T.C. Memo. 1999-399
UNITED STATES TAX COURT
JOHN SHACKELFORD FAIRBANKS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 14863-98. Filed December 8, 1999.
John Shackelford Fairbanks, pro se.
Thomas A. Vidano, for respondent.
MEMORANDUM OPINION
GOLDBERG, Special Trial Judge: Respondent determined a
deficiency in petitioner's 1995 Federal income tax of $3,654 and
an accuracy-related penalty pursuant to section 6662(a) of $731.
Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the year in issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
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The issues for decision are: (1) Whether petitioner was
engaged in the trade or business of consulting in 1995, and, if
so, whether petitioner is entitled to claim Schedule C expenses
relating to the consulting activity for the 1995 tax year; and
(2) whether petitioner is liable for an accuracy-related penalty
pursuant to section 6662(a).
Some of the facts have been stipulated and are so found.
The stipulation of facts and the exhibits submitted at trial are
incorporated herein by this reference. At the time the petition
was filed, petitioner resided in San Diego, California.
In 1991, petitioner began working as an engineer for Silicon
Systems (Silicon) in Orange County, California, and he was laid
off from Silicon in 1992. Thereafter, in the same year,
petitioner established Fairbanks Laboratories (Fairbanks) as a
sole proprietorship to provide state-of-the-art consulting
services to the communications industry. In connection
therewith, petitioner eventually installed several computers and
communication lines in his home.
Petitioner’s first consulting contract in 1992 was with
Silicon, his former employer, in connection with the relocation
of its manufacturing facility. Petitioner earned $17,431 in 1992
from his consulting activity and reported gross receipts of
$17,431 and net profit of $5,630 on Schedule C attached to his
1992 Federal income tax return.
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During 1993, petitioner obtained a subcontracting consultant
job with TV Comm., Inc. Although petitioner earned $5,400 as a
consultant in 1993 and reported this amount as gross receipts on
Schedule C, he also reported a net loss of $7,016 for 1993.
During 1993, petitioner attempted to find additional clients but
was unsuccessful.
In 1993, petitioner was employed as a full-time engineer at
Pacific Communication Sciences, Inc. (PCSI), working between 45
and 55 hours per week.
Petitioner enrolled in graduate engineering courses at the
University of California-San Diego (UCSD), which were paid for by
PCSI. Petitioner attended a graduate course at UCSD in the fall
of 1995 and attended an additional two or three courses in
electrical engineering per semester in 1996. Petitioner
continued to work full time at PCSI until March 1996, when he was
laid off. Petitioner enrolled full time in UCSD's doctoral
program in 1997.
Petitioner generated no income for his consulting activity
for the 1994, 1995, and 1996 tax years. Petitioner was unable to
provide consulting services in either 1994 or 1995 because of the
long hours he worked at PCSI. Even though petitioner worked full
time, he attempted to find clients that he could accommodate
taking into account his busy work schedule. He was unsuccessful.
Petitioner reported no gross receipts from consulting
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activities in 1994, 1995, and 1996 on Schedules C, but reported
$14,161, $16,389, and $12,533 of net Schedule C losses for the
1994, 1995, and 1996 tax years, respectively. On his Schedule C
attached to his 1995 Federal income tax return, petitioner
reported no gross receipts and claimed the following expenses:
Advertising $91.27
Car/truck expenses 2,949.14
Depreciation/section 179 2,755.33
Supplies 131.21
Travel expense 229.17
Meals/entertainment 190.62
Other expenses 1,760.86 $8,107.60
Business use of home 8,281.35
Total expenses 16,388.95
In 1997, petitioner obtained a consulting contract with L
Three Communications, a local aerospace company, but was not paid
until 1998.
In a notice of deficiency dated June 3, 1998, respondent
determined that petitioner was not entitled to Schedule C
expenses of $16,389 for the year in issue because he (1) was not
engaged in an activity for profit pursuant to section 183, and
(2) failed to substantiate his claimed 1995 Schedule C
deductions. Respondent also determined that petitioner was
entitled to additional itemized deductions for real estate taxes
and interest expenses in the amount of $3,361 for 1995.
