Dirkse v. Commissioner

T.C. Memo. 2000-356

UNITED STATES TAX COURT

ROBERT AND JOYCE DIRKSE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 13985-98. Filed November 15, 2000.

Gerald W. Kelly, Jr., for petitioners.

Nicholas J. Richards, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS, Judge: Respondent determined deficiencies and

accuracy-related penalties under section 6662(a) with respect to

petitioners’ Federal income taxes, as follows:

Penalty
Year Deficiency Sec. 6662(a)

1995 $29,719 $5,944
1996 32,687 6,537
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These deficiencies stem from respondent’s determination that

petitioners’ apiary, tree-farming, and rental activities

(hereinafter, collectively referred to as petitioners’ Schedule C

activities) conducted during 1995 and 1996 (the years in issue)

were not activities engaged in for profit, resulting in the

disallowance of claimed losses attributable to these activities.

The issues for decision are: (1) Whether petitioners’ Schedule

C activities were engaged in for profit; and (2) whether

petitioners are liable for the section 6662(a) accuracy-related

penalties.

All section references are to the Internal Revenue Code as in

effect for the years in issue.

FINDINGS OF FACT

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

stipulation of facts and the exhibits submitted therewith are

incorporated herein by this reference.

Background

Petitioners, husband and wife, resided in Corona, California,

on the date they filed their petition contesting respondent’s

determinations. For each of the years in issue, petitioners

electronically filed joint Federal income tax returns; included as

a part of these returns were separate schedules for each of

petitioners’ Schedule C activities. These returns were prepared by

a paid return preparer, employed by H & R Block.
 - 3 -

Robert Dirkse (petitioner) was raised in a small farming

community in Wisconsin. During his teenage years, petitioner

worked on his grandfather’s farm, assisting his family in planting

and growing vegetables and flowers.

For most of his professional career, petitioner was employed

as a public school teacher, at the high-school level, teaching

biology, chemistry, and general science courses. Petitioner

subsequently became a school principal, at the elementary-school

level, and during the years in issue, he was a supervisor at the

Adult School.

Prior to and during the years at issue, Joyce Dirkse (Mrs.

Dirkse) was employed as a registered nurse.

Petitioners’ Apiary Activities

In the early 1980's, petitioner became interested in

beekeeping as a consequence of teaching a science class for gifted

students. In 1981, petitioners acquired a swarm of bees from the

father of one of petitioner’s students and purchased apiary

(beekeeping) equipment and clothing. Petitioners thereafter joined

the local beekeeping society.

Initially, petitioners raised their bees in hives located on

someone else’s property. In 1983, petitioners acquired a 10-acre

tract of land in Corona, California (the Corona property), where

they moved their beehives and worked them. (Corona is

approximately 50 miles from Cerritos where petitioners then
 - 4 -

resided.) Petitioners then moved their beehives to Cerritos, but

in 1985, petitioners relocated their beehives back to the Corona

property in response to neighbors’ complaints.

Petitioners’ apiary activities never generated a profit. The

following chart sets forth the revenues and expenses from

petitioners’ apiary activities between 1992 and 1996:

Year Revenue Expenses

1992 $265 $26,153
1993 470 21,121
1994 0 18,112
1995 400 23,768
1996 945 16,739

The record does not reveal the revenue and expenses from

petitioners’ apiary activities prior to 1992.

Petitioners’ Tree-Farming Activities--Rojo International

In 1983, while attending the Los Angeles County Fair,

petitioners visited a booth manned by the California Macadamia

Society (the Macadamia Society), and inquired as to the feasability

of raising macadamia trees on their Corona property. They joined

the Macadamia Society and attended meetings in order to learn about

the care and cultivation of macadamia trees; petitioners hired the

president of the Macadamia Society as a consultant. She made

specific recommendations as to the type of macadamia trees that

should be planted on petitioners’ Corona property.

Relying upon these recommendations, in 1984, petitioners

planted 300 ungrafted macadamia trees on their Corona property.
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(Based upon their research, and consultation with members of the

Macadamia Society, petitioners calculated that once the macadamia

trees reached maturity (which took between 5 and 7 years), each

tree would produce approximately 150 pounds of marketable nuts.)

