T.C. Memo. 1997-503
UNITED STATES TAX COURT
DAVID E. AND CHERYL G. SMITH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 17071-95. Filed November 10, 1997.
Jon R. Vaught, for petitioners.
Kimberley J. Peterson, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: Respondent, by means of a statutory notice
of deficiency, determined the following income tax deficiencies
and section 6662(a)1 penalties with respect to petitioners:
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years under
consideration, and all Rule references are to this Court's Rules
of Practice and Procedure.
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Penalty
Year Deficiency Sec. 6662
1990 $11,276 $2,255
1991 22,232 4,446
1992 36,483 7,297
By way of an amendment to respondent's answer, respondent
sought increased deficiencies and penalties against petitioners
under section 6214 for each of the years in issue, alleging that
petitioner David Smith received taxable distributions from a
pension plan under section 72(p) and (t). Respondent asserted
that petitioners are liable for increased income tax deficiencies
and section 6662 penalties of:
Penalty
Year Deficiency Sec. 6662
1990 $3,185 $637
1991 13,939 2,788
1992 21,413 4,283
The increases result in combined income tax deficiencies and
penalties in controversy as follows:
Penalty
Year Deficiency Sec. 6662
1990 $14,461 $2,892
1991 36,171 7,234
1992 57,896 11,580
On brief, petitioners conceded that petitioner Mr. Smith received
distributions from his pension plan taxable under section 72(p)
and (t).2 The following issues remain for our consideration: (1)
2
However, petitioners have not conceded that they are liable
for the increased sec. 6662(a) accuracy-related penalties
asserted in respondent's Amendment to Answer.
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Whether petitioners' dog-breeding activity during the taxable
years 1990, 1991, and 1992 was engaged in for a profit; and (2)
whether any underpayment of tax is due to negligence or
intentional disregard of rules or regulations.
FINDINGS OF FACT
At all times relevant to this case petitioners were husband
and wife and resided in Los Gatos, California. They filed joint
Federal income tax returns for all 3 years at issue.
David Smith (Mr. Smith) is a medical doctor and was employed
as a vascular surgeon during the taxable years at issue at Good
Samaritan Hospital in San Jose, California. Mr. Smith generally
worked 10 hours per day, 5 days a week as a physician. In
addition, he was required to be "on-call" as a physician every
third night and every third weekend. Cheryl Smith (Mrs. Smith)
was not employed outside of petitioners’ household during the
taxable years at issue.
Mr. Smith received wages from his medical practice totaling
$289,347, $278,419, and $242,960 for the taxable years 1990,
1991, and 1992, respectively. In addition to the wages, Mr.
Smith received rental income from the leasing of medical
equipment to Good Samaritan Hospital. His net rental income was
$47,872, $51,957, and $38,405 for the taxable years 1990, 1991,
and 1992, respectively. Petitioners also owned an agricultural
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business named Madera Farm. Primarily, farm income was from the
sale of figs and pistachios.
Petitioners first became involved in dog-showing activities
in 1987 when they purchased their first show dog, a standard
poodle. Although petitioners had no interest in dog-breeding
activity in 1987, they built a kennel at their Los Gatos
residence in order to care for a growing number of dogs.
Petitioners became interested in dog-breeding activity during
1989, at which time they began to consult with dog breeders and
research the subject of dog breeding. Mr. Smith also attended
veterinarian seminars for dog breeders.
Petitioners, in addition to breeding standard poodles (a
more common breed), decided to breed Portuguese water dogs (a
rare breed) in the hopes of commanding higher prices. Their goal
was to produce the highest quality dog possible. Mr. Smith did
not prepare formal spreadsheets on the potential profitability of
dog breeding, but he did estimate the annual potential to earn
between $30,000 and $50,000 in gross receipts from dog breeding.
Mr. Smith did not commit these estimates to writing. Petitioners
did not consult with economic advisers or accountants prior to
beginning their dog-breeding activity.
Petitioners placed their names on a waiting list and
eventually received two Portuguese water dogs. Petitioners were
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able to begin breeding their dogs in 1990. They named their
activity Dacher Kennel and began advertising in national dog-
breeding magazines. Petitioners paid thousands of dollars
promoting the name of Dacher Kennel. In addition, they hired
professional handlers to show their dogs and to help establish
their kennel's reputation.
During the taxable years 1990, 1991, and 1992, petitioners
maintained approximately three adult dogs at their Los Gatos
residence and 15 to 30 additional dogs at outside kennels. Mr.
