T.C. Memo. 1999-72
UNITED STATES TAX COURT
RICHARD L. AND MARJORIE A. PITTS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 3937-97. Filed March 10, 1999.
Chester A. Swart, for petitioners.
Bradley T. Stanek, for respondent.
MEMORANDUM OPINION
NAMEROFF, Special Trial Judge: This case was heard pursuant
to the provisions of section 7443A(b)(3)1 and Rules 180, 181, and
182. Respondent determined a deficiency in petitioners’ 1993
Federal income tax in the amount of $3,141 and an accuracy-
related penalty under section 6662(a) in the amount of $628.
The issues for decision are: (1) Whether petitioners
engaged in their horse-related activity during 1993 with the
1
All section references are to the Internal Revenue Code
in effect for the year at issue. All Rule references are to the
Tax Court Rules of Practice and Procedure.
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objective of making a profit within the meaning of section 183;
if so, (2) whether petitioners are entitled to a depreciation
deduction for their barn; (3) whether petitioners realized a
capital gain in the amount of $2,000 in 1993; and (4) whether
petitioners are liable for the accuracy-related penalty pursuant
to section 6662(a).2
Background
As a preliminary matter, both parties raised relevancy
objections to certain exhibits. Rule 401 of the Federal Rules of
Evidence, applicable to this Court pursuant to Rule 143 and
section 7453, defines relevant evidence as “evidence having any
tendency to make the existence of any fact that is of consequence
to the determination of the action more probable or less probable
than it would be without the evidence.” Upon reviewing the
exhibits in question, we find they are relevant within the
meaning of rule 401 of the Federal Rules of Evidence. The
objections are overruled.
Some of the facts have been stipulated, and they are so
found. The stipulation of facts and the attached exhibits are
incorporated herein by this reference. At the time they filed
their petition, petitioners resided in Whittier, California.
Marjorie Pitts (petitioner) acquired her first horse and
started training horses in 1958. She started showing horses
professionally in 1960 for an executive on the east coast. Two
2
Petitioners raised the issue of innocent spouse (as to
one or both) in their petition but conceded the matter at trial.
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of those horses that petitioner showed won New England Champion.
In the early 1960's, both petitioners worked for the California
Breeders Association in Circleville, Utah. Petitioners were in
charge of breeding 12 stallions to over 100 mares on this farm.
After leaving the California Breeders Association, petitioners
moved to California and worked for Mr. John Dick, where they
managed and trained horses on his farm. Then in the mid-1960's,
petitioners took jobs not associated with the horse business.
In 1982 petitioners bought their house in Whittier on a
half-acre parcel zoned “R-1”, which does not permit horses.
However, many of petitioners’ neighbors also kept horses. In
1984, petitioners erected a portable barn on their property. The
barn had a breezeway and four stalls. In back of the barn were
four pipe pens. Petitioners acquired quarter horses around this
time with the intent to breed and race them. In 1985 petitioners
filed a Fictitious Business Name Statement stating that they were
doing business as Midget Acres. Petitioners also received a
public health license issued by the County of Los Angeles. Los
Angeles County Code section 7.04.010 requires a license before
the commencement of any business activity. Petitioners did not
have a business license.
In 1986 and 1987 petitioners worked at the Kerr stock farm
(the Kerr farm) where petitioner trained horses.3 Petitioners
took their own horses with them to the Kerr farm, where they
3
Petitioner testified that Mr. Pitts worked on underwater
treadmills for the horses at the Kerr farm.
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raised, bred, and raced them. The costs for the caring of
petitioners’ horses at the Kerr farm were included as part of
petitioners’ wages. Petitioners hired professional trainers for
the racing of the horses. Their horses were racing at Los
Alamitos, Golden Gate, and Bay Meadows racetracks.
Petitioners left the Kerr farm in 1987 and moved back to
their house in Whittier with their horses. Petitioner was
employed at Lawyers Mutual Insurance Co., and Mr. Pitts,
suffering from a muscle-wasting disease which required drug
therapy, stayed home.
