EMERSON v. COMMISSIONER

T.C. Memo. 2000-137

UNITED STATES TAX COURT

ALTON F. EMERSON, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6276-99. Filed April 12, 2000.

Alton F. Emerson, pro se.

Felicia L. Branch, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PARR, Judge: Respondent determined deficiencies in and

accuracy-related penalties on petitioner's Federal income taxes

as follows:

Accuracy-Related Penalty
Year Deficiency Sec. 6662(a)
1992 $11,579 --
1995 32,499 $5,750
1996 29,522 5,314
 - 2 -

The issues for decision are:1 (1) Whether petitioner's

automobile drag racing activity was engaged in with the intent to

make a profit. We hold it was not. (2) Whether long-term

disability payments received by petitioner in taxable years 1995

and 1996 are includable in gross income. We hold they are. (3)

Whether individual retirement account (IRA) distributions

received by petitioner in taxable years 1995 and 1996, as well as

pension and annuity distributions received by petitioner in

taxable year 1996, are includable in gross income. We hold they

are. (4) Whether petitioner is liable for the 10-percent

additional tax under section 72(t)2 on IRA distributions totaling

$37,500 and $29,500 in taxable years 1995 and 1996, respectively.

We hold he is. (5) Whether petitioner is liable for an accuracy-

related penalty pursuant to section 6662(a) for taxable years

1995 and 1996. We hold he is.

1
The notice of deficiency contains adjustments to itemized
deductions for taxable years 1995 and 1996 and disallows a net
operating loss carryback to 1992 related to the operations of
petitioner's automobile drag racing activity in 1995. These are
computational adjustments which will be affected by the outcome
of the issues to be decided, and we do not separately address
them.
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue.
 - 3 -

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulation of facts and the attached exhibits are

incorporated herein by this reference. At the time the petition

herein was filed, petitioner resided in Orlando, Florida.

Petitioner timely filed his Federal income tax returns in

1992, 1995, and 1996. In 1995, petitioner reported on his

Federal income tax return that he received $49,218.81 as

nontaxable sick pay and $89,100 as nontaxable IRA distributions.

Respondent determined that $51,600 of the IRA distributions were

attributable to petitioner's disability. On Schedule C, Profit

and Loss From Business, of his 1995 tax return, petitioner

reported deductions of $70,428.52 from his automobile drag racing

activity named Emerson Racing Enterprises. Petitioner reported

no income from this activity, resulting in a $70,428.52 loss.

Related to this loss in 1995, petitioner carried back a $63,095

net operating loss deduction to taxable year 1992, which resulted

in a refund to petitioner of $11,579. At the end of 1995,

petitioner was age 57.

In 1996, petitioner reported nontaxable income of $50,628 as

sick pay, $29,500 in total IRA distributions, and $39,506 in

total pensions and annuities. Respondent determined that the

$39,506 in total pensions and annuities was attributable to

petitioner's disability. Petitioner reported zero income or loss

from the automobile drag racing activity in 1996. On his 1996
 - 4 -

return, petitioner stated:

This [automobile drag racing] activity, [sic] still in
existence, is operating at a loss, but since there were
no winnings, all expenses are being absorbed as if they
were "hobby losses" and, as such, have no effect on
Adjusted Gross Income. (Schedule 1).

At the end of 1996, petitioner was age 58.

The sick pay petitioner received was from a long-term

disability insurance policy. Petitioner's former employer, ECC

International, paid the premiums on the long-term disability

policy. Petitioner retired from ECC International after

experiencing medical problems.

During the years in issue, petitioner engaged in an

automobile drag racing activity named Emerson Enterprise Racing.

The only asset of Emerson Enterprise Racing was a race car

purchased by petitioner in 1994. Petitioner located his race

car, a two-door batwing 1959 Chevy El Camino, by placing an

advertisement in an Orlando, Florida, newspaper. The previous

owner of the car was a farmer who had stored the car in a barn.

When petitioner went to look at the car in the farmer's barn, it

could barely run, but he decided to purchase it. By spending

over $100,000 during the years he engaged in this activity,

petitioner revamped the car into a bright red dragster that could

legally be driven on streets as well as for racing. The car was
 - 5 -

featured on the front cover of two magazines in 1997, Hot Street

Cars and Bracket Racing USA.