The advice petitioners received proved to be erroneous; many of the

trees failed to fully develop during the first year. In order to

restore their crop, petitioners planted new saplings using a

technique that, in the prior year, petitioners’ consultant had

recommended against using.

In 1985, petitioners installed a gravity water irrigation

system on the Corona property. Notwithstanding the installation of

the irrigation system, the macadamia trees failed to produce the

quantity of marketable nuts that petitioners expected. Moreover,

in 1991 petitioners lost 50 of their trees due to frost damage.

(Only a portion of the number of trees lost were ever replanted.)

As a hedge against the poor yields of macadamia nuts,

petitioners decided to plant Fuyu persimmon trees on the Corona

property. In 1986, petitioners planted 300 persimmon trees on a

portion of the unused land at their Corona property.

Following a 3-year gestation period, the persimmon trees

yielded a marketable crop of fruit. As the trees and crops grew,

they required more attention. Petitioners hired a part-time

laborer, Carlos Ramirez (Mr. Ramirez), in 1988. On several

occasions, petitioners hired migrant workers to assist Mr. Ramirez.
 - 6 -

The workers were paid on a per-project basis, performing such tasks

as: Packaging and selling the nuts and fruit, watering and pruning

the trees, and performing general maintenance around the Corona

property. In addition to hiring these workers, petitioners

improved the roads to provide easier access to the Corona property

and installed 900 feet of fencing to prevent thieves from stealing

their macadamia nut and persimmon produce.

Initially, petitioners attempted to sell their nut and fruit

produce at the Fuyu co-op in Temecula, California; however, the co-

op’s quality standards prevented a substantial portion of

petitioners’ produce from being sold. In an attempt to increase

revenues, Mr. Ramirez (on behalf of petitioners) began selling the

macadamia nuts and persimmon fruit at roadside stands. However,

this activity ceased after Mr. Ramirez was confronted by competing

vendors and the local authorities regarding his lack of the

required business licenses. Thereafter, petitioners derived most of

their revenue through consigning their goods at swap meets. Unsold

produce was often donated to charity.

During the years in issue, petitioner generally visited the

Corona property three times a week. During weekday trips, he

typically spent the night at the Corona property and returned to

his full-time job the following morning. On weekends, petitioner

usually stayed at least one night, and often he stayed until Sunday

evening before returning home to Cerritos. Mrs. Dirkse often
 - 7 -

accompanied petitioner on weekend visits. (Petitioners failed to

maintain mileage logs for their trips to the Corona property.)

While at the Corona property, petitioner often assisted in the

harvesting and packing of the macadamia nuts and persimmon fruit.

Petitioners grouped their tree-farming activities (i.e., their

macadamia nut and persimmon fruit operations, which they called

“Rojo International”) as a single Schedule C activity. The tree-

farming activities never generated a profit. The following chart

sets forth the revenues and expenses from petitioners’ tree-farming

activities between 1992 and 1996:

Year Revenue Expenses

1992 $440 $55,053
1993 490 61,280
1994 0 57,578
1995 1,900 68,336
1996 1,400 88,075

The record does not reveal the revenue and expenses from

petitioners’ tree-farming activities prior to 1992.

Rental Activity

Beginning in the early 1980’s, petitioners were employed (on

a part-time basis) as teacher/trainers for the Christian Reform

Church (the church). Frequently, petitioners allowed church

members to use the Corona property for religious retreats.

Petitioners maintained six trailers on the Corona property. During

the religious retreats, church members were housed in petitioners’

trailers, for which petitioners received a nominal rental fee.
 - 8 -

In 1992, petitioners disassociated themselves from the church

and began renting the trailers to individuals seeking weekend

getaways. Petitioners failed to obtain the requisite permits or

business licenses for this activity.

Petitioners’ rental activities (which for the years in issue,

petitioners listed as a “consulting” activity) never generated a

profit. The following chart sets forth the revenues and expenses

from petitioners’ rental activities between 1992 and 1996:

Year Revenues Expenses

1992 $7,200 $16,767
1993 1,225 11,810
1994 500 3,967
1995 1,200 13,041
1996 11,200 28,379

The record does not reveal the revenue and expenses from

petitioners’ rental activities prior to 1992.