Around 1988, petitioners decided that racing quarter horses
was too expensive. The trainer’s fees were high, and the purses
were small. Petitioner owned a thoroughbred with five other
people which had won $25,000 in a race in 1987. Petitioners
decided to switch to thoroughbred horses because stakes races
(such as the Kentucky Derby) paid higher purses. Petitioners
sold some of their quarter horses and started acquiring
thoroughbreds.4
Initially, petitioners acquired two thoroughbred mares and
Ding Dong Daddy, a thoroughbred stallion that came from good
blood lines. Petitioners offered Ding Dong Daddy for stud.
According to a promotional flyer that petitioners distributed,
Ding Dong Daddy had earned $24,964 in his first 2 years of
racing. The flyer also detailed the horse’s sire and female
4
Petitioners did retain one quarter horse that they raced,
and another that they bred.
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lines and the racing history of those horses. Petitioners did
not race Ding Dong Daddy. Petitioners bred him with their own
horses and with outside horses for a stud fee. Petitioner bred
Ding Dong Daddy with one of her mares and produced Blue’s Ding
Dong, which she sold. Blue’s Ding Dong became a successful
racing horse.
Petitioners also acquired another stallion named Halyard
that allegedly sired $4 million worth of winners. Halyard, an
older horse, was known to be a difficult breeder. Indeed, he
produced no offspring for petitioners. Halyard died in 1996.
Petitioners listed both Ding Dong Daddy and Halyard in the
Thoroughbred Times in 1993. The Thoroughbred Times is a stallion
directory, and in petitioners’ listings, they listed the
bloodlines and the stud fees. The stud fee for Ding Dong Daddy
was $1,000 and for Halyard, $1,250. But both fees were, as
petitioner stated, “negotiable”. Petitioners did not do any
other advertising.
Midget Acres provided a “stallion service contract” to horse
owners who wanted to breed a mare with one of petitioners’
stallions. Petitioners would board a mare at their barn, and
petitioner would check the mare to see when she was in heat and
then determine when to do the breeding. Petitioners charged a
booking fee which was 10 percent of the stud fee. If the mare
gave birth to a live foal, petitioners would collect the stud
fee. According to petitioner, it takes about a year from
conception for the mare to give birth. Therefore, petitioners
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would typically receive the booking fee in one year and the stud
fee in the next.
During the year at issue, in addition to the quarter horses,
petitioners owned seven horses: Ding Dong Daddy and Halyard,
three mares, and two yearlings. Petitioners also boarded four
additional horses during 1993.5 According to a chart submitted
at trial, petitioners would charge $7 a day for boarding or $7.50
per day if the horse had a foal at her side. These fees included
feed. The cost of feed per month per horse is about $100.
Petitioners would add veterinarian and trimming fees to the bill.
Of the four boarded horses, two were bred for which petitioners
charged a $100 breeding fee. Another horse had a foal at her
side; it had been bred at Midget Acres in 1992, but the stud fee
had not yet been collected.
Petitioners sold two of their horses, Jenny Sport and Actis
Uptis, in October of 1993 for $1,000 each. (It is not clear
whether these horses were included in the seven referred to
above.) Jenny Sport was a racing horse that was a gift to
petitioner after it broke down at the track, and Actis Uptis,
sired by Ding Dong Daddy, was born at Midget Acres. Petitioners
did not have a cost basis for either horse.
Petitioners billed a total of $4,297 in 1993. However, they
collected only $2,892, including the $2,000 for the sales of the
5
With only four stalls and four pipe pens, petitioners had
room for only eight horses. When they had the additional
boarders, petitioners sent their own horses to the neighbor’s
pen.
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two horses. According to petitioner, two of the horse owners
never paid petitioners for boarding and fees; petitioners did not
take legal action and were unsuccessful collecting the debt.