Petitioner raced automobiles when he was younger, but he had

to discontinue the activity because it was too costly. Between

1992 and 1997, petitioner lost over $150,000 on the automobile

drag racing activity in this case. Petitioner did receive a

small number of cash prize awards in the hundreds of dollars from

the activity. However, except for reporting $200 of winnings in

1994, petitioner never reported any income from this activity on

his tax returns. Petitioner maintained no written records

related to races or how he had placed in any races. Petitioner

did not maintain a separate checking account for this activity.

Petitioner had no business plan for his automobile drag

racing activity and made no forecasts of income or expenses.

Although he tried to find one, petitioner had no sponsor or other

financial backers to finance his activity.

Petitioner stopped the racing activity in 1997 or 1998.

Since his departure from racing, petitioner has tried to sell his

race car. Although petitioner has over $100,000 invested in the

race car, the highest offer he has received for the car is

$20,000, which he rejected.

Petitioner devoted about 40 hours per week to the automobile

drag racing activity, which included working on the race car and

racing the car two to three nights a week at a race track.
 - 6 -

Petitioner employed a mechanic on a contract labor basis to do

some of the work on the race car. During 1995 and 1996,

petitioner was retired/disabled and did not have any other

employment.

Petitioner's source of advice for the activity was industry

publications that provided ways of improving his race car to make

it more competitive. In addition, petitioner received advice

regarding improving his car from other drivers who had faster

race cars.

The only type of business or operating license required for

racing was a drag strip license (NHRA license), which petitioner

does have. However, because of petitioner's heart condition, his

NHRA license has speed restrictions which limit his ability to

drive his race car competitively. Because of the restrictions

placed on petitioner's NHRA license and his health condition, to

have any chance of winning "the money races", petitioner's son

has had to drive petitioner's car.

OPINION

Issue 1. Whether Petitioner's Automobile Drag Racing Activity
Was Engaged in With the Intent To Make a Profit

Section 162(a) allows deductions for all the ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business. In the case of an activity

not engaged in for profit, section 183 generally limits allowable
 - 7 -

deductions attributable to the activity to the extent of gross

income generated by the activity. See sec. 183(b).

The test for determining whether an individual is carrying

on an activity for profit is whether the taxpayer's actual and

honest objective in engaging in the activity is to make a profit.

See Osteen v. Commissioner, 62 F.3d 356, 358 (11th Cir. 1995),

affg. in part and revg. in part T.C. Memo. 1993-519; Surloff v.

Commissioner, 81 T.C. 210, 233 (1983); Dreicer v. Commissioner,

78 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. While a

taxpayer's expectation of profit need not be reasonable, there

must be a good-faith expectation of making a profit. See Allen

v. Commissioner, 72 T.C. 28, 33 (1979); sec. 1.183-2(a), Income

Tax Regs.

Section 1.183-2(b), Income Tax Regs., provides a

nonexclusive list of factors to be considered in determining

whether an activity is engaged in for profit. Those factors

include: (1) The manner in which the taxpayer carried on the

activity; (2) the expertise of the taxpayer or his advisors; (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 loss with respect to the
 - 8 -

activity; (7) the amount of occasional profit, if any, which is

earned; (8) the financial status of the taxpayer; and (9) whether

elements of personal pleasure or recreation are involved. No

single factor controls. See Osteen v. Commissioner, supra;

Brannen v. Commissioner, 722 F.2d 695, 704 (11th Cir. 1984),

affg. 78 T.C. 471 (1982); sec. 1.183-2(b), Income Tax Regs.

1. Manner of Carrying on Activity

The manner in which the taxpayer carries on the activity is

one indication of a profit objective. See sec. 1.183-2(b)(1),

Income Tax Regs. Elements relevant to this factor include

whether the taxpayer maintained complete and accurate books and

records, whether the activity was conducted in a manner

substantially similar to comparable businesses that are

profitable, and whether changes were attempted in order to

improve profitability. See Engdahl v. Commissioner, 72 T.C. 659

(1979).

Petitioner maintained no written records. He had no

business plan for his activity, and he made no predictions of

income or expenses.