As an initial matter, we deal with an issue raised by
petitioner concerning respondent's conduct during audit and
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administrative appeal. As we understand it, petitioner contends
that respondent acted in an unreasonable manner by failing to
meet with him in a timely manner during the audit and
administrative appeal process. Petitioner cites Don Casey, Co.
v. Commissioner, 87 T.C. 847 (1986), and asks this Court for
relief. The Don Casey, Co. case involved the award of costs and
certain fees pursuant to section 7430, and it is apparently under
this section that petitioner seeks relief.
A motion for litigation and administrative costs under
section 7430 must be made pursuant to Rule 231. Since the
request for relief is premature and there is no motion pending at
this time, we need not address this matter.
Section 183
Section 162 allows deductions for ordinary and necessary
expenses paid or incurred in carrying on a trade or business.
For a taxpayer to be engaged in a trade or business, the
taxpayer's primary purpose for engaging in the activity must be
for income or profit, and he must be involved in the activity
with continuity and regularity. See Commissioner v. Groetzinger,
480 U.S. 23, 35 (1987). If an individual engages in an activity
without the objective of profit, section 183 generally limits
allowable deductions attributable to the activity to the extent
of gross income generated by such activity. See sec. 183(b).
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Whether a taxpayer is engaged in the activity for profit
depends on whether he undertook this activity with an actual and
honest objective of making a profit. See Elliott v.
Commissioner, 90 T.C. 960, 970 (1988), affd. without published
opinion 899 F.2d 18 (9th Cir. 1990). Whether a taxpayer had an
actual and honest profit objective is a question of fact to be
resolved from all relevant facts and circumstances. See Golanty
v. Commissioner, 72 T.C. 411, 426 (1979), affd. without published
opinion 647 F.2d 170 (9th Cir. 1981). Greater weight is given to
objective facts than to a taxpayer's statement of intent. See
Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), affd. 792 F.2d
1256 (4th Cir. 1986).
Section 183(d) provides a rebuttable presumption that a
taxpayer is engaged in an activity for profit if the gross income
derived from the activity exceeds the deductions attributable to
the activity for 3 or more of the taxable years in a 5-year
period. Petitioner contends that he qualifies for such a
presumption by arguing that Fairbanks is only the latest in a
series of businesses started in 1986 by petitioner and his ex-
spouse Deborah M. Fairbanks (Ms. Fairbanks) while they were
married.
Beginning in 1986, Ms. Fairbanks apparently conducted
various profitable business activities which were eventually
consolidated under the name Integrative Learning Designs.
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Petitioner contends that this Court should view Fairbanks as part
of a continuing business enterprise begun in 1986 and therefore
take into account tax years prior to 1992 when considering
Fairbanks' history of profits and losses. Petitioner is
attempting to attribute earlier Schedule C profits purportedly
reported by Integrative Learning Designs to Fairbanks' consulting
activity and thereby qualify for the section 183(d) presumption.
Petitioner has failed, however, to establish any connection
between the business activities of Fairbanks and Integrative
Learning Designs. Petitioner started Fairbanks in 1992, and its
financial history, therefore, begins from that date. Since the
gross income derived from petitioner's consulting activity does
not exceed the deductions attributable to his activity for 3 or
more of the taxable years in a 5-year period, petitioner does not
qualify for a section 183(d) presumption.