Smith typically spent 8 to 10 hours per week performing various
activities in keeping and caring for the dogs, including
performing basic veterinary procedures. Mrs. Smith typically
spent approximately 12 hours per week caring for the dogs and
spent an additional 12 hours per month in promotional activities
related to dog breeding and showing. For the first
3 weeks after puppies were born, petitioners had to be "on call"
to care for the puppies 24 hours a day.
Mr. Smith kept track of expenses and revenues of the dog-
breeding activity on his computer. Petitioners, however, did not
keep track of which of their dogs were profitable. Although Mr.
Smith maintained a separate checking account for Dacher Kennels,
occasionally he used personal checks to pay for dog-breeding and
showing activity expenses.
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Petitioners achieved their goal of breeding high-quality
dogs. One of petitioners' dogs, Dacher Gotta Get a Gun, won 21
best-of-breed competitions in 1992 and was also the 10th-ranked
Portuguese water dog in the country that year. Unfortunately,
petitioners' success at the shows did not translate into a
profit-making activity.
Progressive retinal atrophy (PRA), a degenerative disease of
the retina that causes blindness, began appearing in Portuguese
water dogs in September of 1990. Within a year, the number of
Portuguese water dogs diagnosed with PRA went from 2 to 42.
However, Mr. Smith did not know that any of his dogs were
afflicted with PRA until 1994.
Petitioners reported net losses from their kennel in the
amount of $38,724, $69,629, and $109,795 for the taxable years
1990, 1991, and 1992, respectively. During that same period,
petitioners reported gross receipts of only $5,055, $4,650, and
$5,950, primarily from the sale of puppies and from stud fees.
Petitioners' losses were due primarily to the high cost of
dog boarding and handling. In 1992, petitioners reported $88,700
in dog boarding and handling expenses. That amount constituted
nearly 90 percent of the expenses associated with the dog-
breeding and showing activity for 1992. In the notice of
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deficiency, respondent disallowed the losses associated with the
dog-breeding activity as not engaged in for profit.
OPINION
Issue 1. Section 183
Initially we must decide whether petitioners’ dog-breeding
activity was not engaged in for profit. Section 183(a) provides
that individual taxpayers will not be allowed deductions which
are attributable to an "activity * * * not engaged in for
profit". This term of art is defined in section 183(c) as "any
activity other than one with respect to which deductions are
allowable for the taxable year under section 162 [trade or
business] or under paragraph (1) or (2) of section 212 [expenses
incurred for the production of income]." Section 183(b) permits
deductions which would be allowable only if the activity were
engaged in for profit, but such deductions may be taken only to
the extent that any gross income generated from the activity
exceeds deductions which are not dependent upon a profit
objective (e.g., State and local taxes under section 164).
Although a reasonable expectation of profit is not required,
the facts and circumstances must indicate that the taxpayer
entered into the activity, or continued the activity, with the
actual and honest objective of making a profit. Keanini v.
Commissioner, 94 T.C. 41, 46 (1990); Dreicer v. Commissioner, 78
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T.C. 642, 645 (1982), affd. without published opinion 702 F.2d
1205 (D.C. Cir. 1983); sec. 1.183-2(a), Income Tax Regs. In
making this determination, more weight is accorded to objective
facts than to the taxpayer's statement of intent. Engdahl v.
Commissioner, 72 T.C. 659, 666 (1979); sec. 1.183-2(a), Income
Tax Regs. Petitioners bear the burden of proving that they
possessed the required profit objective. Rule 142(a); Dreicer v.
Commissioner, supra; Golanty v. Commissioner, 72 T.C. 411, 426
(1979), affd. without published opinion 647 F.2d 170 (9th Cir.
1981).
In determining whether an activity is engaged in for profit,
reference is made to objective standards, taking into account all
of the facts and circumstances of each case. Sec. 1.183-2(a),
Income Tax Regs. The regulations set forth nine criteria
normally considered for this purpose. The factors are: (1) The
manner in which the taxpayer carries on the activity; (2) the
expertise of the taxpayer or his advisers; (3) the time and
effort expended by the taxpayer in carrying on the activity; (4)
the expectation that assets used in the activity may appreciate
in value; (5) the success of the taxpayer in carrying on other
similar or dissimilar activities; (6) the taxpayer's history of
income or losses with respect to the activity; (7) the amount of
occasional profits, if any, which are earned; (8) the financial
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status of the taxpayer; and (9) the presence of elements of
personal pleasure or recreation. Sec. 1.183-2(b), Income Tax
Regs. None of these factors is determinative, nor is the
decision to be made by comparing the number of factors that weigh
in the taxpayer's favor with the number that support the
Commissioner. Id.
Petitioners argue that they had the requisite profit
objective with respect to their dog-breeding activity.