Petitioner had no sponsor for the activity, although he did

unsuccessfully attempt to obtain one. While petitioner hoped to

make large amounts of money from this activity, he understood

that without the "big money" of a sponsor to buy "big expensive

parts", a person "can't win the races." Without a sponsor,
 - 9 -

petitioner had no control over the income from this activity,

because, in his own words, "at any given time the [race car]

engine could just flip off at the line". In the event such an

engine failure occurred, petitioner did not have the financial

resources to replace his race car's engine quickly and continue

this activity.

We find that petitioner did not operate the activity in a

businesslike manner. This factor weighs against petitioner.

2. Expertise of Taxpayer or Advisers

Preparation for the start of an activity through extensive

study of its accepted business, economic, and scientific

practices, or consultation with those who are experts therein,

indicates that a taxpayer has entered into an activity for

profit. See sec. 1.183-2(b)(2), Income Tax Regs. Petitioner

read car-racing magazines and consulted with mechanics and other

racers. However, there is no evidence that the persons with whom

petitioner consulted had made a profit in car racing or advised

petitioner on how to make one, or that they were other than

racing fans or hobbyists. Accordingly, we find this factor does

not help petitioner.

3. Time and Effort Expended in Activity

The time and effort expended by the taxpayer in carrying on

the activity is an indication of whether a profit objective

existed, particularly if there are no substantial personal or
 - 10 -

recreational elements associated with the activity. See sec.

1.183-2(b)(3), Income Tax Regs. Petitioner devoted 40 hours a

week to the activity including working on his race car and two to

three nights attending races. At the same time, petitioner found

automobile drag racing extremely enjoyable. In spite of a

serious heart condition, petitioner described competitively

driving the race car as a stressful, exhilarating experience that

he enjoyed repeating. Therefore, on balance, this factor neither

supports nor detracts from petitioner's position.

4. Expectation That Assets May Appreciate

An expectation that assets used in the activity may

appreciate in value may be an indication of a profit objective.

See sec. 1.183-2(b)(4), Income Tax Regs. During his involvement

in the automobile drag racing activity, petitioner spent over

$100,000 on the sole asset of the activity, the race car.

Petitioner thought that he might be able to sell the race car for

$40,000 to $50,000. Therefore, petitioner had no expectation

that the race car would appreciate in value. In fact, the

highest offer petitioner has received for the race car is

$20,000, and he realizes that used race cars "don't bring in

money." Accordingly, this factor weighs against petitioner.

5. Taxpayer's Success in Other Activities

The success of the taxpayer in carrying on other activities

can be some indication of whether the taxpayer had a profit
 - 11 -

objective for the activity in question. See sec. 1.183-2(b)(5),

Income Tax Regs. If petitioner had engaged in similar activity

profitably in the past, it might indicate that the activity in

question was entered into for profit, even though the activity is

presently unprofitable. See id. Petitioner raced automobiles

when he was younger but had to discontinue the activity because

it was too costly. Accordingly, this factor suggests that

petitioner did not engage in the activity for profit.

6. History of Income or Losses From Activity

A history of income, losses, and occasional profits with

respect to an activity can be indicative of whether a profit

motive exists. See sec. 1.183-2(b)(6), Income Tax Regs. The

presence of losses in the formative years of a business is not

inconsistent with an intention to achieve a later profitable

level of operation, bearing in mind, however, that the goal must

be to realize a profit on the entire operation, which presupposes

not only future net earnings but also sufficient net earnings to

recoup losses that have been incurred in the intervening years.

See Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965), affd. 379

F.2d 252 (2d Cir. 1967).

Petitioner began the automobile drag racing activity in

1992. During the years he operated the activity, petitioner

received only small cash awards; however, he spent over $150,000

on the activity, generating losses in each year, including the
 - 12 -

$70,428.52 loss petitioner reported in 1995. Given petitioner's

record of losses, we see no possibility that petitioner could

recoup his expenditures. Therefore, we find this factor weighs

against petitioner.

7. Amount of Occasional Profits Earned, If Any

The amount and frequency of occasional profits earned from

the activity may also be indicative of a profit objective. See

sec. 1.183-2(b)(7), Income Tax Regs. Other than occasional small

cash awards, about which petitioner was vague and of which he

kept no records, petitioner's automobile drag racing activity

produced no income.

