enough basis to utilize the full amount of the
loss shown on the K-1.
 - 62 -

As to the adjustments made by respondent with respect

to each of the subject three partnerships, Speed Line

Investment, Dondi Presidents' Partnership II, and 1626 New

York Associates, Ltd. Partnership, the issue is whether

petitioner's distributive share of partnership loss exceeds

the adjusted basis of his interest in the partnership at

the end of the partnership year in which the loss occurred,

such that respondent could correctly disallow the loss

pursuant to the limitation imposed by section 704(d).

Petitioners bear the burden of proving that respondent's

adjustment is incorrect and, in that connection, they

must prove Mr. Lemons' adjusted basis in each of the

three partnerships at the end of 1987 and 1988. Pucci

v. Commissioner, T.C. Memo. 1984-672.

Petitioners have failed to meet their burden of proof.

They did not prove Mr. Lemons' adjusted basis in any of the

three partnerships at the end of 1987 or 1988. They rely

on Mr. Lemons' testimony which, in the case of each of the

three partnerships, consists of a description of the

partnership and a general statement that he was liable for

partnership obligations that are not reflected on the

Schedules K-1 issued by the partnership. At no time does

Mr. Lemons state the amount of his basis in any of the

partnerships. We agree that there may be a correlation
 - 63 -

between a partner's basis and the sum of the partner's

capital account at the end of the year and liabilities as

shown on a Schedule K-1. See generally 1 McKee et al.,

Federal Taxation of Partnerships and Partners, par. 6.05

(3d ed. 1997). However, that general correlation is not

sufficient in these cases to permit us to determine

Mr. Lemons' adjusted basis in the three partnerships at the

end of 1987 and 1988. Accordingly, we sustain respondent's

adjustments with respect to Speed Line Investment, Dondi

Presidents' Partnership II, and 1626 New York Associates,

Ltd. Partnership and reject respondent's adjustments with

respect to the other partnerships.

Worthless Stock Issue

Petitioners claimed losses on Schedules D, Capital

Gains and Losses and Reconciliation of Forms 1099-B, due

to the worthlessness of stock in a Canadian oil company,

Windsor Resources. They claim that Mr. Lemons' basis

in the stock was $8,882.72, and each of them claimed a

deduction in the amount of $4,441.36, one-half of the

alleged basis.

Petitioner testified that he was one of several

persons who borrowed $100,000 to purchase stock in the

company. Petitioner claims that he had a 10-percent

interest in the venture and that he repaid his share
 - 64 -

of the note, "$10,000 plus interest". According to

petitioner, "ultimately, several years later, the stock

became worthless." Petitioner's testimony about how he

determined that the stock had become worthless and when

the worthlessness occurred is as follows:

Q How did you determine that the stock
became worthless?

A Well, the price started going down, and
finally it got down to a quarter, and then
finally it wasn't even listed. And finally
the company was put in bankruptcy and as far
as I --

Q Did that occur in 1986?

A I don't know when it occurred. I think
it did, but I couldn't say for sure.

Petitioners claim a deduction under section 165(g)

on the ground that the stock of Windsor Resources became

worthless in 1986. Even if we accept petitioner's

testimony that he borrowed $10,000 to invest in stock of

Windsor Resources, petitioners must still prove that the

stock became worthless in 1986. E.g., Boehm v. Commis-

sioner, 326 U.S. 287, 293-294 (1945).

In view of petitioner's testimony, we cannot find that

the stock of Windsor Resources became worthless in 1986.

Petitioner testified candidly: "I don't know when it [the

bankruptcy of Windsor Resources] occurred." Accordingly,
 - 65 -

we hereby sustain respondent's disallowance of the capital

loss claimed by each petitioner in the amount of $4,441.36.