Conversely, respondent asserts that the activity was not engaged
in for profit. We agree with respondent. Because the parties
argued their respective cases by addressing each of the nine
criteria enumerated in the regulations, we follow the same
approach in our discussion.
1. Manner in Which the Activity Is Conducted
We begin by examining the manner in which petitioners
carried on their dog-breeding activity. The fact that a taxpayer
carries on the activity in a businesslike manner and maintains
complete and accurate books and records may indicate a profit
objective. Sec. 1.183-2(b)(1), Income Tax Regs. In deciding
whether the taxpayer has conducted the activity in a businesslike
manner this Court has considered, "whether accurate books are
kept, whether the activity is conducted in a manner similar to
other comparable businesses and whether changes have been
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attempted in order to make a profit." Ballich v. Commissioner,
T.C. Memo. 1978-497.
Petitioners assert that the fact that they utilized a
software program in order to keep track of expenses is evidence
that they carried on their dog-breeding activity in a
businesslike manner. At trial, however, Mr. Smith admitted that
there were no records kept on which, if any, of his dogs in the
kennel were profitable. Without such knowledge petitioners would
have no way of determining which dog or breed of dogs was
earning, or had the potential to earn, a profit. The lack of
detailed records as to which dogs were or were not profitable is
an indication that the dog-breeding activity was not carried on
for profit. Id.
Petitioners assert that their use of targeted advertising in
numerous trade magazines demonstrates that they conducted their
kennel in a businesslike manner. However, petitioners did not
advertise in any local medium of general circulation.
Perhaps the most important indication of whether or not an
activity is being performed in a businesslike manner is whether
or not the taxpayer implements some method for controlling
losses. Burger v. Commissioner, 809 F.2d 355, 359 (7th Cir.
1987), affg. T.C. Memo. 1985-523. Mr. Smith asserts that he
attended veterinary seminars and performed basic veterinary
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procedures in an effort to help keep down costs. However,
veterinary bills did not represent a significant portion of the
activity's expenses. The vast majority of expenses in connection
with the dog-breeding and showing activity was for boarding and
handling. Petitioners made no attempt to reduce this expense.
To the contrary, the cost of dog boarding and handling increased
precipitously from $19,102 to $88,700 from 1990 to 1992. We
conclude that petitioners did not operate their dog-breeding
activity in a businesslike manner.
2. Expertise of Petitioners
We next consider the expertise of petitioners with respect
to their dog-breeding activity. Sec. 1.183-2(b)(2), Income Tax
Regs. A taxpayer's expertise, research, and study of an
activity, as well as his or her consultation with experts, may be
indicative of a profit intent. Id.
Mr. Smith met with breeders, attended seminars and read
books on the subject of dog breeding. In addition, his medical
background, combined with his attending veterinary seminars,
provided Mr. Smith with some knowledge of basic dog anatomy and
medicine. Nevertheless, the fact that Mr. Smith was "skilled in
the art of dog breeding does not mean that petitioners began or
continued their dog breeding activity for profit." Glenn v.
Commissioner, T.C. Memo. 1995-399, affd. without published
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opinion 103 F.3d 129 (6th Cir. 1996). Significantly, petitioners
did not seek professional economic or accounting advice on the
economic aspects of breeding dogs. Other than Mr. Smith's rough
estimation of potential gross receipts, they made no analysis or
plan for earning a profit from breeding dogs, or even considered
potential costs. Most important, they did not analyze or consult
about the amount of expenses that they were likely to incur. The
failure to seek professional advice is another factor that
indicates a lack of profit motive. Burger v. Commissioner,
supra.
3. Time and Effort Spent in Conducting the Activity
We next consider the time and effort spent by petitioners in
conducting their dog-breeding activity. Sec. 1.183-2(b)(3),
Income Tax Regs. The fact that the taxpayer devotes much of his
personal time and effort to carrying on an activity, particularly
if the activity does not have substantial personal or
recreational aspects, may indicate an intention to derive a
profit. Id.
The record indicates that Mr. Smith spent approximately 8 to
10 hours per week, and Mrs. Smith spent approximately 12 hours
per week in keeping and caring for the dogs. Accordingly, we
find that significant time and effort were spent by the couple in
carrying on the activity. However, we also discern that
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petitioners derived substantial recreational benefit from the
time they spent with their dogs; therefore, this factor is
generally neutralized.
4. Expectation That the Assets Will Appreciate in Value
Another factor is the taxpayers' expectation that the assets
used in their breeding activity would increase in value. Sec.