However, the "opportunity to earn a substantial ultimate

profit in a highly speculative venture is ordinarily sufficient

to indicate that the activity is engaged in for profit even

though losses or only occasional small profits are actually

generated." Id. There is no doubt that the automobile drag

racing activity was a "highly speculative venture". However,

petitioner has not convinced us that he ever had an "opportunity

to earn a substantial ultimate profit" from the activity.

The small cash awards petitioner received were minuscule in

relation to both the losses he incurred and his total investment

in the activity, and without a sponsor, petitioner never had an

opportunity to earn a substantial ultimate profit. Accordingly,
 - 13 -

this factor suggests that petitioner did not operate his

automobile drag racing activity for profit.

8. Taxpayer's Financial Status

The lack of substantial income from sources other than the

activity in question may indicate the existence of a profit

objective. See sec. 1.183-2(b)(8), Income Tax Regs. The

rationale for this rule is that a taxpayer with substantial

income unrelated to the activity can more easily afford to

operate the activity as a hobby.

In 1995, petitioner received $49,218.01 in disability pay,

$51,600 in IRA distributions attributable to his disability, and

$37,500 in premature IRA distributions. At trial, petitioner

stated that the automobile racing activity is "almost like

gambling." To support his addiction to this activity, petitioner

withdrew $37,500 in IRA distributions prematurely. In addition,

he used part of the money designated for his disability to fund

the activity. Petitioner had substantial income unrelated to the

automobile racing activity. Accordingly, this factor does not

favor petitioner.

9. Elements of Personal Pleasure

The absence of personal pleasure or recreation relating to

the activity indicates the presence of a profit objective. See

sec. 1.183-2(b)(9), Income Tax Regs. There is no question that

petitioner enjoyed and obtained pleasure from his automobile drag
 - 14 -

racing activity. Although this factor standing alone does not

indicate that petitioner did not engage in this activity for

profit, the combination of factors is fatal to petitioner's case.

Although petitioner's testimony was frank and generally

credible, it was also vague and unsubstantiated. He had no

records and testified from memory.

On the basis of the record, we find that petitioner did not

engage in the automobile drag racing activity for profit.

Accordingly, respondent is sustained on this issue, and

petitioner is not allowed to deduct Schedule C expenses

associated with this activity in 1995.

Issue 2. Whether Long-Term Disability Payments Received by
Petitioner in 1995 and 1996 Are Includable in Gross Income

Section 61(a) provides that gross income means all income

from whatever source derived. Certain income, however, may be

specifically exempted from inclusion in gross income. See sec.

61(b).

Gross income does not include amounts received through

accident or health insurance for personal injuries or sickness

(other than amounts received by an employee to the extent such

amounts are (1) attributable to contributions by the employer

which were not includable in the gross income of the employee; or

(2) paid for by the employer). See sec. 104(a)(3). In Trappey

v. Commissioner, 34 T.C. 407, 408 (1960), we held that disability

income received through accident or health insurance for personal
 - 15 -

injuries or sickness is within the meaning of section 104(a)(3).

Hence, the provisions in sections 104 and 105 dealing with

amounts received through health insurance are used to determine

whether petitioner's disability benefits constitute taxable

income.

Section 105(a) provides:

Except as otherwise provided in this section, amounts
received by an employee through accident or health
insurance for personal injuries or sickness shall be
included in gross income to the extent such amounts (1)
are attributable to contributions by the employer which
were not includible in the gross income of the
employee, or (2) are paid by the employer.

The parties stipulated that petitioner's former employer, ECC

International, funded the long-term disability plan and paid all

the premiums. Additionally, petitioner presented no evidence

that the sick pay he received from the long-term disability plan

maintained by his previous employer was excludable from his gross

income. Therefore, we sustain respondent's determination that

the disability payments received by petitioner are includable in

his gross income pursuant to section 105(a).

Issue 3. Whether IRA Distributions Received by Petitioner in
Taxable Years 1995 and 1996, as Well as Pension and Annuity
Distributions Received by Petitioner in 1996, Are Includable in
Gross Income

Annuities and pensions are specifically included in gross

income. See sec. 61(a)(9), (11). In addition, under section

408(d)(1), a distribution from an IRA is generally included in

the gross income of the distributee in the year of distribution.
 - 16 -

In general, section 72 deals with the tax treatment of

distributions from pensions, annuities, and IRA's. See secs.