The parties stipulated that the following income, expenses,
and losses from the horse-related activity were reported in
petitioners’ returns for the years 1986 through 1994 and 1996:6
Year Gross Income Expenses Net Loss
1986 $600 $19,900 ($19,300)
1987 1,182 11,055 (9,873)
1988 --- --- (9,032)
1989 --- --- (9,194)
1990 --- --- (12,655)
1991 4,208 13,544 (9,336)
1992 --- --- (15,970)
1993 2,802 13,732 (10,930)
1994 2,000 7,146 (5,146)
1996 15 9,577 (9,562)
The record does not disclose the nature of the various gross
income figures; i.e., whether from stud fees, boarding fees,
sales of offspring, etc. Copies of the various Schedules C were
not exhibited, so we cannot even identify the major expense
groups or whether any cost savings plans were put into effect.
For 1995, petitioners did not file a Schedule C, Profit or
Loss From Business, with respect to the horse-related activity.
According to petitioner, that year the stallions were sent away.
Around 1996, a foal was born to petitioner’s quarter horse mare,
and petitioner is currently training this foal to be a show
horse. According to petitioner, the colt has received “reserved
champion Pacific Coast quarter horse”.
6
For the years 1988, 1989, 1990, and 1992, only the net
losses were provided.
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During 1993, petitioner worked about 35-37 hours a week as a
litigation specialist, and Mr. Pitts, not working because of his
disability, would feed and water the horses every day. After
work, petitioner cleaned the stalls and did the heavy work that
Mr. Pitts could not do. Petitioner consulted her breeding charts
to see if any mares were due to breed, and she would do the
breeding. Ding Dong Daddy was the stud used by petitioner in
1993.
For 1993, petitioner earned $52,815, and Mr. Pitts collected
$11,6597 in Social Security benefits. On their Schedule C for
1993 petitioners listed Midget Acres as their business. They
reported $2,8028 in gross income and claimed the following
expenses:
Expense Amount
Car and truck $2,182
Depreciation 1,818
Office 72
Dues and subscriptions 161
Feed 6,854
Shoeing 400
Trash 744
Vet fees 1,501
Total 13,732
This resulted in a net loss of $10,930. Petitioners retained
receipts for the horse-related expenses.
7
Of this amount, $5,830 was taxable.
8
We note that petitioners’ chart shows that they collected
$2,892. This discrepancy was neither noticed nor explained but
is irrelevant in light of our holding on the sec. 183 issue.
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Petitioners’ return was prepared by a certified public
accountant whom they have used for a number of years.
Petitioners were audited with regard to their horse-related
activity for taxable year 1987 and were represented by their
accountant for this audit. In the end, there was no deficiency
for 1987 with respect to the horse-related activity.
Discussion
In the notice of deficiency, respondent disallowed the
claimed loss on the basis that petitioners did not establish that
their horse activity was entered into for profit. Respondent
also determined that petitioners failed to report a capital gain
in the amount of $2,000 from the sales of two horses.
Substantiation is not an issue except for $753, the amount
that petitioners claimed for depreciation of their barn.
Petitioners no longer have documentation for their cost basis of
the barn.
Horse-Related Activity
We must decide whether petitioners’ horse-related activity
was engaged in for profit. Section 183(a) generally provides
that if an activity engaged in by an individual is not entered
into for profit, no deduction attributable to the activity shall
be allowed, except as otherwise provided in section 183(b).9 An
9
Sec. 183(b) allows deductions for ordinary and necessary
expenses arising from an activity not engaged in for profit only
to the extent of gross income from the activity, less the amount
of those deductions which are allowable regardless of whether
the activity is engaged in for profit.
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“activity not engaged in for profit” means any activity other
than one for which deductions are allowable under section 162 or
under paragraphs (1) and (2) of section 212. See sec. 183(c).
Section 162(a) allows a deduction for all ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on a trade or business. To be engaged in a trade or
business within the meaning of section 162, “the taxpayer must be
involved in the activity with continuity and regularity and * * *
the taxpayer’s primary purpose for engaging in the activity must
be for income or profit.” Commissioner v. Groetzinger, 480 U.S.
23, 35 (1987).