Miscellaneous

During the years 1992-1996, the revenues from petitioners’

Schedule C activities totaled $27,635; whereas, the claimed

expenses from these activities totaled $484,374.

On their 1995 and 1996 Federal income tax returns, petitioners

reported the following income and Schedule C losses:

Year Income Schedule C Loss

1995 $174,761 $102,845
1996 181,678 120,278
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In 1995, the Internal Revenue Service audited petitioners’

1994 return and determined that no change thereto was required.

Petitioners did not maintain a business bank account during

the years at issue; revenues and expenses for each of the Schedule

C activities were channeled through their personal checking

account.

Notice of Deficiency

In the notice of deficiency, respondent determined that

petitioners’ Schedule C activities were neither entered into for

profit nor were the claimed expenses relating thereto

substantiated. (Subsequently, respondent conceded that most of the

claimed expenses were paid or incurred.) Consequently, respondent

disallowed the deductions attributable to those activities for 1995

and 1996 ($102,845 and $120,278, respectively). Respondent

alternatively determined that the losses from petitioners’ Schedule

C activities constituted passive activity losses that were subject

to the deduction limitations of section 469. Moreover, respondent

imposed section 6662(a) accuracy-related penalties for the years in

issue.

OPINION

Schedule C Activities

The primary issue is one of fact: whether petitioners entered

into or carried on all or any of their Schedule C activities with
 - 10 -

an intent to make a profit.1 If petitioners did not have the

requisite profit motive, as respondent maintains, then all

deductions exceeding the revenue attributable to those activities

would be disallowed pursuant to section 183(a).

Respondent contends that petitioners lacked the requisite

intent to make a profit in carrying out their Schedule C

activities. Specifically, respondent asserts that petitioners (1)

did not conduct their Schedule C activities in a businesslike

manner, (2) never earned a profit from any of these activities and

are unlikely to do so in the near future, and (3) realized

substantial tax savings by offsetting the income from their primary

occupations with their Schedule C losses.

On the other hand, petitioners maintain that they entered into

and carried out their Schedule C activities with an intent of

1
For purposes of applying sec. 183, we treat all three
of petitioners’ Schedule C activities as a single activity. In
ascertaining what constitutes an activity or activities of a
taxpayer, we take into account the facts and circumstances of
each case. See sec. 1.183-1(d), Income Tax Regs. Generally, the
most significant factors in making this determination are the
degree of organizational and economic interrelationships of the
various undertakings and the business purpose which is (or might
be) served by carrying on the operations separately or in a trade
or business setting. See id.
In the case at bar, petitioners contend that they entered
into each of their Schedule C activities with the intent of
supplementing their retirement income. All three activities were
operated with the same business purpose, and each shared the
resources and capital of the others; in sum, each Schedule C
activity was organizationally and economically dependent upon the
others. On brief, petitioners treated all three of their
Schedule C activities as one activity.
 - 11 -

making a profit. Petitioners assert that they operated their

Schedule C activities in a businesslike manner. Petitioners

maintain that because the apiary and tree-farming activities were

inherently high risk businesses that often require a lengthy

startup period, their history of losses relating thereto was not

uncommon. Accordingly, petitioners maintain that they were willing

to incur substantial startup costs with the expectation that

eventually their Schedule C activities would provide them with

supplemental retirement income.

For the reasons set forth below, we agree with respondent and

conclude for each of the years at issue, petitioners’ Schedule C

activities were not engaged in for profit.2

We begin our analysis with the applicable statutory

provisions. Pursuant to section 183, deductions with respect to an

activity “not engaged in for profit” generally are limited to the

amount of gross income derived from such activity. Section 183(c)

defines an activity not engaged in for profit as “any activity

other than one with respect to which deductions are allowable for

the taxable year under section 162 or under paragraph (1) or (2) of

2
Because we find that petitioners’ Schedule C activities
were not engaged in or carried on for profit, we need not decide
respondent’s alternative position that petitioners’ Schedule C
losses were passive activity losses subject to the limitations
imposed under sec. 469.
 - 12 -

section 212.” Accordingly, section 183 is considered in pari

materia with sections 162 and 212. See sec. 1.183-2(a), Income Tax

Regs.