Since petitioner does not qualify for a presumption that he
engaged in his consulting activity for profit under section
183(d), we turn to section 1.183-2(b), Income Tax Regs., which
provides the following nonexclusive list of factors which may be
considered in determining whether an activity is engaged in with
the requisite profit objective: (1) The manner in which the
taxpayer carries on the activity; (2) the expertise of the
taxpayer; (3) the time and effort expended by the taxpayer in
carrying on the activity; (4) the expectation that assets used in
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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 status of the taxpayer; and (9)
elements of personal pleasure or recreation. No single factor is
controlling, but rather it is an evaluation of all the facts and
circumstances in the case, taken as a whole, which is
determinative. See Weber v. Commissioner, 103 T.C. 378, 387
(1994), affd. per curiam 60 F.3d 1104 (4th Cir. 1995).
Petitioner alleges that he conducted his consulting activity
in a businesslike manner, but this allegation is belied by the
facts. We note that (1) petitioner did not keep
contemporaneously written business or marketing plans, (2)
petitioner did not keep income or expense projections for his
consulting activity and failed to keep books and records
detailing Fairbanks' financial information, and (3) petitioner
failed to maintain a separate checking account or separate
finances for his consulting activity during the year in issue.1
Additionally, though petitioner was aware that Fairbanks had
generated no gross receipts for the 1994, 1995, and 1996 tax
years, petitioner did not appreciably change his method of
1
Petitioner started a commercial checking account for
Fairbanks in 1996.
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conducting the consulting activity. Petitioner did not alter his
method of business or engage in new methods of finding
prospective clients. Petitioner's only substantiated
advertisement for the year in issue was an entry in the 1994-95
edition of the American Electronics Association directory.
Petitioner conceded that he continued to buy new computer
equipment every year despite Fairbanks' mounting losses and a
dearth of clients.
Before 1992, the year petitioner started Fairbanks,
petitioner had no experience as a computer consultant. Yet,
despite this lack of expertise, petitioner failed to seek out
expert business advice on how to conduct Fairbanks as a
profitable activity. Petitioner contends that he continually
strove to gain expertise in the computer consulting field by
reading books, attending meetings, and speaking with venture
capitalists. Petitioner's testimony on this point, however, is
vague.
Petitioner also failed to establish that he expended
significant time or effort in conducting the consulting activity
during the year in issue. At trial, petitioner conceded that he
was unable to provide consulting services in 1995 because of the
long hours he worked at PCSI. In addition to the time spent
working for PCSI, petitioner spent significant amounts of time at
home with his children and attended engineering classes at UCSD.
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Petitioner has also failed to establish that any of
Fairbanks' assets will appreciate in value. Petitioner claims
that Fairbanks' assets are its intellectual property and not its
computer equipment. At trial, petitioner claimed to have
invented four devices while conducting his consulting activity.
Petitioner consented to discuss only one invention at trial, a
remote-controlled pool heating unit. Petitioner explained that
he would not discuss his other three inventions because he had
not yet applied for patent protection.2
Petitioner estimated that his pool heating unit would earn
him $1 milliion in profit once it was produced and marketed.
Petitioner alleges that this invention alone sustains his
contention that Fairbanks' intellectual property will appreciate
in value.
Petitioner, however, has failed to establish any connection
between his consulting activity and his inventions. Indeed,
petitioner listed "consulting" as Fairbanks' principal business
on his Schedule C for the 1992-97 tax years.
Even if we accept petitioner's claim that Fairbanks' assets
are its intellectual property and we further accept that
petitioner's inventions are somehow connected to his consulting
activity, petitioner has still failed to establish that
2
Petitioner applied for patent protection for the pool
heating unit in February 1999, over 3 years after the year in
issue.
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Fairbanks' intellectual property will appreciate in value.
Petitioner conceded that he has never built a working
prototype of the pool heating unit. Petitioner's forecast of
million-dollar profits is therefore based upon mere speculation.
Petitioner has also failed to produce any projected revenue
stream studies or to substantiate the cost of producing even one
remote-controlled pool heating unit.
Petitioner's financial status also indicates a lack of
profit motive in his consulting activity. From the record, it is
clear that the only year Fairbanks showed a net profit was 1992,
the first year Fairbanks provided consulting services.