In order for taxpayers to deduct expenses of an activity
pursuant to section 162, profit must be their primary or dominant
purpose for engaging in the activity. See Wolf v. Commissioner,
4 F.3d 709, 713 (9th Cir. 1993), affg. T.C. Memo. 1991-212;
Polakof v. Commissioner, 820 F.2d 321 (9th Cir. 1987), affg. per
curiam T.C. Memo. 1985-197; Independent Elec. Supply, Inc. v.
Commissioner, 781 F.2d 724, 726 (9th Cir. 1986), affg. Lahr v.
Commissioner, T.C. Memo. 1984-472; Carter v. Commissioner, 645
F.2d 784, 786 (9th Cir. 1981), affg. T.C. Memo. 1978-202; Hirsch
v. Commissioner, 315 F.2d 731, 736 (9th Cir. 1963), affg. T.C.
Memo. 1961-256. Whether the taxpayer had the requisite profit
objective is a question of fact to be resolved from all relevant
facts and circumstances. See, e.g., Drobny v. Commissioner, 86
T.C. 1326, 1341 (1986), affd. 113 F.3d 670 (7th Cir. 1997); sec.
1.183-2(b), Income Tax Regs. Profit in this context means
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economic profit independent of tax savings. See, e.g., Antonides
v. Commissioner, 91 T.C. 686, 694 (1988), affd. 893 F.2d 656 (4th
Cir. 1990).
Section 1.183-2(b), Income Tax Regs., provides a non-
exclusive list of factors we consider to determine whether the
taxpayers are engaged in the venture with a profit objective.
They include: (1) The manner in which the taxpayers carried on
the activity; (2) the expertise of the taxpayers or their
advisers; (3) the time and effort expended by the taxpayers in
carrying on the activity; (4) the expectation that the assets
used in the activity may appreciate in value; (5) the success of
the taxpayers in carrying on other similar or dissimilar
activities; (6) the taxpayers’ history of income or loss with
respect to the activity; (7) the amount of occasional profits
that are earned; (8) the financial status of the taxpayers; and
(9) whether elements of personal pleasure or recreation are
involved. No single factor is controlling, and we do not reach
our decision by merely counting factors that support each party’s
position. See Dunn v. Commissioner, 70 T.C. 715, 720 (1978),
affd. 615 F.2d 578 (2d Cir. 1980); sec. 1.183-2(b), Income Tax
Regs. Certain elements are given more weight than others because
they are more meaningfully applied to the facts in our case.
1. Manner in Which Activity Is Conducted
The fact that a taxpayer carries on the activity in a
businesslike manner and maintains complete and accurate books and
records may indicate that the activity was engaged in for profit.
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Sec. 1.183-2(b)(1), Income Tax Regs. Petitioners kept records of
what was owed to them and how much to bill for veterinarian
services and trimmings for the horses that they boarded.
Petitioners maintained records for everything they spent on the
activity and were able to substantiate just about every expense
claimed. Nevertheless, petitioner testified that they referred
to these records only when preparing their tax returns, not to
monitor their expenses.
When petitioners determined that the breeding and racing of
quarter horses would not be profitable, petitioners modified
their operations by switching to thoroughbreds. However, other
than owning a successful thoroughbred in a joint venture with
several others, there is no evidence that petitioners
investigated the merits of such a switch. Moreover, petitioners
kept two quarter horses, the expenses for which were claimed on
the Schedule C. Petitioner failed to explain why keeping those
quarter horses reflected a profit objective. Furthermore,
petitioner testified that Ding Dong Daddy and Halyard were
valuable horses, but she did not reveal the price that was paid
for them. Additionally, Halyard was an older horse and known to
be a difficult breeder, and petitioner did not have any bookings
for him. We fail to see a profit objective in acquiring Halyard,
but more significantly, in keeping an unproductive stallion for
nearly 8 years.
Petitioners did not prepare business or profit plans with
cost projections or budgets. Petitioner stated that the
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operation was too small for that. It does not appear that Midget
Acres had a separate bank account. We find that petitioners did
not conduct this activity in a businesslike manner.