The basic standard for determining whether an expense is

deductible under sections 162 and 212 (and thus not subject to the

limitations of section 183) is the following: a taxpayer must show

that he or she engaged in or carried on the activity with an actual

and honest objective of making a profit. See Antonides v.

Commissioner, 893 F.2d 656, 659 (4th Cir. 1990), affg. 91 T.C. 686

(1988); Independent Elec. Supply, Inc. v. Commissioner, 781 F.2d

724, 726 (9th Cir. 1986), affg. Lahr v. Commissioner, T.C. Memo.

1984-472; Ronnen v. Commissioner, 90 T.C. 74, 91 (1988); sec.

1.183-2(a), Income Tax Regs. Although a reasonable expectation of

profit is not required, the taxpayer’s profit objective must be

bona fide. See Hulter v. Commissioner, 91 T.C. 371, 393 (1988);

Beck v. Commissioner, 85 T.C. 557, 569 (1985).

While the focus of this test is on the subjective intent of

the taxpayer, objective criteria may also be used. See Independent

Elec. Supply, Inc. v. Commissioner, supra. Section 1.183-2(b),

Income Tax Regs., sets forth a nonexclusive list of factors to be

considered in determining whether an activity is engaged in or

carried on for profit. These factors are: (1) The manner in which

the taxpayer carried on the activity; (2) the expertise of the

taxpayer or his advisers; (3) the time and effort expended by the
 - 13 -

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 status of the taxpayer;

and (9) whether elements of personal pleasure or recreation exist.

No single factor is necessarily relevant or dispositive; rather,

the facts and circumstances of the case ultimately control. See

Keanini v. Commissioner, 94 T.C. 41, 47 (1990). Further, the

determination of a taxpayer’s profit motive is made on a yearly

basis. See Commissioner v. Sunnen, 333 U.S. 591, 598 (1948).

We now apply each of these factors to the facts in this case.3

1. Manner of Carrying on the Activity

The fact that a taxpayer carries on an activity in a

businesslike manner and maintains complete and accurate books and

records may indicate that the activity was engaged in for profit.

See Engdahl v. Commissioner, 72 T.C. 659, 666 (1979); sec. 1.183-

2(b)(1), Income Tax Regs. Adapting new techniques and abandoning

methods that are economically inefficient may also support the

3
The record does not reveal whether petitioners ever
engaged in other similar or dissimilar activities. Thus, we find
a discussion of petitioners’ success in these activities to be
nongermane.
 - 14 -

conclusion that the taxpayer possessed the requisite profit motive.

See Allen v. Commissioner 72 T.C. 28, 35 (1979).

Here, the record reveals numerous instances where petitioners

did not conduct their Schedule C activities in a businesslike

manner. Petitioners failed to acquire the necessary local business

licenses to sell their produce, resulting in lost revenue.

Petitioners did not maintain any formal business plans, budgets,

ledgers, or other accounting records. In addition, they did not

possess any mileage logs or formal records of payments made to

their undocumented workers. (In this regard, petitioners were

unable to substantiate some of their claimed deductions.4)

Petitioners also failed to keep separate bank accounts; they

intermingled their personal funds with those of their Schedule C

activities and paid all expenses from this account. (Petitioner

testified that he decided against using a separate business account

because the bank charged a per check fee.)

Despite incurring losses over a number of years, there is no

convincing evidence in the record indicating that petitioners

undertook meaningful action to control or rectify the continual

stream of losses arising from their Schedule C activities.

Petitioners’ losses increased during the 3 years between 1994 and

4
For instance, petitioners claimed 89,159 miles on their
1995 return as the distance traveled in connection with their
Schedule C activities; at trial, they conceded that the actual
number of miles was approximately 15,600.
 - 15 -

1996, from $79,157 in 1994 to $120,278 in 1996. In fact,

petitioners acknowledged that they are unable to predict when, or

if, their Schedule C activities will become profitable.

Consequently, this factor weighs against a finding of a profit

motive.