Petitioner reported the following gross receipts and net losses
from Fairbanks on Schedule C for the 1992-97 tax years:
1992 1993 1994 1995 1996 1997
Gross receipts $17,431 $5,400 - - - -
Profit/loss 5,630 (7,015) ($14,161) ($16,389) ($12,532) ($19,296)
Petitioner also reported the following wage and capital gains
income for the 1992-97 tax years:
1992 1993 1994 1995 1996 1997
Wages and $13,816 $37,453 $69,464 $80,046 $49,617 $51,401
capital gains
The record clearly reflects that petitioner used large net
losses from Fairbanks to offset wage and capital gains income.
In the context of section 183 "profit" means an economic profit,
independent of tax savings. See Surloff v. Commissioner, 81 T.C.
210, 233 (1983).
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From 1992 to 1997, petitioner has reported net losses of
only $69,313 while generating a net profit of $5,630. Such a
history of successive and consistent losses does not support
petitioner's contention that he was engaged in a trade or
business for profit for the year in issue. "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." Sec.
1.183-2(b)(8), Income Tax Regs.
At trial, petitioner expressed great satisfaction in owning
the sophisticated computer hardware and software which he had
purchased between 1992 and 1997. Petitioner stated that he
sometimes used the computers for personal reasons, such as to
"interface" with his children.
Petitioner continued to buy new equipment every year even
though Fairbanks was consistently generating large losses. These
tax losses offset petitioner's wage and capital gains income,
and, in effect, subsidized petitioner's yearly purchases of new
and more sophisticated computer equipment.
In sum, we find that petitioner did not conduct his
consulting activity in a businesslike manner or with continuity
and regularity for the 1995 tax year. On the basis of the
record, we find that petitioner did not engage in his consulting
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activity for profit and was not engaged in the trade or business
of consulting in 1995. Respondent is sustained on this issue.
Schedule C Expenses
As stated above, a taxpayer must show that he engaged in an
activity with the objective of making a profit in order to deduct
expenses incurred under either section 162 or section 212. See
Golanty v. Commissioner, 72 T.C. 411, 425 (1979), affd. without
published opinion 647 F.2d 170 (9th Cir. 1981). Where an
activity is not engaged in for profit, section 183(b)(1) allows
deductions that are not dependent on profit objectives, e.g.,
certain interest and State and local taxes. Additional
deductions are allowed under section 183(b)(2) as if the activity
were engaged in for profit, but such deductions are allowed only
to the extent that gross income from the activity exceeds
deductions already allowed under section 183(b)(1).
As stated above, petitioner has failed to establish that he
engaged in the consulting activity in 1995 with the objective of
making a profit. Additionally, petitioner failed to earn any
gross income in the consulting activity for the year in issue.
Since petitioner earned no consulting income in 1995, he is
unable to deduct any Schedule C expenses pursuant to section
183(b), and we need not address the substantiation issue.
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Section 6662(a)
The last issue for decision is whether petitioner is liable
for a penalty pursuant to section 6662(a). Section 6662(a)
imposes a penalty of 20 percent of the portion of the
underpayment which is attributable to negligence or disregard of
rules or regulations. See sec. 6662(b)(1). Negligence is the
lack of due care or failure to do what a reasonable and
ordinarily prudent person would do under the circumstances. See
Neely v. Commissioner, 85 T.C. 934, 947 (1985). The term
"disregard" includes any careless, reckless, or intentional
disregard. Sec. 6662(c). No penalty shall be imposed if it is
shown that there was reasonable cause for the underpayment and
the taxpayer acted in good faith with respect to the
underpayment. See sec. 6664(c).
At trial, petitioner failed to establish that he acted in
good faith with respect to his 1995 underpayment. Petitioner
failed to comply with section 183 and disregarded rules and
regulations by deducting excessive losses for the 1995 tax year.
On the basis of the record, we hold that petitioner is liable for
the accuracy-related penalty under section 6662(a).
To reflect the foregoing,
Decision will be entered
for respondent.