Self-Employment Tax Issue

As discussed above, the self-employment taxes reported

by each petitioner and the amounts determined in the

notices of deficiency are as follows:

Woody F. Lemons, Docket No. 16562-90

Year Per Return Per Notice Adjustment
1986 -- -- --
1987 $2,334.87 $4,465 $2,130.13
1988 1,100.47 4,935 3,834.53

Paula S. Lemons, Docket No. 16799-90

Year Per Return Per Notice Adjustment
1986 -- -- --
1987 $2,334.87 $2,335 --
1988 1,100.47 1,100 --

It is readily apparent that the notice of deficiency

issued to Mrs. Lemons does not adjust the self-employment

tax that she reported. On the other hand, the notice of

deficiency issued to Mr. Lemons adjusts the self-employment

tax that he reported for 1987 and 1988, but it does not

explain the nature of the adjustments or their computation.

The petition filed on Mr. Lemons' behalf does not take

issue with these adjustments, and they were not raised at

trial or in petitioners' opening brief.
 - 66 -

Respondent's opening brief states as follows:

Also, there are two additional adjustments.
In the notice of deficiency issued to petitioner
in Docket No. 16562-90 [Mr. Lemons], respondent
did not adjust the self employment tax for the
1987 taxable year. Respondent has recently
discovered that the correct amount of such tax
is $3,911 instead of $2,335. Also, the adjust-
ment to the self employment tax for taxable year
1987 of petitioner in Docket No. 16799-90
[Mrs. Lemons] is also incorrect. The amount
should be increased from the notice of deficiency
amount of $2,335.00 to $4,465.00. Both of these
adjustments, because they are computational and
unrelated to the other adjustments in the
notices, should be addressed at the conclusion
of this matter under T.C. Rule 155.

Contrary to the above, the notice of deficiency issued to

Mr. Lemons, petitioner in docket No. 16562-90, does adjust

the self-employment tax reported by Mr. Lemons for 1987,

and the notice of deficiency issued to Mrs. Lemons,

petitioner in docket No. 16799-90, made no adjustment to

the self-employment tax reported by Mrs. Lemons for 1987.

Petitioners' reply brief contains the following

statement in response to respondent:

Respondent states that there are two
additional adjustments which were not made in the
Notice of Deficiency relating to self employment
tax for 1987 and that these adjustments should be
addressed in the Rule 155 computation. Neither
of these adjustments was made in the Notice of
Deficiency, neither was mentioned in either
 - 67 -

Petition because Petitioners had no notice that
these adjustments would be proposed, neither side
offered any evidence about these issues, and it
is too late now to raise them for the first time.
Respondent would have had to timely move for
permission to seek an increased deficiency and
properly plead these matters for them to be
issues.

We note that neither party takes issue with the

adjustment made in the notice of deficiency to the self-

employment tax reported by Mr. Lemons for 1988.

Accordingly, that adjustment is hereby sustained. We

also note that no adjustment was made in the notice of

deficiency to the self-employment tax reported by

Mrs. Lemons for 1988.

In the case of respondent's adjustment to the self-

employment tax reported by Mr. Lemons for 1987, petitioners

bear the burden of proving that respondent's adjustment is

incorrect. Rule 142(a). They did not take issue with this

adjustment in Mr. Lemons' petition or at trial.

Accordingly, petitioners have failed to meet their burden

of proof, and we hereby sustain respondent with respect to

this adjustment.

As mentioned, no adjustment was made in the notice

of the deficiency to the self-employment tax reported by

Mrs. Lemons for 1987, and respondent has not sought to

amend the Government's pleadings to raise such an adjust-
 - 68 -

ment. Thus, no adjustment to Mrs. Lemons' self-employment

tax for 1987 is before the Court. In passing, we note that

respondent's brief, quoted above, states that Mrs. Lemons'

self-employment tax for 1987 should be increased "at the

conclusion of this matter under T.C. Rule 155."

Respondent's brief also states that this "adjustment"

is "unrelated to the other adjustments in the notices."

However, if this adjustment is unrelated to the other

adjustments in the notice, it would appear to be a new

issue which cannot be raised for the first time either

in a post-trial brief or in a Rule 155 proceeding. See

Bankers' Pocahontas Coal Co. v. Burnet, 287 U.S. 308

(1932); Cloes v. Commissioner, 79 T.C. 933 (1982);

Estate of Papson v. Commissioner, 74 T.C. 1338, 1340

(1980); Estate of Stein v. Commissioner, 40 T.C. 275

(1963).

To reflect the foregoing and concessions,

Decisions will be entered

under Rule 155.