1.183-2(b)(4), Income Tax Regs. Mr. Smith testified that in 1992
one of petitioners' dogs, Dacher Gotta Get a Gun, was the 10th-
ranked Portuguese water dog in the country. In addition,
petitioners, at the time of trial, owned the first- and second-
ranked Portuguese water dogs in the country. Therefore, there is
evidence that the value of some of the dogs in the kennel has
appreciated. However, petitioners have failed to offer into
evidence any records on the value of any of their dogs, or on the
appreciation in value of their inventory of dogs during the years
in issue. This paucity of evidence makes it difficult for us to
determine whether petitioners had an expectation that the assets
used in their activity would increase, or if they did increase,
in value. See Carson v. Commissioner, T.C. Memo. 1990-508.
5. Taxpayer's Success in Similar or Dissimilar Activities
We next consider petitioners' prior experience in similar or
dissimilar activities. Sec. 1.183-2(b)(5), Income Tax Regs.
Although an activity is unprofitable, the fact that a taxpayer
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has previously converted similar activities from unprofitable to
profitable enterprises may be an indication of a profit motive
with respect to the current activity. Id.
Mr. Smith operated a successful medical practice, and
although petitioners' farm showed losses during the first 3
years, it has since been profitable. Petitioners had little
prior experience in dog breeding and showing. However, while
prior experience may indicate that a taxpayer is engaged in an
activity for profit, the lack of such experience does not
necessarily indicate that the activity was not engaged in with
the objective of making a profit. Pirnia v. Commissioner, T.C.
Memo. 1989-627; sec. 1.183-2(b)(5), Income Tax Regs.
Accordingly, we find that this factor weighs in favor of
petitioners.
6. The Activity's History of Income and/or Losses
An important consideration is petitioners' history of income
and/or losses with respect to their dog-breeding activity. Sec.
1.183-2(b)(6), Income Tax Regs. Losses continuing beyond the
period customarily required to make an activity profitable, if
not explainable, may indicate that the activity is not engaged in
for profit. Id.
By the end of the 1992 taxable year, petitioners had
incurred more than $218,000 in losses from the dog-breeding
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activity. They used these losses to offset their substantial
income from other sources. Petitioners reported static gross
receipts of $5,055, $4,650, and $4,950 for the taxable years
1990, 1991, and 1992, respectively. The magnitude of the
activity's losses in comparison with its revenues is an
indication that petitioners did not have a profit motive with
respect to the dog-breeding activity. Burger v. Commissioner,
809 F.2d at 360. In fact, petitioners' reported expenses for
1991 and 1992 were far greater than even petitioner Mr. Smith's
estimates of the potential for gross revenues from dog breeding.
Petitioners assert that the reported losses were typical for
the startup stage of any profit-making activity. The record
reveals, however, that the massive losses were not the result of
expenses associated with the startup stage of a dog-breeding
enterprise. The losses during the first 3 years were not the
result of purchasing breeding stock, or from building a kennel.
Petitioners had a kennel built on their property in 1987, 2 years
before they became interested in the dog-breeding business. The
losses during the 3 years in issue were primarily the result of
the cost of dog boarding and handling. Dog boarding and handling
expenses are not associated with the startup stage of a dog-
breeding enterprise; in fact, these expenses are likely to grow
as the size of petitioners' dog stock grows. We therefore find
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petitioners' argument that the losses were the result of startup
expenses to be without merit.
In addition, petitioners assert that their losses were the
result of "unforeseen or fortuitous circumstances * * * beyond
* * * [their] control". Sec. 1.183-2(b)(6), Income Tax Regs.
Petitioners assert that the disease PRA caused an unanticipated
increase in expenses in 1992 because they were required to
purchase new stock for breeding. This argument fails for two
reasons. First, PRA did not have a significant impact on
petitioners' dog-breeding activity during the taxable years in
question. Petitioners did not know that any of their dogs even
had PRA until 1994. Second, as already noted, petitioners'
losses were largely the result of the high cost of dog boarding
and handling, and not from the purchase of breeding stock.
7. Amount of Occasional Profits
The amount and frequency of occasional profits earned from
the activity may also be indicative of a profit objective. Sec.
1.183-2(b)(7), Income Tax Regs. Given that petitioners have
never reported a profit on their dog-breeding activity, we find
that this factor supports a finding that the dog-breeding
activity was not carried on for profit. Glenn v. Commissioner,
T.C. Memo. 1995-399.
8. Financial Status of the Taxpayer
We next consider petitioners' financial status. Sec. 1.183-
2(b)(8), Income Tax Regs. Substantial income from sources other
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than the activity, particularly if the activity's losses
generated substantial tax benefits, may indicate that the
activity is not engaged in for profit. This is especially true
where there are personal or recreational elements involved. Id.