2. Expertise of Petitioners
Preparation for an activity by extensive study or
consultation with experts may indicate a profit motive where the
taxpayer conducts the activity in accordance with such study or
advice. See sec. 1.183-2(b)(2), Income Tax Regs. Petitioner has
a long history with horses. Both petitioners have worked with
horses, and petitioner especially has great knowledge and
experience about bloodlines and with raising, training, showing,
and breeding of various types of horses. Petitioners also spent
quite a few years working for horse farms where they observed
operations. Petitioner often helped out friends and business
associates with the purchase of racing horses. Petitioner
testified that she sought advice from Robert Hundley who was a
trainer as Santa Anita Hollywood Park and a breeder of
thoroughbred horses. However, petitioner did not testify as to
the kind of advice sought nor the nature of the advice received.
While petitioners have excellent credentials for horse
breeding, training, and racing, it is not clear whether they were
experienced or sought advice with regard to the financial aspects
of operating a horse business.
3. Time and Effort Spent in Conducting Activity
The fact that the taxpayer devotes much of his or her
personal time and effort to carrying on an activity, particularly
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if the activity does not have substantial recreational aspects,
may indicate a profit motive. See sec. 1.183-2(b)(3), Income Tax
Regs. Petitioner devoted about 20 to 25 hours per week to the
horses, in addition to the amount of time Mr. Pitts spent feeding
and watering the horses. It is not clear from the record how
much time Mr. Pitts spent on the horse activity. Petitioner did
all of the cleaning, breeding, and heavy work that Mr. Pitts
could not do. Petitioner would consult the breeding charts and
keep an eye on the mares to determine when they were in heat.
This factor favors petitioners.
4. Expectation That Assets Will Appreciate in Value
An expectation that assets used in that activity will
appreciate in value may indicate a profit objective. See sec.
1.183-2(b)(4), Income Tax Regs. Petitioner testified that she
expected to get champions out of Ding Dong Daddy and Halyard
since they came from good bloodlines. In fact, one of Ding Dong
Daddy’s offspring was a successful racing horse. However, there
is nothing in the record that shows costs of petitioners’ horses
or fluctuations in their value.
5. Petitioners’ Success in Similar or Dissimilar Activities
The fact that the taxpayer has engaged in similar activities
in the past and converted them from unprofitable to profitable
enterprises may indicate that he or she is engaged in the present
activity for profit, even though the activity is presently
unprofitable. See sec. 1.183-2(b)(5), Income Tax Regs. There is
no evidence that petitioners had been involved in other profit-
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seeking activities before or during the operation of their horse-
related activity. This factor is neutral.
6. Activity’s History of Income and/or Loss
An activity’s history of income or loss may reflect whether
the taxpayer has a profit motive. See sec. 1.183-2(b)(6), Income
Tax Regs. Unless explained by customary business risks or
unforeseen or fortuitous circumstances beyond the taxpayer’s
control, a record of continuous losses beyond the period
customarily required to attain profitability may indicate that
the activity is not engaged in for profit. See id.
Petitioners have not had a profitable year since they
started their horse-related activity. While petitioners may have
expected the switch to thoroughbreds to be more profitable,
according to the history of their activity, their losses
increased. Petitioner testified that they switched because the
stakes races had higher purses; however, in 1993 petitioners were
not racing their horses, only breeding them. Furthermore,
petitioners failed to produce credible evidence that the horse-
related activity had a chance of recovering the losses they had
already incurred. See Bessenyey v. Commissioner, 45 T.C. 261,
274 (1965), affd. 379 F.2d 252 (2d Cir. 1967).
7. Amount of Occasional Profits
Occasional profits which are earned from an activity may
indicate a profit motive. See sec. 1.183-2(b)(7), Income Tax
Regs. The possibility of a substantial profit in a highly
speculative venture may indicate a profit motive even where
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profits are occasional and small or nonexistent. See id. Horse
breeding and racing are highly speculative ventures. Petitioners
did not report a profit in any of the years they carried on the
horse-related activity.