72(a), (e), 408(d). Section 1.72-1(a), Income Tax Regs.,

provides that section 72 prescribes rules relating to the

inclusion in gross income of amounts received under a life

insurance, endowment, or annuity contract unless such amounts are

specifically excluded from gross income under other provisions of

chapter 1 of the Code. The burden is on petitioner to

demonstrate that the payments in question fall into a specific

statutory exclusion. See Commissioner v. Glenshaw Glass Co., 348

U.S. 426, 429-431 (1955).

In this case, petitioner received IRA distributions of

$89,100 and $29,500 in 1995 and 1996, respectively.

Additionally, petitioner received $39,506 in total pension and

annuity plan distributions in 1996.3 Petitioner provided no

evidence nor have we found anything in the record suggesting that

any part of the IRA or pension and annuity plan distributions are

excludable from gross income. Accordingly, we conclude that

petitioner received gross income of $89,100 in 1995 and $69,006

in 1996.

3
In the notice of deficiency, respondent determined that
petitioner received $69,006 from IRA distributions in 1996.
However, the parties stipulated that petitioner received $29,500
in total IRA distributions and $39,506 in total pension and
annuity plan distributions in 1996. The parties' stipulation
does not affect the total deficiency determined against
petitioner.
 - 17 -

Issue 4. Whether Petitioner Is Liable for the 10-Percent
Additional Tax Under Section 72(t) on IRA Distributions Totaling
$37,500 and $29,500 in 1995 and 1996, Respectively

Under section 408(d)(1), a distribution from an IRA is

taxable to the distributee in the year of distribution in the

manner provided under section 72. Section 72(t)(1) provides for

a 10-percent additional tax on early distributions from qualified

retirement plans. Section 72(t)(2) excludes qualified retirement

plan distributions from the 10-percent additional tax if the

distributions are: (1) Made on or after the date on which the

employee attains the age of 59-1/2; (2) made to a beneficiary (or

to the estate of the employee) on or after the death of the

employee; (3) attributable to the employee's being disabled

within the meaning of section 72(m)(7); (4) part of a series of

substantially equal periodic payments (not less frequently than

annually) made for the life (or life expectancy) of the employee

or the joint lives (or joint life expectancies) of the employee

and his designated beneficiary; (5) made to an employee after

separation from service after attainment of age 55;4 (6)

dividends paid with respect to stock of a corporation which are

described in section 404(k). A limited exclusion is also

available for distributions made to an employee for medical care

expenses. See sec. 72(t)(2)(B).

4
This provision, codified at sec. 72(t)(2)(A)(v), is not
applicable to early IRA distributions. See sec. 72(t)(3)(A).
 - 18 -

At the times he received the distributions in question,

petitioner was ages 57 and 58, respectively. Although respondent

determined that petitioner had received some moneys on account of

a disability in 1995 and 1996, petitioner presented no evidence

that the IRA distributions in question were attributable to that

disability. In fact, petitioner presented no evidence that any

of the exceptions to the 10-percent additional tax listed above

apply. Accordingly, we sustain respondent's determination and

hold that petitioner is liable for the 10-percent additional tax

in relation to IRA distributions totaling $37,500 and $29,500 in

1995 and 1996, respectively.

Issue 5. Whether Petitioner Is Liable for an Accuracy-Related
Penalty Pursuant to Section 6662(a) for Taxable Years 1995 and
1996

The last issue for decision is whether petitioner is liable

for an accuracy-related 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 such portion of the
 - 19 -

underpayment and the taxpayer acted in good faith with respect to

the underpayment. See sec. 6664(c). It is well established that

petitioner bears the burden of proof on this issue. See Bixby v.

Commissioner, 58 T.C. 757, 791 (1972).

Petitioner has not sustained his burden. In 1995,

petitioner claimed losses from the automobile drag racing

activity aggregating $70,428.52 with no apparent expectation that

the activity would ever become profitable. Petitioner's

participation in this activity was predominantly for pleasure and

recreation. Additionally, we have found that the income

petitioner reported as nontaxable in 1995 and 1996 should have

been included in his gross income. Petitioner offered no basis

at trial for his decision to report the income as nontaxable.

Accordingly, we sustain respondent on this issue and hold that

petitioner is liable for the accuracy-related penalty pursuant to

section 6662(a) in 1995 and 1996.

Decision will be entered

for respondent.