2. Expertise of Taxpayer or Advisers

Preparation for an activity after conducting an extensive

study or consultation with experts regarding the accepted business

practices of the activity 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. Conversely, a

taxpayer’s failure to obtain expertise in the activity may indicate

a lack of profit motive. See Burger v. Commissioner, 809 F.2d 355,

359 (7th Cir. 1987), affg. T.C. Memo. 1985-523.

Prior to entering into their Schedule C activities,

petitioners consulted with and relied upon the advice of members of

the macadamia and persimmon societies, as well as an experienced

beekeeper. Moreover, they spent a considerable amount of time and

effort researching their Schedule C activities. Indeed, when the

advice of a paid consultant turned out to be incorrect, petitioners

were able to identify the source of the problem and take remedial

action.

The fact that petitioners consulted technical, noneconomic

experts does not necessarily indicate that they carried on their
 - 16 -

Schedule C activities for profit. See Hillman v. Commissioner,

T.C. Memo. 1999-255. Considering all the years of substantial

losses, petitioners did little to demonstrate an expertise for the

economics of these operations. Consequently, this factor weighs

against a finding that petitioners’ Schedule C activities were

carried on with the intent to make a profit. See Kahla v.

Commissioner, T.C. Memo. 2000-127.

3. Time and Effort Expended in the Activity

The fact that a taxpayer devotes much of his or her personal

time and effort in carrying on an activity, particularly if the

activity does not have substantial recreational aspects, may

indicate a profit motive. See sec. 1.183-2(b)(3), Income Tax Regs.

During the years at issue, petitioner traveled to their Corona

property at least three times a week and often spent the weekends

there accompanied by Mrs. Dirkse. While on the property,

petitioner spent significant periods of time supervising his

laborers as well as assisting in the tree-farming and apiary

activities. In addition, petitioners conducted many of the retreat

activities and managed the rental of their trailers. Moreover,

they often spent their free time learning about apiary and tree

farming. Consequently, this factor weighs in favor of finding a

profit motive.
 - 17 -

4. Expectation That Assets May Appreciate

An expectation that assets used in the activity will

appreciate may indicate a profit objective. See sec. 1.183-

2(b)(4), Income Tax Regs. Accordingly, a profit motive may be

inferred even where there are no operating profits, so long as the

appreciation in value of the activity’s assets exceeds its

operating expenses of the current year and its accumulated losses

from prior years. See Golanty v. Commissioner, 72 T.C. 411, 427-

428 (1979), affd. 647 F.2d 170 (9th Cir. 1981).

Petitioners purchased the Corona property in 1983 in order to

relocate their apiary activity, not for speculative appreciation.

Although petitioner testified regarding the appreciation of land in

the vicinity of the Corona property, there is no credible evidence

in the record as to the value of petitioners’ property or that any

appreciation in the assets used in petitioners’ Schedule C

activities will exceed the cumulative losses of their Schedule C

activities. Consequently, this factor weighs against finding a

profit motive.

5. History of Income or Losses From the Activity

A history of losses over an extended period of time may

indicate the absence of a profit objective. See Allen v.

Commissioner, 72 T.C. at 34. Although a long history of losses is

an important criterion, it is not necessarily determinative. See

Engdahl v. Commissioner, 72 T.C. at 669; Allen v. Commissioner,
 - 18 -

supra. For instance, a series of startup losses or losses

sustained because of unforeseen circumstances beyond the taxpayer’s

control may not indicate a lack of profit motive. See sec. 1.183-

2(b)(6), Income Tax Regs.

No profits have ever been generated from petitioners’ Schedule

C activities, and none are expected in the near future.

Petitioners have been conducting their Schedule C activities well

beyond the length of time that can be reasonably called the

“startup” period, and there is no evidence in the record indicating

that their Schedule C losses are the result of unforeseen

circumstances. Rather, the extended period of losses is

attributable to petitioners’ unchecked expenditures and their

failure to develop a suitable market for their produce. Indeed,

the growing disparity between petitioners’ losses and revenue

stream is indicative of an unprofitable undertaking and is

inconsistent with petitioners’ purported intent to provide

supplemental income. Consequently, this factor weighs against a

finding of a profit motive.

6. The Amount of Occasional Profits, Earned, If Any

If an activity generates only small, infrequent profits and

typically generates large losses, the taxpayer conducting the

activity may not have a profit objective. See Golanty v.