8. Petitioners’ Financial Status
Substantial income from sources other than the activity,
particularly if the losses from the activity generate substantial
tax benefits, may indicate that the activity is not engaged in
for profit, especially if there are personal or recreational
elements involved. See sec. 1.183-2(b)(8), Income Tax Regs.
Petitioner earned $52,815 in 1993, and Mr. Pitts received
$11,659 in Social Security benefits. Petitioners derived some
tax benefits from their claimed losses.
9. Elements of Personal Pleasure
The mere fact that a taxpayer derives personal pleasure from
a particular activity does not show a lack of profit motive. See
sec. 1.183-2(b)(9), Income Tax Regs. 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. See id.
It is not clear from the record whether petitioner rode the
horses. We assume that Mr. Pitts could not because of his
disability. It is clear, though, that petitioners enjoyed horses
and have a long history of working with them.
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10. Conclusion
While the matter is not free from doubt, on the basis of all
the facts and circumstances, we hold that petitioners failed to
prove that they engaged in their horse-related activity with the
primary purpose and dominant intent of making a profit within the
meaning of section 183. Accordingly, petitioners are not
entitled to horse-related expense deductions in excess of their
reported horse-related income.
As respondent has already prevailed on the primary issue, we
need not address the substantiation issue with respect to the
depreciation deduction for petitioners’ barn.
Unreported Capital Gain
Respondent determined that petitioners failed to report
$2,000 they received from the sale of Jenny Sport and Actis
Uptis. We find that respondent is in error. According to the
chart detailing the income activity of the business, petitioners
reported the income from the sale of the horses along with the
amounts they collected for boarding and booking fees on their
Schedule C. Petitioners do not have unreported capital gain.
Accuracy-Related Penalty
Section 6662(a) imposes a penalty of 20 percent on any
portion of an underpayment of tax that is attributable to
negligence or disregard of rules or regulations. See sec.
6662(a) and (b)(1). “Negligence” is defined as any failure to
make a reasonable attempt to comply with the provisions of the
Internal Revenue Code, and the term “disregard” includes any
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careless, reckless, or intentional disregard. See sec. 6662(c).
A position with respect to an item is attributable to negligence
if it lacks a reasonable basis. See sec. 1.6662-3(b)(1), Income
Tax Regs. Moreover, taxpayers are required to keep adequate
books and records sufficient to establish the amount of
deductions or other items required to be shown on their returns.
Failure to maintain adequate books and records or to substantiate
items properly also constitutes negligence. See id.
Section 6664(c)(1) provides that the penalty under section
6662(a) shall not apply to any portion of an underpayment if it
is shown that there was reasonable cause for the taxpayer’s
position with respect to that portion and that the taxpayer acted
in good faith with respect to that portion. See sec. 6664(c)(1).
The determination of whether a taxpayer acted with reasonable
cause and good faith within the meaning of section 6664(c)(1) is
made on a case-by-case basis, taking into account all the
pertinent facts and circumstances. See sec. 1.6664-4(b)(1),
Income Tax Regs.
Generally, the duty of filing accurate returns cannot be
avoided by placing the responsibility on a tax return preparer.
See Metra Chem Corp. v. Commissioner, 88 T.C. 654, 662 (1987).
Although a taxpayer remains liable for a deficiency attributable
to a return prepared by an accountant, a taxpayer who supplies a
qualified tax return preparer with all relevant information and
who reasonably and in good faith relies on the preparer’s advice
is not negligent and has not disregarded rules or regulations,
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even if the advice is incorrect and results in a deficiency. See
Freytag v. Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d
1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991).
Petitioners provided all of their records to their
accountant. Since petitioners’ Schedule C loss was allowed after
the audit for taxable year 1987, the accountant continued
treating it as a business without question to petitioners. We
find that petitioners reasonably and in good faith relied on
their accountant’s advice. Therefore, we hold that petitioners
are not liable for the accuracy-related penalty for the year at
issue.
To reflect the foregoing,
Decision will be entered
under Rule 155.