Petitioners concede that their other business activities
were successful and that this factor does not weigh in their
favor. The income of petitioners was substantial and was
sufficient to enable them to maintain a comfortable standard of
living notwithstanding the losses from the dog-breeding activity.
In addition, petitioners were able to receive a substantial tax
benefit from the deduction of these losses. Therefore, the fact
that petitioners had substantial income from outside sources,
showing the lack of need to make a profit from the activity,
supports a finding that petitioners did not carry on their dog-
breeding activity for profit. Golanty v. Commissioner, supra at
428-429.
9. Elements of Personal Pleasure
The final factor is the personal pleasure derived by
petitioners in conducting their activity. Sec. 1.183-2(b)(9),
Income Tax Regs. Although the mere fact that a taxpayer derives
personal pleasure from a particular activity does not mean that
he or she lacks a profit intent with respect thereto, the
presence of personal motives may indicate that the activity is
not engaged in for profit. This is especially true when there
are recreational elements involved. Id.
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Petitioners concede that they derived personal pleasure from
working with and showing their dogs. As this Court has stated,
with respect to this factor:
Unquestionably, an enterprise is no less a
"business" because the entrepreneur gets
satisfaction from his work; however, where
the possibility for profit is small (given
all the other factors) and the possibility
for gratification is substantial, it is clear
that the latter possibility constitutes the
primary motivation for the activity. * * *
[Burger v. Commissioner, T.C. Memo. 1985-523;
fn. ref. omitted.]
Therefore, the fact that petitioners derived substantial personal
pleasure from their dog-breeding activity supports a finding that
the activity was not carried on for profit.
Considering all of the facts and circumstances, we find that
petitioners have failed to prove that their dog-breeding and
showing activity was engaged in for profit. Rule 142(a).
Accordingly, respondent's determination in that regard is
sustained.
Issue 2. Accuracy-Related Penalty Under Section 6662(a)
Respondent also determined that petitioners were liable for
penalties under section 6662(a) and (b)(1) for each of the years
in issue because petitioners were negligent for claiming
deductions from their dog-breeding and showing activity. Section
6662(a) and (b)(1) imposes an accuracy-related penalty equal to
20 percent of the portion of an underpayment that is attributable
to negligence or disregard of rules or regulations.
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Negligence has been defined as "a lack of due care or a
failure to do what a reasonable person would do under the
circumstances." Leuhsler v. Commissioner, 963 F.2d 907, 910 (6th
Cir. 1992), affg. T.C. Memo. 1991-179. Respondent's
determination of negligence is presumed to be correct, and the
taxpayer has the burden of proving that the determination is
erroneous. Rule 142(a). Therefore, petitioners must prove that
they were not negligent, i.e., that they made a reasonable
attempt to comply with the provisions of the Internal Revenue
Code, and that they were not careless, reckless, or in
intentional disregard of rules or regulations. Sec. 6662(c);
sec. 1.6662-3(b), Income Tax Regs.
We sustain respondent's determination. In determining
whether petitioners were negligent in the preparation of their
returns, we take into account petitioner Mr. Smith's business
experience. Glenn v. Commissioner, supra. Additionally, the
size of the tax losses claimed by petitioners in relation to the
revenue earned from the dog-breeding and showing activity
combined with the substantial enjoyment that petitioners derived
from the activity created a situation that was "too good to be
true" within the meaning of section 1.6662-3(b)(1)(ii), Income
Tax Regs. Accordingly, petitioners are liable for the section
6662(a) penalties.
A different result must be reached with respect to the
section 6662(a) penalties that respondent sought by way of an
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increase in deficiency. Respondent bears the burden of proving
the increases in deficiency and penalties asserted in his
Amendment to Answer. Rule 142(a); Sproul v. Commissioner, T.C.
Memo. 1995-207. Although petitioners have conceded that they are
liable for the increase in deficiency, petitioners have not
conceded that they are liable for the accuracy-related penalties
asserted in respondent's Amendment to Answer.
Respondent has failed to sustain the burden of proving the
penalties asserted in the Amendment to Answer. Respondent
erroneously assumed on brief that petitioners had the burden of
proof with respect to this issue, and therefore respondent
presented no proof that petitioners acted negligently or
intentionally disregarded the rules or regulations by failing to
report taxable distributions from petitioner husband’s pension
plan. Accordingly, we hold that petitioners are liable for the
accuracy-related penalties reflected in respondent's notice of
deficiency, but not for the accuracy-related penalties resulting
from the increases in the deficiencies.
To reflect the foregoing,
Decision will be entered
under Rule 155.