Commissioner, supra at 427; sec. 1.183-2(b)(7), Income Tax Regs.
 - 19 -

As stated, petitioners have never made a profit from their

Schedule C activities, and there is no indication from the record

that petitioners can realistically expect profitability in the near

future. Consequently, this factor weighs against a finding of a

profit motive.

7. Taxpayer’s Financial Status

Substantial income from sources other than the activity in

question, particularly if the losses from the activity generate

substantial tax benefits, may indicate that the activity is not

engaged in for profit. See Hillman v. Commissioner, supra; sec.

1.183-2(b)(8), Income Tax Regs.

For 1995 and 1996, petitioners had $174,761 and $181,678,

respectively, in unrelated gross income. During the same years,

they claimed $102,845 and $120,278, respectively, in Schedule C

losses. Petitioners used these losses to reduce their gross income

by 59 percent for 1995 and 66 percent for 1996. These reductions

led to substantial tax savings for petitioners. Consequently, this

factor weighs against a finding of a profit motive.

8. Elements of Personal Pleasure or Recreation

The existence of recreational elements in an activity may

indicate that the activity is not engaged in for profit; on the

other hand, where an activity lacks any appeal other than profit,

a profit motive may be indicated. See Hillman v. Commissioner,

supra; sec. 1.183-2(b)(9), Income Tax Regs.
 - 20 -

Nothing in the record indicates that petitioners used the

Corona property or their Schedule C activities to derive personal

pleasure or recreation. Consequently, this factor weighs in favor

of finding a profit motive.

To conclude, after giving due consideration to the record as

a whole, we find that during the years in issue, petitioners did

not carry on their Schedule C activities with an intent to make a

profit. Accordingly, we sustain respondent’s disallowance of

petitioners’ Schedule C losses.

Section 6662(a) Accuracy-Related Penalty

We next consider whether petitioners are liable for the

section 6662(a) accuracy-related penalties for the years in issue.

Section 6662 imposes a penalty equal to 20 percent of any

portion of an underpayment of tax that is attributable to

negligence or disregard of rules or regulations or to a substantial

understatement of tax. See sec. 6662(a), (b)(1), and (b)(2).

“Negligence” includes any failure of the taxpayer to make a

reasonable attempt to comply with the provisions of the Internal

Revenue Code, and “disregard” includes any careless, reckless, or

intentional disregard of the Internal Revenue Code or its rules or

regulations. Sec. 6662(c). The accuracy-related penalty will be

imposed unless the taxpayers can demonstrate that they acted in

good faith and with reasonable cause with respect to the
 - 21 -

underpayment. See sec. 6664(c)(1). In determining the

applicability of section 6664(c)(1), we weigh the particular facts

and circumstances of each case. See sec. 1.6664-4(b), Income Tax

Regs.

Petitioners maintain that the section 6662(a) accuracy-related

penalties should not be imposed because they made a reasonable

attempt to prepare accurate tax returns and relied upon the advice

of a professional tax preparer. In addition, petitioners note that

their returns for 1994 and earlier years were audited and resulted

in the Internal Revenue Service’s accepting the Schedule C activity

losses as reported on those returns.

On the other hand, respondent maintains that petitioners, as

educated individuals, should have known that “the size of the

losses claimed * * * in relation to their sales, combined with the

enjoyment and tax benefits they derived from the activity, was

‘too good to be true’”. Moreover, respondent asserts that

petitioners’ misclassification of their rental activities as

“consulting” on their tax returns, as well as petitioners’

overstatement of their automobile business mileage, see supra note

4, mandates the imposition of the section 6662(a) accuracy related

penalties.

Although we are troubled by petitioners’ misclassification of

their rental activities and the overstatement of their business

mileage, on balance, we agree with petitioners, and thus hold, that
 - 22 -

the section 6662(a) accuracy-related penalty should not be imposed

for either year under consideration.

We have considered all arguments made by the parties for

contrary holdings, and, to the extent not discussed, find them to

be without merit.

To reflect the foregoing,

Decision will be entered

for respondent with respect

to the deficiencies and for

petitioners with respect to

the addition to tax under

section 6662(a).